Monday, March 03, 2013 - Carry On

Carry On
by Sinclair Noe

DOW – 153 = 16,168
SPX – 13 = 1845
NAS – 30 = 4277
10 YR YLD - .05 = 2.60%
OIL + 2.20 = 104.79
GOLD + 21.70 = 1351.30
SILV + .18 = 21.51

Manufacturing expanded at a faster pace than projected in February. The Institute for Supply Management’s (ISM) manufacturing index rose to 53.2 from 51.3 in January. A reading above 50 indicates expansion in manufacturing activity.

Consumer spending in the US climbed more than forecast in January, reflecting the biggest increase in services in over 12 years. Household purchases rose 0.4%, after a 0.1% gain the prior month. Disposable income, or the money left over after taxes, rose 0.3% after adjusting for inflation. It dropped 0.2% in the prior month and was up 2.8% from January 2013. The saving rate was 4.3% in January, unchanged from the prior month. Wages and salaries increased 0.2% after dropping 0.1% in December.

The big economic report this week will be the monthly jobs report on Friday.

Faster than you can say “the Russians are coming”, they invaded Ukraine. Moscow now has operational control of the Crimean Peninsula, with about 6,000 airborne and ground troops. Russia has military bases on the Red Sea, but the troops have gone off base. The Russians have just taken over without any real fighting; indeed, many Crimeans are sympathetic to Russia.

Ukraine has a large Russian ethnic minority, which it inherited mainly as the result of Soviet policies, including a re-drawing of the inner map of the Union by giving members like Ukraine territories, which historically had little connection to Ukrainians. The end result is that roughly one in four Ukrainian citizens speaks Russian as their mother language. Given that these people were there before an independent state of Ukraine emerged, they are what is considered an historic minority.

 The new government in the Ukraine says the Russians have demanded that Ukrainian forces in Crimea surrender within the next couple of hours or face an armed assault. The Russians deny any ultimatum, but they are in control in Crimea.

Investors sought safe havens in government bonds, pushing down yields of US and German government debt. The dollar gained against the euro and against the British pound, while the yen gained against the dollar as Japanese investors sold overseas investments and repatriated their funds. The Russian central bank announced a temporary 1.5% increase in its benchmark interest rate target, to 7%; the Russian ruble took a big hit, along with the Russian stock market, which dropped about 10%.

Global stock indices were down today with the Nikkei 225 stock average dropping 1.3%. The Hang Seng Index in Hong Kong fell 1.5%. The Euro Stoxx 50 index of euro zone blue chips closed down 3%, while the London benchmark FTSE 100 ended the day 1.5% lower. Companies that have business relationships with Russia and Ukraine were down today. European banks with exposure to Ukraine also fell. UniCredit, the Italian lender, fell 5%, while BNP Paribas of France declined more than 3%.

The MSCI Emerging Markets Index lost 1.7%.

The interim Ukrainian government is negotiating with the European Union, the United States and the International Monetary Fund for a bailout of as much as $35 billion to get it through the next two years. Ukraine has some fairly serious debt problems, and there is concern the International Monetary Fund will seek haircuts on the value of Ukrainian government debt, forcing bond holders to take big losses. 

Ukraine makes up only about 0.2% of global gross domestic product, but we know GDP is an imperfect measure of an economy. For example, it does not take into account that Russia has major pipelines that run through Ukraine, and the Ukrainians get half their natural gas supply from Russia, which has been offering the cash strapped Ukrainians a big discount. That could end or Russia could just cut off the supply altogether; and that could also cut supplies to the European Union. Gazprom supplied about 30 percent of Europe’s gas last year. Out of the roughly 14 trillion cubic feet the EU consumes per year, about 5 trillion cubic feet comes from Russia, and a large volume still flows through Ukraine, with no prospect of this changing for some years to come. If Russia ends contracts to supply Ukraine, it may have a knock-on impact on European supplies.

Secretary of State John Kerry will fly to Kiev on Tuesday, to meet Ukraine’s new government and display “strong support for Ukrainian sovereignty” Kerry, Obama and other senior officials spent the last 24 hours frantically attempting to rally an international coalition of countries to condemn Moscow over the Crimea invasion, and commit to economic sanctions in order to prevent a further advance into other pro-Russian parts of Ukraine. Obama spoke by phone with the British Prime Minister, David Cameron, Polish president Bronislaw Komorowski and the German chancellor, Angela Merkel.

The EU is saying that it will revise its relations with Russia if there is no de-escalation. European foreign ministers threatened to freeze visa liberalization and economic cooperation talks with Russia and boycott a Group of 8 summit in Sochi if Moscow did not take steps to “de-escalate” the situation by the Thursday summit. On the flip side, Moscow is so dependent on gas revenue that it will have little choice but to try to keep the fuel flowing; for the EU it would be foolish to see this escalate to conflict because it’s hard to fight with the lights and the heat turned off.

Entire countries can be paralyzed if the gas stops flowing for a prolonged period. There are no new projects meant to further lessen EU dependence on gas transiting through Ukraine coming on line for the next few years, and there are few viable alternatives to replace such a large volume of gas. The only option that remains if and when this gas flow is lost is to suffer the consequences. Given the EU's fragile economy, the consequences of taking another major hit would be disastrous.

It is expected that 2014 will be the year when the EU economy will finally return to sustained steady growth. It is not much, but given the economic environment of the past few years, growth in the 1-2% per year became something to be celebrated. Such a fragile economy cannot hope to withstand even minor energy supply disruptions.

Things could further escalate, and an economic war can easily take shape between Russia and the West. What this means for the global economy is potentially the loss of as much as 6 million barrels per day of Russian fuel. Russia will be hurt by it for sure, but so will the global economy.

And that’s just the Ukraine today. Look around the rest of the world: Venezuela, Turkey, Thailand, Syria, Libya, Sudan. It seems like a big disorganized mess. So, how will it be resolved?

Here’s the answer;

Vladimir Putin will do something belligerent. (Already done.)

Republicans will demand that we show strength in the face of Putin's provocation. Whatever it is that we're doing, we should do more.

President Obama will denounce whatever it is that Putin does. But regardless of how unequivocal his condemnation is, Bill Kristol will insist that he's failing to support the democratic aspirations of the Ukrainian people.

Journalists will write a variety of thumbsuckers pointing out that our options are extremely limited, what with Ukraine being 5,000 miles away and all.

John McCain will appear on a bunch of Sunday chat shows to bemoan the fact that Obama is weak and no one fears America anymore. (Already done.)

Having written all the "options are limited" thumbsuckers, journalists and columnists will follow McCain's lead and start declaring that the crisis in Ukraine is the greatest foreign policy test of Obama's presidency. It will thus supplant Afghanistan, Egypt, Libya, Syria, Iran, and North Korea for this honor.

In spite of all the trees felled and words spoken about this, nobody will have any good ideas about what kind of action might actually make a difference. There will be scattered calls to impose a few sanctions here and there, introduce a ban on Russian vodka imports, convene NATO, demand a UN Security Council vote, etc. None of this will have any material effect.

Obama will continue to denounce Putin. Perhaps he will convene NATO. For their part, Republicans will continue to insist that he's showing weakness and needs to get serious.

This will all continue for a while.

In the end, it will all settle down into a stalemate, with Russia having thrown its weight around—just like it always has—and the West not having the leverage to do much about it.

Ukraine will....

Actually, there's no telling. Maybe Ukraine will choose (or have foisted on them) a pro-Russian leader that Putin is happy with. Maybe east and west will split apart. Maybe a nominally pro-Western leader will emerge. Who knows? What we do know is that (a) the United States will play only a modest role in all this, and (b) conservative hawks will continue to think that if only we'd done just a little bit more, Putin would have blinked and Ukraine would be free.

Keep calm and carry on.