The Return of the Inflation Machine

The West's conflict with Russia, a commodity superpower, will bring about epochal changes. The world of yesterday will not return. Indeed, the new age of?deglobalization?will radically transform global politics and financial markets.

Crucially, for the first time since the Cold War, geopolitics has returned as a determining factor of market returns. In the future, serious investment policy will no longer be possible without geopolitical considerations. It does not matter whether the war in Eastern Europe lasts another two days or two years. The epochal break is already inevitable today. The carefree days of techno-globalization are over.

Geopolitics was a useless term for investors for a long time. The West and the globalization of capitalism had won the day after 1989. The Soviet Union had disappeared. The peaceful rise of China and the multilateral crisis resolution in 2008 were further indications that investors lived in a new golden age.

For more than 30 years, investors celebrated the "end of history". No one needed any more depressing scenarios about possible military conflicts between great powers. But in the early morning hours of February 24, 2022, capitalism's long age of safety was over. Utopia ended, and history returned.

This sad truth means that we urgently need to think about the changing opportunities for returns in the coming decades. During the last globalization boom, 1980-2021, stocks and bonds emerged as indispensable sources of returns.

In contrast, commodities could shine only briefly during the tame inflationary interlude of 2002-08. After the financial crisis, deflation, not inflation, became the main risk for investors for a long time.

However, commodities will gain in importance again in the future, as the dawning deglobalization will be accompanied by permanently high inflation. Since inflation is the most significant risk for nominal bonds and a substantial return risk for equities, purely traditional portfolios will no longer be able to achieve a positive real return (return after deduction of inflation). Inflation protection thus again becomes the linchpin of any investment decision.???

To better understand this watershed moment, we must first clarify what connects disinflation with globalization. After that, we can turn our attention to the first signs of the new "permanent inflation" and the long-term consequences of the Russian invasion.??????

Only two types of geopolitical epochs are fundamentally relevant for the financial markets: globalization and deglobalization. All globalizations are giant disinflation machines that follow a similar pattern. First, the emergence of a great hegemonic power results in an international peace bonus. The resulting geopolitical stability stimulates worldwide exchange and peaceful competition.

Productivity rises, and intensive growth cycles emerge, characterized by increasing technologization. Confidence in robust growth patterns and fiscal stability increases steadily. Falling prices, lower interest rates, and booming asset markets are consequences. The prime example of the disinflationary potential of globalization is the heyday of the British Empire, 1815-94. The period 1980-2021 was such an anti-inflationary regime, too.

Deglobalizations are very different. They act as inflationary machines in precisely the opposite way. Most important, no all-dominant power exists to guarantee a pacified world market. Thus, the geopolitical order begins to fracture. As a result, the global economy is divided into inefficient, mutually isolated interest blocks in the best case. In the worst case, a war between great powers makes any market economy orientation impossible.

In both cases, real economic growth becomes a rarity, as the political focus is on protectionist security of supply and purely national supply chains. States are thus regularly forced into compensatory fiscal devaluations, which result in negative real interest rates and currency crises.

This economic doom loop ultimately results in a toxic environment characterized by rising prices and higher interest rates. Investors can locate striking examples of inflationary periods around the two world wars: 1895-1920 and 1933-47. Are we experiencing the birth of such a destructive investment regime today?

That's very likely. First, the invasion of Ukraine and the resulting economic war shake the international, war-inhibiting, balance of power necessary for all globalizations. Like 1914, the weaker partner (Russia) of a rising power (China) has created a substantial conflict. And as in the 1930s, long-term discord between two hostile economic blocs no longer seems impossible. Back then, it was the West against fascism. Today this would be the West against the authoritarian regimes of Russia and China.

This ideological antagonism means that, like during past deglobalization crises, the West must strengthen its defenses on all fronts (military, economic, raw materials security). However, all these defense measures have an extremely inflationary effect.???

The most severe consequence of the Russia-Ukraine war is that the integration of former communist Russia into the global capitalist order has finally failed. The Western embargo on the world's eleventh largest economy caused Russian capital markets to vanish into thin air for foreign investors within three weeks.

By freezing Russia's central bank reserves, the economic war even penetrated the previously untouchable heart of the international monetary system. What once seemed unthinkable, namely wanting to completely banish an economy of the enormous size of South Korea from globalization through geo-economic intervention, became a reality.

Russia is now once again part of a radical anti-West. This Hobbesian turn means that, like during the arms race before 1914, or the European rearmament boom after 1933, the peaceful anchoring of globalization and the fiscal stability of the newly militarizing states is in acute danger.

Furthermore, the Russian invasion "militarized" global commodity markets as well. Prices experienced an additional, enormous price surge. As a result of the embargo, energy, grain, and metals have become essential commodity weapons for Russia against the West, making securing raw materials a severe problem for all states.

What is unique about these recent price increases is that the resulting inflation results from a massive supply shock. Since the end of February, the post-pandemic inflation of fiscal origin has thus been reinforced by an additional, recessionary geopolitical price shock. But isn't there a chance that markets can neutralize this "geopolitical inflation" in the medium term by expanding the supply of commodities outside Russia?

No. In all three affected markets (energy, grains, and metals), there will be some, but not sufficient, increase in supply. Since the price elasticity of oil supply in the near term is low globally, there are only the U.S. and OPEC+ (plus the Iran agreement) that could realistically compensate for a total shortfall in Russian oil exports (7.0 mil barrels per day) through additional production.

In the United States, any extra volumes would come primarily from shale. However, none are expected before early 2023, as there is currently a dramatic shortage of labor and an investment deficit due to decarbonization efforts.

OPEC+, with its meager spare capacity (less than 4 mil. b/d), is not a real solution. In addition, a new Iran nuclear deal could release no more than 1.3 mil. b/d of additional supply. As a result, complete displacement of Russian oil exports by spare OPEC+ capacity and growing U.S. shale oil supply is not achievable in the next few years.

Things also look pretty bleak for natural gas in terms of supply expansion. Europe will take at least a decade to get away from Russian natural gas imports. The only way out is liquefied natural gas (LNG), as it is not tied to pipelines. But a total shift of European demand for Russian pipeline gas to the international LNG market would mean that Europe would abruptly become the world's largest LNG importer. This scenario is unthinkable without a massive and very lengthy expansion of LNG liquefaction facilities.???

Next to energy, the grain sector is Russia's most dangerous commodity weapon. The influence of Ukraine and Russia here is enormous: both countries control about 20% of global corn exports and 30% of wheat trade.

In addition, over the past decade, global wheat exports have grown almost entirely due to production increases by these two exporters. This trend suggests that increasing wheat exports from other growing regions will be difficult, if not impossible, in the short term. Thus, much higher prices are inevitable in this sector as well.

The "geopolitical inflation" of war will thus remain a "permanent inflation" since the harsh reality of global commodity scarcity is unlikely to be eliminated by market-driven diversification. The West will have to learn that the hoped-for additional supply will not exist for years to come.

In the past, each economic war resulted in significant inflationary drift. Each time, the vicious circle of deglobalization was drawn tighter and tighter. Indeed, a new global stagflationary economic downturn will become inevitable if the bulk of Russia's commodity exports disappears from the market for the rest of 2022. Massive fiscal bailouts and a renewed rise in prices would surely result.

At this point, at the latest, investors should have stopped dreaming about the world of yesterday and embraced commodities as the only genuine way to achieve inflation protection. History is returning. Globalization is not.

To explore this topic further, please check out the following pieces:

1. "Money, Commodities, and Bretton Woods III" by Zoltan Pozsar
2. "Beijing’s Bismarckian Ghosts: How Great Powers Compete Economically" by Markus Brunnermeier and Rush Doshi and Harold James
3. "Global stock markets in the twentieth century" by Philippe Jorion and William N. Goetzmann