Dr. Putin's Diet Plan And The Folly Of Sanctions

 The sanctions tit-for-tat between the EU and Russia that is making so many headlines is economically less important than it appears on the surface, at least in terms of its direct effects. All actors in the game have taken great care not to hurt each other too much, mainly out of fear of hurting their own economies. The financial sanctions against Russian banks probably smart the most, but even those can be easily backstopped by Russia's central bank, which is sitting on a sufficiently large cushion of foreign reserves to be able to replace a fair chunk of foreign financing (about 30% of the funding of Russian banks comes from foreign sources, so it is not a trivial event even so).

We were slightly astonished though by Vladimir Putin's idea to alter the diet of Russia's citizens by banning fruit, vegetable and dairy imports from the EU. A friend of ours (who was born in Russia) recently came to visit us, right after visiting St. Petersburg.  As he told us, most people living in Russia's countryside probably can't afford to buy much imported food, but it is very different in the big cities (especially Moscow and St. Petersburg), where the higher earning strata of the population tend to be concentrated.

Not only is the ban hurting Russian consumers, it is also a big problem for a great many restaurants and hotels in these big cities and seriously impedes their business. We realize of course that these food-related sanctions were chosen a) because it is probably held that it will be easy to defend them against WTO complaints (one can always fall back on health-related pretexts) and b) because of their effect on specific countries in the EU; they obviously don't hurt all EU countries to the same extent. It is probably not a coincidence that among the countries most affected one can find many that traditionally take a dim view of Russia and have recently campaigned for tougher EU sanctions against Moscow.

Poland's apple industry and Finnish dairies come to mind in this context. Polish apples have recently been rechristened “freedom apples” (remember “freedom fries”?) in the hope that this will attract new customers in the US for reasons of solidarity with Ukraine and agreement with the plan to wrench it away from Russia's sphere of influence. The problem with this idea is that US consumers are a fickle bunch and most of them probably can't even find Ukraine on a map. The average citizen likely has far less interest in what happens in the Ukraine than the political elites (for instance, Hunter Biden likely wants to drill in Lugansk, but there's no mileage in this for anyone else). Also, “freedom fries” were associated with Bush jr.'s Iraq intervention, which can be safely called an ongoing failure of truly monumental proportions. Not that there's anything wrong with Polish apples, but “freedom apples” may actually not call forth the same patriotic fervor those fries once commanded. Just saying – maybe Poland needs better advice on its PR efforts.

Anyway, there is a difference between the EU's sanctions and Russia's. Most of the sanctions imposed by Europe hurt domestic EU producers, but not EU consumers, at least not directly. Putin's diet decree also hurts selected EU producers, but apart from that, it hurts Russian consumers as well. There is a whiff of mercantilist thinking about it in other words. 

 

Vibrant Produce

No more veggies comrades! Putin deprives Russian consumers of euro-legumes

(Photo via elnacional.com.do / Author unknown)

Indirect Effects of Sanctions Far Outweigh Direct Ones

Although the EU's sanctions affect only a very small slice of total economic output directly (we're looking at numbers well below 1%), they nevertheless could have far-reaching effects. Many Russian companies – even those not targeted – are worried that the sanctions list will continue to grow and are therefore actively looking for alternative suppliers elsewhere in the world.

Even more important is however the damage inflicted on economic confidence in both the EU and Russia. A recent article at Reuters listed a number of effects that could be observed so far. While this is largely an anecdotal list, it sure contains a few eye-popping numbers as well, such as e.g. the 23% slide in Russian car sales. Moreover, if 25,000 jobs are held to be at risk in Germany alone, there is likely a non-trivial number of jobs under threat in both the EU as a whole and in Russia. Sanctions are of course useless anyway. They are not going to achieve their stated goals. Per experience, they only serve to exacerbate conflict situations, as they rarely harm their targets (political leaders), but certainly harm the average citizen. Here is the list from Reuters:

“* German utility E.ON posted a 12 percent drop in first-half core profit, hit by a weakening economy in Russia, and said it was concerned about the impact of the Ukraine crisis on its most important foreign market.

* Finnish department store chain Stockmann said the operating environment in Russia was unstable, as it reported a smaller-than-expected second-quarter operating profit, pulled lower by a decline in the Russian rouble.

* Consumer goods group Henkel forecast a tough six months ahead, with political turmoil in Russia and volatile exchange rates hurting sales.

* Russia has returned some cheese shipments to Italy and canceled pear exports from Modena under a food import ban, an agriculture group said.

* Austria's Raiffeisen Bank International (RBI) played down the potential impact of sanctions on its business in Russia, where it is the 10th-largest lender.

* Norwegian salmon prices were seen falling due to Russia's food sanctions, forcing farmers to scramble for new markets at a time when prices are already under pressure.

* The CEO of Finland's Nokian Tyres said he expected sales volume in Russia to be about flat in the third quarter compared to a year earlier

* With foreign lending to Russia frozen, some European banks are trying to refinance existing loans to big companies there in order to protect their business.

* A drop in Russia's car market quickened in July. Sales slid 23 percent, the latest sign that Russians are increasingly worried about the impact of the Ukraine crisis.

* Lufthansa, Air France-KLM and Finnair would be hit hardest by a potential closure of airspace over Siberia, flight tracking data showed.

* Rheinmetall slashed its 2014 operating profit target after the German government withdrew its approval for a contract with Russia and the group shifted some of its automotive business to a joint venture.

* Daimler has seen growth weaken in Russia's auto market due to the Ukraine crisis, Chief Executive Dieter Zetsche told Germany's Bild am Sonntag newspaper.

* Part-nationalised British lender Royal Bank of Scotland said it had placed restrictions on its lending in Russia following developments in Ukraine.

* Adidas cut its profit target for this year and scrapped it for next year, blaming a plunge in sales at its golf business and exposure to a weak Russian market.

* The head of Russia's second-largest oil producer Lukoil said sanctions would force the company to reduce its investments due to limited access to funds.

* Russian mobile phone operator Megafon said it converted foreign currency deposits to roubles and Hong Kong dollars to protect against any more sanctions.

* German retailer Metro AG said conditions were still not right to list a stake in its Russian cash-and-carry business.

* French oil major Total said it had stopped buying shares in Russia's Novatek when a Malaysian airliner was shot down over Ukraine, but it was still too early to gauge the impact of sanctions.

* BP posted a big rise in second-quarter profit but warned more sanctions on Russia could harm business there and its ties to state oil company Rosneft.

* More than 25,000 jobs are at risk in Germany following the latest sanctions, the German Committee on Eastern European Economic Relations said. "Further damage is looming for the European and especially the German export industry. More than 25,000 jobs are in danger in Germany alone," it said.

(emphasis added)

Via Zerohedge we learn that the European “Anti-Putin alliance” is already fraying as a result of the impact of economic sanctions. To this it must be kept in mind that even Europe's “economic locomotive” Germany has suffered a GDP contraction last quarter. So we have Germany, France and Italy all in recessionary conditions at present –  and incidentally these are the three largest economies of the euro area.

Europe also has a problem Russia doesn't have at the moment, which could make it somewhat more vulnerable. European stock markets have risen strongly, with Germany's market even making new all time highs a short while ago. Valuations across the EU are far higher than in Russia and the euro is still trading at quite a lofty level as well (while the ruble is very depressed right now).

We conclude that while in Russia's case, the crisis likely already offers an opportunity for astute investors, in the EU's case it exacerbates already existing risks at the moment. 10 year Bund yields have just collapsed to new all time lows, a sign that the market takes a very dim view of Germany's economic prospects (the same is true of most other euro area government bond yields. With default and conversion risks priced out, they reflect fears of recession and probably deflationary expectations as well – not unreasonably so, since credit growth remains negative in euro-land).

 

10 yr. yield, Germany

Germany's 10 year Bund yield – hello, all time low – click to enlarge.

 

DAX and CAC

German and French stocks – these are among the prices in the euro area most likely to “deflate” as the economy increasingly stumbles – click to enlarge.

 “Headline Roulette”

However, one must not forget that the markets are currently also buffeted by what Bill Fleckenstein refers to as “headline roulette”. So in spite of the technical and fundamental problems highlighted above, these markets could well be close to at least a short term bounce.

Over the weekend it has emerged that Kiev has apparently finally agreed to letting the Russian aid convoy pass, which now waits for security guarantees from both conflict parties before proceeding to its intended destination (of course this is a news item that could change again within hours). More importantly, the foreign ministers of Russia (Sergey Lavrov), Ukraine (Pavlo Klimkin), France (Laurent Fabius) and Germany (Walter Steinmeier) have met in Berlin on Sunday. Steinmeier tried not to raise too many hopes, but it is remarkable that the meeting is taking place at all (not very long before the meeting convened, Eastern Ukrainian rebels shot down a Ukrainian MIG-29).

 

"There are no guarantees that today's meeting will have the desired success, but I also say with regard to the situation today and in the past few days it would be irresponsible not to use the willingness to talk signaled by all sides," German Foreign Minister Frank-Walter Steinmeier told reporters ahead of the meeting. The participants included France's Laurent Fabius, Russia's Sergei Lavrov and Ukraine's Pavlo Klimkin.

Discussions will focus on ending the violence in Ukraine, Mr Steinmeier said, rather than debating Moscow's plan to send what it says is humanitarian aid to the rebel-held territories in the region. Mr Steinmeier voiced support for sending humanitarian support to the region—both by Russia and other parties—and said the talks would see whether "the final difficulties could be cleared."

Diplomacy had been frozen for several weeks as Ukraine pointed the finger at Russia-backed insurgents for downing a passenger plane over the east, and the West and Moscow imposed sanctions on each other. The German minister cautioned that a definitive political solution to the crisis remains a long way off, adding that the real drama in the conflict is the fact that previous deals on brokering a solution remain unfulfilled.

Ahead of the meeting, Mr. Fabius said the "priority must be respecting Ukraine's territorial integrity, the end to violence and the relaunching of political process," according to his official Twitter account.

Earlier, Mr. Steinmeier had said in a statement: "We urgently need fresh political momentum, otherwise we risk the danger of setbacks and renewed escalation."

(emphasis added).

Now, we certainly don't disagree with Fabius and Steinmeier – negotiations are certainly preferable to fighting and the imposition of sanctions. However, we disagree with Fabius that there is anything special about Ukraine's “territorial integrity”. It is well-known that a majority of the population of the Western Ukraine wants to have closer ties to Europe and get out of Russia's orbit. The exact opposite is true of the vast majority of the population in Ukraine's East. All along it appeared to us that either federalization involving a high degree of autonomy for the regions or alternatively an outright (amicable) partition of the country would have been the best alternatives. Either would certainly have been better than sacrificing even a single human life in this war and creating a growing humanitarian crisis. The “territorial integrity” shtick is tied to geopolitical deliberations that have nothing whatsoever to do with what is in the interest of Ukraine's citizenry (as noted above, only political elites care about this nonsense).

Anyway, any sign of a resumption of dialogue (which oddly enough still excludes the rebels – hello?) is likely to be seen as a positive development by market participants deserving of some auto-pilot buying. One reason to think that this is possible is the chart of Europe's current downside leader, Portugal's PSI-20. As can be seen, the recent price low has been put in place in parallel with a higher low in RSI. To be sure, this is not always meaningful, but in a deeply oversold market it is likely to be the prelude to a short term retracement rally unless the economic and news backdrop worsens sharply and immediately.

 

PSI-20Portugal's PSI-20 Index: a recent technical divergence suggests that there is some short term bounce potential – click to enlarge.

 The PSI has diverged from DAX and CAC at the recent low (lower vs. higher lows), just as it did at the high. It should be noted though that regardless of short term developments, the onset of recessionary conditions in both the euro area and Russia was already preordained prior to the Ukraine crisis. In both regions money supply growth has been slowing down considerably in recent months (in Russia it happened much earlier already), which has put pressure on numerous bubble activities. The full effects have certainly not played out yet in Europe (Russia has a headstart in several respects with regard to this), so we would any short term bounces that might occur are likely to be selling opportunities at this stage.

Interestingly, Russia's RTS index has actually been rising all week last week, after putting in a second slightly higher low since the Crimea panic low in March. While its technical condition is certainly not much to write home about yet and the corrective period could easily become more protracted (just remember how much patience Japanese stocks required before a catalyst came along), its below 5 P/E ratio – largely due to its overweighting in energy stocks, admittedly – does provide for a big margin of error. Just keep in mind that one must never get married to Russian stocks (their volatility in both directions is nothing short of legendary).

 

RTSRussia's RTS Index – not going anywhere yet, but this is a market that tends to move big once it begins to move.

Conclusion:

Developed markets currently strike us as especially risky on a medium to long term basis. The increasing divergence in the performance of different markets is ominous (especially the growing divergence between US and European markets). There could be “relief bounces” if some positive progress occurs with regard to the situation in Ukraine, but the recent technical damage is a warning sign, as is the behavior of government bond markets and the underlying fundamental situation.

 

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