The "western world" could not have designed a better package of sanctions to put pressure on Russia. The combination of sanctions (perhaps there are more to come) and declining oil prices has had a significant impact on Russia. As one quite respected economics consulting group has put it, "There is now little doubt that Russia is heading for a deep recession."
There can be also little question that Russia depends on oil. We learned that vividly in 1998 when the price of oil declined 58 percent, Russian oil exports declined and, in time, Russia was unable to make payments on its sovereign debt.
Conditions have not changed. Exports constitute 28 percent of Russia's nominal GDP; oil exports equal 39 percent of its total exports. A decline in the price of oil from $108.66 (the 2013 average price for Brent crude) to $54 (the current price) along with sanctions minimally has caused the economy of Russia to slow. This is not something that has happened overnight. The consensus forecast for the Russian economy for 2015 has been declining each month since January this year from 3.0 percent to -0.2 percent and is likely to decline further.
Based upon the experience of 1997, Russia is pulling out all stops. It has raised interest rates and is on the edge of considering restrictions on capital flows. The ruble and the economy are sinking rapidly.
The real question is "Will the crisis in Russia be transmitted to Europe and perhaps the U.S.?"
The answer that we hear is, "no." After all, Russia only accounts for only 2.7 percent of world GDP and 1.7 percent of world trade. Additionally U.S. bank lending to Russia is 0.1 percent of GDP and lending to Russia is equally insignificant among other important lending countries like Japan, the U.K., and Germany are below 1 percent of GDP. Moreover, the losses from declining oil prices are concentrated among oil producers and the positives are dispersed among many consumers.
That's the argument. We don't really buy it.
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While the case is compelling, there is more to think about. As market historians will tell you, the Southeast Asia crisis began in Thailand in 1997. At the time Thailand was an even smaller percent of global GDP and global trade. Thailand was not nearly as important an export destination in 1997 as Russia is today. Moreover, U.S. bank lending and lending to Thailand by other larger countries was even less significant. But, as insignificant as the crisis in Thailand was thought to be, it was not. The crisis was transmitted throughout the world in ways that very few anticipated.
There are ordinarily three important transmission mechanisms:
Psychology. Declines in the Thailand currency and stock market scared investors throughout the world. I saved the Oct. 28, 1997 Wall Street Journal article: "The Dow Jones industrials sank 554.26 points, or 7.18%, to 7161.15, in a follow-through to selling that began with a plunge in Hong Kong last week."
Trade flows. When the economy of Thailand sank into a recession, exports to Thailand from the nine major economies of Southeast Asia declined. Eight of the nine major economies of Southeast Asia contracted. Only China averted a recession. U.S. exports to Southeast Asia declined in excess of 10 percent. The crisis spread outward.
Commodity prices. As trade flows slowed and economies contracted, the demand for and price of commodities declined. The price of oil declined 58 percent and other commodity prices declined 41 percent. The economy of commodity-export countries to include Australia, New Zealand, Brazil, Canada, and Russia entered recessions; many others came close. The crisis spread outward.
We find it hard to believe that the transmission mechanisms will not again be operative.
Declines in the price of oil and other commodity prices have already scared investors. The view is that the decline reflects a slowdown in the global economy. This is somewhat easy to accept. After all the IEA (The International Energy Agency) has reduced its forecast for global oil consumption five times this year and the IMF (the International Monetary Fund) has reduced its forecast for global economic growth for 2014 to 3.3 percent from 3.7 percent and for 2015 to 3.8 percent from 3.9 percent. This minimally has contributed to the 5-percent decline in the S&P 500.
Can the crisis in Russia be transmitted through declining trade flows? Exports to Russia are important to Europe. Exports equal 27 percent of the European economy and exports to Russia equal 6.9 percent of Europe's exports. In turn, exports to Europe are important to the U.S. U.S. exports to Europe equal 17.5 percent of U.S. exports.
Can the crisis in Russia be transmitted through declining oil and other commodity prices? After all, the price of West Texas Intermediate has declined 32 percent and other commodity prices have declined 24 percent. These price declines are, of course, global. Inflation in Europe is now 0.3 percent. The spread between the yield on a 5-year inflation-indexed note and the yield on a 5-year U.S. Treasury note, a proxy for inflation expectations, has declined sharply.
This is the bad news. But, there is, at least, some good news.
First, although the economies of eight of the nine Southeast Asia countries contracted in 1998 and although U.S. exports to Southeast Asia contracted in 1998, the economy of the U.S. (and the U.S. stock market) continued to expand. We suspect quite strongly that this will again be the outcome. We don't believe the Russian crisis will derail the current bull market-economic recovery.
Second, although the Southeast Asia financial crisis was significant and although it led to a global decline in stock prices, it did end. It drove U.S. stock prices from levels that were arguably over-valued to levels that were undervalued hence, setting up a meaningful move up in prices. A very strong argument could be made that the current crisis is doing the same thing.
Third, the price of oil has declined in part because the global economy and, hence, demand has slowed and also because global production (particularly U.S. production) has increased.
While this is true, it is hard for us to make the case that demand and supply have changed that much. Perhaps the forecast for global consumption was too high and indeed the forecast for global production was too low. But, even if we revise the forecast for consumption lower and the forecast for production higher — to levels that are consistent with the revised estimates from the IEA — we still cannot forecast oil prices that are statistically near $65 per barrel. Perhaps speculation in the oil markets has driven the price of West Texas to this level much the way speculation, not significantly changed fundamentals, drove the price to $140 in 1998.
My guess is that, in time, the price returns to the mid-90s. The only question that remains is … when? That's anybody's guess.
Commentary by Hugh Johnson, chairman of Hugh Johnson Advisors. In this position, he manages $1.2 billion in equity, fixed income, and cash investments for individual and institutional clients and serves as a consultant to $1.2 billion in institutional assets.