In the initial days of the Covid-19 outbreak, there was a prominent belief among investors that the one silver lining to the dark cloud would be that policymakers around the world would adopt a “we are all in this together” stance. This hope has now been crushed with Russia and Saudi Arabia are playing at, how China will respond, and how all this plays into the upcoming US election.
In recent years, we have touched several times on the policy drivers of, and outlooks for, these regional and global powers. But the foundational sands are shifting fast, and an update might be worthwhile.
A (very) brief review of the past decade
According to former US Treasury Secretary Hank Paulson (quoted in this interview), as the US faced the depths of the 2008 crisis, Russia called China to say: “Hey, let’s join together and sell Fannie and Freddie securities on the market.” In doing so, Russia’s goal was obvious: finally to crack the US hegemony over the global payments system, so undermining the US’s greatest comparative advantage.
China did not go along with Russia’s plan for a number of reasons, chiefly because in the preceding years Chinese policymakers were more about promoting stability than revolutionary upheavals. Not only did China not dump its fixed income holdings onto a stressed market in 2008-09, instead it embarked on the mother of all stimulus programs, allowing the global economy to ride China’s coat tails into a 2009-10 recovery. China repeated this course of action in the 2015-16 sell-off, when after the Shanghai G20 meeting, Beijing not only helped stabilize the outlook for the renminbi, but also launched another round of fiscal and monetary policy stimulus.
So it’s understandable why, when Donald Trump was elected and started to call China all sorts of names—cheats, liars, thieves—Chinese policymakers were somewhat taken aback. As far as they were concerned, in the previous 10 years they had helped to stabilize the global system not once but twice. And all the thanks they were getting were threats to ban US semiconductor sales to China, the arrest of the CFO of one of their most successful companies, and growth-crippling tariffs on a wide range of their exports.
Meanwhile, it’s unlikely Russia that felt much more gratified by Trump’s election. If Moscow really did spend several million US dollars on Facebook ads in the 2016 US presidential campaign, Vladimir Putin must feel he got a very poor return on his investment. From the US lobbying Europe to block Nord Stream 2, though the US-backed ban on Russia’s participation in the Olympics, to US sanctions on Rosneft, the current US administration has hardly been Russia’s best friend.
Instead, it seems that Saudi Arabia has been the Trump administration’s friend. But there again, for all the friendship and Saudi’s massive US$110bn weapons orders, the US didn’t exactly rush to punish Iran for bombing Saudi’s oil facilities last year, nor did the Trump administration stand in the way of Russia and Iran taking control of the situation on the ground in Syria. So to some extent, it has been a one-sided friendship. The net result of all this is a situation today where there is little goodwill or trust between these four big geopolitical players—the US, China, Russia and Saudi. It was into this mix that Russia threw its oil market hand grenade last Friday, with the effects on global markets that we all witnessed on Monday.
Why would Russia try to implode the World?
This has been the cry of every energy bull—and ourselves—over the last few days. But anyone asking the question surely knows the answer. Time and again, Russia has proved it can take more pain, for longer, than almost anyone imagined possible, on the premise that the long term outcome would justify that pain. Perhaps not even that; just because suffering is part and parcel of the true Russian soul. After all, Russia was the country that burnt its capital city to the ground so that Napoleon’s invading armies wouldn’t have a resting place for the winter. And the Soviet Union was the country that lost 20mn men and women in the Great Patriotic War against Germany. Suffice to say that Russia is a country that can do sacrifice and belt tightening.
You can argue endlessly about why Putin chose to strike now. Perhaps because:
- US shale is a long term threat, and the Covid-19-induced dip in demand offers the chance to precipitate bankruptcies and eliminate capital spending in the capex-heavy US oil industry for the decade to come.
- The move in Europe, and increasingly across the world, to invest more and more into renewable energy threatens Russia’s main comparative advantage. The present moment therefore is an opportunity to undermine the “European Green Deal” both economically (by making alternative energy economically unviable) and financially (given the unfolding crisis, European governments may be too busy nationalizing their financial institutions to worry about the day after tomorrow).
- Saudi Arabia is stretched, potentially providing an attractive opportunity to trigger havoc across the kingdom.
- Russia did a deal with Turkey in which Moscow helps to deliver a low oil price, which is important for Ankara given Turkey’s perennial balance of payments problems, and Turkey backs off in Syria (Putin and Turkish president Recep Tayyip Erdoğan did meet for six hours last week).
- Putin is seizing the opportunity he missed in 2008 to destabilize US financial markets. This time he is not targeting an implosion of the US mortgage market, but an implosion of the US corporate bond market (as the shale contagion spreads across all signatures, as it did in 2016). Bonus point: if the implosion is bad enough, Trump loses either to Joe Biden (who increasingly looks to be suffering from early-stage dementia) or, better yet, to Bernie Sanders (who honeymooned in the Soviet Union, and on whom Russian intelligence surely has a fat file).
It almost doesn’t matter. Who cares about the reasons? What we are left with are the consequences. Whatever the reason, or combination of reasons, it seems pretty obvious that there is some method to Putin’s apparent madness (and so he is unlikely to back down any time soon). But can the same be said of Saudi Arabia’s Mohammed bin Salman?
MBS joins the high-stakes poker game
In essence, at the weekend MBS said to Putin (and Trump?) “I’ll see you and raise you”; a bold strategy given that by any measure the Saudi economy is far more dependent on oil prices than Russia’s. Not only that, but while Russia has the advantage of being able to take some of the economic pain through a depreciating currency, the Saudi riyal’s peg to the US dollar prevents any such adjustment. So clearly, this is a bold move by Saudi Arabia.
In anticipation of the move, it seems MBS did another round of political house-cleaning (even arresting his own uncle), probably to ensure that as he leads his troops into battle, he doesn’t end up getting shot in the back by one of his own. If nothing else, the reshuffle of Saudi’s political deck indicates that MBS means business.
Of course, one could argue that MBS didn’t have much choice in the matter. If Russia is no longer willing to cut its production, and with most of Opec already cheating on their output quotas, Saudi Arabia is left in a position in which either it unilaterally restrains its own production, losing more market share and helping its competitors, or it unleashes an all-out price war in the hope its competitors eventually go bust—a Hobson’s choice of sorts. And while MBS may share some of Putin’s long term motivations—wipe out US shale, discourage further investment in renewables—the young prince may have an extra incentive: pushing an increasingly fragile Iran over the cliff.
His actions all make it clear that MBS is a leader motivated by the desire to leave a lasting legacy. And what better legacy than being the Saudi prince who took down the Islamic Republic? This might be a pipe dream. But between its shoddy response to the Covid-19 epidemic, its downing of the Ukrainian airliner and subsequent attempted cover-up, rampant inflation, massive youth unemployment, and repeated riots around the country, the Iranian regime appears to be on the ropes. As a result, turning the screw right now might well have some attractions for the Saudi prince, if not for his brothers and cousins (who all live off of the public teet), especially if blame for the near term pain can be shifted onto Russia.
Will China provide stability?
In the 2015-16 sell-off, China helped form the bottom by
(i) promising to not devalue the renminbi and
(ii) launching a massive monetary and fiscal policy stimulus.
Since the start of the coronavirus outbreak, my colleague Andrew Batson has consistently argued that the Chinese economic policy response will not involve a “blanket” stimulus. That doesn’t mean policymakers are insensitive to the plights of businesses hammered by the virus and their response to it. But instead of a blanket response, the stimulus will be targeted, and the policy measures will be micro, not macro.
In any case, China probably doesn’t feel like riding to the rescue of a Trump administration that kept spitting in its face, and—like Russia—may actually prefer a doddery Biden or an ultra-isolationist and likely incompetent Sanders. So the probability of China showing up on a white horse in the last reel, as it did in 2008 and again in 2016, looks very much smaller this time around.
Moreover, with Chinese equities handily outperforming US and global equities over recent weeks (MSCI China has now outperformed MSCI US over the course of the Trump presidency), and with the renminbi strengthening against the US dollar, there seem to be few symptoms of financial panic gripping Chinese markets (unlike in 2008 or 2016). Chinese equity, fixed income and currency markets have been a relative (with a heavy emphasis on relative) safe haven of modest volatility over the past few weeks. Against such a backdrop, China’s policymakers can afford to wait and see, and perhaps enjoy a few months of soft energy prices to cushion the economic blow of their Covid-19 shutdowns.
All this brings me to perhaps the more interesting development of recent days: the weakness of the US dollar.
The weakness of the US dollar
To put my cards on the table, had you told me a few weeks ago that the whole of Italy would be placed under quarantine, I likely would not have pegged the euro-US dollar exchange rate to be flirting with US$1.15. Of course, I also did not expect long-dated US treasury yields to be sporting a zero handle. So to some extent, one could look at the recent weakness of the US dollar and simply conclude that the market is adjusting exchange rates for a world in which the US currency yields only marginally more than its main competitor.
But with the DXY testing the 95 level, the current episode of financial panic strikes me as different from many of its predecessors in that the US dollar is simply not acting as a safe haven. This leads us to the observation that over the course of our careers we have seen crises in which:
- US treasuries rose sharply, and so did the US dollar. This usually indicated that the problem in the system was outside the US.
- US treasuries rose sharply, but the US dollar weakened. This usually indicated that the problem was within the US, for while there was obviously a domestic US liquidity squeeze, in the foreign exchange market there was no shortage US dollars relative to demand.
In a couple of recent papers, we have reviewed what this problem might be. Our first theory is that we live in a world—and nowhere more so than in the US—where everything is optimized to within an inch of its life. Balance sheets, business processes, portfolio construction, equity positioning, everything is measured and the fat is constantly trimmed. Indeed, the very premise of the age of “big data” is to make everything leaner and faster.
So now that the economic temperature is suddenly falling all around the world, it is the US dollar that takes the hit, because the US is the one economy that has most reduced its defenses against a potential shock.
Our second theory, is that the current surge in bond prices reflects a massive asset-liability mismatch among US pension funds and insurance companies. Meanwhile, Europe and Japan have been dealing with this for a while, so their mismatches were already reflected in exchange rates (and in crazy bond market valuations). In short, US treasuries are surging and the US dollar is not, because it is not foreign players that are short US long duration assets, but domestic investors.
Of course, last weekend highlighted a third possibility: that the problem is in the US, and that the problem is that both Saudi Arabia and Russia will now tighten the screws until large reaches of the American energy complex are forced under. These bankruptcies will impact an already stretched US corporate bond market. In turn, this will create a whole new set of problems for the US equity markets, as in recent years listed US corporations have become addicted to financial engineering—leveraging up the balance sheet to boost EPS growth, stock returns and management stock options.
So if Saudi and Russia are now going for the jugular, the only question left is how the US will respond.
- The US government does little, apart from putting pressure on the Fed to do more. This scenario is clearly the path of least resistance. One could almost call it “eurozone bis repetita”. And because it is the most likely scenario, it is increasingly the scenario priced in by financial markets—hence the collapse in energy stocks, the flattening of yield curves around the zero bound, the massive underperformance of US financials, and the weakening of the US dollar. The outlook here isn’t that complicated. Judging by the European and Japanese experience, investors need to avoid domestic consumption names, and instead focus on large-cap exporters and defensives such as staples, health care, and utilities.
The odds of this happening: Very high. This is the path of least resistance and almost the natural progression.
- The US government deals with the crisis by ramping up spending, even as the Fed continues to ease. In essence, this would be “TARP+QE” redux, an outcome that would likely be bearish for the US dollar and possibly bearish for very long dated US treasuries, as the increase in budget deficits coupled with improvements in the growth outlook would lead to steeper yield curves. This outcome would be broadly positive for all the deep cyclicals and financials which in recent weeks have been taken to the woodshed.
The odds of this happening: Remember the scenes of Hank Paulson getting down on his knees in front of Nancy Pelosi? A few weeks before the 2008 presidential election, Speaker Pelosi obviously had little interest in bailing out a George Bush administration she considered corrupt. Obviously, things are much better now and it’s all love hearts, billets doux and hand-holding between the Trump administration and Pelosi. So we probably don’t have to worry about Treasury Secretary Steven Mnuchin having to go down on his knees before the speaker to get something approved…
- The US deals with the crisis by leaning heavily on MBS, and if MBS fails to hear (forget listening), by having him replaced. In days gone by—Iran in 1953, Guatemala in 1954, Chile in 1973—the CIA was adept at covertly pulling strings in to achieve the outcomes preferred by US policymakers (whether those proved the best outcomes for the US over the long run is another matter entirely). Of course, those were times when the CIA was not in open conflict with the US president. With this in mind, can the US really put that much pressure on MBS today?
Sure, the US may signal to MBS that, should he drive the shale oil industry into the ground, then Washington may no longer agree to sell Saudi Arabia all that top-notch US weaponry. But then, in this current game of winner-takes-all high stakes poker, MBS may well respond that if Iran goes to the wall, he won’t need to spend fortunes on military hardware any more. Alternatively, MBS could respond that should the US refuse to sell him weapons, he will buy them from China instead, with the currency he will have earned by selling oil to China in renminbi.
The odds of this happening: MBS will certainly come under pressure from within the Saudi power structure, and from the US. But it seems that he has been getting ready for this possibility by cleaning house around him. His decision to throw the brother of this father the king in the can will surely give pause to anyone within the Saudi power structure who might think of crossing him. In short, the pressure will be applied. But as long as MBS sits on the throne in all but name, this pressure may have little immediate impact on the oil price or on broader financial markets.
- Iran, being on the ropes, lashes out again as it did last year and bombs Saudi. Or Tehran could attempt to block the Straits of Hormuz in a bid to boost the oil price and give itself some breathing space. If the Iranians were to try to close the straits, and the oil price doubled back to US$60/bbl or even tripled to US$90/bbl, the interesting question would be the response of the US. Would the US Navy rush in to secure the seaways so that Europe, China and Japan could one again benefit from low energy prices? Or would the US Navy take its own sweet time before getting there? And if it did, how would Saudi Arabia respond?
The odds of this happening: Given that over the last 12 months we have seen both Iranian-sponsored attacks on Saudi oil facilities and implied Iranian threats to close the Straits of Hormuz, the probability of this scenario must be sizable, even if Trump’s decision to take out a senior commander of Iran’s Revolutionary Guard may have given Iranian leaders some pause. This would obviously be a negative development. Beyond the human suffering and the destruction of capital, wars also bring uncertainties and higher risk premiums. This scenario would be disproportionately bearish for Europe and Asia, and relatively more bullish for the US dollar and US assets.
- Trump decides to impose massive tariffs on oil imports from outside North America in a bid to protect the US oil industry, and not to lose Texas, Louisiana and Colorado in the upcoming election (imposing tariffs on Mexican and Canadian oil would be hard given the now re-worked USMCA). This could mean that while the international price for oil may be US$30/bbl, inside the US the price gets bumped up to US$45/bbl or even US$60/bbl.
In essence, this would be a tax on US consumers to ensure the survival of the US energy industry. This could be justified under national security reasons (“We can’t afford to go back to being dependent on those evil-doers outside North America). Or more cynically, the administration might attempt to justify it on environmental grounds (“We want to encourage people to use less oil by jacking up the price).
The odds of this happening: This may seem to be coming out of left-field but Trump’s entire track record appears to indicate that in a Trumpian view of the world there is rarely an economic problem for which tariffs aren’t the ideal solution. At the very least, investors should consider this possibility and be ready to act if such an idea starts to gain traction in Washington.
Of course, a world in which the Brent-WTI spread not only closes but aggressively reverses would likely create some disruptions for trading desks, while a higher cost of energy would be a new hurdle for the broader US industrial complex.
At the same time, a US government decision to create such a two-tiered market for energy would crush the US dollar as a number of energy producers—Russia? Saudi Arabia? The UAE?—would likely start to price their key export in currencies other than the US dollar—the euro? Renminbi? Gold? If so, this would likely mark the end of the post-Bretton Woods era, and the beginning of a new global currency regime. But the collapse of the US dollar, while harmful to a lot of financial investments (not least US treasuries) would likely be very beneficial for US industry, and the US rust-belt states. The weaker US dollar would return the oxygen that higher energy prices had taken away. The loser would be the US consumer, who would not only face a higher cost of energy, but also a higher cost of imported goods (given the weak US dollar).
We could go on, but readers probably get the drift. As things stand, markets have aggressively priced in the one scenario that is staring them in the face. This is the scenario in which Saudi Arabia and Russia continue their high stakes poker game, the US energy complex is the Poland in their conflict (the one who loses regardless who wins), the US government does relatively little (either because of divisions in Washington or ineptitude), the Fed is left alone to shoulder the burden, and US and global financials get killed by the friendly fire.
Undoubtedly, this is the highest probability scenario. But other scenarios do exist. And if any other scenario materializes, the rotations among different asset classes—bonds to equities, non-cyclicals to cyclicals, the US dollar to other currencies—could prove just as violent as anything we have seen in recent weeks.