OVERLOOKED RISK IN UKRAINE CRISIS: HOW RUSSIAN AGGRESSION STIRS CHINA / BARRON´S MAGAZINE

Overlooked Risk in Ukraine Crisis: How Russian Aggression Stirs China

By Lisa Beilfuss 

Some see initial sanctions on Russia as too soft. Here, a pro-Ukraine demonstration in London this past week. / Justin Tallis/AFP/Getty Images

As the world focuses on Russian President Vladimir Putin’s incursion into Ukraine, investors may be missing the forest for the trees.

The move by the second-largest oil exporter into its neighbor on Wednesday night quickly went from a foray into Ukraine’s eastern tip to airstrikes across dozens of Ukrainian cities. 

Strategists, including some Putin watchers who believed that the Kremlin was ultimately bluffing and would stick within the Donbas region, say they are girding for prolonged turmoil, increased market volatility, and intensified economic ramifications.

But the biggest implication for the U.S. of the Russia-Ukraine military conflict may not actually be what happens in the region. 

Rather, it is likely to be whether the U.S.’s response to the conflict emboldens bigger economic rivals, namely China, and what that means for the long-term investment landscape.

This is not to say there aren’t important economic and political consequences of Putin’s land grab and self-described effort to demilitarize the former Soviet Republic. 

There are many. 

Most obviously, there is the impact on energy prices. 

Oil leapt 8% on Thursday, with the prices of Brent and West Texas Intermediate crude topping $100 a barrel for the first time since 2014. 

Other commodities are similarly surging. 

Analysts call Russia and Ukraine breadbaskets, as together they represent more than a quarter of the global wheat export market and a significant slice of the world’s corn market. 

Consumers, already miserable and expressing the lowest degree of economic confidence in a decade, will pay more at the pump and beyond as sanctions, supply shortages, and traders rushing to buy up commodities hit prices.

Moreover, Russia is in a position where it could threaten to selfembargo commodity exports, says Marko Papic, chief strategist at Clocktower Group. 

He notes that the country’s current account, as a share of its gross domestic product, is the biggest since 2006, while its foreign-exchange reserves are at the highest level since 2014, meaning Russia could leverage both to impose export embargoes for up to six months.

The latest commodity price spikes come at a particularly fraught time for the global economy. 

U.S. gasoline prices rose 40% in January from a year earlier alongside double-digit price increases for basic food items such as flour and meat. 

In Europe, where Russia is the biggest supplier of natural gas, Germany is on the brink of recession. 

That country—Europe’s largest economy—recently reported a record 25% year-over-year jump in producer prices, thanks to a 67% increase in energy costs. 

Nancy Lazar, chief global economist at Piper Sandler, says the euro zone was already destined to slow sharply. 

The conflict will deepen and extend that slowdown, she says, possibly tipping the bloc into recession next year.

As for the U.S., economists at Goldman Sachs say every $10-a-barrel rise in the price of oil boosts headline inflation by about 0.2 percentage point and core inflation by about 0.04 percentage point. 

Based on predictions across Wall Street for $120 oil and some back-of-the-envelope math, that roughly means the U.S. consumer price index goes to an annual pace of 8.1% from 7.5% in January including energy, and to 6.1% from 6% excluding energy.

As Papic puts it, the conflict in Ukraine is the cherry on top of an inflationary sundae. 

That may prove increasingly true if heightened geopolitical uncertainty translates to a less aggressive Federal Reserve—even if the one thing that is certain is more inflation. 

Oren Klachkin, an economist at Oxford Economics, says the conflict in Ukraine will shave up to 0.2 percentage point off real, or inflation-adjusted, 2022 GDP. 

Hardly anything, that is, in part due to the expectation that higher oil prices will drive stronger growth in domestic oil, gas, and agriculture sectors to offset the impact on real household incomes.

Many in Ukraine have fled for safer territory in recent days, including to Poland. Here, a train from Odessa, Ukraine, arrives in Przemysl, Poland, on Friday. / Omar Marques/Getty Images

Despite Wall Street’s expectations for a minimal hit to growth from Russia’s invasion of Ukraine, traders have quickly pared interest-rate hike expectations that had ratcheted higher after the January CPI, and all but scrapped odds of a half-point hike when the Fed meets March 15-16.

“The chance of the Fed raising by two percentage points over the next year is approximately zero,” says Michael Ashton, founder and investment manager at Enduring Investments, referring to recent projections by J.P. Morgan and others for a policy rate of at least 2% by the end of 2022. 

“This is a great excuse for them to wait and see,” he says of policy makers, increasingly suspecting that the Fed will point to geopolitical uncertainty in deferring any more than 0.75 percentage point in rate increases this year.

For all of the potential implications of the crisis in Ukraine for the U.S. economy, financial markets, and the path of monetary policy, concerns over them may mask something more consequential. 

How the U.S. responds to Putin’s play in Ukraine may affect how Chinese President Xi Jinping does or doesn’t proceed with reclaiming Taiwan, which is much more critical to the global supply chain and thus the U.S. economy and financial markets. 

Taiwan’s domination of semiconductor manufacturing is particularly notable at a time when the global chip shortage is one factor behind the everything shortage.

“The importance of what happens in Ukraine is how we respond, because that will affect what happens in Taiwan,” says Ashton. 

“If you persuade geopolitical rivals that we are weak in the knees, that’s where it can get really tense.”

If the recovery in stocks on Thursday was in part spurred by President Joe Biden’s new round of economic sanctions against Russia, then one interpretation is that the punishment is relatively light. 

Specifically, the Biden administration left out punishing sanctions on Russia’s energy sector, with Deputy National Security Adviser Daleep Singh saying the latest sanctions aren’t designed to disrupt the flow of energy to the world.

That isn’t to say that the sanctions announced by Biden and some European countries won’t be painful for Russia, and it isn’t to suggest the U.S. should seek punishments that boomerang—especially at a time when high energy and food prices are already hurting plenty of American households and businesses. 

Nor is it to say that the administration won’t eventually go there. 

For now, Biden isn’t alone. 

Reflecting how precarious the situation is for Europe and how acute the inflation threat is to political leaders, Italy’s Prime Minister Mario Draghi has said that any sanctions the European Union imposes on Russia shouldn’t include energy.

But a response to Russia by the U.S. that is perceived as weak makes it all the more important for investors to consider a potential Chinese play for Taiwan. 

A tepid response could offer a green light for China to proceed with an incursion into Taiwan, says Klachkin of Oxford Economics, adding that there is an ongoing, coordinated effort by China and Russia to grab power from the West and that it probably isn’t a coincidence that Russia waited until after the Olympics in Beijing before invading Ukraine.

For his part, Ashton of Enduring Investments pegs the likelihood of China moving on Taiwan at not quite 50/50. 

But, he says, odds are up from effectively zero a few years ago and are high enough that investors should take the scenario seriously. 

“It’s hard to think of a better time to try for it, if China really does want Taiwan back,” given how the pandemic has hobbled the world, inflation is rattling economies and politicians, and much of the world’s attention is currently on Russia and Ukraine. 

He adds that markets would be a lot lower if they were appreciating Taiwan risk.

As for potential timing, it’s anyone’s guess. 

Clocktower’s Papic calls China’s intervention in Taiwan the greatest geopolitical risk for investors, but he says that Xi has no reason to rush. 

“One benefit for China of the ongoing conflict between the West and Russia is that it can observe from a distance what the U.S. reaction is to Russian aggression,” he says.

Regardless of whether Putin’s invasion of Ukraine portends a similar move by Xi in Taiwan, strategists say that investors should anticipate an extended stretch of increased geopolitical turmoil. 

The bigger point, says Papic, who stresses the need for investors to be political nihilists when analyzing geopolitics, is that the U.S. seems to have realized it is no longer the global hegemon. 

“No other power gives two hoots what Washington wants,” he says, something he observes has been true for several administrations and is characteristic of a multipolar, versus unipolar, world.

The upshot? 

Papic says the coming decade should be a bumper harvest of geopolitical alpha. 

For now, he favors wheat, gold, oil, and palladium as hedges against further conflict.

Prolonged global upheaval augurs prolonged inflation, exacerbated by efforts already under way by U.S. manufacturers to bring supply chains closer to home. 

The trade-offs facing the Fed—more inflation for a less-severe hit to growth, and vice versa—are only getting harsher with the likelihood of both climbing.