Déjà vu?

Executive Summary

Forecasting often is an exercise in pattern recognition. In order to properly asses the market’s response to policy initiatives, economic and political disturbances, it’s helpful to go back in history and find a similar event, and see how the market responded. We find this current environment reminiscent of the 1970s in three key similarities, and as such, explore how events unfolded decades ago in order to gain some insight as to what might happen today.

The first of these similarities is a major shift in the Federal Reserve’s approach to monetary policy, in essence, abandoning their previously stated objectives. In 1971, that shift was the Federal Reserve’s delinking the dollar’s value from gold via the suspension of the 1994 Bretton Woods Agreement. That change brought about a period of high inflation and high unemployment – a miss on the Fed’s dual mandate. Last August, Fed Chair Jerome Powell introduced the idea of the Fed implementing a new framework when trying to achieve their dual mandate. Thus far, they are failing on the inflation front.

The second similarity is in the energy market. Environmental policies in the 1970s led to the enactment of price controls and various other restrictions that increased the cost of producing fuel domestically. This shifted the market share to foreign producers and left US energy consumers beholden to the prices imposed by those foreign producers, such as OPEC. Much of that is similar to today’s energy landscape where we are seeing ever-increasing energy prices and are increasingly relying on foreign production.

The final similarity is evident in current geopolitical events, such as the Russian invasion of Ukraine. In the 1970s it could be argued that the US experienced a decline in our reputation as a ‘global policeman’ that emboldened our enemies to more openly challenge the US. This is evidenced by unpopular wars and the expansion of communist agenda with events such as the revolution in Grenada, the Angolan Civil War and the Iran Hostage Crisis. The invasion of Ukraine, in addition to recent exercises in Asia such as missile launches in North Korea and China’s presence in the South China Sea signal to us that we may be in in similar times.

The impact of these events on investment portfolios is quite clear; asset prices in Russia and Ukraine are down 53.32% and 49.97% respectively, year to date. The next logical region to be impacted by Russia are the former Soviet states and the CIS, next will be Europe, and then the US. War is bad for everyone. If Russia is successful, it would be reasonable to expect other countries to step up and challenge the US and democracy. History has taught us that the length and severity of the negative impacts of conflict are entirely dependent on our response to the crisis. Where we go from here is entirely up to us. The end of the 1970s ushered in the era of deregulation and a restoration of the US’s global standing as the enforcer of peace and democracy with the election of Ronal Regan. While we face a unique challenge with the tail end of the Covid-19 pandemic, history has taught us that a strong response to those that challenge the US’s model for global peace and prosperity may lead to better outcomes for our investment portfolios. Thus far the Biden Administration has chosen a different path. Time will tell whether it was wise to bring an economic sanction to a gunfight.

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An issue that confronts all of us is how to forecast the market’s response to policy initiatives, economic and political disturbances. One approach is to look back at instances where similar disturbances have occurred, and with that information we can get a sense of what the market response will be. When multiple disturbances or policy initiatives coincide, the look back becomes a bit more complicated – it’s difficult to find episodes that replicate a combination of events. But in those instances where we’re able to find historical events that fit the current environment, it can generate a sense of Déjà vu. These days, we find ourselves in that situation. As investors, we look to the past in order to help us position our portfolios for the future, and these days, the future looks a lot like the 1970s.

Here are some key similarities:

• In 1971, the Nixon administration suspended the 1944 Bretton Woods Agreement, dissolving the dollar’s link to gold, and launching the Fed into a new era of monetary policy. The Fed abandoned the gold exchange standard, devalued the dollar, and allowed it to float. In addition, the Fed began targeting the quantity of money with disastrous results – high inflation, high unemployment, and low GDP growth. More than 50 years later, we are seeing similar events. Based on Fed Reserve Chairman Jay Powell’s speech at the Kansas City Fed last August, he too appears to be embarking on a new era of monetary procedures, and subsequently, the US has experienced an increase in the underlying inflation rate not seen in decades.
• In the 1970s, the US’s credibility as the ‘global policeman’ was severely tarnished with unsuccessful and unpopular wars in Vietnam and Afghanistan. The dramatic pictures documenting the chaotic exit of these conflicts may have given the world the impression of a weak and defeated United States – a view that may have emboldened our adversaries to test the US resolve. In the last 18 months, we have seen an increase in the testing of that resolve from our global adversaries with the crisis in Ukraine, the military exercises in the South China Seas, and regular test missile launches in North Korea.
• Environmental policies during both the 1970s and today led to the enactment of price controls and other restrictions that limited and increased the costs of extracting a variety of fuels. The policies effectively reduced the availability of substitute fuels and inadvertently channeled the incremental demand for energy to foreign energy producers. These policies benefitted the foreign producers in two different ways: One being the increased volume of US imports. The other was that the policies reduced the elasticity of demand (meaning as consumers of oil, we had less flexibility) and thereby enhanced the market power of the exporting countries, which they eventually exploited.

The combination of these different policies generated a toxic economic environment for the US and the global economy. The dollar devaluation and the targeting of the money supply combined with the disastrous regulatory tax and price control policies put the US in a delicate position. These policy changes simultaneously enhanced the economic hand of our adversaries, which they proceeded to play much to their benefit when the opportunity arose. One memorable example is the OPEC cartel. The OPEC cartel flexed its muscles through an oil embargo and corresponding price increase. The energy shortage led to rationing; those who were around remember the gas lines of the 1970s. All in all, the embargo and US policy mistakes led to a US recession and a double-digit US inflation rate.

On the international front, the situation was just as bad. It seemed that the fall of Saigon, the economic malaise, and our flawed policies encouraged our enemies to challenge us, and they did so with some success. In the loss of Vietnam, we were losing a friendly country without gaining any allies to our side. The US was being challenged and, in some cases, humiliated by its enemies while losing friends left and right. Recall the Iranian Hostage Crisis and the failed rescue attempt. There was the beginning of the Angolan Civil War, the revolution in Grenada, the uprising in Nicaragua, and many other parts of the world where the Soviet presence and influence were growing.

As we closed out the decade of the 1970s, the economic and political outlook was a bleak one. While some analysts and politicians argued that the US decline was inevitable, not everyone agreed with that view. One presidential candidate argued that it did not need to be that way. He ran on a platform based on a strong dollar, a strong defense, low tax rates, low regulations, and freer trade. The voters liked what they heard and elected him President of the United States.

President Reagan implemented much of his agenda and fought a successful two-front war. One front was an economic one. Once the lower tax rates were implemented the US economy took off. The lower regulation also worked and fueled economic growth. The reversal of oil and energy price controls also led to a resurgence of domestic production and a collapse of energy prices. The Reagan policies significantly weakened the OPEC cartel, inflation subsided, and economic activity surged.

On the foreign policy and national defense side, President Reagan also ramped up the pressure. The US embarked on its famous Strategic Defense Initiative, SDI or Star Wars. The US Navy was expanded and moved to the targeted 300-ship Navy. The US not only built up its armed forces, but it also showed that it was willing to flex its military muscle – think Grenada, the Gulf of Sidra, the bombing of Ghadaffy’s tent, the monetary and military aid of the national forces fighting the evil empire in Angola and Latin America, as well as providing surface to air missiles (SAM) to the Afghan rebels.

In short, President Reagan challenged the evil empire both economically and militarily. As the USSR attempted a response to the challenge, the Soviet economic system could not deliver economic improvements and global domination. The Reagan policies bankrupted the Soviet Union and eventually, the iron curtain was dismantled. President Reagan’s policies cured the US malaise and reversed the steady loss of allied countries experienced during the 1970s.

The parallels between the 1970s and now give us a sense of Déjà vu. But we know that it does not have to be this way. The 1980s showed the way. The policies adopted then led to the collapse of the global inflation rate and the demise of OPEC and the Evil Empire. Our discussion suggests that we are at the proverbial fork in the road. The issue facing us today? Which path are we going to take? This critical juncture will determine whether the next few years will be more like the 1970s or the 1980s.

Using the energy market of the 1970s as a case study will provide us with several guideposts that will help us determine the path that the US and its allies will take. That in turn sets the stage for the portfolio adjustments that we may need to make in order to outperform our benchmark and protect our assets.

The effects of past US energy policies

During the 1970s I wrote an article later published in the Oil and Gas Journal.  Here is part of what I said:

Ironically, until recently the US response to OPEC, from price controls to emphasis on supply-restricting “conservation” such as limiting offshore drilling, have enhanced OPEC’s monopoly power. The result was a higher world price for oil and refined products and a larger net transfer of wealth to the foreign oil producers.

……. Price controls preclude increasing domestic oil production beyond the point where the marginal production cost equals the ceiling price, irrespective of the world price….

There are two important implications of this suppression of domestic supply. First, both the price at which the US becomes a net importer and its dependence on foreign oil increase. More important the oil import elasticity (the sensitivity to oil imports to changes in price) declines. This means that for a given rise in prices imposed by OPEC, demand for its product declines by a smaller amount than it otherwise would. Price controls on US production, therefore, enhance OPEC’s power, raising the world price….

The statement above might seem dense in economic jargon, but the basic premise is this: if a government implements a price cap, domestic producers will stop production once the cost of producing an additional barrel of oil is the same as the price cap – that’s the point at which they cease being profitable. This causes domestic production to go down, which in turn causes foreign producers to pick up market share. Add to this, environmental policies that further restrict production, and foreign producers pick up even more market share. This then feeds a vicious cycle where oil prices and our need to import oil spiral higher, diminishing the US pricing power in the global oil market.

 In a similar way, environmental controls strengthened OPEC’s power over the price of oil and refined products. Restrictions on acreage available for exploration have curtailed domestic production as well. Moreover, environmental controls that limit the use of high sulfur oil limit the flexibility of US importers in obtaining oil. Similarly, constraints on the production and use of coal and nuclear power have suppressed the supply of alternatives to oil.

All of these effects act to increase the level of imports and reduce the elasticity of demand for imported oil, magnifying the negative effects of oil price controls.

The parallel: Today’s energy policies

The previous quotes, written several decades ago, with minor modifications are as vital today as they were then. Today the spirit of the environmental and regulatory policies that led to the creation of OPEC and the subsequent embargo is alive and well both in the US and other countries and regions of the world such as Europe and in particular Germany. The western economies’ Green Energy policies have had an effect similar to the policies enacted during the 1970s. Then like now, the policies had the effect of diverting the demand for energy away from fossil fuels and towards what we consider to be environmentally friendly fuels.

The poster child is a country like Germany that decided to shut down its nuclear and most of its fossil fuel-based energy generating facilities. However, the green-based generating facilities were not enough, and the domestic supply had been decommissioned. As a result, the incremental demand for energy has to be satisfied through imports and hopefully the “cleanest” sources of fuel, i.e., natural gas. Simply put, Germany’s energy policies have simultaneously reduced the country’s flexibility, or demand elasticity, and increased Germany’s dependency on Russian oil and natural gas. Therefore, incremental demand increases result in a higher global energy price and a transfer to the                oil- producing countries, such as Russia and OPEC, among others. Hence as long as the Russians continue to export energy, the higher price will continue benefitting Mr. Putin and make it easier to finance its adventurism.

The US is contributing to the energy conundrum. On his first day in office, President Biden issued an executive order canceling the Keystone Pipeline. The administration also limited drilling in federal lands and further limited the emission of carbon dioxide and other pollutants, reducing the overall supply of carbon-based energy sources. The impact of these policies on US energy production was swift, within a year, the US switched from being energy independent to being a net energy importer.

The Build Back Better economic platform of the Biden administration identifies the environment as one of the administration’s designated “existential crises” of our time. The conclusion of our analysis is that the government policies have increased the demand for foreign energy sources while simultaneously reducing the import elasticity of demand for energy. The net effect is that these policies make energy importing economies like the US and Germany more vulnerable to an adverse energy shock. In addition, these policies are a potentially enormous wealth transfer to energy exporters, such as Russia and Saudi Arabia.

The parallel: The challenge to the US hegemony

The memory of Vietnam and its aftermath suggests to us that the Afghanistan withdrawal could be interpreted by our rivals as having weakened the US resolve and its support for allied countries. Also, to the extent that the energy policies of the western world have created an environment where increases in the demand for energy are being funneled to OPEC, Russia, and other oil-exporting countries. These policies make the Western World much more vulnerable and susceptible to an energy embargo.

As the global economy recovers from Covid-19, combined with the Green Energy policies of the western world, the increased demand for energy has resulted in a large increase in oil prices. The Green Energy policy also induced decreased elasticity of demand. All of this suggests that the increased demand resulted in even higher prices and a larger wealth transfer from the oil consuming countries to the oil producing countries.

The increased resources garnered by the oil producing countries and the economic vulnerability of the oil importing countries may have emboldened Russia and other oil exporting countries to challenge the regional and or global hegemony of the US. In the process these countries may be attempting to redress what they perceive to be unsettled grievances. Looking at the political and economic situation from an equity markets perspective, Russia has been underperforming the global economy, see Table 1. While the global economy’s net worth and/or asset values were rising, the Russian stock market posted negative returns for the 10-year period ending in 2021. The deteriorating economic situation may have altered the Vladimir Putin risk return calculation that triggered the Russian invasion of Ukraine. The question is, how will this play out and what are the investment implications of the Russian offensive actions? If our parallel is correct, US adversaries may sense weakness in the US economy and or political system, and seek to test the US.

Another issue to consider is the Budapest Memorandum of 1994 in which the US, UK, and Russia offered security assurances to Ukraine in exchange for Ukraine’s divesting of its nuclear weapons. Think of the countries with known or undisclosed nuclear programs. In particular, we have in mind the current negotiations with Iran. It does not take a rocket scientist to conclude that given the Ukraine experience, going forward a country will be less willing to give up its nuclear ambitions or weapons. Our reticence to support Ukraine and punish the Russians in a more aggressive manner has clear and negative long-term implications for the west.

 The global equity markets

The resources spent attacking and defending Ukraine will not produce an expansion of the global economic pie. Viewed from this perspective the invasion of Ukraine is a negative sum game; the global economy will be worse off. If one is willing to attribute the global performance to the Russian saber rattling leading to the invasion of Ukraine, then the information presented in Table 1 is consistent with our interpretation – the Ukraine and Russia both posted the worst returns out of their global cohort.

Let us begin by setting up a reference point – the performance of the global economy. During the 3-years spanning the COVID19 pandemic, the global economy posted a positive asset appreciation. Although positive, during the previous year the rate of appreciation decelerated to 3.695% from 11.667%. The deceleration has morphed into global assets declining 10.081% during the calendar year, i.e., YTD. The data is consistent with our view that the Ukraine invasion is a global negative sum game.

The invasion and occupation of Ukraine are quite bearish for obvious reasons. The Ukrainian people will be worse off as a result of the destruction of human and physical capital that the Russian invasion will bring about. The prospect of prolonged Russian occupation and a corresponding loss of economic and political freedom does not bode well for the country’s well-being. A successful Russian campaign also leads to a bleak outlook for the country and the region. Mr. Putin would like to have these economies return to the Russian sphere of influence.

Needless to say, it seems reasonable to conclude that Ukraine will bear the brunt of the Russian invasion and as such we expect Ukraine to be one of the major losers of the invasion. The data reported in Table 1 suggests that the market has already incorporated some of the negative effects of the Russian invasion on the former satellites. The data reported in Table 1 shows that Ukraine’s asset prices have declined more than 40% in value. The magnitude of the decline measured at different intervals (MTD at 44.175%, 3MTD at 49.784% and YTD at 49.967%) suggests that the bulk of the declines has occurred within the last month, reflecting the impact of the Russian invasion. The impact on the former satellites as measured by the Eastern European Emerging (EM EASTERN EUROPE ex RUSSIA), and Frontier Markets (FM CENTRAL & EASTERN EUROPE + CIS), point to a decline in the equity markets in the 20% range (20.631 and 21.361 respectively) or about one half of the impact on the Ukraine markets. Keep in mind that these countries are members of NATO and any incursion into these countries will trigger Article 5 and that significantly raises the cost of a Russian incursion. The impact of the Russian invasion on developed continental Europe, i.e., developed Europe is about half of the impact of that of former satellites.

The bearish sentiment extends to other parts of the global economy. The logical candidate here is the European region. The countries in the region are highly dependent on Russian energy. The dependency hurts these economies in two different ways, one is the wealth transfer as energy prices rise. The other is that these countries will now be vulnerable to an embargo that could easily cripple their economies. Although we contend that the Ukraine invasion makes the world worse off, the deterioration is not uniform across the regions. Our analysis suggests that the former USSR countries and the European countries dependent on Russian gas and oil are more vulnerable than other countries in the world. These economies do not face a threat of invasion and occupation nor are they as dependent on Russian oil and gas. Hence even though their stock market will decline, the non-satellite and non-European countries will not decline as much as the European and former satellite economies.

Other regions of the world are not as dependent on Russian oil as is Europe. However, the oil market is a global marketplace and any supply disruption, irrespective of its location, will lead to an increase in global energy prices, and in turn, will have a negative impact on oil importing countries. The data reported in Table 1 supports our hypothesis of the negative impact. Notice also that the magnitude of the decline in asset prices is about one half of the decline in developed Europe.

The previous results lead to an interesting interpretation of the data. The only adverse impact on the non-European oil importing countries will be the impact of higher energy prices. Within Europe, there are various degrees of adversely impacted countries. The least impacted countries will be developed Europe; these countries do not enter the Russian rebuilding of the USSR and thus pose a lower threat of invasion. Next in line are the former Soviet Union satellite countries. While they are part of Mr. Putin’s long-term dream, they are also a member of NATO and an attack on them will trigger Article 5, making it a less likely event than the invasion of Ukraine.

In the case of an embargo or sanctions, some countries will clearly benefit or suffer smaller losses than the rest of the world. One group of winners will be the economies that will help Russia evade the sanctions imposed on Russia. For geopolitical and economic reasons, China is a logical candidate; it could become an outlet for Russian oil and gas and this way satisfy its energy needs while helping Russia and thus keeping the US occupied outside its sphere of influence. The data shows that China is the one country experiencing the largest improvement in relative performance between the YTD and 1-Year differential performance.

Other likely winners in the dispute will be the energy exporting economies. The data reported in Table 1 shows that the Emerging and Frontier Gulf Countries are posting positive year-to-date returns. The Russian equity markets significantly underperformed the world during the last three years, -17.961% versus 11.667%, suggesting one possible reason for the Russian adventurism, to change the narrative at home and expand its empire. But our interpretation of the data lends support to our zero-sum game. More importantly, the data does not suggest that Russia will be better off. In fact, the data points to a better than 50% decline in asset values of the Russian equity markets, MTD at 48.624%, 3MTD at 54.809%, and the YTD at 53.318%. In spite of the surging energy prices and corresponding wealth transfer to the Russian economy, the deterioration of the equity markets suggests that things will not go well for the Russian economy. But will Russia be better off? To be better off, the gains from annexing part or all of Ukraine and or restoring the old Soviet Union have to be balanced against the cost borne by Russian adventurism. Whether the balance is positive we do not know yet. What we can establish is that based on the West’s response to the invasion, i.e., the imposition of sanctions will fall squarely on the publicly traded liquid assets. Given that the liquid asset of publicly traded companies is a fraction of the economy, the publicly traded liquid assets will bear the brunt of the sanctions. Hence, we expect the Russian equity markets’ underperformance of the global equity markets to accelerate.

Will Russia’s action embolden other countries to challenge the US?

A cynic would argue that much of the joint US and NATO response to the Russian invasion of Ukraine had their tacit acquiesce. For example, President Biden categorically stated that no US personnel would be directly involved in the conflict. NATO did not issue a similar pronouncement, but its actions were consistent with President Biden’s Statement. Did the announcement of no military personnel give Russia a green light? Further arguments in support of this view are the fact that the economic sanctions did not initially include SWIFT, nor did they stop the flow of hydrocarbons to Europe. Did the US cede leadership to Germany, did NATO have veto power over the US decisions? Some in the press argue that the US showed leadership and that our prestige has risen in the eyes of the world. But there is a counter argument. Take the case of Ukraine and the Budapest Memorandum of 1994. What signal does the Russian invasion, and the West’s response say about guarantees to nuclear countries that give up their nukes? The agreement does not seem to be worth the paper it was written on. The invasion will clearly strengthen the resolve of those countries not to give up their nukes. Then there is the recent press conference in which President Biden said that no one expected the sanctions to deter the Russian invasion. Also, the admission that it will take time before we determine the impact of the sanctions, whether they worked or not. The point of all this is that the US and NATO response will weaken the resolve of our allies while emboldening our adversaries. A bearish outlook.

One unexpected surprise is the US stock performance. Of the oil-importing regions reported and considered in Table 1, — The Far East, Pacific, and Emerging Markets–, the US experienced a larger stock market decline. The equity performance lends support to the view that the US will experience the largest loss as a result of the Russian Invasion. But why? Our answer is that the Russian actions and success have two distinct and adverse effects. An obvious one is that the invasion eats up resources and keeps the US occupied. In a way, it forces the US to keep its eye on the rest of the world. If the world senses US weakness, our enemies and or rivals in the other parts of the world will challenge the US hegemony. This is quite a bearish scenario. One can imagine China ramping up its China sea claims while aggressively pushing the silk road initiative and using it to achieve its global objectives. Then there are the Iranians, while the Biden Administration is negotiating a return to the Iran nuclear deal, Iran continues undermining the US. Will Iran be emboldened to become the dominant player in the region?

The US is at a proverbial fork on the road. Whether these challenges to the US are successful or not will depend on which road we take. We know the road to success. As already discussed, we believe that it requires a strong dollar policy, a strong defense, and a pro-growth agenda. The US has done it before and can do it again. It will be interesting if the US goes down this road. Some of the policy triad will have immediate effects. For example, the strong dollar policy could be the basis for slaying the inflation dragon. Here the burden will be on the Fed, not the Biden administration. The pro-growth policies are the responsibility of the Biden Administration. For example, we know that we became energy independent in a short period of time and lost independence within a year. Reversing some of the policies that eliminated our energy independence will have immediate effects and provide us with a signal of the growth path that the administration will take. The defense buildup is the national security component, and it will take much longer. In the next few months, we will see how serious the administration is about the 500-ship Navy. We are not so sure the administration will take this path. So far, the US has shown restraint and appears to be betting on economic sanctions deterring and punishing Russia. Time will tell whether it was wise to bring an economic sanction to a gunfight.