China and the Russian invasion of Ukraine

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MR. MICHAEL CEMBALEST:  Good morning.  The bulk of this week’s note is on China, Russia’s invasion of the Ukraine, and the surge in natural gas, oil, coal, electricity, wheat, copper, palladium, and all the other prices which are going to drag Europe into recession and probably impose a heavy growth drag on the rest of the world, as well. 

Before getting into all that, there’s a chart here that should hang in the office of policymakers everywhere.  Energy transitions are really slow moving, particularly when citizens of the countries adopting them erect NIMBY barriers along the way.  The chart shows just how quickly over the last 20 years smart phones, Ubers, broadband, internet access, social media, things like that skyrocket quickly.  Wind and solar share of global primary energy consumption is still 4% and EV shares of global vehicles owned are still around 1.5 to 2%. 

The point is that countries that reduce their supply of thermal energy at a much faster pace than they reduce their demand for thermal energy are paying a very stiff price for that right now.  We expect some about-face movements on this in the days ahead, but as we’ve discussed often, capital spending by the 1,200 largest energy companies in the world has fallen 75% from peak levels while global demand for oil, gas, and coal is unchanged. 

So, if you do not have a synchronous match between your decarbonization of demand and decarbonization of supply, you can experience what’s going on in Europe this morning which are unimaginable large increases in all sorts of energy-related prices. 

Why are we writing about China this week?  Well, China’s connection to the war in Ukraine is important to watch because a lot of its financial and energy decisions may dilute the effectiveness of sanctions on Russia.  There’s a chart in here showing that Europe and China are the two large importers of energy in the world, while Russia, of course, is a large exporter.  The US is kind of in balance. 

So far, Russia’s gas exports to Europe are roughly unchanged from where they were last year, so if Europe decided to reduce exposure to Russian gas, China could step in gradually over the next decade.  There are some projects in Siberia, in Sakhalin which could add almost half of what Russia currently sells and exports to Europe in terms of gas. 

Russia has expanded its trade with China.  Russia is now China’s largest recipient of state-sector financing.  The countries began using their own currencies to settle bilateral trade.  China has created, it’s still in its infancy, but they’ve created a cross-border inter-bank payment system to compete with Swift, and they also abstained from condemning Russia at the U.N., although I’m not sure how much that actually matters.

The bottom line is that it’s very important to watch China here because we think that it’s going to do a variety of things that will dilute the effectiveness of sanctions on Russia, in which case the war could be prolonged.  Just as a reminder of how China’s geopolitical lens often differs from the West, over the last decade it has been North Korea’s almost sole trade counterparty.  We searched through all 40,000 possible bilateral trade combinations in the world and there’s none of them as high as the North Korean trade reliance on China.

Before getting into some of the China issues, we do comment in this week’s piece on the shock treatment plan advanced by the International Energy Agency to wean Europe off of Russian energy supplies; it’s very ambitious.  Ambitious is a synonym for probably not workable.  Diversifying gas suppliers, well, the next major wave of US LNG export facilities isn’t coming online until 2025.  A lot of that capacity is already contracted since you need to do that to finance construction. 

Europe may agree to build and interconnect some new LNG import facilities; that takes a lot of time.  Accelerate wind and solar; well, wind and solar megawatt hours have been growing at 1% a year in Europe since the year 2000, and electricity also represents just 20% of overall energy consumption.  So, even if they decarbonize the grid more rapidly, Europe would still be heavily reliant on oil, gas, and coil for industrial production of cement, glass, brick, steel, ammonia, plastics, and for transportation and building heat. 

We walk through some of the suggestions the EIA made as well.  The bottom line is that Europe’s energy reliance on Russia is way too high to reduce that quickly.  Any decline in energy prices is probably going to require some kind of resolution of the Ukraine conflict, and the large seasonal drop in gas demand that typically takes place in March, April, that’ll probably help the most.  Then an end to the US and Europe that are now buying oil and gas for strategic reserve purposes; that will run its course, as well.

As for what’s going on in China, that’s a question that has to be triangulated.  I often am told by colleagues and in research pieces that China has a zero tolerance policy for COVID.  I’m not sure exactly what to make of that. 

First, I don’t find the COVID data, I’m not alone here, but I don’t find the COVID data reporting China to be in any way credible.  If you accept China’s officially reported data the COVID mortality rate would just be 2% of the levels reported in South Korea, Singapore, and Japan, and then if you stripped out the people that reportedly died in Hubei province, the official COVID mortality rate in China outside Hubei is 0.05% of its Asian neighbors. 

I don’t find that credible, and it’s very hard for epidemiologists to cross-check by looking at something called all-cause deaths in China, because China is the only place in the world other than Greenland and the Spanish Sahara, which is the area between Morocco and Mauritania, that doesn’t report excess death information on a regular systematic basis. 

Second, and probably more importantly, a lot of the high-frequency data in China is almost back to normal, so whatever COVID measures they’re adopting, a lot of its economic activity is pretty close to pre-COVID levels.  So, we have a chart in here that shows electricity, coal consumption, steel output, road travel, rail travel, and home sales.  The only things that are showing real COVID-related mobility reduction still are domestic air travel in China and movie theater receipts.  But for the most part, whatever this COVID policy is, it’s leaving room for plenty of activity in both goods and services. 

When we look at our China activity monitor, the data looks pretty good outside of residential commercial construction.  Steel production, exports, industrial production, construction, corporate earnings, are all either rising or stable.  The Chinese government just announced the 5.5% growth target for this year.  They’ll need some additional fiscal stimulus to meet that, but so far the Chinese economy has been weathering the storm recently better than a lot of other places have.

Now, for equity investors, China has performed poorly so far, in line with the sell-offs and all the other major regions, in spite of the stable economical and profit data.  The primary reason for that is despite the war the markets are still expecting substantial fed tightening this year, and unfortunately, so do we. 

While these abstract rules on what the fed policy rate should be sometimes diverge from fed decisions, right now all of those rules are pointing to the need for a funds rate that’s much higher than what it is now.  The markets are now pricing in six to seven hikes over the next year.  I think that’s about right; maybe it’s five at the minimum, seven at the maximum.  But we are going to see for the first time in a long time the federal reserve hiking rates in the middle of a war, and a spike in all sorts of commodity-related prices. 

As a result, I don’t think we’ve seen the worst of the current war or stock market levels just yet.  It’s going to be very difficult to time the bottom, but it does seem like there are more difficult days ahead given the deleveraging and risk offloading that’s taking place.

Thank you to those of you that dialed into the webcast last week.  We had about 15,000 people participating globally.  We talked about a lot of the issues we already talked about today, but we started with a discussion of 1,000 years of Russian totalitarianism and that brief window during the 1990s when they were weakened geopolitically because of the collapse in oil prices, the debt default, and the disintegration of their currency in foreign exchange reserves. 

Around that time there were plenty of warnings against NATO expansion and we discussed some of them on the call last week, and at the end of this week’s note we follow up with just a little more of an exploration of some of the paths that might have been taken to prevent the current destruction of Ukraine.  Nothing’s for sure, and nobody knows whether or not these things would have worked or not. 

Here we are 90 years after Stalin imposed a terror famine on the Ukraine deliberately which killed several million people, and the Russians are destroying Ukraine again.  So, it’s very possible that there’s nothing that could have been done to prevent what’s currently happening in the Ukraine.  But at the end of this week’s note we do examine some of those paths and what they might have been. 

So, I’ll be writing and speaking more frequently now as we go through all of this so that all of our clients are aware of our best and current thinking.  Thank you for listening.

FEMALE VOICE:  Michael Cembalest’s “Eye on the Market” offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of JP Morgan Asset and Wealth Management. 

Michael Cembalest is the Chairman of Market and Investment Strategy for JP Morgan Asset Management, and is one of our most renowned and provocative speakers.  For more information, please subscribe to the “Eye on the Market” by contacting your JP Morgan representative.  If you’d like to hear more, please explore episodes on iTunes or on our website. 

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