Niels Clemens Jensen: One Year On

by Niels Clemens Jensen, CIO, Absolute Return Partners

We forgot that war is history’s favourite driver of inflation.
~ Niall Ferguson

The true root problem

Ukraine was invaded by Russia at this time last year.  Russia’s “special military operation” (Putin’s words, not mine) was supposed to last only days, but we are now into its second year.  There can be no doubt that the Ukrainian people have paid by far the highest price so far, and that the price we have paid in the west – mostly higher food and energy prices which have led to falling living standards (Exhibit 1) – is miniscule in comparison.

Exhibit 1: Global real disposable income, year-on-year %  

That said, my inkling is that this could go from bad to worse this year, as I am under no illusions about Putin.  He is not going to withdraw his forces from Ukraine without some concessions that he can present as a victory back home.  The western alliance (Ukraine included), on the other hand, cannot allow those concessions to be meaningful, as that will encourage Putin to have a go at other countries in the former Soviet bloc.

This is a very hard one to resolve, hence why I think the war could drag out.  It wouldn’t surprise me at all if we, a year from now, are no closer to a resolution than we are today.  Having said that, most countries in the west have adapted reasonably well to the challenging conditions.  Living standards are certainly down in many countries (living standards are always under pressure when the rate of inflation exceeds wage growth); however, most countries appear to have escaped a recession – at least for now.

If my prediction that the war will probably drag out is correct, can we continue to avoid recession, though?  You may be surprised to hear my answer, but I don’t think the war in Ukraine is the main reason why inflation has become such a big problem.  Inflation was coming, war or not, because the inflationary pressures you have seen in goods and services more recently is a natural extension of the inflation in asset prices you have seen over the last 10-12 years.  And those inflationary pressures are a function of an extraordinarily benign monetary policy programme, conducted by excessively ‘friendly’ central banks in many parts of the world and has nothing to do with the war in Ukraine.  Of course, the war has had some impact, particularly on food and energy prices, but you should look elsewhere for the root problem.

What to worry about re: Ukraine

Longer term, what you should probably worry most about is the growing relationship between Russia and China, and how the Chinese seek to take advantage of the situation.  Russia’s agenda is simple – they need foreign capital to finance the war in Ukraine, and they need plenty of it.  Consequently, a rising share of Russian oil output is exported to China (Exhibit 2).

Exhibit 2: Primary energy mix, World
Sources: Bloomberg, Kpler

China’s agenda is much more subtle.  They want to de-dollarize the global economy, I believe, as that will have a significant impact on the US economy and the ability to finance the country’s massive deficits (massive in absolute but not necessarily in percentage terms).  To that extent, befriending one of the world’s largest commodity exporters, Russia, comes quite handy.  You should read China’s recent flirt with the Gulf Cooperation Council in the same light.

In the near term, there are other issues to worry more about, though.  Let’s assume the war does indeed drag out, and that no resolution can be found this year.  Under that assumption, in my opinion, two risks stand out, namely that:

(i) energy prices take off again; and/or that

(ii) Putin is pushed so much into a corner that he, out of desperation, does something really stupid.

What will happen if energy prices take off again?

We like to think that renewables will soon replace fossil fuels; however, there is still a long way to go before that happens.  The three fossil fuels – coal, gas and oil – still account for nearly 80% of the primary energy mix, worldwide (Exhibit 3).

Exhibit 3: Primary energy mix, World
Source: Our World in Data

Here in Europe, we like to think we are ahead of the curve on the green transition, but that isn’t really true.  As you can see in Exhibit 4, fossil fuels accounted for 76% of the primary energy mix in Europe in 2021, not meaningfully different from the worldwide number in Exhibit 3.  Many European countries are still very dependent on fossil fuels, particularly natural gas, most of which happens to come from Russia.  The 2022 numbers have not yet been published; however, there can be no doubt that Europe’s dependence on Russia for supplies of gas and other fossil fuels has declined significantly over the last 12 months, i.e. Putin’s hand is not as strong as it was a year ago.

Exhibit 4: Primary energy mix, Europe by country
Source: Al Jazeera

Dependence on Russian fossil fuels is not the only problem, though.  The longer the war drags out, the more inclined most governments will be to accelerate the green transition.  That will not only have a significant inflationary impact (remember – the green transition is very inflationary).  It will also influence the oil majors’ inclination to invest in new exploration projects, which will begin to affect supplies – maybe not in 2023 but definitely within the next few years.  Furthermore, in addition to lower investments in exploration, both Europe and the US are beginning to suffer from inadequate refinery capacity.  This is also a function of the falling appetite for fossil fuel-related investments in the oil industry.

As a consequence of all of this, it is not as farfetched as you might think to expect oil prices to go higher before they begin their ultimate journey downward.  I expect to see $100/bbl oil prices in 2023, possibly even higher prices in 2024.  That could quite possibly be what starts the next recession.  A continuation of the war in Ukraine will only serve to worsen the price spike, but a spike in fossil fuel prices is most likely going to happen, war or no war.

What will happen if Putin plays the nuclear card?

Global media constantly comment on the various options available to the two sides in the war.  The gas card, for example, hasn’t worked as Putin would have liked, nor have the sanctions introduced by the West.  See for example this article from Bloomberg on the latter.  Therefore, it is only fair to ask how many cards Putin has left in his hands?

Some commentators argue that the only card of real value he has left to play is the nuclear card.  His military forces can either ‘deliver’ one or more tactical nuclear bombs, powerful enough to virtually end the war but not powerful enough to damage Moscow, or they can cause some serious problems at one or more of Ukraine’s four active nuclear power stations, which will effectively result in the same outcome.  However, other commentators reason why Putin will not play this card.  See for example here.

The nuclear power station at Zaporizhzhia is not only the largest in Ukraine but the largest in all of Europe with six reactors and a total output of 6,000 MW.  And rather worryingly, it is located in the middle of the war zone (Exhibit 5).  If Putine were to do something really stupid, it could have a cataclysmic effect on economic activity, and on stock markets, all over Europe.

Exhibit 5: Nuclear power plants in Ukraine
Sources: Bloomberg,

Summing it all up

The inflationary headwinds of 2022 are about to turn into (modest) tailwinds.  So far, so good; however, the party will most likely come to a halt, if energy prices begin to rise again.  In my book, the probability of that happening at some point later this this year is 50-60%, and that will most likely change the relatively upbeat sentiment that has driven equity prices higher the first couple of months this year.

Even more worryingly, I fear that Putin, out of sheer desperation, could be tempted to use the nuclear option to win the war.  That could make Kyiv, and probably most of Ukraine virtually uninhabitable for years.  Such an outcome would also do much damage to other parts of Europe.

With those two risk factors in mind, I am not getting carried away about the solid performance in global equity markets so far this year.  Instead, I constantly remind myself that solid long-term performance in equities – actually in virtually all financial instruments – is almost entirely about robust risk management.  The upside usually takes care of itself.

Niels C. Jensen

1 March 2023

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