The headlines of the past few weeks have been reporting on the Ukraine situation day after day, and markets seem to be fixated on the events unfolding in Crimea. So why exactly is Ukraine important? And how does it affect the world economy, and normal people like us? In this post I try to give a quick breakdown on the events unfolding in Ukraine, and how it affects you and me.
There are essentially 4 important points to understand: America, Russia, Oil, and Inflation. We will go through them one by one, and then link them all up.
- Amercia:
In foreign affairs there is a saying ‘internal affairs determine external policies’. Of course sometimes it could be the other way around, like what is happening right now in Ukraine with a foreign power putting pressure on you, but for big countries like US and Russia, their domestic issues are largely self-determined, and not under the influence of any foreign power. The US right now is polarised between the republicans and democrats, and both parties want to win the mid term elections very badly. Therefore, as much as Biden wants to remove trade tariffs on China, he can’t because it would reflect badly on the voters and it will be bad for the democrats in mid terms. At the same time, Biden cannot be seen as being soft on Russia. In the US, politically, there are a couple of “big enemies” that any president cannot be seen as being soft against: Russia, North Korea, Iran, and recently China. As such, Biden cannot go soft on these guys. He has to adopt an aggressive foreign policy against them because that is the way to go to win voters.
2. Russia
Ever since the Crimean crisis of 2014, Russia has been under many sanctions, which has been very deterimental to their economy. This is why Russia has built very close ties to China, so that they can have a strong domestic economy by accessing the Chinese market. The russian economy, in large part relies on exports of oil and natural gas. Both are exported to China and the EU, and also the international market. Currently, Russia accounts for 17% of global natural gas output, and 12% of global oil output, a very significant amount (see BP report). So imagine if the US sanctions Russian exports of Oil and Natural Gas over what is happening now in Crimea, the oil and gas prices of 2022 are going to rise alot in the short term due to a supply shock. It will probably take some time for the price to come down as US shale oil and OPEC increase their output. What this means is that, with energy prices sky high, nobody wants to actually sanction Russia, because it will lead to high energy prices. And energy is leading the CPI component for the US right now. The same goes for natural gas in the EU. Russia knows this, that the EU and US need Russian oil and gas to be exported for energy prices to be stable. As such, it is taking this opporunity to put pressure on Ukraine in an attempt to make the US and EU compromise. But, as mentioned in part 1, the US cannot compromise due to the internal political situation. So, there is a very difficult decision here which will impact energy prices and inflation. If the US and EU let Russia get what it wants, energy prices come down, inflation comes down, but they might lose voter base. If the US and EU do not let Russia get what it wants, and impose sanctions, energy prices come up, inflation stays high, and they still might lose their voter base. It really is a game of poker. And at the end of the day, because Russia knows that the US and EU need it’s gas and oil exports to stabilise the international energy price, Russia is not afraid of being sanctioned. Either way, the US and EU are in a tough spot. And what does Russia want? Russia wants NATO to exclusively say that Ukraine will never be a part of NATO. Because if Ukraine joins NATO, then there will no longer be a buffer between NATO and Russian soil, and it will be very dire for Russian national security.
3. Oil:
High oil prices right now are due to two things: The pandemic, and the green energy movement. The pandemic is pretty much self explanatory, sudden stop in economic activity and investment, then sudden sharp rise due to huge fiscal stimulus, and energy supply unable to keep pace. The green energy movment is also causing energy companies to pause and think twice about expanding demand. Because energy projects typically span more than 10 years, building a new oil project right now might result in large carbon taxes 5 years later. And why should the energy companies be penalised 5 years later for providing the oil the world needs right now? The world wants low energy prices to keep inflation low, but at the same time wants to lower fossil fuel reliance and transition to renewables. The problem is the imbalances that this creates, resulting in the high energy prices we see today. Transition to renewables means less fossil fuels supply, but coupled with a lagging energy supply by renewables, fossil fuels prices go up. Eventually, something has to give, somebody has to compromise. Either energy companies get a carbon tax break/cut or some temporary form of immunity, OR ukraine situation has to be settled. Otherwise, high energy prices from here onwards.
4. Inflation
Energy prices have always been the big reason behind inflation in general. Expensive energy prices cause food prices to increase, cause manufacturing costs to increase, cause economic costs to increase. And if demand cannot keep up with costs, there is always the potential for an economic slowdown. In addition to this, normal folks on the ground feel the pain of inflation and tend to vote out the people in power in the hopes that a new government would be able to solve the inflation issue.
5. Short summary:
Ukraine is important because it affects so many different things at the same time: US mid term elections, Russian national security, energy prices, renewable energy transition, and inflation.
6: Market Impact:
If Russia is sanctioned: Oil prices sky rocket, inflation remains high, Fed is forced to raise rates much more aggressively. This will negatively impact equity prices in general, bearish market scenario.
If Ukraine gets resolved somewhat: Oil prices will decrease slightly, inflation will most likely drop, Fed does not have to change course, markets return back to ‘normal’, and we start to see a drop in the price of Gold.
Little Monkey 