Putin Sees Opportunities

Russia's attack on Ukraine has created a completely new geopolitical and economic situation. This warrants a comprehensive analysis of the situation and its impact on financial markets. However, due to time constraints, this report focuses solely on the consequences for the markets. The following key points form the basis of our analysis:
 
It is likely that Putin believes he must act decisively before it is too late. The Soviet Union collapsed because it could no longer keep up economically with the West. A similar scenario threatens Russia in the coming decades.
 
The West and China are almost certain to continue their energy transition, significantly reducing the demand for oil and gas. The Russian economy, already fragile, is heavily dependent on oil and gas exports. It also lacks the capacity to transition to alternative economic supports in time.
 
In the short term, the situation is different. The prospect of declining demand for oil and gas has resulted in limited investment in production, particularly after the COVID-19 pandemic briefly drove oil prices into negative territory. Despite this, global economies have recovered quickly due to monetary and fiscal stimulus, keeping demand for oil and gas high.
 
This presents a significant opportunity for Putin. Russia can supply large amounts of oil and gas, and Europe is heavily reliant on these resources. Putin sees this as a chance to partially restore Russian influence in former Soviet territories. It is unlikely that Putin will suddenly adopt a more moderate stance. On the contrary, he is expected to try to expand his influence in these regions over the coming years.
 

The West's Vulnerabilities

The West is in a weak position. Russia is one of the world's largest nuclear powers, making military confrontation an unviable option. The only practical action for the West is to impose economic sanctions on Russia. However, this is challenging due to its dependence on Russian gas, oil, and other raw materials.
 
Putin also has additional leverage:

• Alternative Markets: If the West cuts itself off from Russian gas and oil, countries like China are eager to take over these supplies, ensuring Russia retains its revenue, especially with rising energy prices.
• Sanctions Countermeasures: The West can restrict Russia's access to capital and chips, but China could step in to fill this gap.
• Refugee Flows: By threatening Ukraine, Putin could trigger a large refugee influx into Western Europe, creating discord among EU member states.
• European Dependence: Some European countries rely more heavily on Russian imports than others, making it difficult to establish a unified and strict sanctions policy.
• LNG Alternatives: While importing LNG (liquefied natural gas) is a theoretical alternative to Russian gas, Europe's infrastructure is not yet adequately developed.

By applying minimal pressure, Putin can ensure the West remains cautious about escalating tensions. This dynamic is likely to keep gas and oil prices elevated for the foreseeable future.
 

Risk of Stagflation

The question arises: how should the West respond?
 
On the one hand, failing to take a strong stance could embolden Putin to continue his actions, potentially undermining democratic nations worldwide. It could also encourage China to take a more aggressive stance, particularly regarding Taiwan.
 
On the other hand, the West's only weapon is economic sanctions, which will also significantly impact Western economies, both directly and through retaliatory measures.
 
We foresee prolonged tensions between Russia—and potentially China—and the West. The West will likely impose severe economic sanctions, fueling inflation through rising commodity prices and hampering economic growth, leading to stagflation.
 

Monetary Challenges

Stagflation poses a significant challenge for central banks like the ECB and the Fed:
 

Aggressive Tightening 

Raising interest rates too aggressively could cause asset prices to plummet, reducing lending and slowing growth. This could lead to rising credit spreads, a recession, or even a new credit crisis, given the West's high debt levels.
 

Insufficient Tightening 

Conversely, acting too cautiously could spark a wage-price spiral in tight labor markets, making inflation harder to control without inducing a recession.
Central banks must navigate carefully between these risks, but two complications arise:

• Central banks have only blunt instruments, limiting their ability to make precise adjustments.
• COVID-19 remains a wildcard. While the virus may retreat temporarily, new mutations could emerge in the autumn, creating additional economic uncertainty.

Will Inflation Persist?

The key question is how the West will handle this new reality. Some argue that governments should compensate consumers and businesses for rising energy prices to prevent a collapse in purchasing power and economic activity.
 
Higher energy prices must therefore be offset by larger government deficits. However, excessive compensation could sustain high demand for oil and gas, making it easier for Putin to raise prices further.
 
Central banks' responses will be crucial. Will they prioritize low economic growth or high inflation? We expect central banks to prioritize growth, as combating inflation will almost inevitably require a recession, risking a new credit crisis. Higher inflation, however, has the advantage of reducing debt burdens.
 

Impact on Financial Markets

Interest Rates:

We expect the Fed to cease bond purchases and implement a 0.25 percentage point rate hike in March. Beyond this, the Fed is likely to proceed cautiously, balancing high inflation against slowing growth. Short-term rates may rise four to six times this year, lower than earlier expectations of six to nine hikes.
 
In Europe, the ECB is expected to reduce bond purchases and cautiously begin raising rates in the second half of the year. However, the European economy is more affected by geopolitical turmoil, leading to slower rate hikes compared to the U.S.
 

Equities:

Low real interest rates are positive for stocks, but rising costs for commodities, wages, and financing, combined with geopolitical uncertainties, will keep downward pressure on equity markets. European stocks are expected to underperform compared to U.S. markets, while resource-exporting emerging markets may perform relatively well.
 

EUR/USD:

The U.S. economy is less impacted than Europe's, and the Fed is expected to tighten monetary policy faster than the ECB. This suggests continued downward pressure on EUR/USD, with targets of 1.08 and 1.05.
 

Gold:

Gold is expected to play an increasingly important role for investors. It is the best hedge against inflation and geopolitical tensions. With real interest rates likely to decline further, gold prices could rise to $2,200 in the short term and potentially $3,000 in the long term.
 
Disclaimer: Statements and opinions expressed in this report are those of the author and/or guest bloggers and do not necessarily reflect official positions. The articles are intended to help you form an opinion on the precious metals market and do not constitute advice. While the content is compiled with care, The Silver Mountain accepts no responsibility for inaccuracies. Decisions about asset management remain your responsibility.