War and Peace – Cold War 2.0 or WW3?

We have witnessed something we haven’t seen since 1945 in Europe – a world superpower (Russia) invading a weaker country (Ukraine) on its borders to takeover, integrate, and control the state – essentially with the intent of redrawing its borders. From the year 1400 to 2021, there have been roughly 3,708 conflicts within Europe. Each major war since 1600 has lasted about 8 years.

Since the conclusion of WW2 in 1945, Europe has been relatively peaceful, as conflicts continued to be rare events and the forming of the European Union has improved international relations, along with the MAD principle – Mutual Assured Destruction, conflict with a nuclear superpower.

Markets and geopolitics are Complex Adaptive Systems (CAS). CAS is a dynamic and nonlinear network that emerges in the interactions of many entities (elements, components, or agents) that influence and react to one another.

The outcomes of global geopolitics are very difficult to predict, given the many participants and considerations, which makes investing in a changing environment given the amount of uncertainty. The result of the Russia/Ukraine conflict could be Cold War 2.0 or further escalation into World War III or another option not considered.

We have reviewed Russia/Ukraine’s key import and export markets, focusing on food and energy markets. We provide a framework to help investors across the business cycle whether in War or Peace, based on our review of the last 125 years of data across multiple asset classes.

In this post, we will review the current state in the following sections:

  1. Overview of the Conflict – Russia/Ukraine
  2. War and Peace – De-Globalization vs Globalization
  3. War and Peace – Energy Independence and Economic Security
  4. Inflation Expectations and Recession – Stagflation?
  5. Asset Class Capital Returns in War and Peace – A Deep Dive across 125 years  

Key Takeaways:

  • War and Pandemics have been inflationary/stagflationary in general. War and pandemics have been a constant in human history. We have been in a relatively peaceful period since the end of WW2. 
  • The last 20 years may have been an anomaly as peace fostered through diplomacy and trade openness (globalization) has enriched the world and created deflationary forces through higher labor supply from China and former Soviet countries as the first Cold War ended.
  • Over the past 5 years, Cold War 2.0 has emerged with a very different ideology of how to allocate resources and how rewards may be shared with the East (China/Russia adopting autocratic capitalism) and the West (democratic capitalism). With de-globalization, there may be significant inflationary impacts as the supply chain for sovereign security is being re-shored and separated including energy and food. 
  • Over the past 5 years, we are seeing a multipolar looking to be de-globalize and reorient the world order which is expected to have significant impacts on resource markets over the foreseeable future (energy security/low carbon usage, food/agriculture, technology/cybersecurity, defense budgets, and resiliency of the supply chain by reshoring, autocracy vs democracy, and new monetary order). We review the impact of the current conflict on energy markets and the impact on market-implied expectations for growth, inflation, and interest rates. 
  • Even if there is a negotiated settlement in Russia/Ukraine conflict, we do not anticipate the sanctions to be removed quickly or the food supply chain to get back up and running to be able to meet potential food demand. We believe that the economy may continue to see a stagflation/recessionary economy as costs for a basic living (food, energy, and rent/housing) are expected to continue to rise as a result of the Russia/Ukraine conflict.
  • We focus on energy markets in this post. We note that the US and Canada have significant oil and gas reserves which may be used to expand production that could be used to replace Europe’s structural shortage for current energy needs, as it looks to transition to a low-carbon future. Further diplomacy and collaboration on a wider energy policy and effective transition plan to a low-carbon energy policy with allies may enhance the energy independence of the West.
  • By understanding the business cycle and its various seasons (deflation, inflation, growth, and stagflation) within the context of War and Peace we attempt to provide any clues of what may come next, and may help investors allocate capital across the economic cycle by maximizing risk/return tradeoffs. 

1. Overview of the Conflict – Russia/Ukraine

War occurs when there are miscalculations. We saw a number of these miscalculations over the past 2 years which enabled Putin to invade Ukraine:

  1. Underestimating Rivals and International Response:
    • Vladimir Putin (Russia’s President) underestimated Ukraine’s Leader Volodymyr Zelensky and the Ukrainian people’s willingness to defend their country and their way of life.
    • Putin’s view of the West was in shambles, both politically and culturally, with weak and inexperienced leaders.
      • For the last 5-10 years the West has focused on “Culture Wars” with increasing polarization at both extremes of populism (left and right), seeing nationalism and liberalism as opposite ends of the spectrum. However, nationalism and liberalism meet together through political freedom, which has allowed the world to unite and object to Putin’s adventurism.
      • The migration crisis that results from the war from Ukrainian citizens fleeing may increase immigration in the West, which has historically stoked far-right ideologies against immigration in the West. The destruction of Ukrainian cities could be Putin’s attempt to create further cultural divides within democratic countries in the West via immigration.
      • Putin has taken Europe’s dependence on Russia’s Oil and Gas supply and believed that sanctions may not be levied (or similar to those levied in 2014 when Crimea was annexed) if he invaded Ukraine.
      • Europe is also focusing on renewables for energy, but the grid is not yet equipped for intermittent sources like wind and solar to fill the gap. The international media and citizens have condemned the carnage of the war and the targeting of civilians by Russia.    
      • As a result, these miscalculations unified the 30 North Atlantic Treaty Organization (NATO) members like never before, solidified Ukrainian national resolve, debilitated the Russian economy, and turned that country (or at least, Putin) into a pariah for years.  
  2. Crossing Putin’s Red Line: On Nov. 10, 2021, the US and Ukraine signed a Charter on Strategic Partnership, which asserted the support for Ukraine’s right to pursue membership in the North Atlantic Treaty Organization (NATO). Putin cannot afford to allow life to a neighboring state which has even a smidgen of democratic development. The Russian people might get dangerous ideas and overthrow their leader. Also, by including Ukraine in NATO, Russia would be largely landlocked and bordered by NATO – see Table 1. Putin has been clear for many years that if NATO continued eastward expansion would likely be met with serious resistance by Russia, even with military action. The Russian response is similar to that of the US when USSR sought to deploy missiles in neighboring Cuba in 1962.
  3. Enabling Putin – US and China:
  • The US missteps: The Biden administration waived sanctions in May 2021 on Russia related to pipeline to Germany (Nord Stream 2) and slowed military aid to Ukraine which included lethal weapons in June 2021. The controversial withdrawal of American troops in Afghanistan seven months ago may have enabled Putin to test American power and resolve.
  • China’s Missteps: China and Russia on the opening day of the Beijing Winter Olympics declared a “no limits” partnership. In early February, Western intelligence reports indicated that Chinese officials requested that senior Russian officials wait until after the Beijing Olympics had finished before beginning an invasion into Ukraine. At this point, Russia has requested weapons and support from China, but it is unknown at this point whether China will supply and support Russia further. China is also dependent on Russia for energy, food and potentially key resources for clean energy as well. However, China has become Ukraine’s largest trading partner since 2019 and has previously provided Ukraine with nuclear security guarantees upon nuclear invasion or threats of invasion. China also implemented the Western-led sanctions against Russia, despite criticism against sanctions. At the heart of China’s foreign policy strategy lies a conviction that the US is weakened (high debt/internal conflict) from reckless foreign adventures, including goading Putin into the Ukraine conflict.

Table 1 – NATO and Russia’s Eastern Flank

We have seen in the last number of years through strategic competition, the US, Russia, and China have all weaponized their strengths to improve their negotiating power and stop short of going to kinetic war:

  • US – Financial System/USD Reserves
  • Russia –  Energy – Oil and Gas
  • China – Supply Chains.

Throughout history, war has been the norm, rather than peace.  This latest conflict has the potential has the impact of sending shockwaves throughout the markets and potentially redrawing the world order.

We have discussed the potential for the new monetary order with our post on gold in the multipolar systems with different underpinning ideologies (liberal democratic capitalism – the West and autocratic capitalism – the East), the world potentially moving away from the current US dollar centric financial system. We have now seen how a lot of what we previously discussed is being put into action.

Mark-to-Market Relative Economic Power – A Potential New World Order?

  • Aging/High Debt Super Power: As we’ve discussed in our previous posts, the US looks very similar to the UK after WWII (high debtor nation, aging superpower) and China appears very similar to the emerging US power after WWII.
  • Ideal Time to Act as the US is in a Weakened State: Having the inflation at 40-year highs (acts as a regressive tax impacting low-to-middle income earnings disproportionally and makes up a large proportion of the voter base) combined with declining approval rates of the Biden Administration with a stalled domestic agenda and few foreign policy missteps, with a weakened sovereign balance sheet (high debt-to-GDP) coming out of the COVID-19 crisis, may have left an opening for Russia (with limited sovereign debt, a war chest of FX reserves/gold, commodity prices rising, and strong natural resources) to test the resolve of the US while trying to annex Ukraine and other eastern European countries.      
  • We have discussed the possibility of a future multipolar world with China and its allies on one side and the US on the other side based on bilateral central bank liquidity swap agreements. The existence of these agreements tends to be for strong allies and important trade partners.
  • No Limits” partnership: China and Russia have been moving away from the US dollar centric financial system, expanding bilateral trade in their own currencies for years and already conduct at least a quarter of cross-border business in rubles and yuan. More contracts in commodities have moved towards pricing in yuan (gold, oil, and natural gas).  
  • Lack of Energy Independence and Leverage: With a quarter of the European Union’s oil imports coming from Russia, along with almost half of its gas, there are concerns that Russia could restrict supplies in retaliation for measures taken against it.
  • Clock is Ticking, and Now is the Time for Action: With the global transition to a low-carbon future due to climate change along with aging demographics, Russia probably recognizes that there is a limited period to continue to leverage its strong position with Europe’s energy needs relative to clean energy resources, as well as providing a strong military force to expand its current borders to align with its previous imperial borders.
  • Complacency in Globalization/Culture Wars with Populism on both sides: The West has woken up to the fact that energy security/independence is critical to democracy and freedom. Globalization has moved energy production and carbon emissions away from the West to autocratic leaders (Russia, Saudi Arabia, Iran). We review the Energy market balance between the East and West in a multipolar world, as energy independence potentially provides economic security going forward. 

2. War and Peace – De-Globalization vs Globalization

War tends to result in inflationary conditions during and especially in the aftermath of major wars (see Table 2 for major conflicts) due to the following:

  • Long history of using debt-financed spending to fund increased war-related expenditure (before and during wars) and reconstruction efforts (in the aftermath), driving aggregate demand higher relative to war-damaged supply.
  • Wars destroy physical capital, driving investment and interest rates higher: Wars are often associated with the widespread destruction of physical capital, a development that increases the investment demand and pushes interest rates higher.
  • Rationing and disruption of supply chains in food and energy (i.e. restricting supply relative to aggregate demand) tend to cause inflation. Major net exporters of energy or food which are participating in the war may reallocate any surplus from trade to domestic production to support the war effort, making supply scarcer on the world market. Also, destruction of infrastructure, labor shortages, or other transportation modes of moving food and energy to end consumers may cause inflation.

Table 2 – Wars and Pandemics

Source: Goldman Sachs Global Investment Research, Cirillo and Taleb (2020).

Peace generally results in more trade/globalization in which surplus food, labor, and energy supply can be exported to countries to trade for better technology or goods. Peace results in more focus on efficiency just-in-time/reduction of inventory rather than a focus on the resiliency of the supply chain.

In peace, defense spending may be reduced or reallocated to education or health care or tackling other priorities such as transitioning from fossil fuels to providing ongoing energy needs. Generally, with surplus production (labor, energy, food, etc) more than demand due to globalization, deflationary trends begin to persist.  Global trade openness also significantly promotes peace. Global trade openness has expanded from 1950 to now, see Table 3.

Table 3 – Trade Openness

Source: World Bank, OECD, and BeowulfsTreasury.com

An increase in global trade openness reduces the probability of military conflict. Globalization promotes peace through two channels:

1) Increased advantage for bilateral trade independence;

2) Integration into the global market

Trade integration results in economic and political gains through a peace dividend. Some countries have resorted to trade restrictions to protect national businesses and jobs. However, protectionism also puts international relations at risk. We have seen some protectionism over the past 5 years which has strained international relations.

There are aggregate gains from trade, but there are also distributional concerns. Even if the trade is not a major driver of income inequalities, government policy, such as unemployment benefits and other safety-net programs, helps redistribute the gains from trade.

Table 4 has reviewed the last 125 years of US inflation data on a 5-year rolling basis – compound annual growth rates (CAGR). We note that coming out of WWI and WWII and Vietnam War inflation has been high (above 5% on a rolling 5-year basis). We note that short-term rates followed inflation up in WWI and Vietnam War situations, though coming out of WWII most countries had heavy debt loads (similar to what we see today), central banks held short-term rates below the inflation rate (financial repression), to reduce debt levels relative to incomes. We have also built a simple index (blue-line) comprised of costs related to food, housing, energy, and wages based on weights in the Consumer Price index (CPI).  

Table 4 – 125 Years of Inflation – United States

Note 1 – Index – comprised of Energy (15%), Housing (40%), Food (15%), and Wages (Real GDP capita). 
Food is average of Beef, Lamb, Pork, Barley, Corn, Rice, Rye, and Wheat. Energy is the average of Oil, Natural Gas, and Coal.
Source: Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

We note that with globalization/trade openness (peace) increases from the 1980s onwards, CPI (orange-line) has been significantly lower than the Index (blue-line) as lower wages from lower-cost countries have had a significant impact on CPI.  In Table 5, we break out main prices related to Basic Living = Food, Housing, Energy, and Wages and note that Food and Energy can be quite volatile coming out of war/pandemic.

Table 5 – 125 Years of Inflation – United States

Source: Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

So How Have Avoided War in Europe for so long? ….Democratic Peace Theory

Dependent on the ideologies of liberalism, such as civil liberties and political freedom, the Democratic Peace Theory which originated from philosopher Immanuel Kant holds that democracies are hesitant to go to war with other democratic countries. Proponents cite several reasons for the tendency of democratic states to maintain peace, including:

  • The citizens of democracies (the people going to war) usually have some say over legislative decisions to declare war.
  • In democracies, the voting public holds their elected leaders responsible for human and financial war losses.
  • When held publicly accountable, government leaders are likely to create diplomatic institutions for resolving international tensions.
  • Democracies rarely view countries with similar policies and forms of government as hostile.
  • Usually possessing more wealth than other states, democracies avoid war to preserve their resources.

With the rise of autocracies and shift to populism within democracies with attacks on the West’s democratic institutions that provide checks and balances to political power over the last 5 years, the risk for military conflict expanded.  So with this in mind, we aim to cover the sanctions imposed on Russia and why has the West relied on sanctions rather than direct conflict to date. 

What are the Sanctions being imposed on Russia?

A sanction is a penalty imposed by one country on another, often to stop it from acting aggressively or breaking international law. Sanctions are often designed to hurt a country’s economy or the finances of individual citizens such as leading politicians or influential citizens. They are among the toughest measures nations can use, short of going to kinetic war.

Without rehashing the entire Ukraine/Russian conflict and related sanctions, the main sanctions/impacts are:

  • Western leaders have frozen the assets of Russia’s central bank, limiting its ability to access its dollar reserves. This is effectively confiscation of foreign currency reserves, which has much may wider implications going forward.
  • The US, the EU, Canada, and the UK have also banned people and businesses from dealings with the Russian central bank, its finance ministry, and its wealth fund.
  • Selected Russian banks will also be removed from the Swift messaging system, which enables the smooth transfer of money across borders. The ban will delay the payments Russia gets for exports of oil and gas.
  • Western governments have imposed sanctions on some individuals, including a “hit list” of powerful, wealthy businessmen and women close to the Kremlin known as oligarchs.
  • Russian President Vladimir Putin and his Foreign Minister Sergei Lavrov have also been sanctioned. Their assets in the US, EU, UK, and Canada will be frozen. The US has imposed a travel ban on both of them.
  • Energy imports (oil, gas, and coal) from Russia were banned from the US, Canada, UK, and Malaysia. This is expected to be a directly hit only a small amount of Russian oil exports, the indirect hit could be much higher because a growing number of traders and buyers will be shunning Russian crude due to “self-sanctioning”/reputational risks.
  • Many multinational businesses have left Russia
  • Russia has banned exports of fertilizer, which removes a large part of the market
  • Ukraine has banned exports of wheat, oats, and other food staples.
  • Europe sets the 2027 deadline to end reliance on Russian oil and gas. Germany is increasing its defense spending up to 2% of GDP.
  • Russia is being progressively unplugged from the world economy and disconnected from international forums and activities. 

Why focus on Financial Sanctions Rather than Direct Military Force?

The West has focused on Financial Sanctions largely as a result of the ideology in which the West is governed  (Democratic Peace Theory), we can see why the path of avoiding direct military conflict with a nuclear superpower (Mutual Assured Destruction – MAD principle) has been chosen and a focus on financial sanctions to weaken Russia’s economy and a proxy war by providing support and weapons to Ukraine.

However, the outcome of choosing this path specific to financial sanctions may weaken the trust and confidence in banking institutions going forward.

A couple of weeks before the Russia/Ukraine conflict, we observed in Canada, the invoking of the Emergencies Act in response to the trucker’s Freedom Convey protest which effectively shut down the capital in Ottawa. The Emergencies Act identified and froze bank accounts of those citizens that donated to the cause. This type of activity may have also weakened the trust and confidence of the banking system as well.

What Can We Expect Going Forward?

In this section, we dig a little further into the broad trade relationships that both Russia (Table 6) and Ukraine (Table 7) depend on to drive their economy forward, to determine if there be further supply shocks across global commodity/goods markets.

Table 6 – Key Exports and Imports – Russia (2020)

Source: UN Comtrade, BeowulfsTreasury.com

We can expect higher energy prices with restrictions of supply due to the loss of Russian oil and gas due to the sanctions. We note that Energy (Oil, Gas, Coal, and Nuclear) accounts for 43.1% of exports from Russia, and 50% of these exports are with the US and its allies. Also, food prices may increase as well as, Russia and Ukraine combine for nearly 33% of the world’s wheat and barley exports. Ukraine also is a major supplier of corn and the global leader in sunflower seed oil, used in food processing.

Table 7 – Key Exports and Imports – Ukraine (2020)

Source: UN Comtrade, BeowulfsTreasury.com

When combining corn, wheat, sunflower seed oil, and fertilizer, Russia and Ukraine combine for 21% of the global market, which is very significant (Table 8).

Palladium is another significant metal mined and exported from Russia, representing almost 40% of the global market. More than 80% of all palladium in the world is mined in South Africa and Russia. Palladium is used in most gasoline-engine catalytic converters. The price of Palladium was up significantly up 33% from the date of the invasion to March 8th, but has subsequently retraced.

The war could reduce food supplies just when prices are at their highest levels since 2011. Typically when food prices increase, social disruption tends to increase (i.e. Arab Spring in 2011). We may yet see more disruption as a result of food shortages. Countries that are major importers of these agriculture commodities include China, India, Egypt, Bangladesh, and Indonesia (some of which are at risk to a social disruption).

We will be watching how this may plan out over the coming months as food shortages are expected to increase food prices, potentially resulting in a further crisis. The energy price (oil price) has a significant impact on food prices, and oil supply is expected to be constrained – see Table 9.

Table 8 – Impact of Combined Russian and Ukrainian Exports as % of Total Market

Source: UN Comtrade, BeowulfsTreasury.com

Table 9 – Food Price Index and WTI Oil Price

Source: FRED Federal Reserve, BeowulfsTreasury.com

Russia relies on the US and its allies for about 44% of its major imports including Cars, Vehicle Parts, Pharmaceuticals, Aircraft, helicopters, and Spacecraft.

This may have short-term consequences depending upon how long the war with Ukraine lasts, but we expect that the financial sanctions will take some time to be removed even after there is a ceasefire or conclusion to the war. There may also be a long-lasting stigma of Russian exports as well, as trade requires political stability and trust.  

China may be able to replace the imports from the West, except for high tech, at this point. The West has have targeted semiconductors and other emerging technologies with export controls.  

Also, commodity-rich western nations such as Canada, Australia, and Nordic countries over time may be able to replace the exports from Russia through investments in infrastructure and collaborating in the West with like-minded governments (liberal democratic societies) on Energy and Agriculture policy to help secure supply chains, which will be a topic of a future post.

Governments must balance the need for energy security today with a transition to low carbon technologies of the future and this is not a binary decision (i.e. if we build pipelines for natural gas today, we will not invest in climate change, renewables, and electrification of the power grid). The price stability of the economy depends on the price stability of energy from all sources and the encouragement of private investment as well through thoughtful energy policies. 

3. War and Peace – Energy Independence and Economic Security

So Could East and West function in a multipolar world?

  • Energy independence means relying on national or local sources of energy.
  • Russia exports 4 to 5 million barrels of oil and 8.5 trillion cubic feet of natural gas and Europe is their most important partner and is dependent see Table 10.
  • Most of oil and gas moves through pipelines as we note in Table 11.

Let’s take a look at the numbers…

Table 10 – Russia’s oil and gas exports

Table 11 – Russian supply lines – Oil and Natural Gas

  • So the question is with the oil and gas embargos from the West, can Russia redeploy their export supply to China or other Allies. It appears to be complex to move oil and gas physically and could be redeployed through rail but moving through sea or pipeline is going to be a challenge given that Russia currently does not have access to the sea.   
  • The move to Clean Energy in the West has set up structurally higher energy prices (oil and gas) for most of the world due to the lack of investment over the last 10 years has reduced future supply – this is expected to increase inflation going forward as energy is input into almost any produced.  Low carbon power generation sources include wind power, solar power, nuclear power, and most hydropower.
  • Currently, the West has not fully transitioned to low carbon sources, see Table 12 and the world continues to source most energy consumed from fossil fuels (oil, natural gas, and coal) – Table 13.   

Table 12 – Share of Low Carbon Electricity

Table 13 – Global Consumption of Energy and Electricity Production

Source: Our World in Data, International Energy Agency
  • Let’s take a look at Oil and Gas consumption, production, and reserves.   

Structural Energy Shortage (Oil and Gas) – West vs East – Global Shortage Inevitable?

  • We looked at the importance of bilateral swap (BL swap) agreements in the previous posts. These swap agreements stabilize markets when markets become stressed in a fiat currency regime (i.e. debt becomes too much and more than cash flows to repay principal and interest). It also allows us to categorize countries across strategic/trade alliances.
  • For ease of reference, we have referred to the US and its allies as the West and China and its allies as the East.
  • Swap lines keep plenty of currency available during times of stress so that countries can continue to trade and secure important raw materials for manufacturing and production. In a fiat currency system, liquidity is necessary to keep financial markets functioning smoothly during crises.

Table 14 – Structural Energy Production Shortage (Oil) in the West

Source: bp Statistical Review of World Energy July 2021, BeowulfsTreasury.com
  • At this point with the West transitioning to a low-carbon future, has a structural deficit (more consumption versus production) of 7.4 million barrels per day despite having 271 trillion barrels in reserve and relies on imports to meet current energy needs choosing to keep domestic production in the ground – see Table 14. Oil reserves are roughly split 50/50 between the West and the East, though this does not include large producers/reserves such as Saudi Arabia, Venezuela, Kuwait, Iran, and Iraq, though all are members of China’s Belt and Road Initiative and appear to be more aligned with China.
  • In the East, there is a slight surplus of oil, as China’s large deficit of 10.3 million barrels per day could be largely filled by Russia and UAE, and Kazakhstan at current consumption and production. Note we have not included large producers such as Saudi Arabia, Kuwait, Iran, and Iraq – in the table above.  

Table 15 – Structural Energy Production Shortage (Natural Gas) in the West, Structural Production Surplus in the East

Source: bp Statistical Review of World Energy July 2021, BeowulfsTreasury.com
  • In the West, there is a structural production shortage of Natural Gas (Table 15) within European Union consuming 32.7 trillion cubic feet per day more than they produce, offset by excess production in Australia, the US, Canada, and Norway. There is surplus production in the East, as the supply deficit in China is more than offset by Russia and Qatar.  Natural Gas reserves are heavily weighted towards the East.  

Table 16: Significant Oil and Natural Gas Reserves

Source: bp Statistical Review of World Energy July 2021, BeowulfsTreasury.com
  • While oil and gas companies come under pressure to reduce production, the world’s thirst for new supply is only growing. We note that the US and Canada have significant oil and gas reserves which may be used to expand production that could be used to replace Europe’s structural shortage for current energy needs, as it looks to transition to a low-carbon future. Further diplomacy and collaboration on a wider energy policy and effective transition plan to a low-carbon energy policy with allies may enhance the energy independence of the West.   
  • Replacing Russia’s exports of oil and gas with Western allies may be difficult given that current production capacity and infrastructure (pipelines) cannot be easily expanded. Nor are capital providers willing to take the risk, provide investment to expand capacity in an industry with a limited lifespan.
  • Without a significant uptick in investment, demand for oil and gas will surpass supply in the not-so-distant future.
  • This disconnect between the political desire for fewer fossil fuels and the global hunger for fossil fuels could drive the price of oil up potentially higher than the current prices.
  • Hence we are considering how investors may position their portfolios in periods of high inflation or stagflation – Section 5.

In the next section, we look at Nuclear energy as a potential replacement and try to understand the balance of power between East and West.

Nuclear Energy – A Potential Solution to move to a Low-Carbon World?

  • One may ask the question, to reduce the reliance on natural gas exports from Russia to Europe, without significant investment in pipelines in North America, can we look to another source of energy? Nuclear may be another energy source to review.
  • As the West transitions to low-carbon future reliance on nuclear energy (which is about 10% of today’s energy consumption) are expected to aid in the transition. Nuclear energy has the highest capacity factor, which has caused the world to take a second look at nuclear to solve the world’s future energy needs.
  • Uranium is the main fuel for nuclear reactors, and it can be found in many places around the world. To make the fuel, uranium is mined and goes through refining and enrichment before being loaded into a nuclear reactor.
  • Uranium is found in small amounts in most rocks, and even in seawater. Uranium mines operate in many countries, but more than 85% of uranium is produced in six countries: Kazakhstan, Canada, Australia, Namibia, Niger, and Russia – See Table 17.
  • Nuclear energy production emits no greenhouse gases, but some constituents voice concern about the potential for accidents and the lack of a permanent disposal repository for nuclear waste, which is radioactive. Germany was getting about 25% of its electricity from nuclear energy until March 2011, when the government passed a law to phase out nuclear power following the Fukushima accident in Japan.
  • The current Russia/Ukraine war will be a test of nuclear generation given that Ukraine has about 56% of its electricity generated via nuclear and the safety of such power generation in conflict.

Table 17 – Uranium Production

Source: World Nuclear Association, BeowulfsTreasury.com

Table 18 – Nuclear Share of Energy by Country and Capacity by Source  

  • Russia has about 20% of the nuclear enrichment capacity and most of the world’s capacity is in the East – Table 19 as well as, the current production capacity of uranium.
  • Nuclear operators in the West may have to look toward importing enriched uranium from other countries such as France, Japan, and China if there are sanctions put in place on the fuel from Russia.
  • There are reactors produced in Canada that do not require uranium to be enriched, called CANDU nuclear reactors. 15% of total electricity in Canada is produced via nuclear sources. Also, CANDU reactors are used in China, South Korea, Romania, India, Pakistan, and Argentina.

Table 19 – Uranium Enrichment Capacity

  • The current conflict should be a wake-up for the West in that energy independence is required for economic and physical security considering both fossil fuel and clean energy sources.
  • Even if there is a ceasefire in the Ukraine/Russia conflict soon, we believe that the West should transition their trading arrangements to secure, sustainable, predictable trading partners who are also allies and operate according to the democratic peace theory. This includes a comprehensive energy policy including an effective transition plan.
  • Transitioning the energy grid will take physical upgrades and international coordination and diplomacy. A comprehensive strategy is required to protect and assert the sovereignty of current borders and energy infrastructure.
  • Resource-rich countries such as Canada, Nordic countries, and Australia should be able to potentially replace Russia’s exports such as fertilizer, crude oil, natural gas, aluminum, wheat, iron, and gold. We hope to take a deeper dive into Canada’s economic potential in a further post.

We are hoping that the recent events may be a cause for reconsiderations of past populist ideologies in the West, which currently favor binary policy choices such as policies to block investment in infrastructure (Keystone XL pipeline) to export oil and gas as a means to fight climate change at all costs. Instead of looking to Canada to replace oil imports, the US is looking to negotiate with autocratic governments such as Saudi Arabia, Iran, and Venezuela to increase production.

Could the West’s De-coupling from Russia impact the West’s transition to Renewable Energy Sources?

As we mentioned in our previous the Magical Power of the Copper/Gold ratio post renewable energy sources require several minerals (see Table 20) that are mined across Latin America, China, Russia, and North America. As we noted that China and its allies have about 40% of global copper reserves, while the US and its allies have about 23% of global reserves. Russia represents about 7% of total copper reserves.

Table 20 – Minerals Used in Clean Energy Technologies

Source:  International Energy Agency

As Russia represents 2% of the global population but 11% of the world’s landmass, it does have an outsized share (>5% of the total market) with a significant share in Lithium, Nickel, Manganese, Graphite, Chromium, Zinc, Rare Earths, and Silicon, which it may export excess resources – see Table 21.

Nickel is a key material in electric vehicle batteries, and the market price had been rising steadily even before the conflict in Ukraine ramped prices on concerns about threats to Russian supplies. Russia accounts for about 10% of global nickel output and traders have been concerned that supplies could be constrained by Western sanctions.

Though, Russia may not have the same influence in the energy market as it does currently in Oil and Gas, but it still, has outsized resources which will be quite valuable in the future – see Table 21.  In addition to a common ideology, this may also partly explain China’s “no limits” partnership to source important metals and minerals with Russia for future clean energy production.

Table 21 – Russia’s Influence on Minerals Used in Clean Energy Materials

China has emerged as a major force in global supply chains for critical minerals and clean energy technologies over recent decades. Despite its current reliance on coal to power electricity, the country’s rise to becoming the leader of clean energy supply chains has largely been underpinned by its long-term industrial policies, such as five-year plans for economic development, the Made in China initiative, and the Belt and Road Initiatives – See Table 22.

We also note that the current US import reliance on various transition metals and minerals may reduce its future energy independence. However, we believe allies such as Canada and Australia, along with Latin American sources may provide secure supply chains. In January 2020 Canada and the United States signed a Joint Action Plan on Critical Minerals Collaboration to advance mutual cooperation.

Table 22: New Energy Sources Introduce New Trade Patterns and Geopolitical Concerns

Source: International Energy Agency

In the short-term, given the world’s reliance on oil and gas for energy today and Russia’s role in the market, we believe this may increase the cost of energy relative to household spending over time. The next section reviews the market’s view of inflation and as a result a potential recession.

4. Impact of the Conflict – Inflation Expectations and a Potential Recession?

Historically every business cycle has ended in recession as inflation peaks. Oil price shocks are also strongly correlated with these inflation peaks (see Table 23). During previous war periods, energy prices also increased as supply was constrained and supply chains were at risk (physical delivery of oil).

The combination of higher food and energy prices, along with the tightening of monetary conditions are expected to reduce consumer expectations and consumption, resulting in recession.

Table 23 – US Economic Growth vs Inflation 

Source: Federal Reserve, BeowulfsTreasury.com

Inflation Expectations – Starting to become Unanchored in Short-term

  • On Table 24, Inflation has been above trend in 2021 and 2022 due to supply chain and fiscal stimulus as a result of COVID-19, though we have started to note market-implied cyclical expectations have started to become unanchored from the 2% target and are currently at 3.5% as the red-line has moved to the right of the blue-line.
  • In Table 24 we note that the current quarter (Q1/2022) with inflation of ~8% and unemployment below 4%, is a very rare occurrence.
  • Based on historical probabilities since 1955, we note that when inflation is above 4% and the unemployment rate is below 4%, over the next 12-24 months has historically resulted in recession 100% of the time.
  • The amounts do not include the impact on the inflation related to the Russia/Ukraine conflict, which is expected to cause inflation to go even higher. The Cleveland Fed Nowcasting model for Q1/2022 is forecasting an 9% annualized change. 

Table 24 – Inflation and Unemployment – Historical Probabilities

Source: Federal Reserve, BeowulfsTreasury.com
  • In addition to the realization that inflation is not transitory, the conflict in Ukraine/Russia has moved up the expectations as a result of higher energy and food prices. Tightening of monetary policy is not expected to resolve the supply constraints related to energy and food associated with the conflict and supply chain resolutions as a result of COVID-19.
  • The labor market continued to be very strong, though real wage growth remains negative. The Federal Reserve Bank of San Francisco has recently looked at an alternative metric to measure the economic output gap (RGDP and Unemployment) and has suggested direct measures of the degree of labor market tightness, such as the vacancy-to-unemployment ratio (V/UR), provide superior inflation forecasts for prices and wages (Table 25), which may guide the Federal Reserve in monetary policy decision making.

This is an alternative to the statistical measures of output gaps the inflation-targeting central banking typically relies upon. The V/U ratio represents the number of job vacancies, or demand for labor, relative to the number of unemployed individuals, or supply of labor or marginal cost of labor. As both unemployment and inflation are lagging indicators, raising the Fed Funds rate to a level that reduces the V/UR ratio by increasing unemployment to reduce inflation back to the target of 2% and potential GDP. 

Table 25 – Marginal Cost of Labor (V/U Ratio) vs Inflation

Source: Federal Reserve, BeowulfsTreasury.com

In Table 26, we note that the probability of inflation increasing above 3% over the next 5 years implied by markets is about 60% which is much higher than historically observed. This indicates there is a higher probability of inflation tail risk (>3%).

CPI over 5 years: Inflation density is based on the probability density function of CPI inflation derived from caps and floors.
Source: Federal Reserve Bank of Minneapolis

Table 27 – Market-Implied CPI Expectations over next 5 Years and Probability

Source: Federal Reserve Bank of Minneapolis, BeowulfsTreasury.com

However, we note in Table 28, that long-term expectations inferred by 5-year inflation expectations, 5 years forward implied by markets in Table 29 have remained largely unchanged, which suggests to us that higher inflation is largely cyclical as expected in the near term due to supply constraints, up to 3.4% over the next 5-years implied by the market. Structural inflation does not appear to be impacted as 5-Year Inflation expectations, 5 years forward expect to be 2.15% (close 2% target). 

Table 29 – Long-term Market-implied Inflation Expectations

Source: Federal Reserve, BeowulfsTreasury.com

In Table 30, Market-implied Fed Funds rate 1-year from now is expected 200-225 bps (7 hikes – blue-line) up from 6 hikes at the end of January (orange-line), as it is expected to bring creditability back to prices and expected that as monetary policy tightens, unemployment is expected to increase. However, supply shocks via war/pandemic are not going to be directly solved by tightening monetary policy. Central banks tend to be less hawkish during wartime.

Table 30 – Short-term Interest Rate 1-year from now

Source: CME Group, BeowulfsTreasury.com

The Fed will need to balance price stability versus jobs and provide optionality should the war in Ukraine expand beyond its borders and potentially embroil NATO or potentially the knock-on effects of sanctions in Russia resulting in a significant credit event which represents a major risk. So raising rates on autopilot may not be a viable option.

Growth Expectations – Are we starting to see signs of recession?

  • Even before considering the impact of Russia/Ukraine on energy and food prices and any moves by the Federal Reserve in the next few months will be into a slowdown of economic activity as a result of the tightening of financial conditions, and higher energy prices.
  • Over the past 9 months, consumer sentiment has declined by 30% and is the lowest since 2011. Personal finances were expected to worsen in the year ahead by the largest proportion since the surveys started in the mid-1940 pointing out that the high inflation rate is impacting incomes.
  • Further increases in inflation due to Russia/Ukraine conflict are expected to reduce the misery index potential to the low points we have seen during the Great Financial Crisis and high inflation of the late 1970s – see Table 31. 
  • As we noted in the Wealth and Debt, Two Sides of the Same Coin post, the wealth effect and consumption are a significant part of the US GDP (about 70%) and consumer confidence is important to continue to drive this consumption forward. Also as higher energy and food costs disproportionally impact low-to-middle income earnings, which make up a greater proportion of the population, lower consumption may lead to lower GDP growth going forward.
  • The current Real GDP nowcast for Q1/2022 is at 1.3%, which is below-trend growth of 2%, and combined with inflation nowcast of 8-9%, would suggest that we are in the “Stagflation” phase of the business cycle. We review this concept and how asset classes may behave across the different economic phases of the business cycle further in section 5 of this post. 

Table 31 – Consumer Sentiment vs Misery Index (Inflation and Unemployment)

Source:  Federal Reserve, BeowulfsTreasury.com
  • We note that higher energy and food prices may also have an impact on corporate earnings and may see an earnings recession in the next 24 months based on historical analysis – Table 32.
  • Due to the rapid rise of energy prices, higher interest rates, a stronger dollar, higher food prices, and reduced consumer sentiment (represented by the orange line), this is expected to reduce profit margins and profit growth (represented by the blue-line) going forward, which increases the probability of an economic recession.

Table 32 – S&P 500 Earnings YoY vs Index (US dollar, 10-Year Yields, Food, and Oil)

Source: S&P, Federal Reserve, BeowulfsTreasury.com

We have also noted yield curve slope has flattened dramatically in the last few months as the 2-year yields have expanded much faster than 10-year yields, with the higher inflation prints which are looking more persistent. Historically flattening/inverting of the yield curve has been a strong predictor of recession conditions (predicted each recession over the past 60 years – see Table 33.

Table 33: Yield Curve Slopes

Source: Federal Reserve, BeowulfsTreasury.com
  • Given that there have been significant geopolitical moves in the past 3 weeks, we summarize below the main takeaways for investment allocation:

  • The weaponization of the Financial System and US dollar: Countries with significant commodity exports held in FX reserves may be at-risk if significant military aggression is taken as liabilities/frozen may be confiscated by the US. This may further accelerate the de-dollarization of the financial system. This may make sovereigns hold more of their export surplus in gold. It may make others recalculate any aggressive moves on current sovereign borders. Also, these actions may weaken any trust and confidence in the supporting institution of capitalism (banking and capital markets).  
  • Property rights of a private citizen in the foreign jurisdiction may not apply if significant aggression is taken by a sovereign.
  • The energy policy of the West must balance fossil fuels and low carbon sources, as the economy modernizes to new forms of energy to help fight climate change.
  • With globalization, the West has moved the mining of fossil fuel offshore/waged proxy wars, and focused on consumption domestically. In a de-globalized world, energy security may be more of prioritization with local mining from domestic sources and trading with allies such as the European Union, rather than keeping domestic sources in the ground and focusing 100% renewables. A more effective policy may see natural gas and nuclear paired with renewables as a sustainable transition plan, working with like-minded allies that believe in democracy and freedom rather than autocracy.
  • Food and Energy crises may be upon the globe at the same time due to the Russia/Ukraine war given the importance of both countries to energy and food supply chains. We do not believe historically we have seen a similar situation. In section 5, we review the last 125 years to determine if there is an analogous situation, where we may see high inflation and low growth, also known as Stagflation. 
  • With the economic sanctions, the Russian economy may collapse in the next few months resulting in potential debt defaults which may be worse than collapses in 1918, 1991, and 1998. The second-order impacts of such an event are a large unknown at this time which introduces significant market and economic uncertainty. The conclusion is to remain relatively cautious as an investor during this time.
  • Over the past 5 years, Cold War 2.0 has emerged with very different ideas of how to allocate resources with the East (China/Russia adopting autocratic capitalism) and the West (democratic capitalism). With de-globalization, there may be significant inflationary impacts as the supply chain for sovereign security is being re-shored and separated including energy and food.  We hope that the current Ukraine/Russia conflict may be settled through negotiated settlement soon, though, recognize that this may be the opening act of World War III.
  • Even if there is a negotiated settlement in Russia/Ukraine conflict, we do not anticipate sanctions to be removed quickly or the food supply chain to get back up and running to be able to meet potential food demand. We believe that the economy may continue to see a stagflation/recessionary economy.    

In our next section, we will review capital returns over the past 125 years, as well as the past 40-years on a quarterly basis, to get a better idea of what assets perform well in a stagflationary environment

5. Asset Class Returns – War and Peace

  • Given the significance of the conflict to the world economy and related food and energy supply, we have reviewed historical returns by asset class on an annual basis over the past 125 years and the last 40 years on a quarterly basis across 4 economic cycle seasons: 1) Stagflation 2) Growth 3) Inflation 4) Deflation to determine what works as far as portfolio allocation. See Table 34. We looked at how war vs peace may impact these cycles.
  • We note we are currently in the “Inflation” phase which is defined as above-trend growth and inflation. Though, as oil price shocks have tended to result in recession, we look at “Stagflation” as “Recession” asset class returns.   
  • We reviewed financial assets (large-cap equities, long-term Treasuries, REITs, etc) as well as hard assets/commodities (agriculture, base metals, and precious metals).  
  • In measuring trend Real GDP growth and CPI change we used a common method of measuring potential output is the application of statistical techniques that differentiate between the short-term ups and downs (cycle) and the long-term trend (structural) based on demographics, debt, and technology/productivity changes. 
  • The trend is interpreted as a measure of the economy’s potential output and the cycle as a measure of the output gap relative to this trend. The Hodrick-Prescott (HP) Filter is one popular technique for separating the short from the long term. We have used this technique in estimating the Business Cycle.

Table 34 – Asset Classes and Phases in the Economic Cycle  

Table 35 – Economic Growth and Inflation – Actual vs Trend

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com
  • In Table 35, we review the last 125 years of US economic growth and inflation, we note that the business cycle trend (lasting 10 years) economic growth (Real GDP) of 2.0% and 2.2% Inflation (CPI). These trend factors are used to classify the economic cycle across the following – deflation, stagflation, inflation, and growth.  We note that previous wars/pandemics have led to spikes in growth and inflation.
  • Median annual asset class returns are shown in Table 36 over the past 125 years. Real returns have been positive in Real Estate and Large Cap Broad Equities, and slightly negative across all other asset classes.

During high inflation periods (Inflation and Stagflation), Real Estate, Energy (Oil), Base Metals, and Agriculture commodities tend to outperform other asset classes.  Interest rates are significantly higher in a stagflationary environment, which potentially move discount rates higher on large broad equities and result in capital losses on Long-term Treasuries.

Table 36– Asset Class Returns – 1895 to 2021

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

Review of Previous Wars/Pandemics – Annual Asset Class Returns/Economic Cycles – 1895 to 2021

Let’s take a look at asset class returns during war/pandemic periods in more detail considering the various economic cycles we have defined above. We have added one year after the official end of the war/pandemic to see if any supply shocks drive higher inflation as life gets back to peacetime.

In Table 37, we note that war/pandemic years are more likely to see higher than trend inflation either in Inflation or Stagflation phase, which is consist of supply restriction for key goods in production and supply chains may be attacked as well – pandemic (labor) and war (energy/food/housing), which causes demand to outstrip supply and price levels rise.  

Table 37 – Summary of Economic Cycles – 1895 to 2021

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

Table 38 – World War I and Spanish Flu – 1914 to 1921

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

In Table 38, we note that the beginning of WWI started at below-trend RGDP and inflation (deflation). You can see war is highly inflationary given supply constraints, moving between stagflation and inflation. Real interest rates were kept negative over the period (inflation greater than rates), keeping the economy at full production.

Over this period, Real Estate and Energy (Oil) have performed well but failed to keep up with the average rate inflation of 8.1%. Large-cap broad equities (S&P 500) and Long-term bonds (TLT proxy) were largely flat over the period, benefitting largely during deflationary periods.

Table 39 – World War II – 1939 to 1946

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

In Table 39, we note that the beginning of WWII started at above-trend RGDP and below-trend inflation (Growth). You can see war is highly inflationary given supply constraints, averaging 4.2% over the period. Real interest rates were kept negative over the period (inflation greater than rates), keeping the economy at full production to help support the war effort. Real Estate and Agricultural commodities outpace the pace of inflation.

Large-cap broad equities (S&P 500) and long-term bonds (TLT proxy) were negative from a real rate perspective.

Table 40 – Vietnam War 1961-1976

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

In Table 40, at the beginning of the Vietnam War (1961) started in Deflation (below-trend RGDP and inflation. There is a much more gradual build of inflation over the period, which differs from WWI and WWII spikes in inflation during the war years. Real interest rates were positive over the period.

The oil price shock of 1973-74 was significant, causing inflation to move to double-digit growth on an annualized basis, which was a result of a supply-side shock due to an oil embargo by Arab producers against those countries supporting Israel (in the Yom Kippur War).   

During this bout of stagflation, we note that asset returns on real assets (real estate oil, agriculture, base metals, and gold), performed well, despite interest rates rising.

Fed Chairman at the time Arthur Burns argued that the inflation appeared to be the result of a plethora of forces: “the loose financing of the war in Vietnam . . . the devaluations of the dollar in 1971 and 1973, the worldwide economic boom of 1972-73, the crop failures and the resulting surge in world food prices in 1974-75, and the extraordinary increases in oil prices and the sharp deceleration of productivity”

Economists have since come to understand that a central bank can influence the extent to which supply shocks affect inflation, but they face a trade-off.

Higher oil prices, because of the widespread effect they have on commodities throughout the economy, will tend to generate both inflationary pressures and slower growth. In the short run, these forces tend to have an inverse relationship, meaning when one rises, the other falls, and vice versa.

Unfortunately, monetary policy cannot offset the recessionary and inflationary effects of increased oil prices at the same time. If the central bank lowers interest rates to stimulate growth, it risks adding to inflationary pressure; but if it raises enough to choke off the inflationary effect…it may exacerbate the slowdown in economic growth.

The decision to tighten or ease monetary policy ultimately depends on how policymakers balance the risks inherent in pursuing employment and price stability objectives.

History may not repeat, but it certainly rhymes as the fact base appears somewhat consistent when reviewing our current emerging risks due to the Russia/Ukraine conflict as energy and world food prices are expected to increase as supply is expected to be constrained.

However, we do note that there are some differences in the fact pattern as inflation had been building in the economy during the late 1960s/early 1970s as well, and the first Baby Boomers –  whose generation was defined by the boom in U.S. births following World War II  (largest generation the world experience at that point) began to enter the labor force, potentially drove up consumption and demand for resources during this time. The labor force participation and labor force growth are much lower now than in the 1960/the 1970s.    

There is the potential for policy errors from central banks by misreading the situation by continuing to raise rates and maintaining a hawkish stance into a slowing environment, without considering risk management considerations. Also by not recognizing the very clear threat of Russia waging unconventional war via the economy in retaliation for sanctions including cyberattacks on US financial institutions. This may take a dynamic approach by the Federal Reserve.

As well, it may be expected should growth begin to fall and stagflation starts to take hold, that fiscal measures may be taken to offset the higher costs related to basic living expenses – rent, food, and energy which is (largely outside of the control of the Federal Reserve) via direct transfer by the government (which is the tool policymakers introduced during the COVID-19 crisis) to ensure that consumption continues to remain buoyant.

Quarterly Review – Post-Bretton Woods Fiat Currency Regime – 1976 to 2022

As we mentioned in our last post, in 1971 (Type 3 system) the monetary system was delinked from gold and the US dollar and US Treasuries backed by the full faith and credit of the United States has continued to play a central role in the international monetary system during the latter part of the 20th century due to the country’s economic strength and the stability of its political and judicial system.

As we noted fiat money could be created in unlimited quantities through the private banking system to support the real economy or by the government issuing debt and monetizing the debt via quantitative easing, if foreign countries were not willing to buy the debt in periods of crisis, to support the de-levering of the private sector. 

As a result, given the nature of unanchored credit-based systems, business cycles are much longer than pre-1971, and credit cycles do not build quite as high. 

This impacts asset class returns, specifically, gold as fiat currency can be created to drive the economy forward, and we can that cash has been devalued relative to gold as nominal returns are higher across stagflation and inflation. Thus, we have reviewed quarterly data given the move to the fiat currency (Type 3 system). 

Table 41: Summary of Economic Cycles – 1976 to 2022

In Table 41, the proportion of the quarters split by deflation, stagflation, growth, and inflation are very similar to the annual review we provided earlier with growth (higher RGDP than trend, and below-trend inflation) representing 35% of the quarters. However, there has been a lower occurrence of the Deflation phase of about 7% moving from 28% to 21%, as the previous monetary backed by gold had been deflationary at times.   

In Table 42, we show based on the phases of economic cycle based the different quarterly returns (sequentially quarterly returns) by asset class, to pick up changes in the economic season reflected in asset class prices. 

Table 41: Asset Classes by Quarter – Q2/1978 to Q1/2022 (Quarter-over-Quarter Returns)

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

Based on historic probabilities, deflation (below-trend growth and inflation) or stagflation (below-trend growth and above-trend inflation) in combination are about 40% probability in a given quarter.  Growth (above-trend growth, below-trend inflation) is the most likely at 35% probability in a given quarter.  

  • During stagflation similar to what we have noted earlier asset returns on real assets (real estate/REIT, oil, agriculture, and gold), performed well, despite interest rates rising. This is a similar finding to the annual analysis.
  • Technology stocks have performed well across deflationary, inflation, and growth environments, though have specifically underperformed during stagflation. Bonds have performed well in deflationary environments due to capital gains as rates fall in these environments.
  • We do not have a long enough time series to include Bitcoin or Ether, but based on our previous post we believe these assets to act similar to leveraged 5x Technology stocks (QQQ).
  • Overall Bonds (TLT/IEF) have not protected capital from a real return perspective as real interest rates have been declining and are now deeply negative.  
  • REITs perform well across most environments and potentially the wealth effect we described in our previous post drives these asset returns.  

We noted a similar pattern over the past 45 years of quarterly data moving generally moving from Growth to Inflation to Stagflation back to Deflation. This pattern generally takes 4.3 years to play out and since 1976, there have been 11 different cycles – see Table 42.

You will note that generally, each phases lasts about 4 quarters (Deflation, Stagflation, and Inflation) and Growth is about 7 quarters. This table also shows the general stability of returns across asset classes and the importance of portfolio diversification as well for the different economic phases. Being able to anticipate a change in phase, may also help in tilting the portfolio weightings as well. We will go through this topic in a future post.

Table 42: Asset Classes by Phase of the Economic Cycle – Q4/1978 to Q1/2022 (QoQ Returns)

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

To this point, we have only reviewed average asset class returns, without considering the risk of returns. The volatility of returns and potential for drawdown is always important to consider as well across these various parts of the business cycle.

In Table 43, we have calculated Expected Losses by Asset Class. There is a 1% probability that sequential quarter-over-quarter losses are greater than what is shown in the table. We also get a sense of when the largest drawdowns are in each economic cycle. For example, REITs, Technology, Large Cap equities, Copper, Ag Commodities all have a greater likelihood of large drawdowns during Deflationary parts of the business cycle. Also, the largest drawdowns occur in the second quarter in which the economy is in the “Deflation” phase (recall average Deflationary phase is 4 quarters) and tend to be the setup the next bull market for equity markets.

Higher returns in large-cap/technology equities are expected in the deflationary phase, as higher downside risk is taken on by investors during this phase of the economy and returns are commensurate with the risk taken on. We observe the same theme in the stagflation phase as oil prices have high returns relative to high downside risk as well.   

In the “Stagflation” phase, bonds tend to underperform and have the greatest probability of large drawdown. Oil and Gold are expected to have the largest drawdown during the “Growth” phase.

Table 43 – Expected Losses at 99% Confidence Level and Other Measures (Sequential Returns)

Source: US Federal Reserve, BeowulfsTreasury.com

In Table 44, we show the expected losses based on annual returns for each asset class by economic cycles, which generally follow the quarterly results in Table 43. Who says markets are disconnected from economic conditions!

Table 44 – Expected Losses at 99% Confidence Level – Annual Returns – 1895 to 2021

Source: Òscar Jordà, Moritz Schularick, and Alan M. Taylor. 2017. “Macrofinancial History and the New Business Cycle Facts, US Federal Reserve, BeowulfsTreasury.com

Identifying Bottoms in Equity Bear Markets

Now that we have reviewed the Business Cycle Phases and Risk and Return Characteristics of each asset class, we look at another metric in Table 45 that helps identify equity market bottoms. Finding market bottoms is important in the Deflationary phase of the economic cycle, but can been used in any phase.

The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility over the coming 30 days. VIX is interpreted as an indicator of the level of investor confidence or fear in the market, and therefore the level of investment risk, but it is commonly known as the “uncertainty index.” VVIX represents the volatility of volatility in the sense that it measures the expected volatility of the 30-day forward price of VIX

Historically, the VVIX/VIX ratio tends to be lower during periods of extreme volatility and higher during periods of relative complacency. Market participants also use the ever-changing relationship between VVIX and VIX to monitor the market’s prevailing risk dynamic—through a metric known as the “VVIX/VIX ratio.”  

We have calculated the Z-Score (normalized by average and standard deviation) and note that at a Z-Score below -1 (green circles highlight the levels), this provides investors a bottom in which market pessimism is very high and the valuation of the market is cheap. These opportunities tend to be when the economy is in the “Deflationary” or “Stagflation” phases and when the Fed Reserve enacted accommodative monetary policy otherwise known as the “Fed Put”. 

The Fed put is a belief by financial market participants that the Federal Reserve will step in to boost the markets if the price of the markets falls to a certain level. However, we believe the Fed Put is much lower than -1 Z-Score this time, given the acceleration of inflation and we will wait to see how this plays out with the Fed’s plan to hike rates over the coming 12-months.     

Table 45 – Identifying Equity Market Bottoms – VVIX-to-VIX ratio


How to Position Capital Today…..

We have reviewed the current Russia/Ukraine conflict, its impact across markets including sanctions, and provided a framework to help investors across the business cycle whether in War or Peace, based on our review of the last 125 years of data across multiple asset classes.

In a future post, we hope to demonstrate how we may be able to get a forward-looking view of the transitions of the phases of the economic cycle in real-time based intermarket analysis, so that investors may be able to position their portfolios accordingly.

We noted that war/pandemic years are more likely to see higher than trend inflation either in Inflation or Stagflation phases, as a result of supply restriction for key goods in production, and supply chains may be attacked as well.

The combination of kinetic and financial war as a result of Russia/Ukraine, is expected to reduce the global output of energy and food (effectively an attack on food/energy supply chain). We have observed, that expected growth based on the Atlanta Fed GDP Nowcast is below-trend growth of 2%, and combined with the Cleveland Fed inflation Nowcast of 8-9%, would suggest that we are moving from the “Inflation” phase to the “Stagflation” phase of the business cycle.

Based on our review of the past 125 years of data, during high inflation periods (Inflation and Stagflation), Real Estate/REITs, Energy (Oil/Natural Gas/Uranium), Base Metals (Copper/Aluminum), and Agriculture commodities (Wheat, Soybean, Corn, Sugar, Coffee, Cocoa, Swine, Beef, and Cotton) tend to outperform other asset classes.

Historically, interest rates are significantly higher in a stagflationary environment relative to other phase, which potentially move discount rates higher on large broad equities and result in capital losses on Long-term Treasuries, which are asset classes that underperform during this phase.

Though given the current level of debt on Western sovereign balance sheets, interest rates may not be raised to a level that will tame inflation, also supply shocks via a war/pandemic are not going to be directly solved by significantly tightening monetary policy. We may see Western sovereigns let inflation run hot, which potential hurt citizens, lenders and reduce confidence in the government’s ability to manage the economy.

As well, it may be expected should growth begin to fall and stagflation starts to take hold, that fiscal measures may be taken to offset the higher costs related to basic living expenses – rent, food, and energy which is (largely outside of the control of the Federal Reserve) via direct transfer by the government (which is the tool policymakers introduced during the COVID-19 crisis) to ensure that consumption continues to remain buoyant. This type of action would lead us back to the “Inflation” phase. We will continue to monitor.     

We appreciate any questions or feedback you have or other research topics you may suggest.

Please follow us on Twitter or contact us at beowulftreasury@gmail.com.


One thought on “War and Peace – Cold War 2.0 or WW3?

  1. Another exceptional article! 2 Question:
    1) Under table 14 you mention that currently North America has a energy deficit of 7.4 million barrels per day but holds approx. 274 trillion barrels in reserve. If my math is correct (274 trillion/7.4million) that would mean that if we stopped oil production today we would be able to fully support North Americas oil needs for ~37million days or (37million days/365days) over 100,000 years. If this is the case what is the concern around an “energy deficit? What are the key factors that prevent governments from imply using their oil reserves to support consumption rather than importing from other countries?
    2) Under table 45 in paragraph 5 you mention the asset classes that tend to outperform during times of high inflation. Some of these areas are also low return areas and can be quite volatile. How should investors think about balancing portfolio returns vs portfolio protection when assessing how to adequately weight these outperforming asset classes in their portfolios. (not asking for what the “right” thing to do is here, just some insight into how to utilize these findings)

    Thanks again for a great article!


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