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A Failure of Imagination

A Failure of Imagination

April 15, 2022

Q1 2022 Commentary from Andorra

“I cannot forecast to you the action of Russia. It is a riddle, wrapped in a mystery, inside an enigma...”               

-- Winston Churchill, Politician


This past quarter has seen the unimaginable (to some) come to pass.  Russia has invaded one of their former Soviet Republics, apparently in an effort by Putin to rebuild the “empire” which was lost after the dissolution of the USSR.  For careful observers of foreign policy, the invasion didn’t come as a huge shock, as Putin seized Crimea by force from Ukraine in 2014 and Russia has been supporting various pro-Russia separatist groups in some post-Soviet states and elsewhere for many, many years.  The future outcome for Ukraine is very unclear as the US and western allies are unwilling to enforce a NATO-led no fly zone or other military options, which could potentially set off WWIII.  But, while the economic impacts for Europe and to a lesser degree the Western World seem obvious, energy and food costs will increase with the real potential to have long-lasting devastating impacts within the Eurozone economy.

Russia supplies Germany and greater Europe with approximately 40% of its natural gas imports, and about half of German households use natural gas for heat.  Germany is home to one of the world’s largest utility companies, E.ON., who’s chief executive Filip Thon, has warned wholesale electricity rates are running at 8 times higher versus last years’ rates.  To add insult to injury, well over 50% of Germany’s coal supplies come from Russia.  As Germany has shut down virtually all of its nuclear power plants, they rely heavily on natural gas and coal to generate electricity, heat homes and run their factories.  So, for many in the west to simply say “boycott Russian oil and gas” this is a simplistic and unreasonable demand for Germany and most of Europe.  Even before the Russian invasion, inflation was running very high, and if Russian gas imports were halted, many warn that this would have “drastic consequences” for the Germany economy, and by default greater Europe.  There is no quick fix solution for Germany’s energy dilemma, but it underscores the need for energy supplies that are not dependent on, or supporting frenemies, next door.

Economic Commentary

 Here are some thoughts on energy and the serious pickle that Europe, and to a lesser extent the US, finds itself in at the moment.  Germany has made a deal with the devil, pure and simple.  They have exposed their energy supply chain to what management 101 says is “key man risk”.  They viewed Putin (and by default Russia) as an entity that they could control, Germany thought, by building a “business” relationship.  This is what the Germans have engineered with the creation of the Eurozone, which is a shared peace through economic linkage among Eurozone members. 

As Germans are engineers by nature, they thought this relationship made financial “sense” and why would Putin not seek out the profit-maximizing formula of selling gas and coal at a good price to the factory floor of Germany?  Russian energy was good for Germany, as they could secure relatively cheap supplies that help power their factories to remain competitive.  The first major indication of Germany’s error was, among other military actions, Russia’s annexation of Crimea way back in 2014.  Regardless, Germany continued with Nord Stream pipelines to supply the county with gas.

It must be noted that the Germans started deepening their energy dependence on Russia before Crimea, with the completion of Nord Stream 1 around 2011-2012.  Following Russia’s first incursion in 2014, a series of economic sanctions were put into place with little result.  Germany then, to the bewilderment of many, continued to deepen ties with Russia via Nord Stream 2.  The timeline here is important and bears repeating: Construction on Nord Stream 2 began after Crimea’s annexation, and was completed in late 2021 just prior to the current invasion of Ukraine (is it a coincidence that Russia waited to complete the pipeline?) which put Germany in a very poor strategic position.

The United States and many others in Europe have voiced vehement opposition to Nord Stream for many, many years, with the loudest opposition around Nord Stream 2.  Many Baltic (now considered Northern Europe and Eastern European countries) were right in their view that supporting and relying on Russia via bad energy policy could have tragic unintended consequences.  Under the leadership of Angela Merkel, Germany ignored warnings to not rely on Russia for critical energy supplies.  Concurrent with this development, Germany began a “greening” of domestic energy production by decommissioning their nuclear power stations.  These factors are already being called the greatest tactical failure of post-WWII leadership in European history.  Angela Merkel’s blunders and her past energy policies are being quietly buried, but these mistakes should not be forgotten out of embarrassment.  Hopefully, we can learn from these failures in an effort to not repeat them both in the US and in Europe.

Now, we are witnessing the full-blown invasion of Ukraine and unfortunately the same old playbook of economic sanctions (albeit more widespread this time), are being rolled-out in an effort to “stop” Putin.  Numerous sanctions have been tried in the past against Russian government officials, Russian oligarchs, and associated entities to no avail.  These previous actions have yielded virtually zero intended results, and as evident by what we are witnessing right now in Ukraine.  Albert Einstein is credited with saying “Insanity is doing the same thing over and over and expecting different results”.  While doing something is better than doing nothing, unfortunately sanctions are a tool of politicians eager to tout their actions, which unfortunately will likely have little results while at the same time driving up energy and commodity prices for the average citizen.

Unfortunately, economic sanctions alone hurt general economies at-large (meaning the working-class folks) and in the end may not change Putin’s actions.  The world is likely going to have to come up with a new, more painful strategy.  Long-term, Germany will have to shut Russia off from all coal, oil, and gas imports (Germany has said they will need at least four years to come up with alternative energy supplies).  Basically, the world will have to go to an extreme with Russia to effect any meaningful change.  Full stop.

And now, many are beginning to point at these events as an ideological “win” for the West (meaning the United States).  Basically, the world is waking up to the prospect of an unholy alliance between China (who will buy all the coal, oil and gas that will not be shipped to Europe) and Russia, and the importance of not supporting totalitarian regimes.  China is watching closely how the world is handling Russia’s invasion of Ukraine for indications of what may unfold if they took Taiwan.  Further, the economic pain being felt by Russia is something that China likely wouldn’t be willing to endure if they make an incursions into Taiwan, as China has mainly been supported by economic growth to then telegraph its power onto the world stage. 

Within the scramble for energy security, the United States first began the fracking revolution and discovered that we were sitting on possibly the largest natural gas deposits on earth.  Fast forward to now and Europe is in desperate talks to secure new supplies of Liquefied Natural Gas (LNG) from the US that, in time, will make up for losses from Russia.  The United States has taken the lead role as broker and supplier to many countries seeking additional supplies of LNG, but it takes time to re-establish supply routes as these are massive long-term contracts.  Many US companies such as Cheniere and EQT have both the capacity and technical knowhow to step into this void.

Again, energy independence is a big deal and unfortunately “renewables” are in no way ready both in scale and cost to replace fossil fuels.  That’s the blunt truth of it.  In the meantime across the globe, energy end-users are the obvious losers in the very ugly invasion of Ukraine.  Oil and gas supplies are quickly “repriced” and those effects are very quickly felt by you and me.  A little know fact is the third largest oil reserves in the world are located in Canada.  Yes, Canada.  The US is the largest producer of natural gas, and when combined with Canada, North America has a very good standing in terms of oil and gas reserves.  But, current market prices are subject to supply constraints (i.e. Russian gas exports are banned in most of the world).  Also, while the US is the largest producer of gas, Russia still sits on the largest reserves of natural gas in the world (more on this later and how this impacts investing).  Related to supply issues; a potentially more dangerous problem for some parts of the world relating to Russia’s invasion of the Ukraine may be food inflation. 

From S&P Global, “Ukraine is one of the main world exporters of grains as well as vegetable oils. The main agriculture export products are Corn and Wheat. In 2021 Ukraine was the second largest supplier of grains for the European Union (EU) and a large food supplier for low and middle-income countries in Asia and Africa. The longer the Russia-Ukraine conflict lasts, the more insecurity about food supplies it may bring not only to the Ukraine and the region, but also to the whole world.”  Currently the main export terminals out of the Ukraine (grains are primarily exported via ship) are shut down due to the war.  While the US again sits in a very good position regarding food supplies, many parts of the world are very dependent on cheap grain imports. 

We will likely see the effects of food inflation hitting many parts of the developing world hard as move farther into 2022.  What does this mean for the developed world (let's broadly define that as North America and Europe)?  Generally, higher fuel and food costs will be transmitted broadly throughout the economy.  In the US and other “rich” countries we can tolerate higher prices but many in the world will experience doing without which will likely create political instability in some regions of the world (i.e. the Arab Spring and revolution in Egypt some attribute to a spike in food prices).


Circling back to the title of this quarterly “A Failure of Imagination”, we have to imagine that the Fed, with all their glory of pretending to be able to control inflation, may actually be unable to push inflation back down to where they would like it simply by “raising interest rates”.  Too many external factors that have absolutely nothing to do with interest rates, like, the war in Ukraine, phasing out of nuclear power in Germany, supply shocks from China, a persistently tight labor market in the US due to folks retiring or choosing not to work, broad-based commodity inflation, 4 trillion dollars in covid-related stimulus shoved out into the economy, etc. have come into play.  For some background, in January 2022 US inflation reached 7%, up from 1.4% in January 2021.  In the Eurozone for same period inflation was 5.1% versus .9% in the prior year.  Inflation in the US and Germany is sitting at 40 year highs.  Importantly, this all occurred before Russia invaded the Ukraine, so for the current administration to say Putin is to blame for the current inflationary spike is dishonest at best.

If we notice the chart above, it shows inflation basically in the 1% range for many years, preceding the current spike.  This shows us that inflation is running extremely high (exactly how high for how long is unknown, but likely it will be higher this decade versus the last) and current central bankers, while they talk a big game, have become quasi-political animals and the policies needed to control inflation are not popular among US and European elected officials.  Likely, they risk a real policy error of raising rates too far when faced with an expected natural slowdown in Europe due to the war and a slowing Chinese economy due to ongoing covid policies.

Within the very cloudy outlook for Europe due to a number of factors, we must emphasize that US unemployment is back to pre-pandemic lows, the housing market (while at very high levels) is not driven by leverage like the last cycle as cash buyers have exploded, and US households are by all accounts far better off financially than before the pandemic began.  The chart below clearly illustrates that household wealth has drastically increased since 2020. 

Now, will the economy “moderate” from the extreme post-covid gains, most certainly.  But, with unemployment so low, consumers' debt levels also low, and equity markets (while off their highs) still at relatively good levels; barring WWIII staring in Europe we don’t see the US economy or equity markets drastically derailing.  With this, we must keep a watchful eye on the Fed, who is often credited with creating recessions due to raising rates too far too fast (a fact that is, of course, highly disputed by Fed members).

Positioning for Inflation

Within the framework of inflation at 40-year highs both in the US and Europe, we have to look carefully at the classic stock versus bonds, versus cash tradeoff.  With interest rates increasing along with or in sympathy of higher inflation, keeping any significant allocation in medium or long-term bonds seems a sure fire way to lose money.  With inflation running anywhere from 5%-10% in the developed world the only way to fight inflation is to keep a healthy exposure to stocks.  Owning shares in companies that have the ability to raise prices in this environment will have the best chance to keep up with, or in many cases beat inflation.  Fixed income assets cannot adjust to price increases and you will see your real return (nominal returns minus inflation) substantially shrink your total principal in this environment.  Within this context we have made a conscious decision to seek out companies that have pricing power, exposure to rising commodity prices, and can participate in what will likely be a strategic shift worldwide to secure future commodity and energy supplies.

One might ask, “why all the commodity, Ukraine/Russia, and specifically energy discussion in this newsletter”?  The “ESG (environmental, social, and governance) revolution” is being pointed to by many, many seasoned investors as one of the main contributing factors to the current spike in commodities and more specifically energy that we are currently experiencing.  As the realization takes hold that we still need to worry about commodity and energy supplies while gradually shifting to a cleaner energy future, there are certain sectors and companies that will likely reap huge benefits in the coming years.   Normally we don’t like to “name, names” but in this environment highlighting where to place money should be mentioned.

In North America, companies that produce oil and natural gas (companies like EQT, Cenovus and Tourmaline) and the distribution of those resources (by companies like Cheniere and Golar LNG) will likely see huge pricing power with associated outsized returns.  Internationally, companies that can deliver commodities and in some cases build the infrastructure that carries said resources stand to have many, many years of improving business fundamentals and include names like Fluor, Glencore and Petrobras.  In general these are not household names, but all are multi-billion dollar companies that are critically important.  On the bond side, we have added to short-term and floating rate bonds in an effort tamp down equity volatility (avoiding long-term bonds as outlined earlier).  The equity market will likely remain volatile with interest rates increasing and prices for commodities elevated.  But with companies reporting record profits (again) the stock market should continue to reward patient investors and we remain comfortable with our equity exposure for our clients.