[REPLAY] James Aitken – Market Implications of the Situation in Ukraine (Capital Allocators, EP.239)

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1:55Hello, I'm Ted Seides, and this is Capital Allocators. This show is an open exploration of the people and process behind capital allocation. Through conversations with leaders in the money game, we learn how these holders of the keys to the kingdom allocate their time and their capital. You can join our mailing list and access premium content at CapitalAllocators.com. Today's show is another special episode discussing the situation in Ukraine. My guest is James Aitken, the founder of Aitken Advisors, a one-man macroeconomic consultancy based in Wimbledon, England, that works with approximately 100 of the most influential pools of capital in the world.

2:40He's been a repeat guest on the show, sharing his deep understanding of the inner workings of the financial system. Our first conversation from back in 2018, including his background and process, is replayed in the feed, and the rest of the episodes are available on the website. This time around, our conversation covers James' perspective on the unfolding situation in Ukraine and its implications on markets. We discuss the shift in risk tolerance, friction in the plumbing of the financial system, interaction of energy markets and ESG, inflation and interest rates, reserve currencies and crypto, and his most important takeaways.

3:21Please enjoy this special conversation with James Aitken. James, great to see you. Thanks for doing this on short notice. Likewise, Ted, always good to see you. Extraordinary times, right? It is. I thought it'd be really interesting to get your take on the implication of what's happening on markets. And with that, why don't I just open it up to you? Like all humans, I've been wondering, is there any historical analog that I can grasp or my clients can grasp to help us think about this period? We all look for patterns to help us with our judgments. And I'm struggling. I'm struggling that you can pick a bit from the 70s or Cold Wars or 1960s or other periods if one wanted to be really dramatic like 1956 in Hungary, but I don't think any of that's going to help us.

4:11I was just thinking as a way to frame this in a useful way for investors, and perhaps we start with this. I mean, markets are a contest of ideas and an accumulation of positions. That's all they are. And for the past few months, we've had this contest over inflation. How long is it going to last for? And what does that mean for central banks and so forth. And I'm starting to think that as important as that inflation conversation has been, I'm not sure that matters anymore, or at least not to the extent we thought it might three weeks ago, because this is now exclusively about geopolitics. But of course, we will talk about markets, but think about regret and think about the psychology of investing.

4:53And I know this is a bit high max strategy involves selecting the alternative that maximizes the maximum payoff available. And in practical sense, a recent example of that would be those investors who went long everything in March and April 2020, expecting a colossal sustained policy response. So the maxi max strategy is suitable for an optimistic, risk-seeking investor who desires to maximize their returns from the best possible outcome. A minimax regret strategy is one in which the investor seeks to minimize their maximum regret. How do I minimize the damage from the worst-case outcome? And it's the opportunity loss through having made the wrong decision.

5:53That's what regret is. And I just have to say that based upon nonstop client calls over the past several days, and particularly through the weekend, it seems a growing number of investors realize the seriousness of the situation we face today and the desirous of minimizing their maximum regret over getting this Ukraine situation wrong. And that is starting to impact asset prices far beyond energy and commodities as we're seeing all across our Bloomberg screens. What does the maximum regret look like in your client's eyes? Let's again think in practical terms. One client said to me this morning, we are all euro stocks banks now.

6:43Everything is trading off estimated or real damage to European financials combined with a bit of energy volatility. And let's just stick with that. For a number of good fundamental reasons, global investors were starting to return to European financials. There are a number of good fundamental structural changes afoot. European banks were starting to return an awful lot of capital, boost buybacks, increase dividends. The economic outlook in Europe up until recently looked pretty good. And you saw a slow, steady appreciation in European bank stocks. Well, not anymore. and everyone's now an expert about how bad the situation's going to be in Europe.

7:26And indeed, Ted, if one takes the belligerent pronouncements of European politicians and policymakers at face value, it seems that in an effort to thwart Mr Putin, Europe is prepared to tolerate a recession or at least something that looks awfully like a textbook definition of stagflation. So unsurprisingly, there's been some people trying to get out of their positions in European financials. But that's the short-term money. The long-term money is like, oh dear, we had a number of cogent reasons to own European financial institutions. But this is a very real exogenous shock. What do we do? Now, in putting some numbers on it, and these are approximate numbers, in European recessions, and we've had a couple of them over the past decade or so, European financial stocks tend to drop anywhere between 40 % and 45%, in some cases a lot more.

8:22So if late last week, European financials generically are down 25%, they're now down more, then it's a bit of a dilemma for the patient long-only investor who thinks that European financials are actually due to outperform for the first time in many, many years. What do you do? Do you sell something that's down 25 % or 30 % thinking it might drop another 10 % or do you just try and ride it out? And that's the dilemma quite a few people are facing right now. But if in doubt, if you're engaging in the minimax regret strategy and you think this Ukraine situation could drag on, you just hit a bid. And it's a really tricky one.

9:01When you start talking about the financials, you really do have a deep understanding of the plumbing of the financial system. There's talk about SWIFT. How should we be thinking about the implications of sanctions of SWIFT on markets? it's interesting how the sanctions haven't actually come into effect yet. And the US Treasury in particular has been very keen to point out that the entities that have been sanctioned, the ones that have not, and how keen they are not to do anything that might jeopardize not just energy, but energy payment chains. And we'll come back to that payment chain idea in a moment.

9:46But it's interesting, Ted, because there's a 30-day grace period when Washington, or should I say Treasury, announced the sanctions. The bulk of the US sanctions don't come into effect until March 26th. So you think to yourself, okay, there's an opportunity here for market participants to trim their books, trim their exposures in a sensible way. A 30-day grace period, everything should hum along nicely, which is obviously exactly what has not happened. and there's some important historical context. So as much as the official sanctions don't kick in for a bit, the private sector, large global banks, have started self-sanctioning because look at the fines that all these big global institutions or one particular European institution had to pay over the past decade when it became apparent they had breached sanctions on Iran or Venezuela and elsewhere.

10:40So if I'm a big European bank or a global bank, and I can see that there's a window for the sanctions before the sanctions come into effect, I'm going to start to wind everything down now. So to me, it's not the official sanctions that are driving the turbulence under the surface of commodity markets in particular. It's the eagerness of private sector financial institutions and banks in particular to self-sanction lest they inadvertently release payment to an entity or a company or a person who is going to go onto these sanctions lists, that ultimately comes back to haunt them in three to six months' time.

11:23So it's, okay, if in doubt, no, no, and no. And to drill down into the real plumbing, as ever, it's all about documentation. What's been happening over the past week, and I know some of these people, is that general counsel of various large European financial institutions and global institutions have been going through all their loan and derivative documentation with all sorts of Russian counterparties. They're trying to understand if they can stop payment or stop lines of credit being drawn down. And happily, in many cases, there is a what's called a draw draw stop clause. So if I'm an Italian bank and the Russian counterparty says, oh, I want to draw down on my billion euros, you say, well, actually under our draw stop clause, this is a trigger event.

12:15And I'm sorry that our line of credit is no longer valid. And you're seeing that snowball across all sorts of markets. But of course, Ted, it's not just a European financial institution guarding against breaching sanctions with a designated Russian counterparty. It's all these payment chains that run through SMEs across Europe or banks in Europe that might have used Russian banks to clear certain payments on certain transactions. It's not just related to energy cargos, it's also energy infrastructure and everything else. And untangling that unsurprisingly is complicated. And in the case of energy, you've still got some fairly antiquated methods for confirming commodity-related transactions.

13:05And to unwind all of that in a smooth way in a 30-day window is obviously not a sensible thought, but people are trying. So it's the self-sanctioning that's driving markets. Now, let me give you another practical example to help them think about what's happening. It is known, and this is in the public domain, that Gazprom PLC here in London is the entity that hedges Gazprom's energy cargos. Now, as best one can determine, it's a pretty simple business. Gazprom PLC uses listed commodity contracts with a dabbling of over-the-counter contracts to hedge all the cargos that Gazprom may be selling. Now, there's a reason that Gazprom Bank has not gotten on and may not go on at all the sanctions list.

13:57Because what US Treasury learned in 2014 is that if you put Gazprom Bank on the sanctions list, you break energy payment trails everywhere. Because Gazprom Bank is the key intermediary, or has been the key intermediary, for all sorts of global payments from global energy companies to and from Russia. So if you put Gazprom Bank on the sanctions list, and it may yet happen, I don't know, then you irrevocably break all sorts of energy payment chains between Western institutions and Russia and vice versa, and who knows what happens. So what's that got to do with Gazprom PLC here in the UK? Well, for a number of reasons, who knows if Gazprom PLC will be a going concern beyond the next one to three months?

14:51We don't know. But what happens to all those hedges on listed exchanges that Gazprom PLC may have had? Right now, I'd imagine they're probably at some level trying to buy them all back, as are many other people. But if Gazprom bank is no longer a going concern and walks away from these listed energy futures that it is used to hedge their cargoes. What's the ripple effect through certain clearinghouses? What does it mean for default funds at the clearinghouses? We have to start to think about some pretty interesting plumbing problems. And look, again, the key point here is untangling all these commodity payment chains, or should I say energy payment chains to and from Russia, is a very complicated thing.

15:37But the mood of the private sector financial institutions is, if in doubt, say no, decline, chop lines, and then ask questions later. But I think we've still got a long way to go to sort this out. And I think the ripple effects through the plumbing of what's happening to these energy payment chains has barely begun to be felt. And this is before, Ted, we ratchet up sanctions. Because I think as Marco and other people have pointed out, as much as the West is very keen to impose sanctions on Putin, and very keen, it seems, to believe that the sanctions may result in regime change in Russia, so far, these sanctions have had absolutely no impact on Mr.

16:22Putin's behavior. So if we're going to start to think about sanctioning Russian oil, do we then move on to other Russian commodities? Do we then move on ultimately if we can secure other supply Russian gas? And then how do we think about all those payment chains that are starting to open up between Russia and China? Should we start to sanction those as well? This is where it gets very tricky. If we take a step back from the plumbing, And there's certainly risk. I'm hearing many versions of Lehman going on in my head with the complexities of stopping the source of liquidity in this one sector. I'd love to hear your thoughts on the energy markets.

17:06We knew going into this that there were various energy supply constraints. Now, that's a bit of an understatement. And we knew that there was a very keen political clamour towards net zero. In fact, it seemed like a lot of countries were in a race to net zero. Any thinking market participant or any thinking citizen knew that there was a huge cost to the climate transition, even if it wasn't publicly discussed. And we also knew that as a result of ESG and other things, that there was not a great number of incentives for any oil and gas company around the world to invest in more oil and gas capex to boost supply.

17:51We knew all of that. This development has effectively exacerbated and exposed existing supply side constraints in global energy markets. Now, there's a bit of a problem here. I know and believe me, I am very tempted to just say this is all ESG. It's nonsense. Okay, there's perhaps some hints of that in Europe, particularly Europe, contributing to this energy shortage. But we need to go back a little bit. And again, let's try and make it practical. I gave a presentation to some friends of mine at the end of July last year. And it was a room of, I'll just say, large institutional patient capital in North America.

18:34And the topic of my presentation was oil, ESG, and inflation, three sides of the same coin. Sounds very clever, doesn't it? But I think you can intuit what the message was, look, we're going to need a lot of oil for the climate transition. We're going to need a lot of gas. ESG probably disincentivizes oil and gas companies to invest in oil and gas capex because you're not going to be allowed. And then all of that probably feeds through to high gasoline prices, inflation, and here we are. So it was intuitive. But the feedback from the people in the room controlling enormous amounts of capital was super interesting.

19:10It's like, We agree on oil and gas. They were even back in July last year being offered high single digit returns way up the capital structure in all sorts of energy opportunities across North America. Couldn't touch it. And they couldn't touch it because their regents or their investment committee or student body or all of the above had said, no, no, no, no, no. You need to get out of all of that. You cannot invest in fossil fuels. It's all renewables or nothing. So from that perspective, it is tempting to say, oh, it's ESG, ESG, ESG. I'll just be a little bit more subtle and say that, yes, the climate transition juggernaut, the net zero juggernaut, and the ESG juggernaut does have to accept some responsibility for the energy market constraints that we're all discovering now, or at least we're all more aware of now.

20:02But there's something else that we need to keep in mind with regards to US shale. And you recall that nobody blew more capital more spectacularly than US shale. I think in the 10 years to 2017, Ted, when I looked it up, US shale companies blew through about 300 billion of capital. If in doubt, drill a hole, pump it out, borrow as much as you could against the oil coming out of the ground and do it again and again and again. There was no shale capital discipline to speak of. And then from 2017 onwards, you had activist investors went on the register of some of the better US shale producers and said, no, no, no, no, no, no.

20:45You need to be much more disciplined with your capital. You need to be much more responsible. We're not telling you no CapEx, but none of this drill a hole, pump it out, borrow, rinse, repeat. You're going to be a responsible business. And that also changed the incentives for these US shale producers before the ESG juggernaut, when the climate transition and net zero juggernaut took hold. So to be clear, what's been happening over the past year or so, it has, I think, opened people's eyes to just how constrained global energy markets are. are. And unless oil and gas companies are given unambiguous political cover to expand CapEx once more in the naughty stuff, the non-renewables, then I'm afraid it's difficult to imagine a rapid solution to the energy supply bottlenecks that we're all seeing right now, Ted.

21:47It's very difficult. All of that leads to, on the energy side, oil prices over$100. There's been lots of inflation in the recent statistics. Only fuels it more. So how are you thinking about the implications of inflation for a longer period of time on portfolios? Well, I'm not going to win any prizes here, but you'd have to guess that the probability of sustained higher inflation has gone up. There you go. Genius. More seriously, even as we turned into 2022, the odds were quite high that it would be more difficult and take longer to address the supply chain bottlenecks and therefore goods price inflation.

22:36We also had ample data in the United States in particular, that services inflation was broadening out across sectors and increasing. Nominal wage inflation in a very tight labor market is ongoing, although real wages are not quite rising. And then, of course, you've got this climate transition humming in the background. I'd say, best I can tell at least, as we turned into 2022, the odds were already rising that over the next several years, average inflation would turn out to be higher than in at least the 10 years prior to, say, 2020. That would be my best guess. And I think this tends to underwrite that idea.

23:16So, of course, perhaps by the end of this year, we unclog some of these supply chain bottlenecks, although it's less likely if the Ukraine situation extends. So goods price inflation may or may not come down, services inflation broadening out, it's probably, I think, increasingly likely that average inflation over the next several years turns out to be uncomfortably higher than people are used to, or at least that their asset higher than their asset allocation models may have considered or factored in. And Ted, if average realized inflation over the next several years is likely to be comfortably higher, then it probably means that average realized interest rates are going to be somewhat higher, and more precisely, that average realized interest rate volatility is going to be higher, all of which is probably a pretty strong headwind for some of the most loved assets that we're seeing on screens today.

24:14And obviously, most of all, that would probably continue to be a very strong headwind for what remain hideously overpriced long duration hyper growth stocks. I mean, obviously, but it's also a bit of a headwind for credit. And on balance, it probably means that financial conditions need to tighten or will continue to tighten, which makes for a big challenge for markets. But maybe all of this misses the point. I mean, we are market participants trying to understand how to not lose money and then trying to figure out how to make it. But first and foremost, we're all trying to process a very serious geopolitical event.

24:53And as I said at the start, we've had this debate in markets over inflation and how central banks can or should respond. And there's also been this rather strange discussion in markets about, oh, does the Fed, for example, face a hard trade-off between growth and inflation, which I found a bit strange. But I do think it is fair to say that we now have a very different trade-off for central banks, because maybe it's not a trade-off, if you will, between higher realised inflation and growth. Maybe it's a trade-off between which is more important, addressing inflation or national security and geostrategic concerns.

25:35I mean, for example, I do think the Fed can get away with a few rate hikes here, even though the situation is deteriorating in Ukraine, because the underlying growth of the US economy heretofore has been pretty solid. So I think the Fed can get away with a handful of rate hikes here. We shall see. But that doesn't mean they're just going to keep fighting inflation at all costs. If sanctions keep going up, if disruption in financial markets keeps going up, and if key global energy markets remain extremely volatile, given the direct read through to households and household consumption and so forth.

26:09And look, it's even a worse problem in Europe, because up until three weeks ago, the ECB, in their idiosyncratic way, were moving towards withdrawing monetary stimulus. And Ted, it was incredible, again, up until three weeks ago, to think that the main policy rate in Europe at a time of much higher realized inflation was still minus 50 basis points and the ECB still buying assets. And they were just building consensus about the need to tighten policy later this year. And now they've been smacked by this Ukraine situation. It's a horrible, horrible situation for the ECB to be in. And perhaps unsurprisingly, the shock absorber for this in Europe is European financials, shares, and of course, the euro.

26:59But just on that, there's a lot of people saying, oh, this is all about dollar strength, the dollar's gapping away and everything else. That's not quite right. It's more a story of euro weakness. So where am I going with all of that? It's a very different environment for investors. I think it's a very brave investor that says, right, I am going to go in and buy X now on the assumption that the Ukraine situation is going to dissipate and that eventually we'll find a solution. I think it's too early to do that because as best I can tell, sanctions are going to go up a couple of notches to have any hope of altering Mr.

27:35Putin's behavior. And if we think sanctions are going to continue to tighten, if we think belligerent in the literal sense of the word, certain belligerent European politicians egged on by their citizens are willing to help Ukraine arm and help Ukraine fight back, then my best guess would be that the volatility that we've started to see in financial markets is set to continue and expand across all asset classes. And that's a tricky time for us all. With equities, credit, commodities looking to be volatile in risk, the other area that relates to all the banking activity, to some extent, is crypto.

28:17And I'm curious what you think the implications are of these events on crypto markets. Unsurprisingly, Ted, as soon as Washington, and let us not forget, Europe impounded Russia's foreign reserves, there was an immediate, aha, told you so, you can't trust reserve currencies anymore. This is great for crypto. I get why a bunch of people might like to say that. And then in parallel, there were people saying, you can't trust the United States. You can't trust Europe. It's a no-brainer. The renminbi will be the world's new reserve currency. And there's just a couple of points on that. If the United States alone had impounded the Central Bank of Russia's dollar reserves, then I would say, oh gosh, this is not a good time for the dollar hegemon, etc., and start to think about long-term spillovers on other potential reserve currencies.

29:20But of course, it was both the United States and Europe that impounded the dollar and euro reserves of the central bank of Russia. It was not the United States going alone. And I think therefore people need to recalibrate this discussion that the US is somehow losing dollar hegemon. We'll get to crypto in a moment. But on the subject of the remnambi being a reserve currency, I have a few doubts about that. I'm not sure you can be a true reserve currency if your capital account is shut. And as much as various active and passive investors have increased their remnambi exposure over the past couple of years, I wouldn't fancy going into a Chinese court under Chinese law looking to recover full value of my RemNimbi assets.

30:08I'm not sure that's an upgrade from the rule of law as we understand it in the West. Time will tell. So I don't think there's any immediate reappraisal of the RemNimbi as a global reserve asset and we start to see colossal flows into it, or should I say accelerated inflows out of dollars and euros into RemNimbi. I'm not convinced. As for crypto, it's really tricky because I think the dumbest thing any Russian oligarch could do now would be to attempt to put hundreds of millions of dollars or whatever they want into crypto because I reckon it would rather show up in the price, would be my guess.