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Russia-Ukraine war will cause tectonic shifts in global energy and geopolitical instability for decades

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Was the war already priced in? Or is the resilience a sign investors are more focused on what the Federal Reserve does with US interest rates next week than what Putin does to Ukraine over the next few months?

Or are equity investors underestimating the seismic shifts that the most dramatic conflict since World War II has set off?

Two ways the war will play out

While the idea that Russia’s invasion of Ukraine could represent a pivot point in modern history has been building for a few weeks, tea exquisitely timed Australian Financial Review Business Summit helped confirm two of the key ways this will play out across global economies and financial markets.

The first is the redrawing of the global energy map. Sanctions imposed on Russian energy exports this week by the United States and Britain, which have sent oil and gas prices to near-record levels, have ushered in a new era of energy insecurity, which Woodside chief executive Meg O’Neill told the Summit will last for decades.

This is not just about how Russian cargoes are replaced in the short term, something Santos chief executive Kevin Gallagher said is all but impossible.

Rather, O’Neill argued Western nations will now be much more selective about whom they rely on to provide their energy needs. While this will probably result in a tilt towards like-minded suppliers in Australia and the United States, broader shortages of oil and gas and higher prices look certain, and volatility looks guaranteed.

The second major trend was best illustrated by Summit sessions with Prime Minister Scott Morrison and chief intelligence adviser Andrew Shearerwho both warned a period of dangerous geopolitical instability was certain.

The pair made it clear Australia would need to become more self-reliant. This will include sharply increasing defense spending, but also building stronger manufacturing capability at home and shortening supply chains by pulling back from the globalized just-in-time world we knew before the pandemic.

Clearly, Morrison and his party are intent on playing the national security card in full campaign mode. But the Prime Minister is hardly alone in ramping up this type of rhetoric.

As Matthew Klein, author of the influential macroeconomic policy newsletter The Overshoot, wrote this weeka “global increase in capital spending to promote self-sufficiency (or at least supply chain resiliency) and to limit the risk of security-related disruptions seems likely”, while an increase in military spending is also clearly under way.

What’s most interesting here, as Klein points out, is that so many nations will be pursuing the goals of self-sufficiency and stronger defenses at the same time. “While all of these developments should be broadly positive for global growth in the short to medium term, there is a real danger that a synchronized surge in demand for physical goods will continue to put upward pressure on industrial commodity prices, especially since many of those commodities used to come from Russia.”

Chaos in nickel markets

Goldman Sachs sees a danger in a sudden surge in commodity demand tooparticularly given supply in many commodities – oil, gas, copper, nickel – was already struggling to keep pace with demand well before Putin sent his army into Ukraine.

It sees the chaos on nickel markets – where an extraordinary short squeeze on the London Metals Exchange resulted in the nickel price soaring 300 per cent in two days, and the market being suspended until next week – as an example of the sort of stress commodity markets have been placed under.

The ramifications of this sort of shock are difficult to quantify. As Credit Suisse strategist Zoltan Pozsar has argued, there is some potential for the turmoil on commodity markets to spill over into the broader financial markets if, as we’ve seen in nickel this week, the use of derivatives leads to margin calls that can’ t be met and sudden issues of liquidity.

But as Goldman says, the impacts will be both physical and political. Europe provides the best example of this. Already policies around decarbonsiation and defense spending are being reconsidered or even unwound, while windfall taxes on energy company profits and power price caps are now being mooted to try to blunt the impact of higher prices on consumers.

Obviously, the energy shock and the synchronized shift to self-reliance will push up commodity prices. At the Business Summit on Wednesday, Reserve Bank governor Philip Lowe expressed hope that this inflation could be transitory, but given the long period of underinvestment in energy commodities and many minerals over the past five years, that may be a forlorn hope.

How these inflationary pressures flow through to interest rates is obviously the key question for equity investors. With inflation already elevated, Lowe and his central bank colleagues find themselves with little choice but to raise rates, knowing that these increases will do little to actually ease the commodities squeeze.

How else will these shocks hit equity markets? Australia may actually be well placed given our position as one of the CARBN group of commodities exporters: Canada, Australia, Brazil, Russia and Norway. Local investors can get exposure to producers of many of the commodities that are soaring now and probably have further to run, from oil and gas to wheat to aluminum to nickel. As Lowe argued this week, higher income from higher commodity prices should also provide the Australian economy with a buffer from broader inflationary pressures.

But the threat of stagflation caused by the Ukraine conflict – an environment where interest rates rise as economic growth slows – hangs heavy over large chunks of the ASX and indeed global markets.

Exactly how this plays out in individual stocks is of course difficult to predict, but in an environment of heightened concerns about energy and geopolitical security, the potential for unexpected second- and third-order effects seems much greater than equity investors are currently anticipating.

The start of the Fed’s rate increase cycle next week will add another element to a complex picture.

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