Topics: China and the Russian invasion of Ukraine; full steam ahead for the Fed; the paths not taken
The bulk of this note is on China, Russia’s invasion of Ukraine and the surge in natural gas, oil, coal, electricity, wheat, copper, palladium and other prices which will probably drag Europe into recession, and impose a heavy growth drag on the rest of the world as well. But before getting into it, the chart below should hang in the offices of policymakers everywhere. Energy transitions are inherently slow moving, particularly when citizens of countries adopting them erect NIMBY barriers along the way (a topic we cover in this year’s forthcoming energy paper). As we have discussed often, capital spending by the world’s largest energy companies has fallen 75% from peak levels while global demand for oil, gas and coal are all at or above pre-COVID levels. Countries that reduced their supply of thermal energy at a much faster pace than they reduced their demand are paying a very stiff price for that right now. We expect some about-face movements on this in the days ahead.
After issuing an Executive Order banning new oil and gas leases on Federal lands, Biden is now reportedly considering a trip to Saudi Arabia to ask for more crude supply (Source: Axios), his team already visited Venezuela to do the same, and the administration is engaging in “outreach” to the oil and gas industry. Wow.
China and the Russian invasion of Ukraine
In this note we examine the latest on China’s economy and markets. First, comments on China’s connection to the war in Ukraine since its financial and energy decisions may dilute the effectiveness of sanctions on Russia:
Energy. As shown below, Europe and China are large importers of energy while Russia is a large exporter. So far, Russian gas exports to Europe are only down 15% from 2021 average levels (2nd chart). But if Europe permanently reduced exposure to Russian gas, China could step in over the next decade. The Power of Siberia expansion and Sakhalin projects could eventually add ~80 bcm per year to Russia’s gas exports to China, compared to its gas exports to Europe which have averaged ~190 bcm per year since 2017
Trade. Since Russia’s invasion of Crimea in 2014, Russian-Chinese trade has risen by 50%. Russia is now Beijing's largest recipient of state sector financing, securing 107 loans and export credits worth $125 billion from Chinese state institutions
Currency. China and Russia began using their own currencies to settle bilateral trade in 2010 and opened a currency swap line in 2014, sharply reducing reliance on the US$ for bilateral trade (3rd chart)
Payments. While China’s Cross-Border Interbank Payment System is mentioned as an alternative to SWIFT, it only processed 13,000 transactions per day in Q4 of last year compared to 41 million per day for SWIFT
UN. I’m not sure it matters, but China abstained from condemning Russia at the UN
As a reminder of how China’s geopolitical lens often differs from the West, since 2010 it has been North Korea’s almost sole trade counterparty (4th chart). We searched through all 40,000 bilateral trade combinations in the world and there is none as high as North Korean trade reliance on China
Before we get further into China, some comments on “shock treatment” plans advanced by the IEA to wean Europe off of Russian energy. It is VERY ambitious:
“Diversify gas suppliers”? That may drive prices up by narrowing European supply but not global demand. Also: 80% of US LNG is already going to Europe (and as discussed last week, is sold at high spot market “TTF” prices). The next major wave of US LNG liquefaction facilities is not coming online until 2025, and much of this capacity is already contracted as is usually the case since developers need such contracts to finance construction. In Europe, it will take time for completion of any new German LNG import facilities and to improve connectivity between Spain’s LNG import facilities and the rest of the continent
“Accelerate wind and solar”? European wind and solar MWh have been growing at just 1% per year since 2000; bottlenecks are often transmission and interconnection queues. Furthermore, electricity represents just 19% of European final energy consumption. In other words, Europe can decarbonize the grid more rapidly but the region would still be heavily reliant on thermal energy (oil, gas, coal) for industrial production of cement, glass, bricks, steel, ammonia, plastics; and for transportation and building heat
“More heat pumps for residential heating”? European electrification of residential heating is unchanged since 2013 at 25% of residential energy consumed. These are very slow-moving transitions; heat pump adoption is confined so far mostly to Scandinavia whose adoption rates are 9x the rest of Europe
“Maximize nuclear power”? Oh, the irony. In any case, European nuclear plants already operate at 80% capacity factors with much of the residual unavailable due to maintenance downtime (US levels are ~90%)
As shown below, Europe’s energy reliance on Russia is too high to reduce quickly. A decline in European energy costs is mostly dependent on (a) resolution of the Ukraine conflict, (b) the large 2.5x seasonal drop in gas demand in March/April and (c) an end to US/EU oil and gas buying for strategic reserve purposes.
In any case, what is going on in China? As usual, that’s a question that has to be triangulated
I often read that China has a zero COVID tolerance policy but I’m not sure what to make of this. As shown below, China’s reported COVID mortality rate is just 2% of South Korea, Singapore and Japan levels. Once you strip out people that reportedly died in Hubei province, the official COVID mortality rate in all of China outside Hubei is just 0.05% of its Asian neighbors. It’s hard for epidemiologists to cross check by looking at “all-cause” excess deaths in China, since China is the reportedly only place in the world other than Greenland and the Spanish Sahara (the area between Morocco and Mauritania) that doesn’t report this data on a regular basis1.
Second, a lot of high frequency economic data in China is almost back to normal. In other words, whatever COVID measures China has adopted, much of its economic activity is close to pre-COVID levels including electricity and coal consumption, steel output, road travel, rail travel and home sales. Only domestic air travel and movie theatre receipts show signs of much lower mobility.
Of course, the other challenge regarding China analysis is that not that many people are allowed to go there right now. As a result, we have to rely on triangulated data to draw our conclusions.
The next three charts show our China activity monitors separated into positive, stable and negative signs. The 5.5% GDP growth target just announced by China’s National People’s Congress will likely require some additional fiscal stimulus to meet (this GDP growth target is 1% lower than targets for 2019-2021). The third chart may not change anytime soon: the Chinese gov’t reiterated its stance that “housing is for living in, not speculation”.
For equity investors: China has performed poorly in 2022 so far, in-line with the selloffs in other major regions this year in spite of stabilizing economic and profits data. The primary reason: despite the war, markets still expect substantial Fed tightening this year (and so do we). While abstract rules can diverge from Fed decisions, the last chart below from JP Morgan Economic Research shows the rising pressure on the Fed to act in 20222.
Bottom line: we have not seen the worst of the current war, or stock market levels just yet.
The Russian invasion of Ukraine, military balances and paths not taken
On our webcast last week we discussed 1,000 years of Russian totalitarianism and the window during the 1990’s when Russia was geopolitically weakened that coincided with NATO’s eastward expansion. Factors driving that brief period: Russia’s sovereign debt default, oil prices collapsing to $10 per barrel and the disintegration of Russia’s foreign exchange reserves, current account surplus and currency. In the late 1990’s, Russians were already anxious for change back to the old ways, and NATO understood this risk very clearly:
“…the inclination to the authoritarian forms of government is not limited by the ruling elite only. Diverse social groups are more and more actively revealing their interest in authoritarianism”
“the notion of enlightened, liberal, civilized and tame authoritarianism in Russia where there are such strong and deep historical traditions will hardly work…if society does not resist authoritarianism, the present authoritarian forms of government will acquire a much more brutal and despotic character”
“Authoritarianism in Russia: Dangers for Democracy”, A. Galkin/NATO Office of Information and Press, 1999
Around the same time, there were warnings against NATO expansion from George Kennan and from 50 US foreign policy experts, politicians and retired military officers who signed a letter entitled “Opposition to NATO expansion”. Signatories included Bill Bradley, Gary Hart, Sam Nunn, Paul Nitze (Secretary of the Navy), Stansfield Turner (Navy Admiral, commander of Second Fleet, Supreme Allied Commander NATO Southern Europe and CIA) and Robert McNamara (Secretary of Defense), who by then had realized the mistakes the US made during the Vietnam War.
Was there a path that might have prevented the destruction of Ukraine? One might have been “Finlandization”, and the other might have been a path to NATO membership with explicit military protection along the way. Last November, the US and Ukraine signed a “Charter on Strategic Partnership” that asserted US support for Ukraine’s right to join NATO, but with no protections. Neither path was taken, and now 90 years after Stalin imposed the Holodomor terror-famine on Ukraine which killed 4 million people3 , Russia is destroying Ukraine again. At this point, in addition to the bravery of its defenders, the only thing that might preserve an independent Ukraine is the “protection of divine Providence”, requested by Thomas Jefferson in the US Declaration of Independence in 1776.
1 "Beijing is intentionally underreporting China's COVID death rate", George Calhoun (Forbes), January, 2, 2022
2 "A series of hikes coming, but carefully not steadily", M Feroli, JP Morgan Economic Research, March 3, 2022
3 Outside aid was rejected and Ukrainian food supplies were confiscated, leading some scholars to believe that the famine was deliberately imposed by Stalin to eliminate the Ukrainian independence movement.
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2 "A series of hikes coming, but carefully not steadily", M Feroli, JP Morgan Economic Research, March 3, 2022
3 Outside aid was rejected and Ukrainian food supplies were confiscated, leading some scholars to believe that the famine was deliberately imposed by Stalin to eliminate the Ukrainian independence movement.
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The views, opinions and estimates expressed herein constitute Michael Cembalest’s judgment based on current market conditions and are subject to change without notice. Information herein may differ from those expressed by other areas of J.P. Morgan. This information in no way constitutes J.P. Morgan Research and should not be treated as such.
The views contained herein are not to be taken as advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.
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China and the Russian invasion of Ukraine
The bulk of this note is on China, Russia’s invasion of Ukraine and the surge in natural gas, oil, coal, electricity, wheat, copper, palladium and other prices which will probably drag Europe into rec
FEMALE VOICE: This podcast has been prepared exclusively for institutional wholesale professional clients and qualified investors only, as defined by local laws and regulations. Please read other important information which can be found on the link at the end of the podcast episode.
[Music]
MR. MICHAEL CEMBALEST: Good morning. The bulk of this week’s note is on China, Russia’s invasion of the Ukraine, and the surge in natural gas, oil, coal, electricity, wheat, copper, palladium, and all the other prices which are going to drag Europe into recession and probably impose a heavy growth drag on the rest of the world, as well.
Before getting into all that, there’s a chart here that should hang in the office of policymakers everywhere. Energy transitions are really slow moving, particularly when citizens of the countries adopting them erect NIMBY barriers along the way. The chart shows just how quickly over the last 20 years smart phones, Ubers, broadband, internet access, social media, things like that skyrocket quickly. Wind and solar share of global primary energy consumption is still 4% and EV shares of global vehicles owned are still around 1.5 to 2%.
The point is that countries that reduce their supply of thermal energy at a much faster pace than they reduce their demand for thermal energy are paying a very stiff price for that right now. We expect some about-face movements on this in the days ahead, but as we’ve discussed often, capital spending by the 1,200 largest energy companies in the world has fallen 75% from peak levels while global demand for oil, gas, and coal is unchanged.
So, if you do not have a synchronous match between your decarbonization of demand and decarbonization of supply, you can experience what’s going on in Europe this morning which are unimaginable large increases in all sorts of energy-related prices.
Why are we writing about China this week? Well, China’s connection to the war in Ukraine is important to watch because a lot of its financial and energy decisions may dilute the effectiveness of sanctions on Russia. There’s a chart in here showing that Europe and China are the two large importers of energy in the world, while Russia, of course, is a large exporter. The US is kind of in balance.
So far, Russia’s gas exports to Europe are roughly unchanged from where they were last year, so if Europe decided to reduce exposure to Russian gas, China could step in gradually over the next decade. There are some projects in Siberia, in Sakhalin which could add almost half of what Russia currently sells and exports to Europe in terms of gas.
Russia has expanded its trade with China. Russia is now China’s largest recipient of state-sector financing. The countries began using their own currencies to settle bilateral trade. China has created, it’s still in its infancy, but they’ve created a cross-border inter-bank payment system to compete with Swift, and they also abstained from condemning Russia at the U.N., although I’m not sure how much that actually matters.
The bottom line is that it’s very important to watch China here because we think that it’s going to do a variety of things that will dilute the effectiveness of sanctions on Russia, in which case the war could be prolonged. Just as a reminder of how China’s geopolitical lens often differs from the West, over the last decade it has been North Korea’s almost sole trade counterparty. We searched through all 40,000 possible bilateral trade combinations in the world and there’s none of them as high as the North Korean trade reliance on China.
Before getting into some of the China issues, we do comment in this week’s piece on the shock treatment plan advanced by the International Energy Agency to wean Europe off of Russian energy supplies; it’s very ambitious. Ambitious is a synonym for probably not workable. Diversifying gas suppliers, well, the next major wave of US LNG export facilities isn’t coming online until 2025. A lot of that capacity is already contracted since you need to do that to finance construction.
Europe may agree to build and interconnect some new LNG import facilities; that takes a lot of time. Accelerate wind and solar; well, wind and solar megawatt hours have been growing at 1% a year in Europe since the year 2000, and electricity also represents just 20% of overall energy consumption. So, even if they decarbonize the grid more rapidly, Europe would still be heavily reliant on oil, gas, and coil for industrial production of cement, glass, brick, steel, ammonia, plastics, and for transportation and building heat.
We walk through some of the suggestions the EIA made as well. The bottom line is that Europe’s energy reliance on Russia is way too high to reduce that quickly. Any decline in energy prices is probably going to require some kind of resolution of the Ukraine conflict, and the large seasonal drop in gas demand that typically takes place in March, April, that’ll probably help the most. Then an end to the US and Europe that are now buying oil and gas for strategic reserve purposes; that will run its course, as well.
As for what’s going on in China, that’s a question that has to be triangulated. I often am told by colleagues and in research pieces that China has a zero tolerance policy for COVID. I’m not sure exactly what to make of that.
First, I don’t find the COVID data, I’m not alone here, but I don’t find the COVID data reporting China to be in any way credible. If you accept China’s officially reported data the COVID mortality rate would just be 2% of the levels reported in South Korea, Singapore, and Japan, and then if you stripped out the people that reportedly died in Hubei province, the official COVID mortality rate in China outside Hubei is 0.05% of its Asian neighbors.
I don’t find that credible, and it’s very hard for epidemiologists to cross-check by looking at something called all-cause deaths in China, because China is the only place in the world other than Greenland and the Spanish Sahara, which is the area between Morocco and Mauritania, that doesn’t report excess death information on a regular systematic basis.
Second, and probably more importantly, a lot of the high-frequency data in China is almost back to normal, so whatever COVID measures they’re adopting, a lot of its economic activity is pretty close to pre-COVID levels. So, we have a chart in here that shows electricity, coal consumption, steel output, road travel, rail travel, and home sales. The only things that are showing real COVID-related mobility reduction still are domestic air travel in China and movie theater receipts. But for the most part, whatever this COVID policy is, it’s leaving room for plenty of activity in both goods and services.
When we look at our China activity monitor, the data looks pretty good outside of residential commercial construction. Steel production, exports, industrial production, construction, corporate earnings, are all either rising or stable. The Chinese government just announced the 5.5% growth target for this year. They’ll need some additional fiscal stimulus to meet that, but so far the Chinese economy has been weathering the storm recently better than a lot of other places have.
Now, for equity investors, China has performed poorly so far, in line with the sell-offs and all the other major regions, in spite of the stable economical and profit data. The primary reason for that is despite the war the markets are still expecting substantial fed tightening this year, and unfortunately, so do we.
While these abstract rules on what the fed policy rate should be sometimes diverge from fed decisions, right now all of those rules are pointing to the need for a funds rate that’s much higher than what it is now. The markets are now pricing in six to seven hikes over the next year. I think that’s about right; maybe it’s five at the minimum, seven at the maximum. But we are going to see for the first time in a long time the federal reserve hiking rates in the middle of a war, and a spike in all sorts of commodity-related prices.
As a result, I don’t think we’ve seen the worst of the current war or stock market levels just yet. It’s going to be very difficult to time the bottom, but it does seem like there are more difficult days ahead given the deleveraging and risk offloading that’s taking place.
Thank you to those of you that dialed into the webcast last week. We had about 15,000 people participating globally. We talked about a lot of the issues we already talked about today, but we started with a discussion of 1,000 years of Russian totalitarianism and that brief window during the 1990s when they were weakened geopolitically because of the collapse in oil prices, the debt default, and the disintegration of their currency in foreign exchange reserves.
Around that time there were plenty of warnings against NATO expansion and we discussed some of them on the call last week, and at the end of this week’s note we follow up with just a little more of an exploration of some of the paths that might have been taken to prevent the current destruction of Ukraine. Nothing’s for sure, and nobody knows whether or not these things would have worked or not.
Here we are 90 years after Stalin imposed a terror famine on the Ukraine deliberately which killed several million people, and the Russians are destroying Ukraine again. So, it’s very possible that there’s nothing that could have been done to prevent what’s currently happening in the Ukraine. But at the end of this week’s note we do examine some of those paths and what they might have been.
So, I’ll be writing and speaking more frequently now as we go through all of this so that all of our clients are aware of our best and current thinking. Thank you for listening.
FEMALE VOICE: Michael Cembalest’s “Eye on the Market” offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of JP Morgan Asset and Wealth Management.
Michael Cembalest is the Chairman of Market and Investment Strategy for JP Morgan Asset Management, and is one of our most renowned and provocative speakers. For more information, please subscribe to the “Eye on the Market” by contacting your JP Morgan representative. If you’d like to hear more, please explore episodes on iTunes or on our website.
This podcast is intended for informational purposes only and is a communication on behalf of JP Morgan Institutional Investments Incorporated. Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation. Outlooks and past performance are never guarantees of future results. This is not investment research.
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