Investment thesis: While a bit late to assume its responsibilities, the US Federal Reserve is now trying to rein in inflation. The negative consequence of being late is the fact that inflationary pressures crossed into self-sustaining mode. inflation that persists for a prolonged duration tends to create upward wage pressures, as workers demand at least partial inflation adjustment to help them cope. The late response by the US Fed and the ECB provides for a convenient scapegoat, the original source of inflationary pressures, namely scarcity continues to persist, and risks getting far worse, meaning that central bank actions cannot bring us back to a sustained healthy recovery. In fact, we risk through our actions, such as sanctions a situation where scarcity will beget scarcity. Food scarcity in particular, but also energy scarcity risks destabilizing commodities-exporting states, which can lead to prolonged outages in the production of certain commodities that are important in the maintenance of our increasingly intertwined and interdependent global supply chains. The end-result from an investments point of view is a stagflationary global macroeconomic environment, regardless of what central banks will decide to do, or not to do. Investing wisely enough just to protect one’s wealth from being eroded by inflation will prove to be a great challenge for the foreseeable future.
Transitory inflation theory was blown out of water. Expectations that higher interest rates will slow inflation will be proven wrong as well.
In hindsight, the whole “inflation is mostly transitory” point of view, seems to have been hopeful thinking at best, or weak, incompetent leadership on behalf of the US, as well as EU leaders, if one likes to get a bit cynical. Regardless of the underlying factors that led to such a flawed position, we now know that those assumptions were wrong and we entered this crisis with the wrong monetary and fiscal policies in place. Now that the flaw in thinking has been remedied, it is widely assumed that we are finally on the right path. The thinking goes that even if it will lead to a massive slowdown in economic growth, higher interest rates will help to tame the current inflationary trend, and perhaps we can start rebuilding economic growth momentum on a healthier path thereafter.
There are plenty of flaws in these latest assumptions. I will highlight only a few:
1) It is assumed that an economic downturn will not only break the inflationary trend but also the global commodities bull market.
The problem is that the commodities bull market is built on severe supply constraints that are geological & geopolitical in nature, not so much an issue of economics or political initiatives. The global oil supply/demand situation looked bleak even before the Ukraine war. There are many data points that one can cite, ranging from Rystad’s global oil & gas discoveries data, which shows that currently, we are discovering roughly eight times less conventional oil & gas than we are producing, to OPEC’s demand forecast which suggests that we will surpass previous global record highs in the last quarter of the year, while there seems to be no hope of global production also hitting all-time highs. Perhaps the most indicative chart that tells us where we stand in regards to the oil scarcity issue is the dramatic decline in US crude and product inventories since the post-COVID crisis economic recovery took hold.
We went from record-high inventories in the summer of 2020, to lows not seen since the summer of 2014 currently. It means that since the 2020 recovery started, we have been compensating for a lack of supply recovery with inventory drawdowns. An economic slowdown would perhaps put an end to the supply-demand imbalance, which is probably what central banks are aiming for. As soon as recovery will take hold, we will find ourselves right back to where we are right now, namely facing a severe shortfall, not only in global oil supplies but also in many other key commodities that we need in order to see continued economic expansion.
As of April, global liquids supplies were 98.7 mb/d. OPEC is estimating that average global demand by the fourth quarter will be around 102.6 mb/d, in other words, 4 mb/d higher than recent supply volumes. Especially when taking into account our current efforts to curtail Russian oil exports, it is hard to see how we can come close to closing that gap. A further severe drawdown in global oil inventories, followed by a price shock that will lead to a spike in inflation, followed by a massive demand destruction event is the most likely scenario for the second half of this year as things stand.
It is a bit of a tradition on SA, for contributors to provide readers with some predictions at the end of the year, for the following year. I wrote an article entitled “2022 Will Be The Beginning Of The Era Of Widespread Global Scarcity” as my main prediction. It provides a more detailed analysis of where we stand in terms of the global commodities scarcity crisis. So far, it seems that my prediction is coming true, unfortunately. We do seem to be faced with constant global shortages of crucial commodities, ranging from oil to food and there are very limited prospects for an improvement in the situation. In fact, it seems that things are only set to get worse. It is unlikely therefore that we will see a break in inflationary pressures, even if the global economy will slow down.
2) Some of the negative effects on the global commodities supply chains that stem from our economic confrontation with Russia are likely to persist, especially in North America and Europe.
As of right now, the Ukraine war seems to be settling into a stalemate. The Ukrainian government feels the wind at its back, with a successful PR campaign centered around their president, making any option other than full support for Ukraine by any Western government, as well as most private companies impossible.
That support is being translated into massive material support for its war effort that is turning this into a proxy war that is perhaps reminiscent of the Vietnam conflict, where the Soviets were arming the communist forces, to the detriment of America’s efforts to reach its goals. Russia on the other hand cannot back down either. Defeat would likely result in regime change.
The result is a stalemate, where neither side is backing down, and neither side is likely to inflict a major defeat on the other side. This in turn puts pressure on the Western World to constantly ratchet up the economic war. The problem is that we are trying to isolate the world’s largest commodities exporter in the midst of an already aggressive secular commodities bull cycle. The unavoidable end result is a further exacerbation of the inflation problem, as well as a further major drag on the economy. To put it into perspective, there seems to be a very imminent and severe threat for the East Coast economy facing transport disruptions as it seems Diesel supplies are running dangerously low, as the US exports more diesel to the EU.
The disruptions to the global supply chains, especially in the commodities sector, as a result of our efforts to isolate Russia, and also Russia’s blockade of Ukraine are set to last past a ceasefire, as the two sides will likely drag out negotiations for years. Things will not get better, but rather worse and then stay there for years.
3) Higher interest rates will themselves become a source of upward producer price pressures.
Exploding producer prices in the US and in the EU are putting pressure on consumer prices, which is the underlying factor that is causing the inflationary trend we are seeing.
As we can see, average EU industrial producer prices are now deep in double-digit yearly growth territory. In fact, those costs increased 5.4% from February to March of this year. We are not far away from seeing triple-digit growth in this respect if the trend continues on its current path.
US producer prices are also rising at an accelerated pace.
If higher interest rates also start feeding into the rise in production costs, it will make it hard to bring the situation under control. Add in prospects of higher commodities prices, as well as supply disruptions due to continued effects of COVID and it begs the question of whether rising interest rates will do much to counteract the multiple factors that are set to push inflation higher. It will probably contribute to a significant slowdown in economic growth, thus stagflation continues to be the most likely outcome, contrary to expectations, or perhaps hopes for a mild economic slowdown that will help to break the inflationary cycle we are caught in.
Stagflation will hit the EU harder than the US, at least initially. The second wave of consequences will hit the entire world very hard, unless we do something urgently to prevent it.
If the optimistic scenario plays out and inflation will be tamed by higher interest rates, with only a mild slowdown in economic growth, then we are looking at a classical selloff in stocks followed by a rebound, which will present us with a good buying opportunity. If however, the stagflationary outcome comes to pass things are set to become far more difficult for investors.
Right now, all signs point to the latter being the case. US inflation came in at 8.3% for April, even though it was a month when oil prices retreated from the March levels when inflation came in at 8.5%. Q1 GDP contracted, suggesting that the economy is decelerating, perhaps more than hoped, even as the Federal Reserve is yet to truly start monetary tightening.
The EU situation is headed in a far more dangerous direction. Q1 GDP seems to have come in alright, with quarterly growth of .2% in the Euro area.
While the Euro area is still in positive economic expansion territory as of the last quarter, the inflation situation seems to be spiraling out of control. Official EU stats that were just released as I was working on this article. Nine member states reported double-digit inflation rates so far for the month of April. Some of the highest rates were reported in countries that use the Euro currency, especially in the Baltic region, where inflation is starting to average about 15% between the three states.
In the past few months, the dire situation in regards to EU energy supplies has been masked by unsustainable American efforts to shift some of the domestic supplies to the EU, so it can claim that it is reducing its reliance on Russian energy. As I pointed out already, the US East Coast is now under threat of actual physical shortages of diesel, as the US is now exporting to the continent of Europe, even as in the past it tended to import diesel from the EU. The higher LNG exports to the EU also risk leaving the US in a bind going into next winter, if the widening gap in inventories continues on the current path.
As we can see, in the past few months a gap opened up between current gas levels in storage and the five-year average. The current inventories are 16% below that average, even as there has been a slight improvement in the EU in this regard.
Clearly, the US will have to pull back from its current efforts to help the EU in order to safeguard its own economy. I don’t think there will be a lot of political will to deal with an outright shortage of diesel along the US East Coast. Nor do I believe that it will be politically tenable to allow for households to be saddled with a massive increase in household natural gas bills by allowing for the inventory gap to continue to widen, going into winter. The negative effects on many industries are not to be neglected either
In the meantime, Qatar refused to sign a contract with Germany for LNG supplies. The proposed terms, including the duration of the contract, as well as Germany’s insistence that it should be able to share the gas with other nations, have proven to be deal-breakers. It is emblematic of the difficulties that all of the EU members are set to face when it comes to securing energy supplies from other parts of the world. Russia is itself looking to decouple from the EU as its main customer, so it is not like it will be there to pick up the slack once EU leaders realize that securing alternative supplies will not be an easy task.
The Hungarian refusal to sign on to a total oil ban may have temporarily saved the EU from plunging into the economic abyss. The Hungarian speedbump on the way towards a self-inflicted economic catastrophe in the EU is expected to be overcome through a series of incentives that the EU can offer, coupled with a series of threats. OPEC has been warning for months now that it will not replace Russian energy shortfalls in the EU. It seems that no one is listening.
The EU is faced with an imminent slowdown in energy help from the US, while the rest of the world seems uninterested or unable to help, even as Russian energy flows to the EU are apparently starting to decline. The average inflation rate in the EU will probably surpass 10% in the next few months, while the economy will continue to decelerate. The real magnitude of the inflation crisis will be partially masked by lower inflation in France, where its massive nuclear power capacity will most likely provide it with some protection from rising energy costs. In some countries it will likely reach dangerous levels.
Current estimates of average EU economic growth in the 3% range seem overly unrealistic at this point. We will likely see a further deceleration, which will develop into a full-blown stagflationary crisis by the end of this year. The ECB will do nothing of real consequence to try to rein in inflation, which will also lead to a further decline in the euro currency versus the dollar.
The effect of the lower euro on the EU economy will be mostly negative within the context of a continued global commodities bull market environment. It will make it more expensive to import commodities, which will feed into the inflationary trend. A lower exchange rate should help EU exports somewhat, but not enough to make up for the much higher commodities imports bill.
The US dollar on the other hand is getting stronger as the traditional safe-haven play continues. It should tame commodities-fueled inflation to some extent. The US Federal Reserve is also more committed to fighting inflation, which should also help. Lower energy prices compared with the EU should also help to lessen the impact on economic growth. I still think other factors such as wage pressures, supply chain issues, and rising interest rates will likely push inflation over the 10% threshold at some point later this year or going into next year. Economic growth will be severely stifled by rising interest rates and other pressures related to Fed tightening. The EU will nevertheless be impacted far worse, due to its dependence on commodities imports, and in particular its deteriorating relationship with its most important supplier of commodities by far.
I want to highlight the fact that what I have discussed so far is only the first wave of crisis and its effects on inflation and economic growth prospects, mostly centered around the Western World. As a number of factors continue to converge, with the continued Ukraine war and its fallout exacerbating the entire situation, we are likely to see an intensification of the economic crisis by the end of this year or early next year at the latest. The commodities scarcity issue is set to hit in the worst possible way as the energy crisis will morph into a global food crisis, which can destabilize crucial commodities producers in the developing world, which will in turn cause a further intensification of the commodities scarcity problem. I want to highlight how such a scenario will play out, within the context of investment implications, because of the correlation between the two.
The investment implications for both the US & the EU entering into a stagflationary trap are broad-based. Some investors might be tempted to respond by seeking investment opportunities elsewhere with developing market ETFs for instance, or individual foreign stocks that trade on the NYSE. Geopolitical issues make that a risky proposition, as we saw with Russian assets. There are few opportunities to find stocks, sectors, ETFs or bonds that will beat inflation in terms of gains.
Furthermore, it would be a mistake to assume that there is no geopolitical threat to Western assets. I recently covered BASF (OTCQX:BASFY) as an example of how the surge in natural gas prices in Europe, due to frictions with Russia has been affecting its production costs. It has also been affecting its stock price, which is down 27% YTD, and down almost 40% in the past year. If a total cessation of Russian gas flows to the EU will occur, this stock can crater, while a sustained disruption in gas flows could even leave it bankrupt. This is a company that is otherwise solid and yet it was heavily caught out by geopolitical factors. As the geopolitical fallout of the Russian invasion of Ukraine turns into an economic trainwreck, with energy, food, and other commodities prices skyrocketing, all investments one can possibly think of have become far riskier assets than they were just a few months ago.
For instance, the impending food crisis would definitely impact a very poor country like the Democratic Republic of Congo, which risks disruptions to its cobalt industry, if not enough food will be made available to its people. Food riots can easily escalate into civil wars, revolutions, and institutional collapse. It could take years or even decades to stabilize the situation. It currently produces about 70% of the world’s cobalt supplies, with Russia, which we are actively trying to isolate from the world’s supply chains, sitting in second place in this regard. This mineral is a crucial ingredient in many technologies. Two-thirds of it ends up in EV batteries. The rest goes into components for the aviation industry, defense, power generation, and so on. So whether one is invested in Tesla (TSLA), Rivian (RIVN), Boeing (BA), or GE (GE), the increasingly real prospects of a prolonged disruption to global cobalt supplies, due to an impending global food crisis, in part caused by the war in Ukraine, can have a broad devastating impact on most industrial producers.
There is no shortage of similar examples where the current situation can lead to severe supply chain collapse issues. There are few safe havens that one can identify on financial markets, which one can feel comfortable owning as a sleep-well at night investment within this context. Not when our increasingly sophisticated, intertwined global supply chain is at risk of breaking down, causing a very real risk of global economic paralysis.
There is of course always hope that common wisdom will prevail and we will avert this scenario from unfolding. The Ukraine conflict needs to end urgently and we need to get Russia to allow for the export of the grains stuck there. This is a solution that has been highlighted throughout the media and by officials as a way to put pressure on Russia to help facilitate the flow of those soft commodities, even as the conflict continues. The intense focus on this one issue could lead the public to falsely assume that the solution lies in this one sole problem being resolved. The reality is that the Ukrainian grains supply issue is just a drop in the bucket. We need to resolve the global fertilizer issue, which is a two-pronged problem. One has been the disruption of exports from Russia & Belarus, which together account for a significant percentage of global exports. The other is the problem of high natural gas prices, especially in Europe, which led to the disruption of fertilizer production in the past year.
At this point, none of these measures will be enough to avert a global famine, given that farmers around the world already planted crops using reduced fertilizer inputs, or in some cases, they gave up on planting altogether. A significant reduction in global biofuel production should be considered as an emergency measure in order to divert food to where it will be needed in the short term. This of course would mean a reduction in global liquid fuel supplies, which is why once more we need to reach an urgent cessation of hostilities, and we need to cease our efforts to try to economically isolate the Russian economy. As things stand, even before this conflict, we were facing a very tight oil market supply scenario, starting with the second half of this year. We simply cannot make this puzzle fit, without Russian exports of energy, food, petrochemicals as well as other crucial goods. Biofuels currently make up about a billion barrels of global liquid supplies per year or roughly 3% of all global liquid fuel supplies.
While there is still a way out, since the world does have the resources to get it done, we are unlikely to find a way out of the geopolitical predicaments that are keeping us clenched in a confrontational posture that we cannot back out of. In the meantime, with every day that passes, we are more and more likely to lose resources that are necessary for remediation of an impending global famine crisis that threatens to destabilize the entire supply chain that we depend on to address most of our needs and wants. We are just a few months away from the start of the winter wheat planting season and there are still roadblocks to Russia & Belarus fertilizer exports. Continued high prices for natural gas in the EU threaten fertilizer plant activities there. What fertilizer does get produced is being sold at a much higher price, which many farmers around the world cannot afford to pay. Neither can they afford the high price of diesel to run their machines.
Affordable and plentiful supplies of food and energy are essential to maintaining global social and economic stability. It seems to be a basic fact that is lost on too many policymakers. If it is a lesson that we need to re-learn the hard way, then the investment environment will be very difficult this decade, and there are truly very few opportunities to grow one’s real wealth, once inflation is factored in. It might even prove near-impossible to preserve one’s real wealth this decade if we enter a dangerous vicious cycle where scarcity creates socio-economic disruptions that will cause even more scarcity.
After generations of investors being told to “Watch the Fed”, it is hard to unlearn it and focus on factors that the Fed is no longer able to control. The US Federal Reserve, the ECB and other major central banks around the world can create demand destruction in order to bring supply/demand back into balance. It will get out of balance again as soon as they reverse their policies. Allowing demand destruction to take place will pretty much have the same impact in the long-run. Demand destruction can occur, bringing the market back in balance, while any recovery will lead to the supply/demand situation getting unbalanced again. The Federal Reserve is therefore no longer in the driver’s seat. It is all about the availability of crucial commodities, ranging from oil to palladium. Investors might as well stop watching the central banks and start paying attention to commodities and the drag effect that any shortfalls might have on the broader global economy, on regional economies, or on specific sectors of the economy. We are living in a new era. It is unpleasant, but it is important to understand its nature in order to try to do the best we can for ourselves.