«Everything Is in Place for a Capex-Driven Commodity Super-Cycle»
The situation in Ukraine remains volatile. Marko Papic, Partner and Chief Strategist at Clocktower Group, talks about the consequences of the war for financial markets and explains why he sees political destabilization in Russia as a catalyst for a structural bull market in commodities.
The war in Ukraine is keeping the world on edge. Earlier this week, explosions damaged the Kerch Bridge between mainland Russia and Crimea. Meanwhile, Moscow has halted the agreement that had allowed Ukraine to export grain across the Black Sea. For Russia’s leader, Vladimir Putin, the invasion is turning out to be a disaster. Since the mutiny of the Wagner mercenaries, speculation has been growing about a change of power in Moscow.
According to Marko Papic, political destabilization of Russia would have significant implications for investors. «A weakened Russia not only opens up several scenarios that could see some risk premium seep back into the markets,» says the chief strategist at investment boutique Clocktower Group. «It also threatens to derail the capex-driven cycle that depends on the availability of commodities to fuel the many policy prerogatives of Western policymakers – from de-risking supply chains away from China to transitioning to a green energy future.»
In an in-depth interview with The Market NZZ, which has been edited for length and clarity, the expert on geopolitics and macroeconomics comments on the further course of the war in Ukraine, the importance of Russia for global commodity markets, and the consequences of a possible regime change in Moscow. He also explains why he expects meaningful stimulus measures in China and why he does not believe in a severe recession in the US.
«When you look at the skew of risks, it seems prudent to put on hedges, to worry that something stupid will happen in the world»: Marko Papic.
What do the latest developments in Eastern Europe mean for financial markets?
As far as the market is concerned, the war in Ukraine has been over for months. It is not moving asset prices anymore. There is not much geopolitical alpha left as the war-sensitive assets such as gas, wheat, and oil have all fallen below the pre-invasion levels, while European equities have recovered above pre-invasion levels. So all of the geopolitical risk premium has drained from the market, no one is paying extra for geopolitical risk. I think this is appropriate, the market is right. But I also think that as an investor you have to be worried now.
Why?
Because if you agree that the market is right, there is nothing to gain, you can no longer make money by being sanguine about the world. But if you’re wrong, there are a whole lot of ways to lose money. So when you look at the skew of risks, it seems prudent to put on hedges, to worry that something stupid will happen in the world like Russian troops blowing up the Zaporizhzhia nuclear power plant in southeastern Ukraine.
How do you think the war will unfold in the coming weeks and months?
If you look at the map, the war has been in stasis, the frontlines haven’t changed since November in any significant way. On both sides, the war is starting to prove that defense is easier to play than offense, because at this point, it’s very easy and cheap to defend against very expensive offensive military platforms. The Russian troops went into Ukraine with tanks, helicopters and fighter jets, and they got shot down. So I think it’s naive of the West to believe that somehow magically Ukraine is going to do better with the same kind of weapon systems. It’s not that Russians troops haven’t shoulder launched missiles, too. They have so many of them, they don’t know what to do with them.
Does this mean that the new weapons deliveries from the West won’t have a significant impact?
Russia can protect the parts of Ukraine it has already conquered with air defense quite well. That’s why the issue with the F-16 fighter jets is kind of ridiculous. It’s not going to help, because it would be very dangerous for Ukrainian pilots flying F-16s near Russian borders. Providing them these jets would be like buying my ten-year old son a Bloomberg terminal because I want him to learn how to trade stocks. It would be way better for him to start with a less complicated platform. All those F-16s are going to get shot down basically on the first day. Hence, I think the Ukrainian offensive will fail, and when it fails, we will just be stuck where we are now. That’s why we’re finding out that the West is putting out feelers for negotiations, because this is coming to an end, and the market sniffed it out and faded all the risks.
But what if there are more surprises like the Wagner rebellion just a few weeks ago?
I could be wrong on three things. First, as mentioned, a sabotage or attack against the Zaporizhzhia nuclear power plant remains a possibility. Even though it is unlikely to cause a massive nuclear disaster, emotions would lead to a risk-off move. We know from the accidents in Chernobyl and Fukushima that the market impact would last for about a month. Importantly, proximity will matter in terms of market reaction. So if the Zaporizhzhia plant is blown up, I can see the Euro falling 10%, and European assets going down significantly.
In what other ways might your assessment be wrong?
My take on the Ukrainian offense could be wrong. I highly doubt it, but there could be a huge breakthrough because of moral issues in the Russian military after the Wagner mutiny. Morale is a non-linear concept, once it collapses, it’s gone. So if Kyiv is actually successful in its ongoing offensive, the worst-case scenario for the market is if Ukrainian forces threaten Crimea. The two Ukrainian oblasts that make up Donbas, Luhansk and Donetsk, are now considered Russia, but Moscow may be willing to consider modifying its borders. Crimea is a totally different story; it has been annexed officially for nearly a decade and Moscow considers it to be an integral part of Russia. So if Ukrainian troops threaten Crimea, I think the Kremlin could consider using nuclear weapons.
And what is the third thing that could surprise markets?
The political situation in Russia could get much worse. Russia’s leadership signaled to the world during the Wagner mutiny that they need these 20,000 soldiers so much that they can’t imprison them. On that Saturday, when the column of 2000 to 5000 Wagner mutineers was heading towards Moscow, they had no air cover. So why didn’t the Kremlin just send a dozen Sukhoi-25 jets to stop them? There are only two explanations: One, the Russian air force said no, and if that’s the case, that’s terrible for the Kremlin, that’s open disobedience. Second, Russia’s military is so desperate that it needs these mercenaries. Think about that: A country of 140 million people needs 5000 Wagner soldiers so much that Moscow didn’t want to kill them and instead probably paid off Prigozhin. So the political situation in Russia could be even worse than I think, and I thought it’s bad since February 2022 when the invasion started.
What about Putin’s political position in Moscow after these events?
The Wagner mutiny was merely a symptom of a deeper rot that has struck Putin’s rule well before the war. It has laid bare the political dysfunction in Russia. In my view, Moscow invaded Ukraine for petty rather than profound reasons which puts me in a strange position where I disagree both with the Russia apologists and the consensus in the West. In other words, I neither agree with the view that Putin was forced to invade Ukraine out of defensive necessity due to NATO’s expansion plans nor that he was trying to reconstruct a Soviet sphere of influence. The invasion was executed so poorly that neither argument holds up. It was planned by politicians who didn’t know what they’re doing. The Russian military has a lot of problems, but they’re not incompetent. So in my view, this war was conducted to forestall precisely the unraveling that is now occurring in Russia. But as such moves often do, it has now backfired and has accelerated it.
What does this mean from a big picture perspective? Also in view of the fact that no other country has a larger arsenal of nuclear weapons than Russia.
Since the market is sanguine about the war, I think the volatility of everything – bonds, commodities, European equities – has to go up if there is some sort of political crisis in Russia. I don’t know how to play it, though. In the short term, I’m biased being an oil bull, but what will matter for oil much more than the destabilization of Russia or the production cuts of OPEC is Chinese stimulus.
And how does it look long-term?
Long-term, I have a very high conviction view. In every scenario, from a stable regime change to a Mad Max outcome resembling Mel Gibson roaming the highways of Russia, there’s no way that Russia is going to increase the production of critical commodities over the next five years. Even if a pro-Western politician comes in, you have to keep in mind that there was no investment in Russia and a huge drain of human capital since this war started. A million people left the country, most of them are smart and well educated. I doubt they will go back. So it’s a pretty safe forecast to say that Russia is going to struggle in the next five years.
What are the consequences for the commodity markets?
Russia’s oil production peaked around 1988-89, then collapsed in the 90s, and it still hasn’t recovered fully. It never reached the peak from the late 80s. Why? Obviously, there was a war in Chechnya and an insurgency in Ingushetia and Dagestan, but there was no civil war or warlordism in Russia. It wasn’t a Mad Max scenario, it was just political instability, but that was enough to make investment in new production, human capital, and advanced technologies difficult. And keep in mind: These highly complex oil fields and mines in places like Siberia are very hard to manage. This is not like digging for oil in Oklahoma.
In other words, political developments in Russia will become a decisive factor for commodity prices and thus for financial markets in general?
A weakened Russia not only opens up several scenarios that could see some risk premium seep back into the markets. It also threatens to derail the capex-driven cycle that depends on the availability of commodities to fuel the many policy prerogatives of Western policymakers – from de-risking supply chains away from China to transitioning to a green energy future.
What do you mean by that exactly?
In the US, industrial investment is through the roof for the first time since a very long time. We’re building a lot of stupid things, in my opinion. For instance, the semiconductor fabs in Arizona are one of the dumbest things in the history of mankind because you need a lot of water to build semiconductors and Arizona is one of the driest states in the US. I think the Fabs in Arizona are being built for political reasons. It’s essentially a jobs program in a politically highly critical purple state, and it’s a great example that this new government-driven industrialization is going to be very inefficient. It’s not only the US; Europe is doing the same thing, and the Chinese have been doing it for a while. So it’s really ironic and kind of hilarious that we’re all becoming Chinese by trying to de-risk from China and focusing on sector driven policies. But here’s what I’m getting at: This is a capex intensive effort, and it’s happening everywhere in the world.
And what about investments in a climate-friendly energy infrastructure?
The green energy transition is a capex intensive effort as well. And then, you have the irony of ESG: We’re trying to solve climate change and to de-risk from China, which requires massive amounts of capex, but the one place where we are not going to invest in is commodities. It’s this paradox where we are investing massive amounts of capex in every possible sector; from biotech, to healthcare, to industrials, to new materials, except in commodities which you need to accomplish all these other goals.
What does this all mean for investors?
If you add to this mix the destabilization in Russia, the world’s largest commodity exporter, it’s pretty clear that we’re not going to solve inflation for the rest of this decade, and we’re going to have a secular commodity bull market. Of course, commodity prices won’t always just go up, but if you’re managing a pension fund in Switzerland or Germany, the time to give a commodity manager money is right now. And by the way, it’s not just oil and natural gas, it’s basically all commodities. For instance, let’s talk about nickel.
Why nickel?
There are two countries producing nickel: Indonesia or Russia. That’s basically it. And Indonesia has already telegraphed its intention. They banned the export of raw, unrefined nickel and forced China to invest $20 billion worth of infrastructure to move its nickel production to Indonesia. Next, they’re going to ban the export of refined nickel as well, so other countries have to build their battery factories in Indonesia. And then, they’re going to wait another couple of years and ban the export of batteries, so the manufacturing of EVs has to take place in Indonesia too. That’s why I’m super bullish on Indonesia, they know what they’re doing. But my bigger point is that Indonesia has its own priorities, and if you suddenly have destabilization in Russia, we have no other alternative to get nickel which is required for this EV revolution. So nickel is another example of how Russia matters.
On the other hand, however, China’s economy, which is very important for demand for raw materials, is weakening. Doesn’t that suggest pressure on commodity prices?
China has a huge problem. Despite Beijing’s reopening push, the country is facing a burgeoning deflationary spiral and renewed weakness in the property sector. That’s why I think Chinese policymakers are reaching the endpoint of their ability to be prudent and patient because there is such a huge downside to the economy. In the West, after the global financial crisis it took us seven years to try to stimulate the economy with policies like QE and ZIRP, but only when we actually started focusing on fiscal policy, the economy stopped being in secular stagnation. For political reasons, I don’t think China has seven years to figure this out. They have to act much faster, and they will realize the massive political risks of not stimulating their economy.
So China remains a key factor for your investment case?
If you want to be long commodities, you don’t need China to go crazy with stimulus. There are plenty of reasons to be bullish on commodities, but you cannot have China collapse. You just need their economy to stabilize, and that’s what they will try to do, they are going to do a mix of monetary and fiscal policy. In this scenario, the green energy transition and de-risking from China in the rest of the world are enough. So for my case to work, I have to be right that China is not run by Austrians, people like former US Treasury Secretary Andrew Mellon in the Great Depression who wanted to let everything go bankrupt. China’s leaders have to be pragmatists, and one thing that they have proven over the last six months is that they really are pragmatists.
The opposite is the case in the US, where the Federal Reserve is trying to cool down the economy. What happens to commodities when America falls into recession?
Eventually, and probably within the next twelve months, the US will be in a recession. But if you believe in the commodity super-cycle like I do, a recession in the US will be a great moment to buy because these secular forces are bigger. Then again, the question is do you want to buy commodities now, and then you risk that they go down? Or do you just wait until the recession hits?
What do you think?
Consider how much fiscal stimulus we did during the pandemic. It’s basically equivalent to World War II, except there were no Nazis to fight and there were no nuclear weapons used. This money is stuck on household balance sheets which is why the savings rate in the US is down to less than 5%. Everybody expects it to go back up, but I don’t see why. If you live in America, you just had a recession during which your net worth went up. So why would you precautionarily save now? Psychologically, the American government proved to you that every time you’re at risk to lose your job, you’re actually going to make more money.
And what does that mean for oil and other commodities?
Even if we have a recession in the US, there is almost no way it’s going to be deep. It will be very mild, maybe like the 2001 dotcom recession where real wages actually went up and the nascent commodity bull market looked through that downturn completely. So commodity prices might not even fall, since they’ve already corrected as if a recession was coming as every investment bank wrongly told us.
But the Fed has tightened monetary policy as aggressively as it last did in the early 1980s. Can the US economy really cope with that so easily, especially since it is no longer used to high interest rates?
The beauty of the 500 basis points of rate hikes since March 2022 is that there are now 500 basis points of possible cuts - and I have zero doubt that they are going to cut more than the 200 basis points the market has priced in by January 2025. Or let me put it this way: If you as an investor think that twelve unelected FOMC members are going to cause a calamitous recession, putting millions of Americans out of their job, just because they want to reach some theoretical academic inflation target of 2%, then have fun being a commodity bear. You’re reading Disney fantasyland stories. The Fed is going to zero when a recession happens and we will start another re-leveraging cycle.
Lastly, a practical question: How do you express your confidence in commodities in your portfolio?
I think a global asset allocation should reflect the 2001-2007 period. That means you want to be short the US dollar, you want to be in European and Japanese equities, you want to be in industrials and materials relative to tech, and you want to be in emerging markets. China is obviously part of the emerging markets universe, but you have to understand that China is in a different world. The country is in a deleveraging cycle and there are just too many risks. So with respect to stimulus, China is more like a trading opportunity than an investment opportunity. That means from a long-term asset allocation perspective, emerging markets ex China should do very well since everything is in place for a capex driven commodity super-cycle.
Marko Papic
