Ukraine, Russian, and the End of Free Trade

            As this is written, the invasion of Ukraine continues to evolve.  While talks are scheduled, there is little hope of a diplomatic solution.

            A product of the Ukraine war waged by Russia is an international condemnation of the conduct of the Russian government in general and of its head, Vladimir Putin, in particular.  A number of sanctions have been levied by the Western European states and the US against Russia and its leaders and benefactors.  The sum total is to make the transfer of financial assets more difficult between Russia and abroad.  It also makes Russian exports more difficult to purchase.  Travel by certain Russians is also restricted.

            These barriers, while on only one country (albeit the largest country in the world by land mass), come as the ability to do business in Hong Kong is imperiled by decrees issued by China.  The EU is placing limits on the conduct of American social media companies to operate in Europe; further, airlines are having to reroute planes to avoid Russian airspace after Russian carriers lost the right to land in any number of foreign airports.  Taken as a whole, these incidents point to a trend where international trade is being made either more expensive or not available.  This has led to a scramble as companies try to find alternative sources of supply. 

            International trade is becoming more expensive and less reliable than even three years ago.  While Covid-19 did disrupt trade in 2019-21, the current changes in the terms of trade have nothing to do with the pandemic.  There is now a palpable level of corporate distrust in the ability of foreign sources to deliver goods or materials free of government interference.  Most businesses feel that they can plan around a change in public health, as there is an assumption that things will return to normal.  Changes in government decrees are a different matter. 

            The easiest way for a firm to address these issues is to move all production to their host country for assembly; however, this will result in higher prices.  The original premise of free foreign trade was the economic argument of “comparative advantage”.  This idea is that each country makes what it is best at making, passing the savings on to other countries so that all can benefit.  Tariffs, which raised the price of imports, were considered a tax on consumers as it made goods more expensive to assemble.

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            Sanctions are considered even more disruptive than tariffs, as they make output from the sanctioned countries more expensive by being no longer accessible at any price. This requires alternative sourcing.  In the case of Russia, most of their exports consist of energy and other industrial and agricultural commodities.   

            These actions represent a reversal of the free trade movement that began at the end of World War II.  In 1945, a group of financial heads of state met in Bretton Woods, New Hampshire.  Out of the meeting came a framework for lowering tariffs to expand free trade throughout the world.  The idea was that if two countries had commercial relations then they would be less likely to jeopardize the same with an armed conflict.

            Putin’s conduct effectively ended this assumption.  In his effort to bring the former Warsaw Pact countries back into the orbit of Russia and re-create the USSR in the process, Putin has gambled that Russia could maintain trade ties even in the face of its belligerent conduct. Most of the rest of the world has called his hand on this, and this leads us to the current situation.

            China seems to be the only major country to maintain trade ties with Russia.  China and Russia share a common border, and Russia has agreed to supply China with oil and gas. This relationship is expected to deepen as both countries have totalitarian governments.  Should the relationship strengthen, western countries operating in China will be pressured to leave.

            A world of more expensive trade will be inflationary for all involved. Such higher prices will slow down economic growth.  It will also be a world more polarized internationally, as countries limit sports ties and cultural travel among nations.  This is expected to go on so long as the current leadership in Russia and China continue to exist.  Barring the unforeseen, this could be a long time.

            Of particular note are the deposits of materials in both countries necessary for the production of electric vehicles.   Cobalt, rare earths, lithium, etc., are all needed to create the batteries for EV use. Most of the known reserves are in China and Russia.  It will be interesting to see if such materials are available and at what price.

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The Economy

            The disruption of Ukraine production could be a supply chain shock as great as was Covid-19.  Many crucial components for autos are made in Ukraine.  About 20 percent of the world’s wheat is grown in Ukraine, as well as barley and other farm products. 

            Of great concern is Ukraine’s output of neon, which is used in the production of semiconductors.  Neon is a gas which is a byproduct of the production of steel. 

            The situation in Ukraine is still fluid.  However, should Ukraine fall to Russia, there would likely be significant disruptions to the world economy. 

Interest Rates

            There is a group of investors that believe that interest rates will impact the economy and stock market more than Ukraine will.  Given the events of the past few days, that may be debatable.

            The official line is that interest rates will go up by either .25 or .50 in March.  If the events in Ukraine prevail, that schedule may be overtaken by events.  This is especially true if the US Federal Reserve is required to pump money into the international economy to offset Russian payments, which may not be made due to the conflict.

Inflation

            Inflation will probably be revised up with the events in Ukraine.  Gasoline prices will probably stay elevated, and companies are becoming increasingly aggressive in raising prices.

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            The biggest brake on inflation is the prospect that, at some point, demand will contract in the face of higher prices.  This will happen sooner if the Federal Reserve raises interest rates next month. 

The Stock Market

            Stocks have proved the truism that it is the unknown rather than the foreseeable that often moves markets.

            While the US is not expected to be directly impacted by the events in Ukraine, the supply chain disruptions are not to be ignored.  With elections slated for November, it is expected that increasing stock market volatility will be a way of life. 

Warren M. Barnett, CFA

February 28, 2022

Barnett & Company is a fee-only registered investment advisory firm registered with the U.S. Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations.  For a brochure on the company and its available services, please contact Elizabeth at 423-756-0125 or elizabeth@barnettandcompany.com

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