Ukraine war: Zeitenwende

By Helen Thomas, CEO of BlondeMoney

The Prime Minister of Germany, Olaf Scholz, was not wrong when he stood before his parliament and announced this was a Zeitenwende. Not just as some have translated it, a ‘turning point’, but more specifically ‘the end of an era’. And with that he tore up several decades of German policy towards Russia, announcing commitment to at least the 2% NATO goal along with 100bn EUR for a special defence fund. He threw in changes to energy policy including the acceleration of renewables and supplementary coal and gas reserves. Germany is very much embracing Going Left and Going Green.

But it’s not just for Germany that this weekend marks a new world. The announcement by the West that they would prevent Russia from using most of its FX reserves is a breath-taking acceleration into an economic war of which we are all now part. The West has decided that a G20 nation should no longer be part of its financial system. Previous freezes on FX reserves have happened to the likes of Iran and Venezuela. Russia has spent the last two decades insinuating itself into the western world; the plug has now been pulled overnight. The outbreak of Covid was a similar shock but one that would follow a clear path: a virus predictably evolves and people’s fear predictably waxes and wanes. We now have a non-linear actor playing a central role in events while the West has decided to escalate its response.

This will have far reaching ramifications politically but also delivers a short term shock to the markets:

1. Nobody will know what the price of the rouble is, aside from it being far lower than it was on Friday. No western institution can therefore afford any exposure to Russia. The uncertainty is too great, both over the value of the asset and the creditworthiness of the counterparty.
   1. This is akin to the liquidators walking into Lehman Brothers on the morning of Monday 15^th September and turning all the computers off. It wasn’t just that asset values had fallen, it was that it set off a chain reaction through the system whereby nobody knew who held the hot potato nor how little it was worth.
2. There are now two financial systems: those for the Western world and those for the pariah states. It is up to the geopolitics to determine which becomes more powerful in the long term but in the short term the financial system is too interconnected to bifurcate overnight.
   1. Monetary authorities will only support the system in which their institutions operate.
3. The disruption is deliberate and ultimately can be contained, for example by bailing out any systemically important institution if that should be required. But the disruption itself can and must continue.
   1. The US Treasury has operated a Department for Terrorism and Financial Intelligence for almost two decades. Their mantra is “Follow the Money”. They know who to hurt and how.

1 + 2 + 3 = western financial institutions will have to divest from anything that even hints of Russia.

But this chain reaction cannot be contained to Russia. Uncertainty levels have gone through the roof. The system has to deleverage.

1. More collateral will be demanded as volatility will increase.
   1. This will force unwinds of positions, not least as some funds have to sell liquid assets in order to fund positions that have been rendered illiquid at the stroke of a pen. If you own an index whereby a portion sits in Russia, you will be forced to get out of it.

1. What looked safe might now be far less safe.
   1. Gold isn’t particularly useful in a world where ease of payments becomes king. It’s expensive to store and can’t always be liquidated. Not to mention that Russia itself is likely to need to liquidate the Gold part of their FX reserves that they still have access to.

1. Leverage had risen to high levels following almost two years of money printing.
   1. But the gamma/vanna position does not – yet – denote a crash risk. We are likely to see an orderly sell off in risky assets.

4 + 5 + 6 = cash is king. Everyone’s risk manager will tell them to take some risk off the table.  But what kind of cash?

1. The demand for USDs will go up just as their supply goes down.
   1. Western institutions will simply have to own more US Dollars in exchange for ditching any less liquid currency. But where some emerging nations might have been selling dollars to stimulate their economies, that will no longer be possible. Throw in Fed Quantitative Tightening and supply of Dollars falls as demand goes up.

1. Crypto currency is legitimised.
   1. A decentralised asset is valuable in a world where centralised powers can decide to seize assets at will.
   2. But its transparent and pseudonymous nature means good actors can burnish their credentials to ensure assets remain under their control, leaving the authorities to pursue the bad actors.

7 + 8 = USD, BTC, ETH = even Ukraine has tweeted it wants to receive the latter, raising $6m in the process. 

And then we come to Putin’s response. Nobody can with any authority predict what is in his mind. We knew in March 2022 that a virus would evolve to survive. Vladimir will attempt the same, although human logic is more non-linear than that of a pathogen. But we can all see the possible outcome of risks has now changed substantially. You probably didn’t start the year thinking you had to factor the capture of Chernobyl and the threat of nuclear war into your portfolio, but this is now a world where the impossible becomes possible uncomfortably quickly.

1. The most immediate concern should be a cyberattack that disrupts western financial markets.
   1. The “Hound of Hounslow” apparently managed to spoof the most liquid stock market in the world from the bedroom in his parents’ house in 2010. We have seen countless more flash crashes since then as the system has become more automated. Even if hackers manage to cause a brief wobble in one market, the outbreak of hostilities will lead us to imagine that far more could be round the corner.

1. Beyond that the hacks could hit health systems, national electricity, flights and so on.
   1. Facebook managed to take itself offline for six hours in October 2021 because their system was so interdependent. BA had to cancel all short haul flights this Saturday due to a technical issue.

9 + 10 = Be ready for what feels impossible. 

And then we have the long run impact:

1. Opportunity and threat for China
   1. They can step in to help Russia where the West has frozen them out, but at a price that Russia may not be prepared to pay. Equally China is already reeling from the pandemic, both geopolitically and economically. They might like to think the renminbi can now challenge the USD for reserve currency status but they’ve just found out their 3 trillion dollars of FX reserves is worth less than it was yesterday. If they provoke the west now, they face the same bankruptcy threat as Russia.
      1. They might decide to distract from this by invading Taiwan – again we cannot know with any certainty but the likelihood has just increased.

1. Global recession.
   1. We already anticipated long-run growth would struggle in the wake of the pandemic until we adjusted to the impaired velocity of people. Now we can throw in a monumental cost shock as the price of energy and food will rise further. This will weigh on Aggregate Demand.
      1. As if the world wasn’t already burnt out from two years of fear, this will panic consumers once again. Banks are unlikely to lend as much credit as confidence ebbs.
      2. Whereas Demand has outweighed constrained Supply, we now enter a period of depressed Demand – which will ultimately bring inflation back down.

1. Monetary and Fiscal Response.
   1. This will be tougher to execute than in the pandemic.
      1. More spending will go towards Defence, which famously has a low multiplier in terms of its impact on growth.
      2. Debt and deficits are already creaking, although war provides a decent excuse to avoid bringing them back down.
      3. If central banks were already worried about a possible wage-price spiral with oil at $100, how will they feel if it gets to $200? They need to ensure they remain vigilant on the inflationary threat.
      4. Whatever It Takes was already dead. Now it’s a world of least worst options where either Russia withdraws its gas or Europe stops buying it, leaving everyone economically worse off.

The game has changed. This is no longer just about Ukraine. As Chris Pratt’s character in the remake of The Magnificent Seven puts it, “it was never about the cards”. The land war is just one front. We are now all in an economic war.