• Jan

Weaponizing the petro-dollar commodities




With the world running into hot inflationary pressures amidst the global energy squeeze, it might just be topical to address how this might affect commodity prices in the near future, as the implications for markets are severe. To put it bluntly, nothing else currently out there is moving the macro markets more than the supply chain bottlenecks feeding into commodity prices, which feed back into all markets as a result, whether its currencies, equities or commodities themselves.


The ability to price global commodities under one's own reserve currency can be a significant advantage to the one wielding it, whether intentional or not. The petrodollar component is the major point of the article, as it is the crucial driver impacting emerging market currencies, shortages, and productivity if markets were to face further debt or dollar liquidity-related issues from too high commodity prices.

Since the US is a significant beneficiary of buying its commodities under reserve currency, it faces no liquidity or import-related inflationary pressures and it could even be exporting inflation through the petrodollar exports and a combination of a strong dollar and high commodity prices. The article will address some ways how that have been done over the past two years.


So how did it come to this? Is the result of rallying commodities just a fault of a single man in the Kremlin, or is this a broader situation in the making? If one does not address this properly by digging into details, unoptimal conclusions can be made.

And to leave the answer at rest, no, this is not just the making of Kremlin; the pie was sent into baking way before that. Let's address some critical factors on how this might impact commodities over the next two years.



Are we heading into an inflationary or deflationary environment?


An interesting topic of discussion is whether the global economy is heading in either the inflationary or deflationary stage. What makes it interesting is not the difference of opinions out there but the facts on the ground, which are confusing and very much mixed. The actual reality is there are major both inflationary and deflationary forces present at the same time, more now than ever before.


Whether you listen to Cathy Woods's deflationary thesis or any Austrian inflationary prognosis, the most obvious is that both of those camps are equally right as they are wrong. Meaning that the globe has, over the past five years, not been moving completely in a single direction, but it was somewhat mixed, depending on industries and factors of focus, and especially zooming on specific economies, some went into a much more deflationary state (Japan) while others the other way around (Turkey, Argentina, and other emerging markets) into the inflationary stage.

And for the US itself, the tech boom provided (and still is) plenty of deflationary force but at the same time supply chain shocks and high energy prices lately provide the exact opposite force into the economy, the inflation that is. The mix of those two forces at strong opposites will provide a cocktail into the future as well most likely, where it won't be as straightforward to form a general opinion, but it is a much better idea to be specific about the targeted sector, to create accurate diagnosis/prognosis.


If one breaks down all the reasons which are not speculative and highly "prediction" based but rather just facts, its quite easy to see that forces present in global economy are very mixed and will likely lead to asymmetric inflation and deflation in the near future, especially for developed markets that is, lets lay out some quick reasons why that might be.


Highly financialized developed economies with substantial borrowing power at low rates have a much more deflationary environment because the cost of borrowing never presents as significant pressures or the need to raise rates as it does in emerging markets to retain the capital and still produce growth. The more "financialized" the economy, the more deflationary, at least until the economy is somewhat stable and debt distress is not an issue yet. So there could be a very big disconnect between US and Belorus, for example, in inflationary or deflationary net sum just from that factor alone because one is much more financialized and more developed market. And with many emerging markets being very indebted in foreign-currency denominated debts, this equation will likely spill with further inflationary pressures into emerging economies (especially if the dollar strengthens next years due to rate hikes) while being a bit more deflationary (in comparing terms) to developed markets. This is especially important for FX markets and exchange rates, but also commodities.


The technological revolution of the past three decades is especially to the advantage of developed economies as those have most corporations and deployed per-capita workforce (although China is quickly catching up). That is highly deflationary as it drives down the cost of production and labor, and it is highly prioritized in developed economies. And on top of that, it is also a challenge within developed economies, as the ones running ahead, such as the US, can win more technological micro races and, therefore, import more deflation as result. Importing more deflation leads to a higher ability to borrow and attract more capital flows at lower % yields; the advantages are not that quickly seen in the short term but do matter long term.


Globalization of supply chains drives the costs of production down, because there is more flexibility to select the suppliers and get anything that is needed from pretty much anywhere as distances play a lesser role in a globalized world where costs have priority over efficiency and distances, therefore spreading deflation into developed markets as access to cheap emerging market labor and resources is at hand. Globalization, therefore, is deflationary. However, that is highly driven by geopolitical relations. Simply put, when there is much love in the air between major powers globally, globalization and deflation will spread as result. When hardship arrives and relationships get under strain, inflation starts to advance rapidly.

Let's not forget that globalization took off mainly once the US got rid of its main rival, the Soviet Union in recent history at least. There was ample space in Eurasia open for connectivity without needed disruption to supply chains (to block countries in the "wrong camp").


That is why many, when they look past 40 years of globalization charts, and project that the world is probably leading into a highly deflationary environment, using nearby past as projection. But what they miss is a huge factor, that being if one stretches history wider than 40 years, those globalization micro-cycles are often disrupted by deglobalization cycles which lead to inverse, which is historically always been inflationary. Over the past several years, the Asian continent and the US actions have mainly had a strong footprint towards the deglobalization stage, where supply chains are being torn apart due to challenging countries becoming adversaries to the US long-term political projections and wishes.


Each time this deglobalization phase started, it typically lasted for 10 to 20 years, under which global inflation was on the rise. Therefore, it is very important to understand that the microcycle we are in is no longer the same that was present from 1990 to 2015ish. "The pivot to Asia" doctrine formed by the US administration was the igniting stage for the shift in that cycle in its formation in 2015. More about this on article under the 6th point.


However, as mentioned before, this does not lead to the fact that "deglobalization" means the end of globalization in general; that's not what historically actually happens. It just means selective parts of the globe become fractioned and deglobalized, while portion of economic activity still undergoes the globalization. However as result of deglobalization, most of the world faces higher inflationary conditions, as supply chains in too many economies break down as a result of it. This is the process we currently see evolving over the past several years.


As you can see, the outlook and the facts on the ground are far more mixed than just being strictly deflationary or strictly inflationary to either side. There is a mix, depending on which economy one is focused on, not to mention the sectors of economy itself. For example, we could be moving into a corporative deflationary technological environment and on the other hand, an inflationary environment from a consumer standpoint (gas, food, etc.).


And while someone might consider that it is only possible to comprehend the economy as inflationary or deflationary depending on what CPI print you get, and it cannot be a mix of both, that is not really how realistically one should look at it. Especially not in an era where the tech sector is becoming a bigger and bigger portion of the economy and is a major deflationary driver impacting much more economic weight than just speculative market bubbles like cryptocurrencies.


It is a much better idea to look at both sides of the table as the modern economy is a mixed bag of both (especially in a developed market like US, Japan or Germany), except that in some countries, it is much more tilted to one side and the others to the other side. So details matter, and when it comes to investing or trading, one has to formulate that picture well to know what economy, what sector, and then what ticker, and obviously, what direction. Everything matters.



Petro-dollar shortage in era of high commodity prices




Without spending too much time on what eventually leads to the economy to be under potential supply shortages, let's focus on one point which is the highlight of the article, the petrodollar and the use of the dollar as a reserve currency, as it will play a significant role on why emerging markets might face shortages much quicker than developed markets in upcoming years.

Understanding the functioning of petrodollar recycling has never been more important than in upcoming years, well that since the last time when it was under focus, in mid-1970s.


The advantage that developed markets have is that imports, mainly energy, can be bought and imported in their own currencies, or those economies, due to more substantial productivity, already have more significant FX reserves of USD, leaving them with a bigger capacity to withstand energy imports or commodity imports at high prices.

For example, the EU might import the bulk of its energy in Euro, which poses a minor issue for such an economy to come under currency shortage with which it would be unable to pay international energy suppliers for their resources. On the other hand, the US already has a theoretically infinite supply of reserve currency and plenty of commodities and energy internally. Hence, there is almost no such thing as running out of currency to pay for those needed commodities.


That, however, cannot be said for many emerging economies such as Turkey or Sri Lanka as in those two examples, although the list is far longer (nearly 80 plus economies) that are paying for imports under petrodollar status typically in dollars, which means that if those countries trade deficits have went into negative too much (import much more than they export) or their import costs have increased primarily because of rising energy prices (and they are not energy net producer) then that could lead towards the path of where country runs out of forex reserves to pay for those imports.

While that is not typical under normal circumstances as the economy will slowly always be able to adjust its trade balance, it can happen when very unusual global conditions are present under which the economy is unable to adapt quickly enough, which worsens the trade deficit and quick run on FX reserves. Many such emerging economies face similar conditions if commodity prices, especially energy, do not revert to lower prices (Peru as recent example).


As FX reserves run out, the country might be unable to purchase any imports other than imports it has from the closest nearby countries for which it might be able to pay in its national currency. Historically this has happened many times before, but this time this is an event present at a global rate and is even bigger than the 70s/80s example in South America.


In the image below Sri Lanka's FX reserves in a consistent downtrend over past two years, while the exchange rate is depreciating against the dollar fast, hitting almost a zero.



FX reserves and their correlation to commodity prices


The relationship between FX reserves and commodities is that if a few economies combined would run out of reserves; the imports would shrink, leading to strain and a significant decline in economic output for such a country, therefore shrinking exports at the same time into nearby countries. This can lead to a reduction of commodity exports that such countries produce (or final products which also impact commodities), leading to higher pressures on commodity prices since the supply of those would reduce more than the demand for them would, especially if it concerns food or energy as those two resources cannot just be rationed easily without major costs. This is one of the additional reasons why prices for commodities might remain bidded higher over next years as a lack of FX reserves in some EM countries creates an artificial restriction on supply and output, leading to more scarce commodities. The most exposed countries to this regime are non-energy producing countries, as FX reserves do not get refilled by high-priced energy exports, more easily leading to depletion of FX reserves through such imports.

The feeding-loop of shortages:

An example for country of Peru recently of how this all feeds into a loop of potentially increasing commodity prices for that country and external countries is if there is a lack of FX reserves and the inability to import as much due to high commodity prices, economic production gets decreased or partially shut down. All of this leads to protests, leading to more reduced productivity, which reduces the exports that the country is providing for other economies, leading to a rise in prices of such exports (commodities and products). This then feeds into higher prices for another economy and pushes into a deficit area or higher strain of reserves for that next economy, creating a loop.


And the longer high commodity prices remain present (especially energy) at majorly elevated levels across the board as they have been over the past year, the more chain reactions this can lead to, especially if rise is quick and large in % terms. Adding on top to that strong dollar, which weakens the exchange rates of many other countries, leading to even higher import costs (as many petrodollar imports are priced in USD) and further pressure on reserves. Again this is not big issue if just one or two commodity assets rise in price; it becomes a significant issue only when it is across the board for all commodity assets, as it has been over the past year.


Run-on exchange rate:


Example of rising import costs for Turkish economy over past year due to falling currency and reserves.


One of the side effects of declining reserves is that the exchange rate of the national currency will weaken, making all imports even more costly. For example, in Turkish currency terms, the energy import costs went up drastically higher than in most of the other economies in Europe or Asia. As the national currency weakens against the dollar, all petrodollar-denominated products will become more expensive, primarily energy, leading to further higher costs of those imports and worsening economic conditions. As the exchange rate declines, the population starts to exchange national currency for USD, which further on weakens such national currency as demand drops, further fueling the fire.



Commodity supercycle likelihood of continuing


Before we dive deeper into further defining why using commodity and resource price projections higher is probable for upcoming years, let's first determine why it is likely to see that. This is an outline from my personal view, however, there are no subjective biases in it; what it is, however, is that certain statements are based on projections and not the currently present facts. But as with anything in investing, some things require projections as otherwise, one cannot build longer-term views.

To layout 7 key points on why the supercycle and strength in commodities over the past year is likely to continue over the next 2-3 years:


-China's severe economic slowdown from 5% into recession (unlikely)


-Russian sanctions inversion (unlikely)


-Global growth decline due to rising energy and resources (likely)


-Supply chains reopening fully (highly unlikely)


-Removal of QEs and fiscal boosting in US/EU to give consumer buying power amidst rising commodities and expenditures, which would lead to a further rise in inflation (unlikely)


-Geopolitical resolutions for Russia/China/Iran for US relations (unlikely) -The 1970s replication without getting inflation (unlikely)

Everything labeled "unlikely" is commodities bullish; anything "likely" is negative for commodities. Total six bullish factors and one negative factor, weighting towards the bullish side quite strongly.

While there is more to include under the equation, those are some of the more important current present factors that will impact the resources across the board.

So let us dig into each of those topics a bit deeper to outline why some of those are given facts and some of which are my projections; whether you want to trust those is up to the reader, but they are based upon the years of research and careful observations, no rushed decisions.

1. China's severe economic slowdown from 5% into recession (unlikely)


While it is no secret that significant pressures are currently facing the Chinese economy from:


1. Property market bankruptcies due to economic activity dropping from lockdowns and higher commodity prices and the unwillingness of the government to save major companies,


2. Shrinkage of demand for housing for the first time in a long time,


3. Covid lockdowns limiting the industrial output and clogging supply chains,


4. Pressures on growth due to increasing energy prices, and more.


None of that is secret, but something has to be acknowledged, its economy is still within high growth % numbers, and when facing a downturn, the buffer that the economy has in terms of 1,2,3,4 or more % matters a lot.

To see a significant decline in demand for commodities from the Chinese economy, the growth would have to collapse quickly to closer to 0% rather than just 4% if that was to result in sustained negative pressure on commodities. Even with all the negative factors outlined above, this is unlikely to happen as, based on current projections, the growth might not decline by more than 1% using conservative and even less conservative projections of 2%, the total growth would still be at the numbers where the demand is present.


The reason why 1% growth decline would not create a sustained dump in commodities is that the prices are already elevated globally due to clogged supply chains, energy shortages, and other structural reasons which will not go away regardless if Chinese growth declines slightly by one percentage point. That is why to outbalance those factors significantly the growth really would have to collapse quickly and sharply.

To further highlight why even if growth in China declines, it won't create a decline in commodities any time quickly because supply chain issues and lockdowns create inventory drainage/shortages, all of which are possible for commodity bidding. So while declining growth is negative, the positive force of which outbalances it and partially explains why we have seen this phenomenon over past years where the economy is somewhat under restriction diet, yet the "food" prices of economy (the commodities) just keep rallying.


Obviously, that is as well one-sided view, since demand was heavily lifted as well from another angle globally by all the liquidity provision programs launched by central banks and fiscal authorities, including PBOC. So, on one hand, covid lockdowns that cause shrinking productivity or activity and on another hand major stimulation on demand side, which makes it quite difficult to see this super-rally in commodities in hindsight.

Therefore is it likely to see next year's growth decline from 5-0%, which would be the kind of shock that would really outbalance the demand and supply towards the supply side and therefore drag commodities down? Unlikely. 2% decline maybe or 1, but not more than that at least not within the first several months unless some other shock event comes soon after that (a global hacking attack for example).

2. Inversion of Russian sanctions (unlikely)


There is no need to spend many words describing why and how those two nations are significant exporters of many commodities and how the sanctions have led to a major rally among the commodities. Let us focus on what matters for projections, that which is not mentioned often in media or from market observers.


Are sanctions potentially going to be inverted and removed if Russia withdraws from Ukraine? My answer to that is highly unlikely, and there are many ways to justify such view, most of which would extend the article past the reader's interest, so let's stick with a conclusion. To highlight the first issue, which is that strategically it would make no sense for Russia to get involved in the attack on the capital city and then pull back while taking massive economic sanctions as a result, without finalizing the objective that was set in first place, which is to take the Kiev and install a proxy government. This means that until this happens, there is likely no walking back, and if it does finalize, Russia will always be looked at as capturing and invading force, making it very unlikely for the EU to take any further diplomatic talk route in the near future. It would most likely take a lot of passed time before that wound would get healed, as the EU would see it from their point of view. This means that the proper diplomatic and sanctions-inversion window is much more likely to remain closed for a while.

Using history as a projection, sanctions don't typically just get inverted within a year; although that has happened before (US-Mexico in 2020), it usually only happens among friendly countries and not adversaries (US-Russia). The majority of sanctions over the past eight years did not get inverted; if anything, they mostly got expanded when it comes to dealing with EU or US-Russia relations.

Additionally, we can look at what happened to Russian imposed sanctions in 2014. This gives us insight that it is more likely than not that the same path will be now kept in place, and sanctions will remain.


Conflict in Ukraine will last until Russia replaces govt and splits the country most likely, or the EU keeps financing the counter proxy forces, which would lead to a relationship between the EU and Russia unlikely to resolve any time soon, especially if Russia is unable to secure victory fast (which it cannot due to cost of civilians in Ukraine most likely if the full-scale invasion was to be used). This situation guarantees that strain will be set in place for a while.

The link below is the list of 2014 and onwards applied sanctions to validate the point above:

https://ec.europa.eu/info/business-economy-euro/banking-and-finance/international-relations/restrictive-measures-sanctions/sanctions-adopted-following-russias-military-aggression-against-ukraine_en

With that said, many resources being exported out of Russia and Ukraine will remain restricted, at least for another year since the writing of this article, since we are mainly focusing on one-year projection, as well long term cycle duration such as three years.

The arguments outlined above are essential because many observers are under the impression that the EU will sooner or later remove all the sanctions. After all, the costs to the EU economy would be just too severe to keep them in place. Historically, that statement is not justified because when geopolitics escalate, the countries are unwilling to step back, especially when it comes to significant powers, until one prevails through the very prolonged challenge. EU has helped to put on itself the burden it will now try to carry with the help of Russia, and it is less likely to see any major steps back in the near future, although nothing in history is always linear, so I could be wrong as well. But since this is about projections on what is more likely to happen, the point remains. Any subjective reasons and wishes should be discarded as its important to remain fully objective, to prepare the right view, especially in situation like this where its easy to get misjudged by sentiment.

3. Global growth decline due to high energy and resource prices (likely)



The only negative factor from my view in the next 1-2 years is that global growth might decline, especially in (some) emerging markets which can eventually lead to a decrease in commodity prices, since emerging economies consume a lot of such resources. However, it is important to establish that "eventually" factor as precisely as possible.

And not just that, since a major portion of commodity exports comes out of emerging markets, if growth declines to the huge degree where commodity exports become shrank and reduced (as often happens if economic growth plunges), that could in fact serve as stabilizing factor to commodity prices and prevent them to plunge further lower (since developed markets would cap the demand from beneath).

This creates an interesting pro-contra view and makes it difficult to assume which direction the tide might turn, that if, if emerging markets solo are taken under zoom.


One thing that is especially core thesis of current commodity rally is that energy is a significant component of it, unlike some other historical commodity rallies, which plays into a role that even if certain economies decline on growth, the bid for energy remains present, especially if supply is constricted pushing prices towards the ceiling rather than the floor. The basic equation is that the higher the growth, the more economy consumes, the more it imports, and the better the bid on commodities. If growth declines, the need for imports decreases; however, even slow-growing economies need a large amount of energy imports.

But let us consider the facts. Growth in the EU, especially within industry, is likely to decline or be under severe strain, not just due to high energy prices, which the EU imports the majority of it, but also the cut on Russian gas supplies, which would just shut down a portion of industry and consumption from the population as countries (mainly Germany and Italy) would be forced to ration the gas supplies and potentially electricity to some extent (as US LNG would not be able to replace it quickly). As strange it might sound to talk about the rationing of energy in modern economy, it could happen since the energy hole in the EU is large and Russia sanctions just dug it very much deeper. It goes without saying that any such measures would be highly disruptive to economic growth and would dampen the consumption of commodities, therefore, serve as a negative on price. How much industry or power rationing can happen due to that is still to see, but it is safe to assume that current growth GDP numbers do not include this, and the revision to the downside is highly likely if that were to come about.


To keep things in perspective as of the writing of this article there are already three countries under the regime of strong or mild rationing on energy/resources: Sri Lanka, Turkey and Lebanon.


If other economies that also import gas from Russia could then become a target for US sanctions, it might even push other countries to block the imports ahead to avoid any potential sanctions, all of which would contribute to declining growth as it creates energy imbalances in such countries (China as one example). Again those are not fictional speculations. The probability for those is well in the land of realism and it could spread to many countries.

Along with that, we have significant issues in emerging economies already since the past year, such as Turkey, Sri Lanka, Argentina, and others which are all facing inflationary pressures or the decrease in FX reserves pushing them on the brink of energy supply cutoffs on the imports. Few economies in a row under such same shared issue can contribute to drag on global growth, which net-net is commodity negative if we don't consider other counter-balancing factors.

However, let also point out one very significant factor: if global growth was to be highly isolated and present within mostly just emerging economies and not too much in developed markets, then that might not be bearish for commodities. Since emerging markets are the primary commodity producers, if growth was to decline there, the output of commodities would, too, restrict supply and lead to price pressure to the upside from developed markets that would still grab those commodities regardless.

This highly depends on how focused the slowdown would get on one or the other market. Still, one certain thing, the majority of economies that faced the most substantial economic declines over the past two years were pretty much all emerging economies. And this is likely to resume since those are less resilient (lesser access to borrowing, weaker supply chains, higher GDP consumption costs, etc.). That could be the counter rationale for global growth decline being negative for commodities if it was highly concentrated in emerging economies.

Or to keep it in short, if emerging markets would went into severe recession the output of commodities they produce would decrease, which even with their growth slowing would still keep commodities at high prices as the supply would get constricted as developed markets would still have demand for it. That would be the potential scenario, if growth decline in next 2 years would be highly focused on emerging markets specifically.

This does not even scratch the surface of all the negative and potential further negative catalysts present in the global economy, as there is a lot more to list. Still, without going too deep, let's say that there are rational factors that can support the decreased economic growth in the near future unless some country (like the US) could heavily outbalance those with growth, which would be less likely as the negative factors are far more significant in total net.

4. Supply chains reopening fully (highly unlikely)


Supply chains came under pressure from a few different fields over the past two years:


-pandemic related restrictions (shutdowns of factories or services)


-geopolitical blockades (sanctions and conflicts)


-political agendas (pipeline shutdowns, ports clogged without any effort to unclog them, etc)


If we discuss pandemic-related supply chain issues, those did plenty of damage but might or might not be relieved shortly. There is too much unknown and its why placing them into mid term thesis is not that good idea. As with July 2022, there is a hint to the global opening from those restrictions, which then would play a role in commodity prices to receive some mid-term release on price pressures; we still are unsure if this really is the end to it or something new might come along. Because of that, let us stretch this point into what is more probable to define that being the geopolitical blockades.

As with three key challenging powers in the Asian continent Russia, China, and Iran, the US has already signaled from all angles over the past several years that supply output from these countries will be and has been reduced, in some cases heavily (Russia) and some cases for now mildly or lightly (Iran and China).

Whether that is through imposed tariffs, sanctions on oil exports, sanctions on diplomats and reduced new opportunities for deals, technological restrictions such as a ban on semiconductor imports, there is a lot to list for all three countries. Without going too much into details, it is evident that the path is set towards further deglobalization of Asian supply chains and is unlikely to resolve shortly with inverse as that is part of US long term strategic vision. Whether the new pandemic comes around or not, it is very probable that Asian supply chains will come under further pressure, which is essential for a few reasons.


On the one hand, it can restrict the output of needed resources to other global economies. It can reduce global growth if the growth of those three and their nearby countries is damaged. It can create proxy conflicts (Ukraine, Taiwan) which can completely shut off the functioning of supply chains for primary transport on roads or sea, creating issues along the whole supply chain not of just that particular proxy country but even all nearby or external economies in large proximity.


Because of the need for "full-spectrum dominance" (as per Z. B.) status to be maintained by the US administration, it is unlikely to see supply chain pressures on Asia come under relief in nearby future. And let's not forget the population cluster and the demand in Asia is huge, which has an influence on the global economy in all directions and its supply chains as a result (both consumption-high population and output-plenty of factories).

Therefore the geopolitical pressures on supply chains of Asia and, as a correlated result, the whole globe will continue likely, pushing commodities to the upside since the supply constrictions and demand of population is likely to outpace the demand decline created by dampening growth rates in those economies. And that perhaps might be one of the most crucial points to keep in mind and can be to the extent currently seen in Sri Lanka.

It's important to understand the geopolitical aspect of why supply chains got to where they are, as it would be an incomplete view to blame this on just the virus. Or just the president of Russia, for that matter. This goes far beyond just that, as it was in the making for at least six years, if not more, not just the last two. Everything contributed bit by bit to where the situation currently stands, some things contributed slightly more, some less.

5. Removal of QEs and fiscal boosting in US/EU (unlikely)



So lets put a tin foil hat on for a moment and ask ourselves: "If you were to raise global inflation, how would you do it?" One way would be is by boosting spending and therefore demand in major G8 economies by excessive consumption. The way to do it is through direct stimulus checks, and central bank QEs that flows into corporations that import a large number of resources abroad and create bidding spree, and creation of boosting checks that address the rally of any consumer-related product, such as "gas checks" to address high prices at petrol stations. Whether that was or was not done intentionally (inflation hike) it isn't the key point, it has happened and it still is in progress, therefore we must direct it as "in play" since it impacts the commodities onwards.

Inflation in emerging economies often is localized; when emerging economies overspend, often the results in inflation do not spread too much across, other than a few things breaking in financial markets (Russia LTCM in 90s, for example). Often those events are isolated to a decent extent. Developed markets inflation is never localized, but it spreads, like a wildfire. everywhere. When many G8s start to stimulate all at once (not just QEs but fiscal too), what happens? That inflation spreads to all global markets because as G8s start to bid up everything it impacts all portions of supply chain.

For example from consumer electronic products increased demand, which then bids the price for electronics for all nations since those are priced globaly, which then bids the price for raw materials to produce those (rising commodities), which often leads to a boost in energy/transport costs due to demand increase (energy up), which feeds slowly into inflation everywhere including emerging markets (higher costs of production), even though the receiving end of higher commodity prices is bullish for specific emerging markets, likely the end consumer product will be more expensive and not net-net benefit long term. That being said, even though if FED and ECB do tighten the QE and unwind a portion of balance sheets as they said, it is still very likely fiscal stimulus would still be part of play for next two years. High gas prices at petrol station? How about a 500 USD check to address that. High grocery prices? How about 2000 USD check to address that. Result? More demand, more further upward price pressure on each of those commodity related fields.

Rebates, stimulus checks, and other fancy further inflation-inflicting things



Lately, we have seen US (California) implementation of the gas rebate, which would address higher gas prices with up to 400 USD rebate.

Before that pandemic, we have seen the US giving out 1000 USD consumer purchase checks which boosted online shopping, sending freight rates higher along with helping to clog the shipping ports.

On top of that, all of that combined with significant QE expansion by central banks. Some of those stimulus bills have also been implemented across other G8s (UK) and are very likely to be in the near future further provided. Not because that is what i think it should be done, but because that is the playbook in play by those playing the game.

One has to think about it from this perspective. How many economies globally can afford such expenses and checks to be given to people out freely without causing a significant increase in internal inflation? The answer is not many, not at least without very high cost. Emerging market economies mostly cannot afford such moves without facing a considerable increase in money supply, damage to exchange rates, worsening trade balance very quickly, and pushing capital flows out of the country, and very quickly breaking the economy in full collapse. That is essentially what has happened to Sri Lanka.


The difference is G8s can afford it at a much lower cost, but still costly non the less, but there is major difference in total, because G8s can print a lot more money and absorb the assets because the total M0/M1 money supply is much bigger and market cap of economies are larger, allowing for more monetary expansion, relative to emerging markets.


This matters as it creates a demand imbalance that is tiled to developed economies with higher buying power. Those same developed economies with such policies create self-inflicted inflation (export inflation), which spreads across the globe, even to the nations that do not wish or can deploy such policies. It worsens the supply chain issues and rises global inflation; however, the G8 consumer is not complaining as long as those stimulus checks keep coming in. Heh, well not really; pretty sure everyone is on board that when you are facing 8-10% inflation present for years to come, and as side relief 500 USD stimulus checks, the majority would prefer no stimulus checks if inflation can be removed as well. But anyway, to not theorize or moralize what is better or good, let's face the world we are heading into so that the right actions can be applied.

So which one is it, the chicken or the egg? Is the major monetary stimulus in G8 past two years the consequence of worsening economic conditions and it was needed to stimulate economy or is the stimulus pre-planed to push the globe into inflationary overdrive for G8s that weaken the challenging economies (most of which are in Asia)? Or could it be both? As the saying goes: "Never let the crisis go to a waste." It is very likely both based on my research, but since it would take long explanation to justify those points let leave it there.


What matters more is whether we can expect this to remain present over the next three years?

Suppose you take all the above on article as likely to happen in terms of supply chain issues, and commodity prices to remain high. In such case, it is expected that more such stimulus from central banks and fiscal authorities will come in the next three years, creating even further floor and pushing commodity prices higher.

Remember, what this comes down to, is that excessive stimulus prevents from commodities unwinding in prices lower, as the consumer demand and cooperative/industrial demand in those economies keep over-bidding for them, creating further push on commodity prices as "the normal" or non-stimulatory process of supply and demand do not get their chance to function letting normal market to settle the prices back to equilibrium.


To conclude on this point, likely that further stimulus is to happen, especially non-central banking stimulus, or in other words of previous FED chairman Bernanke, "the helicopter money" directed into peoples hand, rather than just central bank balance sheets or investment banks. Those might include food, energy, and housing stimulus checks, but really anything directly related to commodities is where the stimulus might be directed to. Keep one thing in mind, the 2009-2012 QE was different in structure that the money supply was not expanded much, and therefore did not impact inflation or consumer prices as much. This time the broad money supply was expanded strongly and stimulus was much broader. Although by no means that was the sole source of inflation that we have over the past two years, it certainly did help increase it, one could only argue by how much relative to other factors such as clogged supply chains.


On the image below Chart of M1 money supply expansion over past few decades.



6. Geopolitical resolutions for Russia/China/Iran and US relations (unlikely)


The last point that was already addressed above is that the geopolitical relationship between those four countries is unlikely to improve shortly due to many reasons. While the initial reasons (2010-2020) were the challenging or adversary ones, by now (2018-22), the relationships have declined so much that often in geopolitics, it is much harder to improve such strained relationships, and it is instead easier to keep worsening them further as both countries are more unwilling to cooperate as the disconnect grows.


Typically to improve such a decline in relations, there had to be some significant country that stepped in between and acted as a mediator or counterbalance, at least that's often how it worked on the European continent historically.

It is unlikely any of those countries would be willing to flip the side that much (and enough) because there is too much to lose by doing that. Mainly for any of those countries to revert to neutral status and become an adversary to a nearby Asian counterpart (while pledging a deeper alliance to US), it would mean sacrificing a lot of future potential for regional appetite, which is what drives all of those three countries close together (but not close other than what is truly necessary) against the common adversary, the US.




However let's not forget, that most observers overstate how strong and willful those collaborations are between those three countries. Most of those are forced relations that are deeply routed by historical clashes and potential future competitiveness in the Asian landmass, which makes them all very cautious of the next steps. Yes the common adversary is strong glue that binds them together, but a lot of those collaborations are very limited and only done at the point of what is must and not a step more than that.


As outlined above in the article, this strain on US/Asian relations is significant for functioning supply chains and its impacts on commodities in general. Let's list some of the commodity price-driven actions that were taken over past years, all of which are driven by that "challenger" policy of the US and the nearby Asian economies that revolve around it:


-Indonesia's coal import ban into China

-Australia's coal ban into China

-Fertilizer export ban from China to nearby countries

-China / Iran oil deal decreased the chances for the US to step on the side of the Iran nuclear deal and to release more crude oil on the open market

-Russian sanctions of many resources into EU market The point of the above examples is not to underestimate how much the hidden hand of the US administration had to do for ensuring those actions had a follow-through and to firm up the decisions for the cooperative allied countries against the three key adversaries. That hidden hand has a significant impact on supply chain dislocations that have and will be driving further movements in commodity prices, due to policy changes in upcoming years, between the importing and exporting countries, especially within the Asian landmass.

This strains the relationship often by creating sanctions that have shown the ability to push commodity prices higher as sanctioned countries are unable to export. Still, they also can (and already have in Ukraine) produce proxy conflicts that engage those countries, leading to completely disconnected supply chains sending commodities and final industrial products into much higher prices. The probability of such events in further future is there, with several Asian countries being a stronger possibility of proxy escalation. While Russian-related or Iran-related proxy conflicts are high commodity-related with upside squeeze potential, the Chinese involve a lot more industrial and final products that impact not as many factories or producers but more direct consumers. But the net result is the same, fewer products in stores that simultaneously push commodities higher and factories forced to overproduce and make up for the shortfall, and the net result could be just the same (that in the case of South sea-related event). This explains shortly why the current geopolitical environment is highly prone to being bullish for commodities and is unlikely to get resolved soon.




We are in the active process of deconstructing supply chains as the globe is heading towards deglobalization as a result of a decent chunk of Asian landmass finding itself on the list of nametag "adversaries" from the side of US administration. There are plenty of cases in the 1930s and 40s, especially along with 1970s that help to shine more light on what this really means for commodity prices and the functioning of supply chains themselves. So lets jump towards 1970s example since that is probably the most comparable replication example.

7. The 1970s replication but without inflation this time (unlikely)



It is always a good idea to use historical examples as potential replication guides for the current situation if there are any guides. Often the macro situation will have to be unique enough to be comparable to the historical situation. Otherwise, it might be too difficult or too noisy to draw opinions. Many macro observers believe that the 1970s might be the closest to the current situation, and there is a good point to that. The inflation ran hot in the 1970s, and FED responded first slowly and then faster once inflation started to ramp at a speedier pace, leading FED to hike rates significantly.

While we are not there with the FED response in terms of escalating inflation numbers relative to the 1970s yet all of this can be explained why; typically, FED will respond to inflation with delay (hence "transitory" rhetoric in 2021).

Therefore, it makes sense that initiation and commodity rally is the first component before any rate-hiking takes place at a significant pace if in next years we are about to witness similar rate-hiking procedure that mimics the 1970s (although rates could be only compared in relative and not absolute terms since the starting base is lower) .


The main issue of focus is not the action of the FED for now; rather, from the perspective of this article, the focus is all on commodities, and regardless of short term FED actions, it is likely that supply chains and increase in the monetary base (as shown on images above) will still lead to commodities performing in a way that is not directly related to FED actions, unless the dollar was to strengthen a lot quicker due to very ramping rate hikes. And if that was to come, it is still very likely at least a year away, just as it was in the 1970s, when it took time before FEDs chairman Volcker stepped up with rate hikes.


In other words, for the commodity rally to be stopped and the dollar to strengthen significantly the rates would first need to pass certain high threshold in my view at least, above 2%, most likely 3% (with further dot-plot projections 2% plus). Until that, the path is open for further rally, at least for another year or two, depending on how fast the FED will be tightening. This would then reflect a similar situation to the end of 1970s when rates peaked, and inflation along with commodities collapsed.


The chart below shows the US commodity price index and its rally at the height of the cold war from the late 60s into the late 70s when interest rates were hiked strongly, and liquidity was tightened, leading to inverse and crash.


The chart image below highlights the rally in inflation in the early 70s at very similar ramp and % increase to today's inflation hike which came all of sudden at a fast increase.



Chart of today's inflation increase on the image below as per CPI report (not wholistic but good enough for comparison). While the increase was not as parabolic, it is just as strong if not stronger since we have much more deflationary economy overall today relative to the 1970s.



One thing that especially should be taken under the note is that, while there are many comparisons between the 1970s and today, especially in terms of inflation and general commodity prices relative to costs of production, or just the geopolitical cold war situation itself (Soviet Union-US / Russia,China,Iran-US), something should be noted why in some sense, it's even more severe this time across the board, using 1970s as a comparison:


The 1970s:


-base deposit/interest rates were relatively higher than today's ones, providing more buffer to fight inflation


-the economy is more inflationary as the global economy was not as connected yet, especially in global terms GDP. The US was carrying a bigger load back then, which made rate hikes to fight inflation a bit more localized than in today's market.


-10% inflation in an era where globalization was not as strong as today, global rates of other central banks were at higher levels on average, and debt levels lower; if FED was to hike, it gave a bit easier room for everyone else to catch up, relative to today's markets, as global rates in the 70s were higher



The 2020s:


-base deposit/interest rates are a lot lower today than the 1970s providing less fighting buffer against inflation in the cash area


-The economy is much more deflationary due to globalization, where a 1% increase in inflation is more significant than a 1% inflation increase in the 1970s


-10% inflation in an era where rates have been falling for decades has much more structural pressures on all global economies if FED is forced to hike more, it can cause other central banks (G8s especially) to fall behind, creating selloff in global currencies, and creating inflows into the US as part of safety, further strengthening dollar and causing global dollar shortages in emerging markets, creating significant growth pressures as costs of imports for markets with plunging currencies increase dramatically.



Using the previous point above about how the geopolitics of Asia plays a major role in supply chain issues lately and shortly, let's take the context of 70s inflation and how the cold war was correlated as a de-globalization event just as we see the current one within the big picture of Asia. It is possible that the current inflationary cycle globally will be the same lasting as the 60/70s one as the macro conditions on geopolitics match quite a lot.

Many micro-events contributed bit by bit to where the inflation rates went in mid of the 70s, and it was hard to tell precisely where does the line start and end (1960 expansion by proxy conflicts and monetary issues, emerging market weakness in the late 60s, oil embargos in 71, etc).

Just as much is true with the current situation (China tariffs 2018 and worsening of trade, sanctions on Iran 2019, pandemic lockdowns 2020, then Russian 2022 sanctions, etc.). No single critical event is forcing this rally in inflation or commodities, but one thing is for sure, the line is continuous and is progressing at speed, and what matters the most, it is spearheaded towards a single common direction: more inflation.


The petrodollar component and financing of US expenditures and its linkage to the 1970s inflation hike:




It should go without saying that nothing the US does is random. The amount of capital spent by the US on what is being called running a "predictive forward geopolitical analysis" for its national security is the same as what the rest of the world spends combined. That means US is not spending large amount of resources in capital or human resources on reactionary policies, but on predictive policies 10 years forward into future. Who will be where, at what time, at what strength, helped by whom?


And there is a good reason for that, as the benefits the US receives from running the dominant position are huge, even though the majority of its internal population does not realize it. To outspend most countries via liquid borrowing/debt system all of which is the core of the petrodollar is a major benefit to the internal economy and population as a whole, especially when compared nation to nation globally and not internally (US capitalist vs US capitalist).


As the petrodollar was formed in the 1970s via the deal with Saudis, where the US technically defaulted a few years ahead of that due to the Vietnam war and other cold war prox expenses, the aim was to create a functional capital/debt recycling system where the liquid commodity such as crude oil would be used to finance the US debt with help of countries which sell the crude, as a return if those countries would then finance the US debt by buying the T-bills, storing dollars and pushing portion of spare capital into US equity market investments.


All of which created a perfect environment and reason to come up with another much more hidden reason. If such a system were to be created, obviously, the advantage would be to ramp the crude oil price as high as possible so that the crude in dollar terms being sold is expanded, the more of those petrodollars are then returned as debt financings into the US. Here comes the "random" Saudi Arabia oil embargo, creating just that, sending oil prices into the stratosphere, and providing a big additional buffer to petrodollars' financing.


The image below shows both events on the timeline:

The reason why the above matters is because the current situation fits closely to the 1970s in many aspects, especially how it relates to the petrodollar situation. The US debt has been ramped along with liquidity into the system since the 2020s pandemic crunch. All of which makes "the balance sheet" of US look a lot worse. However, nn the other hand, the crude oil prices have been ramped substantially, increasing inflows of petrodollars from abroad as a result and the ones pulled from US energy-exporting companies, which on other hand strengthens the "balance sheet" of the US as petrodollar inflows outbalance the net increase of inflation and other structural components.

Let's not forget over past years the US has become a major energy exporter, all of which overlaps with all the rest quite well as either a very beneficial coincidence or rather intentional forward-strategic move. And again, it is most likely not a coincidence if one looks at the coordination of actions that correlated to the petrodollar over past 10 years.

This is a critical point that many tend to miss and is why the dollar might not lose much value relative to other currencies even with increased money supply because no other country enjoys the reserve currency status while being a major energy exporter currently (for example Euro is to some extent reserve currency but EU has no energy exports to benefit from rising crude oil prices on its exports).

The situation in the 1970s was not the sole creation of Saudis that resulted in a significant rally of oil price, as external proxy conflicts were behind it as well, such as actions in Iran and Kuwait in later years, which is why precisely that fits the current situation. The 2020 pandemic supply chain crunch was the replication to some extent of the Saudi's move, leading to shortages slowly of many resources or just slowdown in supply chains, but at the same time, conflicts in Eurasia and sanctions (Russia, Iran, etc.) are correlated reasons leading to support for high crude oil prices. The situation is very much comparable overall.

The upcoming dollar crunch as a result of comparable 1970s to the current situation:

It is precisely because of that why in my view, the FED will raise interest rates a lot more in upcoming years, and while the interest (real) rates will never get above actual inflation, what matters is that many global central banks will struggle to keep up with FED, which will cause emerging markets to come under pressure just as they did in the 70s, leading to defaults and dollar shortages very likely.


The summary for this point, therefore, is that while it is visible that the 1970s situation is similar to the current one today, it is unlikely that we will not see a further rally in inflation or see similar actions taken from FED, all of which at least in the short term means likely strength to commodity prices and strength to the dollar. And while the dollars' value can fall against the commodity value in mid term, the value of the dollar, when measured in other currencies, will most likely rise as a result and already has, as a matter of fact.


From standpoint of forex, this matters as it shapes a different picture relatively to the internal value lost for US residents through the dollar (well known Dalio's statement of "cash is trash" in an inflationary environment). US residents might be unwilling to take dollars or park them at the bank as real rates will be under inflation, but non-US residents are likely to take dollars because their currency will be most likely under negative exchange rate pressure in upcoming years (with exception of major energy-exporting nations).



Total summary of all (7 points) and implications on commodities:



If we take a look at behavior past six years, as the supply chains began to crunch (first slowly, then faster after 2020), the behavior of the cycle was so far split between the microcycles of heavy demand constriction (2020 mainly) followed by micro cycles of supply constriction. Opening valve and then closing it, opening it again and then closing, repeat. Two opposing forces, but what matters the most is while demand has been "shut off and shut on," the supply constricting factors never went away; they keep building up over time, leading to further shortages and, therefore, consistent macro higher highs. This behavior likely keeps repeating where micro cycles shift, but over the long run, the supply restricting micro cycles leads the way for the supercycle direction to the upside. The economic activity so far has not been that significantly dampened (major drop in growth rates or recession), the major disruption came actually much more on the supply side, through those factors many of which are still actively present:


-supply chains not functioning properly because the workforce is restricted due to virus isolation (China)


-sanctions (Russia) dislocating a portion of supply away from the market


-damped productivity (whole globe) due to lockdowns causing the output of primary producers (such as miners, farming, etc) to shrink decreasing available supply, therefore demand remains present but demand is falling behind in many sectors


-high commodity prices make companies reluctant to bulk on inventories, leading to undersupply (especially in lower capitalized producers)


-protests in many countries leading to supply chain disruptions and supply disconnects (Canada, Peru, Sri Lanka, Kazakhstan, Germany, India...)

All of above events create further disruptions to supply chains, clogging the needed distribution arteries to function normally. Those events will likely keep mounting in upcoming years, as the inflationary pressures combined with shortages and high commodity prices keep increasing, therefore worsening the situation altogether, as the secondary problem feeds into the primary problem loop itself.


While so far, the current biggest "shut off from demand" event was the pandemic; the biggest such future event might be a major cooldown of the Chinese economy due to skyrocketing commodity prices as Chinese economy is a heavily commodity-intensive economy. This in itself would lead to damp demand and, therefore, correction from the industrial side, not as much for regular consumers but for the industry. That is still yet to see if it comes into fruition and if so is most likely more than just a year away, based on the toolkit that PBOC and government can still deploy short term to prevent it. However it is something to consider as it could play the opposite drag on upside for commodities, if demand really was to have a bottom-fallout.


Due to this, it is always important to keep the big picture in mind for long-term projections. Many economists or macro observers might be under the impression that this is just a short term spike in commodity prices due to the strange pandemic situation; the article above highlights thy that is very much an oversimplification and highly likely wrong view since using the factors combined above. The only thing standing between the further rallying commodity prices in near future is the major drop in economic productivity and consumption, until then the path is relatively clear to where it is likely to lead.





0 comments

Recent Posts

See All