Ukraine - Russia war likely to accelerate de-globalisation trend as risk of stagflation looms large

03 May 2022

When the dust settles, the consequences of the current Russian/Ukrainian conflict are likely to be with us for long after the politicians have withdrawn the troops and countries have started rebuilding efforts. Pre 2022, the decades old globalisation trend had already been showing signs of slowing, with domestic and global geopolitical drivers having an increasing influence on domestic trade policy.

The Russia/Ukraine conflict will fast track this de-globalisation trend.

We are likely to see the further de-coupling of global supply chains, which have been built up slowly over the past decades. Supply chain security will be an increasingly important consideration, even if at the expense of lower costs of production in faraway regions. Countries will start focusing on their own factors of production while reassessing their energy and sovereign security.

Energy security had, in many cases, been outsourced to other countries, often in the name of Environment, Social and Governance (ESG) friendlier green policies. Energy prices and policy are likely to remain a key pressure point and source of friction in the years ahead.

The lack of new greenfield investment in new replacement baseload hydrocarbon capacity, because of diminishing investor appetite from ESG concerns, has led to a dramatic fall in supply.

During Covid lockdowns, the supply and demand mismatch wasn’t immediately apparent as demand was artificially weak. However, as we emerged from Covid lockdowns and energy demand started recovering, prices have skyrocketed. Given the long-dated capital cycles required to stimulate new replacement capacity, absent of large demand destruction due to a global recession, this supply imbalance looks set to be with us for some time.

This theme of lack of investment in new greenfield capacity extends beyond just energy markets and affects the broader commodity complex.

After being punished by investors for their pro-cyclical capital allocation decisions in the previous commodity cycles, commodity companies’ boards have now swung to the other extreme and have been prioritising shareholder cash flow returns over new greenfield capacity expansion. This capital restraint theme has resulted in several commodities prices trading well above what one would consider their long run equilibrium prices and has led to a significant commodity price inflation push.

Globalisation over the past few decades had a global disinflationary impact as production shifted eastwards to take advantage of lower labour costs, loose capital allocation and state subsidies and support.

As we now unwind this theme, the reverse should hold true.

This onshoring of the factors of production will exacerbate the inflationary push beyond just the impact that we are seeing from higher commodities prices and energy.

This leaves central banks in a precarious position as they are now forced to tighten monetary policy in response to rampant inflation despite being very aware of the risky state of their economies’ recovery post Covid.

The risk of stagflation looms large.

Yield curve differences between long and short-term duration bonds have gone negative or ‘inverted’. Inverted yield curves have in the past been a reliable indicator of a looming recessions. Recent yield curve inversions have nailed bond investors ‘colours to the mast’ in terms of where they think economic growth is heading.

Finally, if the above is not enough, the withdrawal of quantitative easing (QE) during the quarter will only increase financial asset price volatility as this backstop of yesteryear is removed. The end of QE, together with rising global interest rates, will mean that financial conditions have and will continue to tighten considerably this year. Many past behaviours, such as growth without any regard for economic profit (which were previously being rewarded by financial markets awash with liquidity), will no longer attract the same level investor interest as the opportunity cost of capital increases. 

Investors may be forgiven for feeling somewhat ‘punch drunk’ given the numerous current uncertainties and macro risks.

However, we take comfort that while South Africa has many faults, many of which are of our own making, we currently find ourselves well positioned from a global and emerging market standpoint.

We are blessed with a rich endowment of natural resources in our commodities), that is allowing us to participate in the current commodity price cycle upswing. This natural resource ‘dividend’ is resulting in a strong terms of trade position and budget surplus, flowing through into rand strength versus the US dollar and other emerging markets.

On average, our listed companies have managed the Covid pandemic very well and have emerged with lean cost bases and balance sheets are not over extended and are now largely repaired. This leaves them well positioned to capitalise on the incremental improvement in economic conditions as the negative economic impact of Covid lockdowns wanes. Furthermore, our positioning at the foot of Africa also leaves us far from the current conflict zone, thereby increasing our relative attractiveness to foreign capital looking for a home in turbulent times.