Another crisis resulting from Ukraine

Monday, 19 September 2022 — Albert Park

[7 min read]

Dear Reader,

While Ukraine is well known as an agricultural nation and energy transit hub, its role as a major manufacturing centre is not appreciated as much. Going back to the former Cold War economies in the 1970s and 1980s, much of the manufacturing capacity and high-technology development of the former Soviet Union was based in Ukraine. Today, Ukraine has an important role in global manufacturing supply chains in terms of finished products and intermediate manufacturing to supply parts to German auto manufacturers and other key industries in Western Europe.

The immediate impact of the war in Ukraine on global manufacturing supply chains was reported on 27 February 2022 by The Wall Street Journal:

‘Russia’s invasion of Ukraine is piling new troubles onto the world’s already battered supply chains. The fighting has shut down car factories in Germany that rely on made-in-Ukraine components and hit supplies for the steel industry as far as Japan. It has severed airways and land routes that had become crucial since the pandemic began gumming up sea trade.

‘Economists and business leaders fear this will hit supply chains that rely on components and little-known commodities from Russia such as neon gas and palladium, important ingredients to make semiconductors. Industries such as car manufacturing have already been disrupted by a surge in demand after the easing of pandemic lockdowns and persistent production bottlenecks…

‘Volkswagen AG said that it could no longer get wiring systems produced in Ukraine and would have to stop production at plants in Zwickau in eastern Germany, the most important factory in VW’s push into electric vehicles, and Dresden for several days this week. VW said it would have to furlough more than 8,000 workers until it could resume production.’

Global supply chains are only as strong as their weakest link. This commonplace observation applies with a particular vengeance to the semiconductor supply chain. Most highly advanced semiconductors come from Taiwan, South Korea, or the US. Some less technically advanced semiconductors are produced by China.

There are very few products today that don’t have semiconductors. Your washing machine, dishwasher, refrigerator, and other appliances all have semiconductors to control settings (and to communicate with manufacturer databases). A typical new automobile has more than 1,400 semiconductors. In short, any disruption in semiconductor supply chains has an adverse impact on every supply chain in the world.

The US has threatened to cut off exports of semiconductors and sophisticated machinery to Russia. This type of thoughtless embargo ignores the rest of the supply chain. How are semiconductors actually made? One of the key processes involves the etching of minute circuits on silicon wafers. This etching process is done with precision lasers. The lasers are powered with a processed form of neon gas. It’s the case that 90% of world exports of neon gas come from Russia and Ukraine. More than 65% of this neon gas is processed by a single company based in Odesa, Ukraine.

In short, if the US and EU embargo semiconductor exports to Russia, Russia will embargo shipments of processed neon gas from Odesa. Once existing stocks are used up, this gas embargo could cripple semiconductor production, which would bring the production of consumer durables, automobiles, electronics, and many other products to a halt. When it comes to semiconductors, a trade war with Russia is an example of ‘be careful what you wish for’. If the US cuts off semiconductors to Russia, large parts of the global economy could shut down once Russia retaliates by turning off neon gas supplies.

Strategic metals dependence

As if disruptions to energy, food, and semiconductors weren’t enough, Russia has a chokehold on many of the most critical strategic metals in the world. Russia is home to the third-largest titanium producer in the world, VSMPO-AVISMA. That company is owned by Rostec, a State-controlled holding company run by an ex-KGB officer and friend of Putin.

Russia and Ukraine together control 30% of the global output of titanium. This metal is critical to aircraft manufacturing. Boeing obtains about 35% of its titanium supplies from Russia. These are used in the manufacture of engines, fans, and airframes. Airbus gets more than 50% of its titanium from Russia. As US and EU sanctions on Russia damage the Russian economy, Putin can be expected to return the favour by cutting off titanium exports, which would have a devastating impact on global aircraft production.

Russia is also a major global supplier of aluminium, which is used in everything from aircraft to automobiles to consumer appliances and more. Putin’s response to sanctions would be the same. As Russia is cut off from supplies of finished products, it will cut off its exports of source materials, which will then damage the entire global economy. Aluminium prices have risen 20% just in the past two months and will go much higher as these threats play out.

The world has a similar dependence on Russia and Ukraine for palladium, platinum, nickel, cobalt, copper, and vanadium. In particular, nickel and cobalt are critical in manufacturing electric vehicle batteries. Palladium is a key input in catalytic converters.

Even in cases where the world has alternate sources of supply for some of these metals, such sources aren’t necessarily available on short notice. Supply chain participants prefer long-term contracts and stable logistics channels. This means that suppliers can’t immediately take on new customers and shippers can’t easily redirect vessels to new destinations. These adjustments can take months or years to implement. In the meantime, shortages increase, and prices increase even faster.

Conclusion: Investment opportunities emerging from the chaos

Trade and financial sanctions are a double-edged sword. It’s possible to cut off Russia from imports of needed goods and services. It is also possible to exclude Russia from financial systems and payment channels. But trade and finance are a two-way street.

The targeted party — in this case, Russia — can retaliate by prohibiting its own exports of critical commodities of food, energy, metals, and chemicals. These inputs are critical to manufactured outputs and even to the ability to avoid starvation. Even powerful financial sanctions have workarounds involving friendly third-party banks, non-reserve currencies, and barter that uses gold as the ultimate form of money.

The war will not go on indefinitely. If Russia fails to conquer Ukraine, we can expect turmoil inside the Kremlin and a possible regime change. If Russia does conquer Ukraine, it will emerge from the war even stronger, while NATO will be shown to be a dysfunctional alliance of little real military import.

The US loses either way. The US looks weak for not being able to stop the war with diplomacy. It looks even weaker for not being able to assist Ukraine in timely and effective ways. And it may emerge relatively weaker if Russia is successful in implementing its regional hegemony. This will be the legacy of weak leadership by Biden and his recent Afghanistan retreat, which left some Americans dead, and others abandoned behind enemy lines. Putin took notes during the Afghanistan debacle and acted accordingly in Ukraine.

The most long-term legacies of the war in Ukraine will be disrupted supply chains, shortages of consumer goods, and much higher prices. Modern supply chains took 30 years to build and are being blown up in a matter of months. They’ll take years to rebuild.

The resulting market disruption doesn’t leave investors helpless. There are numerous attractive investment opportunities emerging from the chaos, including under-priced energy stocks, agricultural producers, mining plays, and long positions in commodities markets.

Regards,

Jim Rickards,
Strategist, The Daily Reckoning Australia

This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.

Dear Reader,

‘The Fed signals it’s not for turning’, was a headline in the Financial Times last week.

For now, the Fed is sticking with its rate hikes. And investors seem to be waking up to what that will mean. Ray Dalio says a 4.5% Fed rate (still nearly 400 basis points BELOW consumer price inflation) would knock stocks down another 20%. Mark Mobius says the Fed’s key rate may go to 9%. Larry Summers says the ‘Fed needs big rate hikes’ to control inflation.

MarketWatch: ‘Why the stock-market selloff could get ugly if S&P 500 falls below 3,900’.

Markets Insider: ‘Billionaire “Bond King” Jeff Gundlach says it’s time to get more bearish on US stocks, as the risk of deflation is much higher now’.

On Wednesday, five stocks — Amazon, Tesla, Alphabet, Microsoft, and Apple — lost more than half a trillion dollars in value. But there’s still a long way to go to get back to ‘normal’.

Getting back to normal probably won’t happen. Too much of our economy now depends on very abnormal interest rates. As real rates go up, businesses, households, and the federal government will be unable to refinance. They will go broke, default, or, in the case of the feds, print more money.

Naturally, the people who’ve made the most money from the Bubble Epoch’s ultra-low interest rates are least eager to see them go away. They’re also the same people who control the media, the universities, Wall Street, the Fed, and the government itself. Our guess is that they could lose as much as US$50 trillion in wealth if the Fed sticks to its program and wrings inflation out of the system.

And as the losses mount up, they will all tell Mr Powell what an idiot he is. They will tell him to reverse course. Will he have the backbone to resist them?

Iron Lady

‘The lady’s not for turning’, was the famous line from Margaret Thatcher used in 1980, describing herself. She was not about to depart from her conservative program, she told a party conference.

At the time, Ms Thatcher’s approval rating had fallen to 23% — a record low. She had cut spending and fired government employees. She even took away the free milk from school children. The unions were against her and threatening widespread strikes. The universities were against her; she reduced government support to education, prompting Oxford to withhold a proposed honorary doctorate. The press and even many members of her own party were against her. Many expected her to do a U-turn.

She did not.

And it got worse. Unemployment rose; there were three million without jobs in the early ‘80s. Inflation hit 18%. An open letter, signed by 364 ‘leading economists’, told her she was going in the wrong direction, that there was ‘no basis in economic theory’ for her program of budget cuts and higher interest rates.

Ms Thatcher also had to fight with the coal miners. Anthony Scargill, formerly a member of the Young Communist League, later founder of the Socialist Labour Party, was head of the miners’ union in the early ‘80s. When the Thatcher government proposed to close unproductive mines, Scargill led the union in a head-to-head confrontation with the government. The miners walked off the job, leaving Britain short of fuel.

But Ms Thatcher didn’t flinch. She was convinced that overspending and overregulating were ruining the country; she was determined to squeeze them out.

A tale of two cities

Our first trip to London was in 1969. It was a grim place. Our hotel was shabby. You had to put coins in a heater to get any warmth. The bathroom was down the hall.

But the whole town seemed shabby. Almost no new buildings. The shops were as dreary as the weather.

Britain was not a wealthy country then. Rationing was not fully eliminated until 1958. A friend of ours, who grew up in London, recalls how delighted he was to eat an orange…for the first time…in the 1950s.

Britain’s economy had not been destroyed during the Second World War. But after the war, instead of removing the wartime controls, the government nationalised whole industries, introduced more regulations, raised taxes, and set up an expensive welfare state.

In effect, what Britain put in place was an extensive form of central planning and socialism. Ms Thatcher is credited with finally getting rid of it — or the worst parts of it. She made no U-turn and by 1983, inflation was settling down and the economy was already on the mend. Later, it boomed. After the ‘Big Bang’, in which the UK’s financial sector was turned loose, London became the money centre of the world — rich and dynamic, where people from all over the planet came to invest, shop, and buy expensive apartments.

We had lunch with Ms Thatcher later in life, in the 1990s. We were surprised by how small she was — delicate, almost frail. But she had nothing to prove then. She had shown the world what she was made of. She was an ‘Iron Lady’. And she got the job done.

And Mr Powell? What is he made of? Iron? Or willow?

We’ll find out.

Regards,

Bill Bonner,
For The Daily Reckoning Australia