Category: The Big Picture

“The economy of imaginary wealth is being inevitably replaced by the economy of real and hard assets”.

Vladimir Putin gave some insight, last week, into his strategy to force Europe to withdraw its support for Ukraine. It involves two steps:

1. Use energy shortages to drive up inflation;
2. Use inflation to undermine confidence in the Euro and Dollar.

Will Putin succeed?

There are plenty of signs that Europe is experiencing economic distress.

When asked whether he expected a wave of bankruptcies at the end of winter, Robert Habeck, the German Federal Minister for Economic Affairs and Climate Action, replied:

Belgian PM Alexander De Croo also did not pull his punches:

“A few weeks like this and the European economy will just go into a full stop. The risk of that is de-industrialization and severe risk of fundamental social unrest.” (Twitter)

Steel plants are shutting down blast furnaces as rising energy prices make the cost of steel prohibitive. This is likely to have a domino effect on heavy industry and auto-manufacturers.

Aluminium smelters face similar challenges from rising energy costs.

How is the West responding?

Europe is reverting to coal to generate base-load power.

And increasing shipments of LNG. Germany is building regasification plants and has leased floating LNG terminals but there are still bottlenecks as the network is not designed around receiving gas from Russia in the East, not ports in the West.

Also, extending the life of nuclear power plants which were scheduled to be mothballed.

The new British prime minister, Liz Truss, is going further by lifting the ban on fracking. But new gas fields and related infrastructure will take years to build.

The President of the EC, Ursula von der Leyen’s announcement of increased investment in renewables will also be of little help. It takes about 7 years to build an offshore wind farm and the infrastructure to connect it to the grid.

Energy subsidies announced are likely to maintain current demand for energy instead of reducing it. A form of government stimulus, subsidies are also expected to increase inflation.

Price cap

The G7 has also responded by announcing a price cap on Russian oil. The hope is that the Russians will be forced to keep pumping but at a reduced price, avoiding the shortages likely under a full embargo.

Vladimir Putin, however, will try to create an energy crisis in an attempt to break Western resolve.

Putin responded to the price cap at the Asian Economic Forum, on Wednesday, in Vladivostok:

“Russia is coping with the economic, financial and technological aggression of the West. I’m talking about aggression. There’s no other word for it…….

We will not supply anything at all if it is contrary to our interests, in this case economic. No gas, no oil, no coal, no fuel oil, nothing.”

Ed Morse at Citi has expressed concerns about the price cap, calling it “a poor judgement call as to timing.” His concerns focus on the political implications of Winter hardship in Europe, especially with upcoming elections in Italy, the potential effect of lower flows out of Russia, and the impact increased demand for US oil would have on domestic prices.

The Dollar

Attempts to undermine the Dollar have so far failed, with the Dollar Index climbing steadily as the Fed hikes interest rates.

While Gold has fallen.

Conclusion

The West is engaged in an economic war with Russia, while China and India sit on the sidelines. War typically results in massive fiscal deficits and soaring government debt, followed by high inflation and suppression of bond yields.

We expect high inflation caused by (1) energy shortages; and (2) government actions to alleviate hardships which threaten political upheaval.

The Fed and ECB are hiking interest rates to protect their currencies but that is likely to aggravate economic hardship and increase the need for government spending to alleviate political blow-back.

We maintain our bullish long-term view on Gold. Apart from its status as a safe haven — especially when the Dollar and Euro are under attack — we expect negative real interest rates to boost demand for Gold as a hedge against inflation. In the short-term, breach of support at $1700 per ounce would be bearish, while recovery above the descending trendline (above) would signal that a base is forming. Follow-through above $1800 would signal another test of resistance at $2000.

Acknowledgements

Brookings Institution: Discussion on the Price Cap
FT Energy Source: How Putin held Europe hostage over energy
Alfonso Peccatiello: Putin vs Europe – The Long War
Andreas Steno Larsen: What on earth is going on in European electricity markets?