The Absolute Return Partners March 2023 Letter

One 12 months On – What’s Subsequent?

We forgot that struggle is historical past’s favorite driver of inflation.

Niall Ferguson

The true root downside

Ukraine was invaded by Russia presently final yr. Russia’s “particular army operation” (Putin’s phrases, not mine) was alleged to final solely days, however we are actually into its second yr. There will be little question that the Ukrainian folks have paid by far the best worth to date, and that the worth we now have paid within the west – principally greater meals and vitality costs which have led to falling dwelling requirements (Exhibit 1) – is miniscule compared.

Exhibit 1: World actual disposable earnings, year-on-year %

That mentioned, my inkling is that this might go from dangerous to worse this yr, as I’m below no illusions about Putin. He is not going to withdraw his forces from Ukraine with out some concessions that he can current as a victory again dwelling. The western alliance (Ukraine included), however, can not enable these concessions to be significant, as that may encourage Putin to have a go at different nations within the former Soviet bloc.

This can be a very onerous one to resolve, therefore why I believe the struggle might drag out. It wouldn’t shock me in any respect if we, a yr from now, aren’t any nearer to a decision than we’re right now. Having mentioned that, most nations within the west have tailored fairly nicely to the difficult situations. Dwelling requirements are definitely down in lots of nations (dwelling requirements are at all times below strain when the speed of inflation exceeds wage development); nevertheless, most nations seem to have escaped a recession – at the very least for now.

If my prediction that the struggle will in all probability drag out is right, can we proceed to keep away from recession, although? You might be shocked to listen to my reply, however I don’t assume the struggle in Ukraine is the primary cause why inflation has turn out to be such an enormous downside. Inflation was coming, struggle or not, as a result of the inflationary pressures you have got seen in items and providers extra just lately is a pure extension of the inflation in asset costs you have got seen over the past 10-12 years. And people inflationary pressures are a operate of an awfully benign financial coverage programme, carried out by excessively ‘pleasant’ central banks in lots of elements of the world and has nothing to do with the struggle in Ukraine. In fact, the struggle has had some influence, significantly on meals and vitality costs, however you need to look elsewhere for the foundation downside.

What to fret about re: Ukraine

Long term, what you need to in all probability fear most about is the rising relationship between Russia and China, and the way the Chinese language search to make the most of the scenario. Russia’s agenda is straightforward – they want overseas capital to finance the struggle in Ukraine, they usually want loads of it. Consequently, a rising share of Russian oil output is exported to China (Exhibit 2).

Exhibit 2: Major vitality combine, World

China’s agenda is way more delicate. They wish to de-dollarize the worldwide financial system, I consider, as that may have a major influence on the US financial system and the power to finance the nation’s large deficits (large in absolute however not essentially in share phrases). To that extent, befriending one of many world’s largest commodity exporters, Russia, comes fairly helpful. You must learn China’s latest flirt with the Gulf Cooperation Council in the identical gentle.

Within the close to time period, there are different points to fret extra about, although. Let’s assume the struggle does certainly drag out, and that no decision will be discovered this yr. Underneath that assumption, in my view, two dangers stand out, specifically that:

1. vitality costs take off once more; and/or that
2. Putin is pushed a lot right into a nook that he, out of desperation, does one thing actually silly.

What’s going to occur if vitality costs take off once more?

We wish to assume that renewables will quickly substitute fossil fuels; nevertheless, there’s nonetheless a lengthy option to go earlier than that occurs. The three fossil fuels – coal, fuel and oil – nonetheless account for almost 80% of the first vitality combine, worldwide (Exhibit 3).

Exhibit 3: Major vitality combine, World

Right here in Europe, we wish to assume we’re forward of the curve on the inexperienced transition, however that isn’t actually true. As you possibly can see in Exhibit 4, fossil fuels accounted for 76% of the first vitality combine in Europe in 2021, not meaningfully completely different from the worldwide quantity in Exhibit 3. Many European nations are nonetheless very depending on fossil fuels, significantly pure fuel, most of which occurs to come back from Russia. The 2022 numbers haven’t but been printed; nevertheless, there will be little question that Europe’s dependence on Russia for provides of fuel and different fossil fuels has declined considerably over the past 12 months, i.e. Putin’s hand isn’t as sturdy because it was a yr in the past.

Exhibit 4: Major vitality combine, Europe by nation

Dependence on Russian fossil fuels isn’t the one downside, although. The longer the struggle drags out, the extra inclined most governments will probably be to speed up the inexperienced transition. That won’t solely have a major inflationary influence (keep in mind – the inexperienced transition could be very inflationary). It should additionally affect the oil majors’ inclination to put money into new exploration tasks, which is able to start to have an effect on provides – perhaps not in 2023 however undoubtedly inside the subsequent few years. Moreover, along with decrease investments in exploration, each Europe and the US are starting to undergo from insufficient refinery capability. That is additionally a operate of the falling urge for food for fossil fuel-related investments within the oil business.

As a consequence of all of this, it isn’t as farfetched as you may assume to anticipate oil costs to go greater earlier than they start their final journey downward. I anticipate to see $100/bbl oil costs in 2023, presumably even greater costs in 2024. That would fairly presumably be what begins the subsequent recession. A continuation of the struggle in Ukraine will solely serve to worsen the worth spike, however a spike in fossil gasoline costs is most certainly going to occur, struggle or no struggle.

What’s going to occur if Putin performs the nuclear card?

World media continually touch upon the assorted choices obtainable to the 2 sides within the struggle. The fuel card, for instance, hasn’t labored as Putin would have favored, nor have the sanctions launched by the West. See for instance this text from Bloomberg on the latter. Subsequently, it is just honest to ask what number of playing cards Putin has left in his arms?

Some commentators argue that the one card of actual worth he has left to play is the nuclear card. His army forces can both ‘ship’ a number of tactical nuclear bombs, highly effective sufficient to just about finish the struggle however not highly effective sufficient to wreck Moscow, or they’ll trigger some critical issues at a number of of Ukraine’s 4 lively nuclear energy stations, which is able to successfully end in the identical end result. Nonetheless, different commentators cause why Putin won’t play this card. See for instance right here.

The nuclear energy station at Zaporizhzhia isn’t solely the most important in Ukraine however the largest in all of Europe with six reactors and a complete output of 6,000 MW. And relatively worryingly, it’s positioned in the midst of the struggle zone (Exhibit 5). If Putine had been to do one thing actually silly, it might have a cataclysmic impact on financial exercise, and on inventory markets, throughout Europe.

Exhibit 5: Nuclear energy vegetation in Ukraine

Summing all of it up

The inflationary headwinds of 2022 are about to show into (modest) tailwinds. To date, so good; nevertheless, the celebration will most certainly come to a halt, if vitality costs start to rise once more. In my ebook, the likelihood of that occuring sooner or later later this this yr is 50-60%, and that may most certainly change the comparatively upbeat sentiment that has pushed fairness costs greater the primary couple of months this yr.

Much more worryingly, I concern that Putin, out of sheer desperation, could possibly be tempted to make use of the nuclear choice to win the struggle. That would make Kyiv, and possibly most of Ukraine just about uninhabitable for years. Such an end result would additionally do a lot injury to different elements of Europe.

With these two danger components in thoughts, I’m not getting carried away concerning the stable efficiency in world fairness markets to date this yr. As a substitute, I continually remind myself that stable long-term efficiency in equities – really in just about all monetary devices – is sort of totally about strong danger administration. The upside often takes care of itself.

Niels C. Jensen

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Editor’s Notice: The abstract bullets for this text had been chosen by In search of Alpha editors.