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Proper Risk

MON 28 FEB 2022

An observation we have often made is that “volatility” is not an adequate measure of risk. Rather, proper risk is the permanent loss of capital. Two important causes are default and war. Inflation is a another pernicious example, but tends to occur overtime. However, inflation driven by a complete collapse in a currency can clearly destroy wealth and purchasing power overnight. Developments over the weekend suggest that Russia is rapidly moving to that point with the currency down by around 40% (at the time of writing) and much of the domestic banks cut off from the international system. In addition, sanctions imposed on the Russian Central Bank also appear to critical or non-trivial for the local banking system.


The conflict has also clearly caused a chain of global risk aversion and a commodity squeeze. While geopolitical events tend not to have a lasting impact on global asset prices, a critical point we stressed on Friday was that this episode has essentially amplified the existing macro challenge of persistent inflation that had already contributed to the correction in equities. That is also true of oil where spot crude had already been rising due to global supply constraints. Put another way, the impact of the conflict was arguably about magnitude, not direction in those assets.


The decision to cut “some” of the Russian banks out of the SWIFT payments system and the sanctions on the central bank have clearly contributed to further risk aversion this morning in Asian trade. As we noted on Friday, the key implication is the potential for a larger commodity price shock. Russia accounts for 41% of European gas imports and 10% of global oil production. Other commodities such as nitrogen fertilisers, palladium, copper, nickel, potash and aluminium are also important. Ukraine and Russia are also large grain exporters. As we also noted on Friday, if oil rises above $125 per barrel that would increase oil consumption above 4% of global GDP or a level which has historically contributed to a recession. While the direct financial contagion from Russia is not large in a global context (Russia is around 1.3% of world GDP) there will be some actual credit (bank) losses from the probable collapse in the Russian system.


For markets, as we have noted, the key macro challenge is persistent inflation, the necessary rise in short-term interest rates and run-off of the Fed’s QE program. The episode in Ukraine has probably amplified this problem, in spite of the potential impact on growth. While the odds of higher short-term interest rates have been reduced, the December 2022 Eurodollar contract is still priced for an implied yield of around 1.85% and the 2 year Treasury yield is only marginally below the recent high in yield at 1.48%. Put another way, the fixed income markets still anticipate the Fed to normalise monetary policy over the course of this year. Our sense is that most of the near term re-pricing has been about “risk perceptions” or risk premium, rather than a genuine deterioration in the growth and profits outlook. Of course, the obvious point is that a broader global conflict might lead to a much larger growth shock, particularly if energy prices rise by another 20% (or so).


The good news, as we noted on Friday, is that some of our tactical indicators such as investor sentiment, demand for protection and price itself are close to outright panic (or capitulation). Indeed, the impulsive breakdown in price last Thursday suggested that we might have entered that phase which could conclude over the coming days or weeks. In addition, risk compensation is also considerably more attractive in Asia Pacific in outright terms and relative to the United States. While our sense is that headline inflation is also somewhere near peak velocity, interest rate settings are completely inappropriate in the context of current price pressure and still need to rise.


The developments over the weekend also increase the odds of an “oil shock recession” which is probably the key driver of the additional risk aversion today. The good news is that the impulsive drawdown, while warranted in the short term, might set up a buying opportunity for risk over the coming days or weeks in the absence of a genuine oil shock recession.


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