Marko Papic, Partner and Chief Strategist at Clocktower Group, talks about possible scenarios for the war in Ukraine, consequences of the military conflict for the markets and prudent investments in uncertain times.
The news rattles the free world: Russian troops are invading Ukraine. The financial markets react ambivalently to the attack. After an initial shock, the S&P 500 closed 1.5% higher after a sharp reversal on Thursday.
But what’s in store for investors with war in Eastern Europe now? How should the conflict be factored into investment decisions? And what is the best way to hedge the portfolio against further military escalation?
We asked Marko Papic these questions. As a Partner and Chief Strategist at Clocktower Group, he leads the firm’s Strategy Team, providing bespoke research to clients and partners on geopolitics, macroeconomics, and markets.
In this in-depth interview with The Market/NZZ, which has been lightly edited and condensed for clarity, he talks about possible scenarios in the course of the war in Ukraine, consequences for the markets and prudent investments in uncertain times.
Mr. Papic, the war in Ukraine is keeping the world on edge. How do you assess the crisis in Eastern Europe with regard to the financial markets?
The first market reaction is very interesting because traditionally geopolitical safe havens are government bonds like US Treasuries, gold and the US dollar. The dollar is not that much higher. But what’s really interesting is how little ten-year treasury bonds have rallied with the yield still at 1.97%. That’s very important because it suggests that this event is happening in a macro context that’s deeply bearish for bonds.
What do you mean by that?
Here’s an analogy: In 2014, when Russia annexed Crimea and the Islamic State conquered Mosul, the second largest city in Iraq, and almost conquered Baghdad, the oil price collapsed. So, if I asked you: «What happens if the second and fifth largest exporters of oil in the world are each embroiled in a war?», you would have answered: «Of course, oil goes up». But it didn’t - and that’s something that’s important for investors to understand: Geopolitics doesn’t happen in a vacuum; it happens in a macro context. In 2014, the macro context was deeply deflationary and highly negative for commodity prices, particularly oil. But today, we’re in an inflationary context.
What are the implications for investors?
So far, the best hedges against this geopolitical conflict have been commodities. I know, a lot of investors are saying: «Of course, they are». But it’s not self-evident. In 2014, if you bought oil because a bunch of lunatics tried to take over Iraq, you would have had your shirt torn. So the most important thing the market is telling us right now is that we remain in an inflationary context.
The price of crude oil has risen above $100 for the first time in eight years in the wake of the Russian attack. Is it now rewarding to bet on investments in the energy sector?
This might surprise you, but my favorite hedge is not oil. I know, oil prices are going up, but the problem with oil is that it’s much more of a macro driven global story. So if this conflict were to end tomorrow, I think there is more downside risk to oil than there is to metals. That’s because oil prices can respond more to Fed hawkishness or flattening demand. In addition to that, I think a deal between the US and Iran will get done no matter what, and you will see UAE and Saudi Arabia pump to punish Russia on behalf of the US.
Are you generally bullish on metals?
I’m advocating for palladium and wheat, because these two commodities are more likely to be impacted by some sort of potential conflict. Palladium is actually the metal that Russia produces the most as a percentage of global output with a share of 43%. And, if Russia were to stop exporting palladium for six months, it would only cost them around $3 billion which is not a lot. Moreover, their foreign exchange reserves are the highest since 2014 at over $500 billion. In addition to that, their current account surplus is the highest since 2006.
And what’s your bull case for metals in general?
The reason I like metals is multifaceted. We’re in a commodity super cycle, and there’s a green energy revolution which is creating a high demand for metals. There’s also a demand for rebuilding what I call redundancies: Countries want to re- and onshore production. So globalization is not unraveling or ending, it’s just softly being rewired, and that has created an interesting bid for metals. What’s more, mining companies have not started to expand their capex for whatever reason. And on top of all that, you have Russia which could self-impose embargoes on these critical components if this situation gets out of hand. That’s why I prefer metals like palladium and platinum over oil as hedges against the risks of this conflict.
And what is the bull case for wheat?
First of all, it’s not just about a geopolitical risk premium since fertilizer costs are going through the roof due to high natural gas prices. Secondly, when I look at a conflict, I try to look at direct links in supply, not just a general financial risk premium. Right now, there is definitely a risk to the supply of wheat. Ukraine is a major exporter, and Russia has basically imposed a naval blockade for several weeks now.
The USA and Europe are now stepping up sanctions against Russia. How drastic are these measures?
Since 2014, Russia has largely de-westernized its financial system. It doesn’t really issue that much debt to finance itself in the west. And, as I said, its current account and its foreign exchange reserves are very high. That’s why I think Russia feels it has around six to eight months where it can weather almost anything the west throws at it, including potential energy bans. Russia feels it has this window during which it can really be aggressive. That’s probably right, but that doesn’t mean it’s not going to hurt Russia’s economy. The ruble is collapsing, and inflationary pressures have been building up in Russia anyway. So there’s a difference between being able to weather something as a country, which they can, and your own people being happy about weathering a crisis they didn’t really ask for. As a result of that, I think there is growing political risk for Putin because of this crisis.
What does the war in Ukraine ultimately mean for today’s world order?
I have been writing for a long time about the concept of multipolarity: A Pre-World War One world where it’s every country for itself. Of course, for Europe, it’s a little bit different because these countries are in a confederation. But in a multipolar world, it’s very difficult to establish an equilibrium. Also, it’s very difficult to create coalitions of the willing. For example, it’s very difficult for Europe and the United States to coordinate with one another because their interests are diverging. You’ve seen this in the situation with Russia where Western Europe has always been quite unsupportive of Ukraine’s membership in both the EU and NATO, whereas the US has been much more aggressive about it, much more adamant that Ukraine should join.
What does a multipolar world mean for financial markets?
From Russia’s perspective, a multipolar world is an opportunity because they can play on these cleavages on the western lines, and they can try to create wedges in these cleavages. That’s what they have been trying to do for twelve months. But that multipolar world is something that investors have to really come to grips with. Once you understand that the world is multipolar, you have a number of things that you can essentially say are facts: First of all, globalization cannot survive because it requires one country to be in charge and to create rules and norms. In his book, «The World in Depression», the American economic historian Charles Kindleberger argues that the reason the world went into a depression in the 1930s is because there was hegemonic instability: Nobody was going to pick up the cost of being a world policeman, of resolving trade disputes, of being the consumer and lender of last resort. There was no one to step into that. This is the first consequence of multipolarity; and this time around, the erosion of globalization started already before Brexit and before Trump.
What’s the second consequence?
The second principle of multipolarity is a higher frequency of conflict. This has been proven in political science theory. It’s like a schoolyard where you don’t have a single bully that kind of bosses everyone, so fights are breaking out everywhere. Yet, investors have to realize that this doesn’t necessarily mean that this is a bearish world. Just because there is more conflict it doesn’t mean that you have to just own gold. It just means that military conflict – predicting it, assessing it, understanding it – is now part of your job as an investor. It’s not just going to happen in South Sudan, it’s going to happen a three-hour flight away from Zurich. That’s the world we are in today.
Then again, that doesn’t sound very encouraging.
Our predecessors, the investors in the 19th Century, like the famous Rothschilds, didn’t shirk geopolitical conflict, they embraced it. And they understood how to analyze it, and how to think about it. In other words: Not every single war is going to lead to World War III. So if you are worried about Ukraine and Russia, you hedge it appropriately with wheat and palladium.
What is the next stage of the crisis in Ukraine?
As an investor, I focus on the material constraints. For Russia the material constraints of invading Ukraine are vast. Ukraine is the largest country in Europe, if we ignore Russia. It’s bigger than Germany and the United Kingdom combined in terms of territory. It has 43 million people. Its population does not want to join Russia, not even in the eastern part of the country. Many people don’t understand that just because you are a Russian speaking citizen of Ukraine that does not mean you are pro Russia. So even if you look at the oblasts of Donetsk and Luhansk - which are most impacted by this war and are the most pro-Russian parts of Ukraine - the pro-Russian rebels only conquered 40% of the territory. That’s because a vast majority of Russian speakers in Ukraine are not pro Russia. Even Ukraine’s president Volodymyr Zelenskyy barely speaks Ukrainian. So the constraints on Russia, if it were to come in and occupy all of Ukraine, would be incredibly large.
Sounds like Russia is putting quite a lot on the line by invading Ukraine.
Here’s another issue: Russian speakers in Ukraine tend to be urban elites. A lot of their ancestors, grandfathers and fathers, came during the time of the Soviet Union to industrialize Ukraine. So when Russia shows up and asks «Who’s a Russian speaker? Who’s Russian?», it’s a bunch of professors of anthropology, engineers and journalists. It’s not peasants and farmers who know how to use an AK-47. Hence, the problem that Russia faces, if it were to occupy Ukraine, is that the part of the population that would support it is small, urban and educated. That means they’re in deep trouble if they try to invade and occupy all of Ukraine. What’s more, the Ukraine military is not terrible. That’s why this is going to be a highly complicated operation.
How do they think this war will end?
My point is that the probability of an occupation of the whole country is very low. The worst investors can expect is something like the 2008 Georgia crisis where it first looked that Russia was going to annex all of the country but then it withdrew. But just to be clear: I don’t want to sound bullish for stocks here because we’re not going to be able to distinguish between a full occupation and a Georgia like scenario for some time because both of them include military operations across the whole country.
In the light of the growing tensions between China and Taiwan, another conflict is currently smoldering with considerable significance for the markets. What impact is the war in Ukraine having on developments in Asia?
The next twelve months are going to be very critical. But from my point of view, for China the risk/reward of a war against Taiwan is skewed extremely to the downside.
I’m in a small camp of people who think that China’s power has probably peaked. Therefore, my argument is that if you wanted to talk about the conflict between China and the US, you should have talked about it in 2012. That’s when it all started. Now, we are in stasis, and the reason for that is that China is trapped by three factors: geography, demographics, and a decelerating rate of GDP growth. These three traps will force China to remain far more addicted to export-led growth and increasingly dependent on foreign capital than is generally assumed. And we know that a highly leveraged economy facing a demographic downturn and pivoting to advanced manufacturing is highly unlikely to engage in geopolitical adventurism.
So what does all this mean for the outlook for the stock markets?
I remain pretty bearish, and I would fade this rally right now. I’m not primarily bearish because of the conflict between Russia and Ukraine, but because the Fed is laser-focused on inflation, and the Ukraine/Russia conflict will only add more to the risk of not just persistently high inflation but stagflation. So I’m worried about the Fed’s hawkishness.
Tech stocks in particular recorded significant gains on Thursday. Does the market therefore perhaps believe that the Federal Reserve will not raise interest rates too much for the time being because of the political uncertainty in Eastern Europe?
Yesterday’s market action, with Nasdaq closing more than 3% higher, is not about the Fed. I think the Nasdaq is reacting this way because tech stocks are perceived to be a safe haven asset - which is crazy. Think about the time during Covid: Every time there was a new wave, growth outperformed value, and growth stocks are mainly US tech. That made sense during Covid which brought forward earnings and customer acquisition for a lot of these companies. For instance, I didn’t have an Amazon Prime membership before Covid. Hence, it made fundamental sense for tech companies to outperform in a pandemic.
I wouldn’t be chasing tech because I think the pandemic is over, the final act was Omicron. So the pulling forward of customer acquisition is at the end. I understand the argument that tech is an inflation hedge and I’m open to that being correct. But there are better things to own when there is inflation: commodities and value. In addition to that, China is stimulating its economy. From the outside, it looks like it’s doing it tepidly, but we have signs that it’s doing it hard. And what helped tech in 2021 was that China was basically in austerity.
From a macroeconomic perspective, what are the main arguments in favor of commodities?
In the past years, the risk party strategy was basically that you own a little bit of bonds and you own the Nasdaq, and it’s awesome. Every pension fund in the world did this. To me, the new risk parity approach is to own a basket of commodities instead of bonds. Commodities are going to be your safe haven. They won’t act the way they did before, where in a downturn of economic growth they would suffer significantly. I don’t think that’s going to be the case this time around because it’s not just demand but also supply constraints that are pushing commodities up.
Where else do you spot opportunities?
If China stops stimulating its economy or the conflict between Russia and Ukraine tips us somehow into a recession it’s stupid to be long emerging markets. But when we are in a rotation instead of a recession, as I think, then US assets are going to suffer and emerging markets will do well. It’s very simple: If the yield on ten-year US treasuries is going up, the dollar is going down, and Chinese total financing is going up, Karl Marx can rise from the grave and run for the presidency of Brazil and you should still own the Brazilian real. Because it doesn’t matter: Brazil’s external trade is going to be great, their banks are going to be flushed with deposits, their currency is going to be supported, and they are going to be able to lower their interest rate.