Condoleeza Rice: How Putin will push up gas and oil prices for longer than you think (and why this is good for Aus)

Andrew McAuley

Credit Suisse

Credit Suisse’s annual Asian Investment Conference usually throws up some special insight and this year was no exception. In particular, the keynote sessions by Dr Condoleezza Rice, US Secretary of State (2005-2009), and James Bullard, President and CEO, Federal Reserve Bank (Fed), St Louise have provided us with important investment guidance.

Dr Rice had some pointed comments regarding the motivations of President Putin. While she was in office it was her observation that President Putin was not overly concerned with NATO. He did voice some objection to missile systems in Poland and did get more nervous with the colour revolution in Ukraine. In her view, something has changed over the last few years. She sees Mr. Putin as a dictator, who sees re-establishment of the Russian empire, and the absorption of Ukraine as his duty. What is looking clearer as the war progresses, and the Russians experience setbacks, is that absorption is off the table. She believes the likely outcome is recognition of the special status of eastern Ukraine and the recognition of Crimea as part of Russia.

In her eyes there are three key outcomes from the war:

  1. The West and NATO have never been more united.
  2. Russia will remain isolated for as long as Mr. Putin remains. The outcomes will be a brain drain from Russia and ongoing sanctions, including a restricted market for Russian exports including gas and oil.
  3. The Chinese/Russia strategic relationship is uncertain at best. The Chinese position themselves as an understanding neutral, at the same time their banks are sticking to the sanctions to the letter. There is a limit to Chinese support as you would expect with a sovereign nation.
The investment implications are that commodity prices, especially gas and oil will be higher for longer. This will benefit countries self-sufficient in energy such as Australia, Canada and the US. OPEC cannot be relied upon to increase production. 

The Iran nuclear deal will be difficult to conclude as Russia is part of the negotiations as a member of the security council. Russia has no interest in ensuring more supply of oil. The carbon transition will be slower than previously thought. Investment in traditional energy sources including nuclear must occur at the same time as investment in renewables. Those companies and regions that can be relied upon for supply will benefit even if the products are delivered into Europe at higher cost, again places such as North America and Australia are set to benefit. Russia and Ukraine are large food producers particularly for wheat. Companies in the agricultural sector and agricultural land will become more valuable. Technology that improves efficiency in food production will be needed. Finally, the “neutralisation” of the Russian central bank and its reserves shows if you can control a country’s currency through a united international central bank front, you can isolate a country. The idea that the US dollar is losing its reserve currency status has been discredited for now. It remains the “safety trade” in times of market turmoil. The Ukraine war has made a difficult situation in terms of inflation, even more difficult.

Federal Reserve President of St Louise James Bullard was frank in his assessment of inflation, it had surprised the Fed to the upside. Over the last few months, the data has changed and the Fed has had to change with it. Fast tightening is needed to push headline PCE (Personal Consumption Expenditures) down from its current 6% growth to the 2% target. In 1994, when similar conditions prevailed, the cash rate had to increase by 3%, a little more than what the market is expecting now, in order to achieve the 2% target level. GDP has returned to the pre-pandemic growth trend. There are excesses in certain markets such as housing and non-traditional assets by which he means digital currencies and similar. The labour market is strong, the Kansas City Fed Labour Markets Conditions Index is at an all time high, there are 1.7 job openings for every unemployed person. The labour market is likely to improve further with more post pandemic reopening, early retirements not returning to the workforce, and dual income families not reverting to both partners working having enjoyed the extra time with family the pandemic created.

The investment implications centre on higher rates as you would expect. Bullard hints 3% is a reasonable peak cash rate based on history. Coincidentally, that is almost exactly what the bond market has factored in. 

He is also saying they need to get there quickly, again, the bond market is in agreement, expecting the peak of 2.75 to 3% within 12 months time. This is good news for equity markets as it looks like longer term bond yields, being the discount rate applied to the valuation of shares, is close to a peak or peaked, which is supportive of valuations. However, a word of warning. As rates rise, both globally and in Australia, the economy will slow. That is necessary to take inflationary pressure out of the system. Eventually, that slowing should impact company earnings. If the Fed, RBA and other central banks can engineer a soft landing, we shall see equity returns moderate but not crash. Also, bond yields are starting to look more attractive, the sell off in fixed income markets will end at some point. That said the bond sell off has been sharp, but what we learnt from 1994 is better returns follow a sell off like we have experienced.

Drawdown, peak to trough returns Australian and Global Bonds – the current sell off is worse than the rout in 1994, and is a 2 standard deviation event.

Source: Bloomberg, Credit Suisse

In short, it will be the re-establishment of the normal economic cycle, and in our view the best way to navigate economic cycles is a multi-asset class portfolio which can take advantage of the changing environment. Bonds have had a difficult six months, but are still very much part of the portfolio tool kit for the future.

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Andrew McAuley
Chief Investment Officer
Credit Suisse

Andrew McAuley is a Managing Director of Credit Suisse Wealth Management Australia. As Chief Investment Officer, he is responsible for developing discretionary and advisory investment strategies across multi asset class portfolios for clients in...

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