The risks looming for markets, inflation and supply chains from the Ukraine crisis

Nicholas Glinsman | February 23rd, 2022

For some seasoned Ukraine watchers, financial markets are underplaying  the crisis, especially given Russia’s central role in providing oil and gas to continental Europe. More broadly, markets have already absorbed a fair amount of Russian stress. In a note earlier this week, Goldman Sachs estimated that the tensions over Ukraine that had been bubbling up for months are responsible for a little over half of the 9 per cent drop in the S&P 500 benchmark index of US stocks so far this year. The nerves had also pushed some investors into the safety of US government bonds. Gold, another classic bolt-hole for jittery investors, is also higher in price than it would otherwise have been. 

The rouble, meanwhile, is around 9 per cent weaker than it would have been without this latest military adventure, considering how far it has fallen compared with a generally upbeat run in similar emerging market currencies. All in all, nasty, especially for Russian markets, but very manageable.

The big risk is that through the energy market Putin effectively makes the inflation shock biting into markets much worse and saps economic growth momentum. The US Federal Reserve has already indirectly acknowledged this. Geopolitical “risks”, “tensions” and “turmoil” crop up in the minutes of its January meeting no fewer than four times.

In a more extreme scenario, oil prices could hit $120 to $140 per barrel, well above current levels of a shade under $100. Europe’s already elevated natural gas prices are also likely to keep climbing, potentially adding as much as 2 percentage points to inflation in advanced economies. In normal times, central banks would tend to look through an energy-led rise in inflation, but given the current high rates of inflation, and corresponding concerns about it feeding higher inflation expectations, it’s possible that this adds to the list of reasons for policymakers to raise interest rates.

The upshot is that, in markets at least, the latest Ukraine crisis is likely to get lost in the noise about inflation. But it is stalking investors nonetheless. And, in contrast to the pandemic crisis of 2020, if the market reaction does get messy, the Fed could well be unwilling to step in to help. This current price action and complacency does remind me somewhat of the period after the tsunami that led to the Fukushima nuclear accident, which occurred on March 11, 2011. It basically took until July for the markets to discount the extent of the economic damage inflicted thereby. This time around, with the already behind-the-curve central banks, higher market volatility  and the diminishing market liquidity, we may well get to the equivalent point in a shorter pace of time.

However, this is not my main preoccupation when it comes to the consequences of Putin’s manoeuvres. No, my concern returns supply chain disruptions. A little noted point is that Russia, and thus Putin, controls the supply chain of western technology.

Bear in mind what Putin has lost by this action: he has killed the Minsk accord and therefore ended the possibility of controlling Kyiv’s foreign and security policy through the veto power of these two puppet regions. If he left it there, he would emerge from this crisis in a weaker strategic position. This stretches credulity, since two-thirds of the Russian army is coiled for a strike on the border, with little to stop them except Ukraine’s valiant but ill-armed reservists. Putin is not even hiding his intention. As he said in his diatribe yesterday, Ukraine was an artificial creation of the Bolsheviks after Brest-Litovsk in 1917 and “never had a tradition of genuine statehood”.

Meanwhile, the Munich Security Summit over the weekend was a love-fest of transatlantic unity, a choreographed effort to show that all key countries agree on far-reaching sanctions if he attacks. The words “massive” and “devastating” were repeated ad nauseam, as if it were an agreed script. But this Potemkin unity is unlikely to alter the Kremlin calculus. The West cannot activate serious measures because it risks an asymmetric response – a lighter variant of ‘mutual assured destruction’ from the Cold War.

As mentioned above, it is already well understood that Europe is a captive of Russian gas, and as a result, it dares not eject Russia from the SWIFT system of international payments because it would suffer a more immediate crisis than fortress Russia itself. However, less understood is the technology angle.

Washington professes to have a killer weapon that avoids such a risk of blowback and will therefore cause Putin to hesitate: it threatens to cut off Russian access to the global market for semiconductor chips. This would be the modern equivalent of a 20th century oil embargo, since chips are the critical fuel of the electronic economy. It would gradually asphyxiate Russia’s advanced industries, and would in theory reduce Putin’s regime to a stunted technological dwarf.

But this too is a dangerous game. Putin has the means to cut off critical minerals and gases needed to sustain the West’s supply chain for semiconductor chips, upping the ante in the middle of a worldwide chip crunch. Furthermore, he could hobble the aerospace and armaments industry in the US and Europe by restricting supply of titanium, palladium, and other metals. If he controlled Ukraine, his control over key strategic minerals would be even more dominant, giving him leverage akin to Opec’s energy stranglehold in 1973. The Kremlin could unleash an inflation shock every bit as violent as the first oil crisis, with a recession to match.

The White House has been slow to wake up to Russia’s counter-strike capability. It did not canvas US semiconductor companies on the risk until the critical materials firm Technet revealed the extent of US dependency on Russian supply of C4F6 gas, neon, palladium, scandium. Some 90pc of the world supply of neon, used as laser gas for chip lithography, comes from Russia and Ukraine. Two-thirds of this is purified for the global market by one company in Odessa. There are other long-term sources of neon in Africa but that is irrelevant in the short run. Technet said Russian C4F6 gas is used for etching node logic devices. Palladium is used for sensors, plating material and computer memory (MRAM). 

The world’s biggest producer of titanium is VSMPO-AVISMA, located in the ‘Titanium Valley’ of Western Siberia. It is owned by Rostec, the state conglomerate controlled by Sergey Chemezov, an ex-KGB operative who served with Putin in East Germany. Russia and Ukraine together account for 30pc of the global supply of titanium, but this understates their hegemony over the production chain. VSMPO-AVISMA supplies 35pc of Boeing’s titanium, mostly for 737, 767, 777, and 787 jets. It is used in engines, fans, disks and frames, prized for its resistance to heat and corrosion, and for its ratio of weight to strength. The US Bureau of Industry and Security published a report last October warning that VSMPO-AVISMA was providing titanium sponge to customers in the US at “artificially low” prices, with Russian state support, enabling it to capture a “significant share of Boeing’s business”. This should have raised a red flag. Weeks later Boeing committed to even deeper ties with the company.

In effect, Russia has been doing what China did earlier with rare earth metals: establishing a lockhold by selling below cost and knocking out the Western supply chain. The report said Russia is increasingly able to use this dominance “as a tool of geopolitical leverage”. The Bureau warned that the US is down to one ageing plant capable of producing titanium sponge at scale, and no longer has any titanium reserve in the National Defense Stockpile. It relies on supply from a hostile state-controlled entity to build US fighter jets, rockets, missiles, submarines, helicopters, satellites, and advanced weaponry. The report called for urgent measures to rebuild domestic production and acquire strategic reserves. What a shambles.

Airbus is even more vulnerable. Half its titanium sponge comes from Russia. Britain’s aerospace industry depends on Russian supply. VSMPO-AVISMA has an operation near Birmingham, making commercial alloys for aerospace, medical technology, and the military.

Putin knows that the pain threshold in the West is low after the fiasco of US sanctions against the aluminium producer Rusal in 2018. The US Treasury thought aluminium was a fungible commodity and that cutting off Rusal supply would not matter much. It learned a harsh lesson in market reality: global alumina prices doubled; the supply chain seized up; and there was collateral damage everywhere.

The bureaucrats had failed to understand the stringent certification process in the industry. But the point is deeper. Russia cannot be strangled because it is systemically central to the world economy.

Nor can Washington easily deny Russia semiconductor chips over the long run. The country has its own home-grown chip companies, led by Baikal and Micron. They can make mid-grade chips down to 28-nanometres (nm), adequate for mobile phones and the like. These companies could undoubtedly raise their game if it were a top national priority. Russia cannot make 5nm and 7nm wafers needed for 5G mobile, artificial intelligence, or CPU and GPU technology. The US controls the global ecosystem of advanced chips and could prevent Taiwan’s TSMC or Korea’s Samsung from supplying Russia. It would hurt over time. But the semiconductor chain is notoriously complex and populated by middlemen. There would be all kinds of work arounds: Russia wouldn’t be able to get the cutting edge stuff but it could get by with intermediate chips for most of its weapons. They can always fall back on the Chinese, and this would dilute the sanctions. It would not be easy for Russia because you can’t just switch over. Everything has to be redesigned to accept the Chinese chips, and they’re not the best either. It would set them back two or three years.

Chinese companies were reluctant to breach US sanctions after the annexation of Crimea in 2014. It is a different world today. Xi Jinping has made it illegal for them to comply with US extraterritorial sanctions. Even if the strategic deal between Russia and China at the Beijing Winter Olympics is overstated, Xi must have given Putin a green light of sorts over Ukraine. Otherwise Russia would not have pulled most of its military forces out of the Far East to wage war in the West, leaving the Chinese border exposed.

As the Russia-Ukraine situation escalates, there will naturally be a focus on potential impacts to commodity trade flows over the coming months. We would expect a diversion of Russian exports of commodities away from Europe and North America, and towards China. Some experts are estimating that 15 million tons of wheat exports from the Black Sea region could be at risk if there were disruptions. Ukraine may still have 7 million tons of wheat available to add to Russia’s export quota of 8 million tons, he wrote in a report. 

Now, just to emphasize the point, let’s consider a roster of commodities in which Russia and Ukraine has a significant presence. For example, the region is a major global supplier of wheat, corn and sunflower oil and Ukraine’s rich, fertile soils have earned its nickname as the breadbasket of Europe. The country is the second largest global grain shipper, while Russia often tops the ranking for wheat exports and is also one of the world’s most important sources of metals including aluminum and nickel.

Aluminum gained 0.7% to settle at $3,303 a ton on the London Metal Exchange, as traders braced for potential supply disruptions. Nickel topped $24,000 for the first time since 2011.

Aluminum consumers are already facing growing shortages during a booming period for demand, with surging orders from sectors including construction and packaging helping to drive inventories in European warehouses tracked by the London Metal Exchange to a record low. With stockpiles tumbling globally, analysts and traders including Goldman Sachs Group Inc., Trafigura Group and our own Tracy Shuchart  see further gains ahead as regional shortages worsen.

Palm oil also rocketed to a fresh record in Malaysia, climbing past 5,800 ringgit ($1,386) a ton on concern the global vegetable oils market would tighten further. Russia and Ukraine make up 80% of global sunflower oil exports.

Once you drill into the menu of western sanctions, it becomes painfully clear that the economic deterrent does not add up, either because the measures are less than they seem or because retaliation risk makes them unusable. The Munich conference was a three-day obfuscation of this fact, a ritual of collective denial, a pretence that anything short of weapons for Ukraine actually matters. The venue of Munich was all too fitting. The fate of Ukraine’s people is not so different from the story of the Czechs in September 1938.