- Frank Byrd and Stephen Korn
Impact from Ukraine
“Oil reserves have defined geopolitics for the last five decades. Where the fabs [factories] are for a digital future is more important. Let’s build them where we want them and define the world that we want to be part of in the U.S. and Europe.” Pat Gelsinger, CEO, Intel CNBC Interview (3/23/22)
Just in Case
The Ukraine crisis shifts the way our world works. The way that we navigate it – as leaders and investors – needs to shift accordingly. As we mourn the devastating loss inflicted by Russia’s invasion of Ukraine, we struggle to make sense of what Putin’s motivations truly are. Regardless, we have increasing conviction in the consequences. The horrific images of mass dislocation and death tell us everything about the immediate impact on the people of Ukraine – and Russia. There will be longer-term consequences for millions more around the world – less lethal and tragic, though significant nonetheless. Consequence: Deglobalization Ukraine has amplified countries’ fears of being dependent on other countries for key resources such as food and energy. The past century of globalization made our supply chains more efficient, but as COVID shortages revealed, it also made them more fragile. The Ukraine crisis makes this even more painfully obvious. US automakers need chips from Taiwan, while Taiwan needs Xeon from Ukraine to make the chips, and so on. Following COVID, the mantra shifted from “just-in-time” to “just-in-case”. The Ukraine crisis intensifies this sense of urgency. Witness the dramatic examples already underway:
Germany is accelerating two liquified natural gas (LNG) import terminals to begin weaning itself off Russian hydrocarbons.
Intel is spending over $20 billion building two leading edge semiconductor plants in Ohio. And it's not just U.S. chip manufacturers bringing production back to our shores. Taiwan Semiconductor is building a $12 billion plant in Arizona, and Samsung plans to construct a $17 billion plant in Texas.
Ford plans to invest $11 billion building a car plant and three battery plants in Tennessee and Kentucky. "Bringing the battery supply chain to the U.S. insulates Ford from being held hostage by battery shortages the way the industry has been kneecapped by the global semiconductor chip shortage," reports the Detroit Free Press (Sept. 28, 2021).
Consequence: Dollar Fragility
The U.S.’s decision to freeze Russia’s currency reserves was unprecedented. Many commentators have fretted this has “weaponized” the dollar. While this may be hyperbolic, we believe there are negative consequences – at least marginally. Near-term, amid the Ukraine turmoil, the US dollar is benefiting from its perceived safe haven status. Longer-term, we believe the central banks of foreign countries will diversify away from the dollar to avoid the risk of finding themselves in Russia’s shoes. China and Russia both were already doing this over the past several years. The following chart shows China’s significant reduction over the past decade in foreign currency as a percent of its central bank’s reserves from over 80% in 2015 to under 55% last month (most of which has been in U.S. dollars).
Source: Factset, PBOC, Yardini Research
Even friendly countries like India may reduce their U.S. dollar reserves as a precaution against future conflicts with the U.S., or rather in anticipation of dollar weakness, as “troublemakers” like China, Iran, or Venezuela shed their own dollar reserves.
Consequence: Inflation
A more robust supply chain is not the cheapest one. Do we really want to be reliant on China for N95 masks, or should we make some here? Even if it costs more, wouldn’t it be worth it? Every manager of every production line is surely asking similar questions. This can lead to wage inflation, as employees demand raises that keep pace with their own rising cost of living. This will happen quicker than the longer-term disinflationary forces of robotics and automation. The upshot is that an anti-fragile world is more reliable, which may be more cost effective longer-term, if not downright cheaper. But we’re years away from that potentially positive outcome.
Consequence: Volatility
All of the above will not be smooth. We should all brace for more volatility – geopolitically and in markets.
Investment Implications
Gold and Bitcoin: Some central banks have been shifting a greater share of their reserves to gold. Over the past 20 years, China and Russia's central banks have increased their gold holdings by approximately 400%. We expect other central banks to allocate more to gold as well. Some believe that central banks could also increase their holdings of Bitcoin or cryptocurrency. While we agree that it could be positive for Bitcoin at the margin, crypto remains too small relative to gold in order to make much of a dent in central bank balance sheets. Gold’s market size is ~13x that of Bitcoin’s. Global central banks would thus have to acquire all of Bitcoin’s market value to make a dent, and even then, it would total less than 40% of their existing gold holdings. It’s far easier and faster to grow their gold holdings. Still, Bitcoin could benefit as central banks of smaller countries build meaningful positions (as El Salvador has recently done).
Commodities and natural resources: The combination of onshoring, re-militarization, and fortifying strategic reserves increases the demand for oil, grains, metals, and minerals. For example, President Biden recently floated the Defense Powers Act to make sure we have enough battery metals.
Companies with pricing power: We continue to believe that the best defense is a strong offense. For investors that means owning companies that have pricing power through an inflationary period. That includes (but is not limited to) companies that are leaders in innovation. We are on the cusp of profound innovation in technology, biotech, clean energy, and new materials, to name a few examples. We want to own a piece of this innovation as shareholders.
Energy: Nuclear power will play a bigger role as well. We expect continued investment and innovation in renewables and conservation, along with policymakers seeking to source fossil fuels domestically or from “friendly” foreign sources.
As we fortify ourselves and portfolios for a rough period ahead, we believe it is crucial to remain open-eyed, open-minded, and adaptable.
Yours in the Field,
Frank Byrd, CFA Steve Korn, CFA
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