Sanctions Smackdown

Russia has now invaded Ukraine.  Soldiers and civilians have been killed and the human toll is not yet calculable. 

President Zelensky of Ukraine, a former stand-up comedian who turned to politics, has done an impressive job acting as the commander-in-chief during the crisis. The U.S. offered to provide transportation to evacuate Zelensky from Ukraine and in response Zelensky said, “I need ammunition, not a ride.” Bravo! Comedian Jon Stewart, impressed with Zelensky, said “We’re seeing the transformation of Shecky Green into Winston Churchill.” Of course, Zelensky never played the Catskills nor does he smoke cigars or have a pet bulldog, so the analogy has some imperfections. Let’s hope Zelensky hangs tough and Ukraine can hold off Russia.

Meantime, the invasion has affected U.S. and financial markets around the world.  Today, (Feb. 24) the DJIA was down over 500 points at noon but bounced back to end the day in the black.  There’s almost always a tendency to overreact to bad news, so we should expect more volatility.  Beyond that, this is a good time to think about what measurable effect the Russia invasion of Ukraine will have on U.S. markets.

* Assuming Russia stops in Ukraine and does not invade other countries, the effect will be felt most directly in energy markets.  Europe depends on Russia for oil and natural gas.  The U.S., which has cut back on drilling, also imports oil from Russia.  When the U.S. and Europe stop imports of Russian oil and natural gas, energy prices will increase.  The current price of West Texas Crude is $100+/barrel after hitting a low of about $17/barrel in April 2020.  Futures investors think WT crude will drop to $90 by July.

* Oil and natural gas account for 60% of the Russian GDP, but Russia may be able to continue exporting to China and other countries that don’t participate in sanctions.   With rising prices in the world market, Russia may not feel much pain from the U.S. and EU sanctions. 

* Frackers in Canada and the U.S. have already started reopening old wells and expanding exploration for new sources of oil and gas.  In general, fracking is profitable when the price of oil is $60/barrel or more.   New supply from frackers will bring down oil prices, but it will take a while (maybe 6-9 months?) for this supply to become available.

* All businesses use energy, so higher energy prices will contribute to more inflation and/or reduced business earnings. Lower earnings will tend to depress stock prices, so the market may be in correction mode until the full effect becomes clearer or more oil and gas becomes available. 

* Households will feel a budget pinch from the higher cost of gas at the pump and the cost of heating and cooling homes.   This will tend to reduce consumer discretionary spending which will affect businesses and possibly employment levels.

*Bottom line, from the Russia-Ukraine situation we can expect more price inflation, reduced consumer spending and possibly higher unemployment …trending toward 1970s stagflation.

*However, that’s assuming Russia is not able to successfully mount cyberattacks on important U.S. networks like the power grids, financial or government networks. Putin said that he would respond to economic sanctions “tit-for-tat”, yet he has no economic levers of any consequence. What he does have is some very good cyber hackers who could do great damage to the U.S. via ransomware attacks or simply by destroying data.

As negative as the Ukraine invasion may be, the U.S. would be hurt much more if China now decides to invade or annex Taiwan.   Taiwan is the world’s largest manufacturer of computer chips.  If this supply were cut off, the effect on the U.S. economy would be severe. 

What would the U.S. do in response to an attack on Taiwan?  Many of our products are manufactured in China as are many of the components used in our technical products.  A military conflict or a trade war in which imports from China were stopped would be an economic catastrophe for American business. Many U.S. companies with no alternate source of supply would have to cease operations, leading to unemployment and losses for equity holders. Not a pretty picture.

On PBS today, a China expert reasoned that China would never risk a war over Taiwan.  He argued that China would much prefer to annex Taiwan peacefully through a political process.  He explained that China already has support within Taiwan’s political hierarchy. 

In a Forbes magazine column, a computer industry analyst argued that the main reason China wants Taiwan is for the chip manufacturing plants.  He explained that because of the complexity of semiconductor fabrication, the chip plants require the expertise and experience of the Taiwanese workers.  China could not operate the plants without the help of the current Taiwanese companies and personnel.   Because of this, he reasoned, China will not take Taiwan by force.  

Taking the other side of the debate, a few commentators on CNBC and elsewhere have argued that an invasion of Taiwan is now almost a certainty. 

We’ll see who is correct.

Xi Jinping’s stated objective is for China to be the predominant economic superpower in the world.  The U.S. has helped China’s economy grow over the past 30 years but lately the U.S. government has become more suspicious of China.  Both the Trump and Biden administrations have expressed a desire to reduce U.S. dependence by moving manufacturing out of China or at least diversifying sources of supply. 

At present, China has the U.S. over a barrel, but that won’t be forever. This may be JinPing’s last chance to exercise China’s significant leverage. 

In a full-scale cold war with the U.S., China would lose its biggest customer, but would gain Taiwan’s semiconductor industry. China may suffer higher unemployment for a time, but JinPing and the CCP have the luxury of being able to take a longer view.  They may not care so much about short-term consequences.  Unlike politicians in the U.S., Jinping doesn’t have to worry about being voted out of office.   

Also, recently JinPing and the CCP have taken a more anti-business position, attempting to reduce the power of large Chinese companies even at the expense of economic growth. This may provide a clue regarding their future policies.  

Let’s assume that China does invade Taiwan and the U.S. decides not to take military action, but to employ only economic sanctions. China would then respond in kind.

What weapons would each side employ? China would nationalize U.S. manufacturing assets in the country.  The U.S. would take possession of Chinese assets in the U.S., but most of these assets are real estate or financial related, not manufacturing or technology. China could sell its considerable holdings of U.S. Treasuries and terminate future purchases.  China may also sell its large reserve of dollars and stop use of the dollar as its reserve currency.   The CCP has stated that the Renminbi should be the world’s reserve currency.

U.S. equity markets would crash, wiping out savings for many individual investors and producing losses for institutional investors. This would have ripple effects on consumer spending and pension fund solvency.  The dollar would lose value and the Federal budget would be pushed to the breaking point.  The Federal Reserve would need to purchase the Treasuries that China sells and pick up any shortfalls in future Treasury auctions.

So, both sides would suffer economically with higher unemployment, business failures, stock market losses, and national budget issues, but because the CCP takes a long view and doesn’t care as much about short-term consequences, China could win an all-out economic sanctions war.   In the end, the U.S. would weakly acquiesce to an invasion of Taiwan.

If I’m right, it may be a good time to hedge on the possibility of a sanctions war with China.