Macro Letter – No 6 –28-02-2014
Trading – the Ukraine and other geopolitical risks
This week I want to look at the impact of the events which have been unfolding in the Ukraine over the past fortnight. Below is a link to the leader from last week’s Economist – Ukraine’s Crisis: A tale of two countries, which describes the fractured nature of this country of 46 mln people:-
The Ukraine is also being commented on widely by the mainstream press, yet, barring a slightly heightened price of Gold and Oil together with some weakness in certain Eastern European markets, the global financial markets appear to have taken the situation in their stride.
Here is a one year chart for Spot Gold: –
Below is the front month NYMEX WTI future:-
Both Gold and Oil started to rise before the Ukrainian situation deteriorated but the heightening of risk has helped them move higher.
The dip and subsequent recovery in Eastern European stocks and currencies is typical of many geopolitical events and makes trading financial markets in this environment, more often than not, profitable for the shorter term “contrarian” trader.
1. German Unification
There are few exceptions to this general “contrarian” rule but one which I would like to review was the unification of Germany in 1989 since this example highlights the way geopolitics events can impact an economy – most events simply don’t meet these criteria.
German Unification led to a substantial restructuring of the unified East and West Germany. The decision in July 1990 to allow Ostmark conversion at one to one parity with the “mighty” Deutsche Mark was considered a major factor in the protracted adjustment process. A closer examination of this action shows that the reason for its significant impact on the economy and financial markets lay in the seismic economic consequences of the political edict. East German wages were well below those of workers in West Germany and their manufacturing productivity was also well below that of the West.
The relative degree of integration of the EZ at the time of the fall of the Berlin Wall meant that the shockwaves from the Unification effected pan-European bond markets. Added to this, Germany’s significant trade with the US and other major economies meant the ripples were felt globally.
The chart below shows German 10 yr Bund yields from 1986 to 1993:-
Source: Trading Economics
Here is the same period for the DAX Index: –
Source: Trading Economics
It took the German financial markets more than two years to recover from the initial effects of Unification. In the broader economy this process took much longer. The Hartz Plan and subsequent reforms – a reaction to the effect of Unification – only took place between 2003 and 2005.
Below is a chart of the EuroStoxx50 from 1987 to 1996 showing the impact of German Unification on the wider EZ economy: –
Source: Trading Economics
2. Other major geopolitical events
9/11/2001 is a date few will forget. The bombing of the World Trade Center had a unique impact on financial markets in that it knocked out the settlement systems of the New York Stock Exchange in additions to its psychological affront to western democracy.
The S&P500 started the week of 10th September 2001 at 1092, by the following Monday it was at 965. The recovery was swift, however, by the mid-October it was back above 1100.
The US equity market was already in a down-trend prior to the attacks and never breached 1200 over the next six months. It then began the next leg of its downturn to bottom at 800 in October 2002. I would argue that this was principally due to the bursting of the internet bubble of 2000 rather than the terrorist attacks on 2001.
The Gulf War of August 1990 was another major geopolitical event. The chart below shows how the nascent bull-market after the 1987 crash was stopped in its tracks. During the 1987 stock market crash the S&P500 had made a low around 220. During the Spring of 1990 the market came under pressure but staged a strong recovery into the early Summer. The Gulf War broke out in August 1990 prompting a 20% correction by October – that was the last buying opportunity below 300. By March 1991 it was above the pre-war highs.
There are a number of other events which have had a significant impact of the economy and financial markets for a shorter period, for example: – The Iranian Revolution – January 1979, The Bay of Pigs crisis – August 1960, Suez crisis – July 1956. The vast majority of geopolitical events, however, have limited impact economically beyond their immediate borders; to have a wider influence the actors must play a pivotal role in the global economy. I’ll come back to a couple of these potential risks later.
Analysis of Ukrainian contagion
Among the major Eastern European markets likely to be impacted by the Ukrainian situation are Poland, Hungary and Romania, yet brief look at their currencies and stock markets indicate little cause for concern. Another casualty has been Russia; its stock market looks sanguine but the RUB has made new highs for the year.
As the rhetoric gathers momentum, the risk that Russia withholds or substantially raises the price of the Natural Gas it supplies to Europe and, in particular, Germany, may create significant problems for the German and wider EZ economy. Whilst this provides an incentive for LNG producers, especially in the US, to grab market share, the US DOE has been slow to issue LNG export licenses.
The chart below shows the wide price differential for Natural Gas between the US, Europe and Asia:-
Source: World Bank and Knoema
For an in-depth analysis of the Nat Gas market you may interest in this paper from the Carnegie Endowment for International Peace – Natural Gas Pricing and its Future: –
The paper was published in 2010 but it is still prescient, here is an extract from the summary: –
Unlike other internationally traded commodity markets, natural gas has disparate regional benchmark prices. The dominant mechanism for the international gas trade, however, remains oil indexation, which originated in Europe in the 1960s and spread to Asia. A contrasting mechanism based on hub pricing and traded markets developed in the United States and has spread to continental Europe via the UK. Today, Europe is witnessing an unprecedented collision between these two pricing mechanisms and gas industry cultures. According to the International Energy Agency, one of the most essential questions related to global energy supplies and security is whether the traditional link between oil and gas prices will survive.
While Europe is currently the battleground, the implications stretch beyond Europe’s borders because once-isolated regional gas markets are now interconnected through the rising trade in liquefied natural gas. If the spot market model gains the upper hand in Europe, Asia will be the last remaining stronghold of oil indexed pricing, possibly making it unsustainable. Alternatively, if oil indexation re-exerts its predominance, there is the prospect that spot prices in North America will be influenced by this model.
Though the outcomes are far from certain, the stakes are high. Any modifications to existing contractual arrangements will directly impact exporters that depend on gas revenue—including Russia, Algeria, Indonesia, and Malaysia. And these changes will enhance or exacerbate energy security and dictate the sustainability
of future supply. Gas pricing will impact the competitiveness of industry and the potential to achieve environmental targets around the world.
The UK and Norway should benefit from Nat Gas price increases. I doubt the EUR will weaken significantly in this environment since international investment flows will be repatriated if Europe heads into another recession. A higher Nat Gas price will act as a tax on production rather than stoking EZ inflation. There will be stock specific opportunities, both long and short, but I expect the higher Nat Gas price to be positive for European Government bonds. The positive capital flows are likely to be less pronounced for German bunds than for the peripheral markets since the “quest for yield” is still a major factor in European fixed income markets. Lower bond yields will support European stocks unless the “slowdown” in German growth precipitates a serious EZ wide recession.
It is also worth remembering that Russia was elected to the World Trade Organisation in August 2012. Whilst they have far to go in reforming their international trade relations, there is some hope that being a member of the WTO may temper their retaliatory tendencies. This paper from the European Centre for International Political Economy – One Year after Russia’s WTO Accession: Time for Reform goes into more detail about Russia’s prospects: –
Other geopolitical risks on the horizon
The sudden deterioration in the Ukrainian situation caught many market participants by surprise. The Ukraine, however, is not the largest geopolitical risk in terms of the potential for economic contagion. Putting candidates in order of magnitude is a rather subjective task but here are my top two “flash-points”:-
1. China and Japan
The territorial dispute over the Senkaku/Diaoyu Islands needs to be seen in the context of the US as global hegemon in retreat and China moving from regional hegemon to challenge the position of the US in the Asia Pacific region. Japan – which relies on the US for military support – being the next largest economy in Asia after China, is more critical to the global economy than Taiwan, South Korea, Vietnam, Malaysia or the Philippines. All of these countries have regional disputes with China over territory in the South and East China Sea. See map below: –
Sources: Daily Mail and Globe Money Morning staff research NIPR, Google News
2. Iran and Saudi Arabia
There has been much relief in diplomatic circles since Iran agreed to talks with the US, UK, Germany, France, Russia and China about the permissible scope of their nuclear activities. With a deal in the offing I believe the risk of conflict in the Middle East is higher rather than lower, this Spectator article sums up my cause for concern: –
The Middle East is not simply falling apart. It is taking a different shape, along very clear lines — far older ones than those the western powers rudely imposed on the region nearly a century ago. Across the whole continent those borders are in the process of cracking and breaking. But while that happens the region’s two most ambitious centres of power — the house of Saud and the Ayatollahs in Iran — find themselves fighting each other not just for influence but even, perhaps, for survival.
The way in which what is going on in the Middle East has become a religious war has long been obvious. Just take this radio exchange, caught at the ground level earlier this month, between two foreign fighters in Syria, the first from al-Qa’eda’s Islamic State in Iraq and Syria [ISIS], the second from the Free Syrian army [FSA]. ‘You apostate infidels,’ says the first. ‘We’ve declared you to be “apostates”, you heretics. You don’t know Allah or His Prophet, you creature. What kind of Islam do you follow?’ To which the FSA fighter responds, ‘Why did you come here? Go fight Israel, brother.’ Only to be told, ‘Fighting apostates like you people takes precedence over fighting the Jews and the Christians. All imams concur on that.’
… There has always been the ongoing tension of Bahrain, which is under Saudi domination but which Iran seeks for itself. But then there is the quieter battle for influence in the Gulf states, which, while interventionist at times, quiver before the clashing of these bigger beasts. It was only as Syria fell apart and the regional powers were pulled inexorably into a more open battle, that the cold war between Iran and Saudi found its hot battleground.
There are those who think that the region as a whole may be starting to go through something similar to what Europe went through in the early 17th century during the Thirty Years’ War, when Protestant and Catholic states battled it out. This is a conflict which is not only bigger than al-Qa’eda and similar groups, but far bigger than any of us. It is one which will re-align not only the Middle East, but the religion of Islam.
… Saudi officials more recently called for the Iranian leadership to be summoned to the International Criminal Court in The Hague for war crimes. Then, just the month before last, as the P5+1 countries eased sanctions on Iran after arriving at an interim deal in Geneva, Saudi saw its greatest fear — a nuclear Iran — grow more likely. And in the immediate aftermath of the Geneva deal, Saudi sources darkly warned of the country now taking Iranian matters ‘into their own hands’. There are rumours that the Saudis would buy nuclear bombs ‘off the shelf’ from their friends in Pakistan if Iran ever reaches anything like the nuclear threshold.
Here is a map of the Middle East region divided into Shia and Sunni spheres of influence: –
Sources: CIA World Factbook; Adherents.com
As at 2010 1.6 bln people 23.4% of the world population was described as Muslim. Here is a world map which shows the potential global nature of this risk. Green = Sunni, Red = Shia and Blue = Ibadi: –
Source: Wikimedia commons
The Council for Foreign Relations take a wider view of the world and pointed out that there are Ten Elections to Watch in 2014: –
Beyond this expanded “risk list” one can include the Nuclear Weapons capable (or nearly capable) nations, these are always a source of unexpected risk: –
Map of Nuclear Armed States of the World
LIGHT BLUE = NPT-designated nuclear weapon states (China, France, Russia, United Kingdom, United States)
RED = Other states with nuclear weapons (India, Pakistan, North Korea)
YELLOW = Other states believed to have nuclear weapons (Israel)
DARK BLUE = NATO nuclear weapons sharing states (Belgium, Germany, Netherlands, Italy, Turkey)
GREEN = States formerly possessing nuclear weapons (Belarus, Kazakhstan, Ukraine, South Africa)
The current situation in the Ukraine may prove contagious but appears, at this stage, to be of minor economic importance. This situation may change if Russia becomes more belligerent. However, the weakness of Emerging Markets is likely to be more protracted and the risk of further capital repatriation, heightened by this event. The risk to Europe from a Russian Nat Gas embargo is also real and this could threaten the US recovery.
I believe the Ukrainian situation may reduce the likelihood of a rapid increase in tapering by the Fed and increase the prospects for ECB Outright Monetary Transactions. In aggregate that amounts to more QE which should support stocks and higher yielding bonds.