The Best Performing Stock Market in 2016 is Russia!

2016 has seen a remarkable turnaround for the Russian stock market. Russia's RTS index (denominated in USD) was up 52%, while the Micex (denominated in Rubles) was up by an impressive 27%.

It was a turbulent year for the oil market. After all the price of oil went sub US$ 30 in the first quarter, and for much of 2016 fluctuated between US $ 40-50. Yes, natural resources (including oil) have staged a sharp recovery after Trump emerged as the President elect, but the Russian stock market has been up sharply well before the US elections.

Perhaps the explanation is that the Russian stock market had been badly beaten down prior to 2016, so investors saw an attractive risk-reward proposition and piled back into the Russian market. The real reason is probably the Putin's aggressive posture on the world stage. With little to loose, Putin decided that that an activist foreign policy was necessary to restore the "respect" that was due Russia. For example, as opposed to an ambiguous policy on the part of the US, Putin decided that Russia would support Syria with all but combat troops. Syria's brutal campaign has been possible because of Russian air and artillery support, as well as Russia's diplomatic cover. Following on the heels of capturing Crimea and effectively controlling Eastern Ukraine, it is clear that Putin is willing to use hard power. More interestingly, Putin has demonstrated a great deal of ingenuity in using power and influence which has plausible deniability - cyber attacks (Ukraine and the US) and militia (in Eastern Ukraine).

So why did investors reward Putin's brinkmanship with an influx of investment in 2016?? The answer is simple. Russian money invested (primarily) in Euros and also in US$ has been quietly making its way back home. This is a defensive move. Why should Russians (oligarchs and otherwise) risk having their investments frozen as a result of new sanctions being imposed by the West!

The other explanation is the expectation that the Trump regime would attempt another "reset" with Russia and may even roll back some of the sanctions in exchange for Russian "good behavior" in the Baltics and the Ukraine. This only explains the sharp uptick in Russian stocks after the US elections.

Russia's cyber intervention in the US elections appears to have paid off in that Trump was able to score an upset victory. However, Obama's recent sanctions raises the ante for Putin. It makes it extremely difficult for Trump to attempt a reset and/or ease sanctions on Russia. In fact, there is a simple reason why Putin did not retaliate to the most recent sanctions. This would have put both Trump and Putin into corners with little room for maneuver.

With Trump unlikely to apply additional sanctions, but unable to roll them back, Russia is back in a difficult position. Yes, oil and natural resources may well see an uptick in 2017, but that is predicated on a strengthening US economy pulling the rest of the world along.

So capital flight is likely to resume from Russia in 2017.

Russian Gambit: It's the Price of Oil, Stupid

In January 2000, Vladimir Putin became the Prime Minister of Russia. WTI crude oil price which had hit a low of ~ $10 a barrel in early 1999, had tripled by the time Putin first assumed office. [When the financial markets froze up in Fall of 2008, oil prices crashed once again, but within a year had staged a remarkable recovery.]

Oil prices continued to rise through 9/11, US intervention in Iraq, and the sanctions on Iran. Russia's recovery under Putin was bankrolled by the sharp rise in the price of oil that accompanied US actions in the Middle East. As the petrodollars flowed in, Russia began an ambitious program of re-exerting influence over its "near abroad" in the Caucasus and Central Asia. From Putin's perspective Russia was reclaiming its historic role in the comity of nations.

Russia took full advantage of US preoccupation with the Middle East. Moves such as NATO's eastward expansion could be fed to the Russian public as clear signs of hostile intent. After all, why was NATO expanding east when the Warsaw Pact had already been dismantled?

Then came the shale revolution in the US. Between 2009 and 2015 US oil production doubled. In addition Iranian sanctions were eased and oil prices started slumping in 2014. This created a sense of urgency in Putin's inner circle that time running out on building back its reputation and place among nations. Hence the the adventurism in the Ukraine and the recapture of the Crimea. These were calculated acts of desperation on the part of a Russian elite.

If Russia was in fact involved in the hacking related to the recent US Presidential elections, then this too is an attempt by Russia to attract attention to its covert capabilities. It is an attempt to reassert attention to its military and nuclear power which backs up its covert and black ops capabilities. In a sense it is blackmailing the US to come to the table and accord Russia the respect that it deserves. Doubling down on its support to Assad in Russia is a signal to (potential) allies that Russia is back and will stand by them even if the US is vehemently opposed.

All this is to signal to the world that the unipolar moment of US hegemony is finally at an end and Russia is a global power and not a has-been regional player.

But through all of this, the real challenge for Putin's Russia is the price of oil. US shale oil production acts as a brake on rising oil prices. As soon as oil prices start inching up, shale producers in the US can crank up supply and cause oil prices to go back down. From the highs of $110 per barrel, oil prices have varied between $30 and $60 in 2015-16. At this price level, Russia is hard pressed to address its budgetary woes. It cannot be guns and butter. Something has to give. Unless of course the US comes back to the bargaining table and sanctions are eased on Russia, and some breathing room is achieved.

The US needs to call Russia's bluff and challenge it by covert and overt means. As also ensure that oil prices stay depressed for the next few years. This will make it much harder for the Russian elites to continue to back Putin. It will be Russia that comes back to the bargaining table.

Unless of course the US under Trump decides that the threat from China far outweighs the damage that Russia can do. In which case, detente with Russia is the price that the US must pay to to focus its energies on containing China. This would be a very calculated gambit since it is very unlikely that Russia is going to abandon its carefully nurtured strategic alliance with China.

In 1971, the US started weaning China away from the Russian orbit. Trump's attempt to wean Russia away from the Chinese embrace is going to be much harder and fraught with many complications.

Trump's Asian Pivot

Obama struggled to extricate US forces from the Middle East as a prelude to full blown Asian Pivot. The TPP was also envisioned as an integral part of the Asian Pivot. Despite protestations to the contrary, the Asian Pivot and the TPP were two sides of the same coin - US strategy designed to contain China and slow down a true global peer competitor.

The guiding elements of US foreign policy in Asia over the last twenty five years have been:

• Foster the growth of free markets, especially in China
• Encourage the foundation of liberal and democratic institutions that accompany free markets
• Manage the regional rivalries between China and Japan, and between India and Pakistan
• Foster the development of ASEAN as a countervailing force against China
• Prevent a North Korean army breakout south of the 38th parallel
• Lastly, avoid committing the US army in a land war in Asia

Things have not gone according to plan. Post 9/11, the US was sucked into Afghanistan and then intervened in Iraq. Bogged down in both these wars, the US watched Russia help upgrade the Chinese armed forces. Expansion of the Chinese defense budget was made possible by the remarkable growth in the Chinese economy over the last two decades. Its growth trajectory makes it just a matter of time before the Chinese economy exceeds that of the US sometime by 2025.

With few surviving institutions, both Afghanistan and Iraq have proved to be impossible to reconstitute as coherent governable nation states. Obama's goal of drawing down US forces in the Middle East to check the rapid military expansion of China - the Asian Pivot - has remained a bridge too far.

A fundamental flaw in Obama's idea of the Asian Pivot was that it was fundamentally defensive in its posture. The goal was to create an alliance of Asian powers that would work with the US in their shared fear over Chinese designs. In case of a shooting match, the strategy was to enforce a naval blockade at the first island chain which would bring China to the negotiating table.

What the US did not count on was the sophistication of Chinese strategy to create situations on the ground in the South China Sea in an attempt to enforce the "nine dash line". Chinese diplomacy has also been adroit. ASEAN is unable to speak with a single voice. More recently, with Duterte coming to power as the President in the Philippines, the US alliance is looking frayed. The Asian Pivot has been called into question.

It is clear that Trump will not go forward with the TPP. However, Trump is trying to change the rules of the game that governed the US as a status quo power attempting to contain China by forming an alliance with China's neighbors. This pure defensive posture is being cast aside. Trump has shown that he will be unconventional and unpredictable. During his campaign Trump came down hard on China, but I believe that he will follow up the rhetoric with actions which will have multiple dimensions.

Trump has already fired the first salvo by taking a call from the President of Taiwan. Expect to see a set of fines levied on Chinese goods which are being "dumped" in the US market. Yes, this is a dangerous game as China can retaliate. But the bottom line is, China is much more dependent on trade than the US is. Also expect to see a series of naval exercises conducted by the US Navy with Japan, South Korea, Vietnam, and Indonesia.

As tensions rise between the US and China, expect to see the Yuan come under pressure and capital flight from China accelerate even further. If China attempts to keep the Yuan from depreciating, it is going to have to further deplete its foreign exchange reserves. Even $3 Trillion does not go that far when it comes to a run on the Yuan. Eventually, capital flight from China could serve to deflate the real estate bubble. This in turn could cause a crisis of historic proportions as the probability of a "hard landing" in China increases.

China's military trajectory has been remarkable. On paper, it could even hold its own in a showdown with the US in East Asia. But China has not fought a major conflict since 1979 when it blundered into a border war with Vietnam. China's brand spanking new weapon systems and war doctrine are largely unproven, as is the training and preparedness of its fighting forces. Do not be surprised if there is a short and sharp naval engagement between the two super powers as they feel each other out.

2017 will be an eventful year in US-China relations. Xi Jin Ping is attempting to pull off a successful 19th Party Congress in Fall 2017 and thereby consolidate his hold on power. He can well do without US provocations that undermine his power and prestige on the eve of the Party Congress. Trump is likely to take full advantage of this vulnerability in 2017.

If the US is to take on China in a military showdown, it has to do it now before the Chinese military modernization is complete. Five to ten years from now, China will likely have parity in various aspects of force deployment, especially as one takes into account its advantages in cyber warfare. China will have also completed large chunks of the One Belt One Road initiative in which China gets deeply intertwined with its neighbors' economies and infrastructure. By then the US alliance structure in Asia will have melted away.

Bottom line is that if the US needs to find a way to slow down China's military modernization. If the US is able to do this for the next two decades, China's demographic decline will do the rest. It will also give time for India and Indonesia both rising powers to start providing real balance to China in Asia.

For China the choice is likely to be a stark one (A) guns and butter while facing off against a more belligerent US, or (B) less guns and more butter and better relations with the US. After all the Communist Party in China has an unwritten compact with the people - Economic Prosperity but Limited Political Freedom. Can the Communist Party of China survive a severe economic downturn and still retain its absolute hold on power?

The challenge for US foreign policy is how to engineer a slowdown of Chinese military buildup without actually having to fight a war which neither side can truly "win". One key element is to wean Russia away from a defacto alliance with China. I wrote about this in a separate blog post.

American Foreign Policy - A Reorientation

We are just weeks away from the 26th of December. On that date in 1991, the Soviet Union was dissolved. In August of 1990 the US and allies initiated what we now refer to as the First Gulf War, which saw the amazingly quick destruction of Saddam Hussein's much vaunted armed forces. With the dissolution of the Soviet Union, began the uni-polar moment that lasted essentially for a decade.

There is an old Chinese proverb - "Kill a chicken to scare the monkey". The complete route of Iraqi forces had terrified potential adversaries - Soviet Union, Iran and China. All three had come to the realization that their armed forces would meet a similar fate if conflict with the US were to break out. Only the Soviet threat of a Mutual Assured Destruction based on nuclear weapons could prevent such an outcome. But Communism had been proven to be a bankrupt ideology, and the Soviet Union came apart at the seams. Warsaw Pact was added to the dustbin of history.

The nineties were in many ways a golden time for the US. China was an economic midget on the global stage, hungrily seeking investment from all corners. US had established a military presence in the oil rich Arabian peninsula and Iraq. Japan was beginning its "lost decades" as managing the transition from a deflating real estate bubble sapped the vitality of the land of the rising sun. With demographic decline on the horizon, Japan would no longer be the global threat that many Americans had feared.

This US dominance was the backdrop for the following major transitions in the nineties:

1. Innovation and US dominance in new technologies based on network connectivity - the internet as we know it today, as well as the building blocks of our daily life - Search, eCommerce, to name just a couple.
2. A rapid expansion in trans pacific trade as China started to re-industrialize and Asian countries began to move up the technology ladder. Nobody understood the full impact of Chinese industrialization. Nobody heard the sucking sound as jobs and industries from the US and Western Europe started to be permanently move to China.
3. NAFTA also came into being creating a common market in North America.
4. The Glass Steagall Act was repealed, setting the stage for financial risk taking that was understood by very few, and almost brought the world to its knees within a decade!
5. A significant draw down of US defense spending was justified by the collapse of the Soviet Union and enabled the Clinton administration to reduce the US budget deficit.

In the main, challenge to US dominance was muted in the 90's. The challenge by definition had to have an asymmetrical aspect, since the US enjoyed such tremendous advantage in all aspects of military power. In the Islamic world, the challenge was based on opposition to unbelievers (US military forces) being deployed in Islam's holiest land - Saudi Arabia. Osama Bin Laden had taken advantage of state dysfunction in Sudan, and then moved on to the collapsed state of Afghanistan and allied himself to the fundamentalist Taliban regime. Major terrorist incidents were planned by Bin Laden's inner circle in Afghanistan and executed in Yemen (1992), World Trade Center in New York City (1993) and in Nairobi (1998). Iranian funded Hezbollah operatives similarly carried out the Khobar City bombing in 1993. State sponsored terror with plausible deniability as carried out by Iran (and Pakistan), and non-state sponsored attacks by Al-Qaeda emerged as major threats to US military domination. The culmination of these were the attacks on 9/11.

However, the Islamic opposition was a side show. The main action was in Asia. China was rapidly industrializing and had launched a radical modernization of all branches of its armed forces. In Russia it found a country with military technology that had fallen on hard times. Russia was more than happy to sell arms and technology to China with the full knowledge that the Chinese would reverse engineer most of the weapons systems. But there was an even bigger investment underway in China - building the tools and personnel for cyber warfare. This was once again classic asymmetric warfare - gain an advantage where the adversary is not adequately invested. The US believed that it had a huge lead in computer software and networking, but this advantage proved to be fleeting and was limited to the 90's. A unique aspect of cyber warfare is that it all it really needs is smart techies. There was no shortage of these techies in China and Russia.

As the Soviet Union collapsed, there was a gold rush to gain control of the natural resources and means of production/manufacturing. Unlike the Marshall Plan which enabled Western Europe to rebuild itself and its industrial base, there was no similar initiative forthcoming from the US or Europe. If Germany had been handled differently by Europe in the 1920's, the world would likely have been spared the rise of Hitler and the slaughter of World War II. Perhaps learning from this mistake, after World War II the US launched the Marshall Plan to turn Axis powers Germany, Japan, and Italy into allies. One key motivation was to prevent these states from falling into the Soviet orbit. However, when the Soviet Union failed, there was no real threat posed to the US or Europe. What strategic thinkers failed to understand was that the biggest potential threat from the collapsing Soviet Union was lawlessness and potential relapse of Russia into a totalitarian state. Russia in the nineties went from one crisis to another, since almost all institutions had collapsed with the demise of the Communist Party. The ship of state would be steadied by the ascent of Putin.

The Chinese Communist Party tenaciously hung on to power. The expectation that China would over time transition from a totalitarian state to some semblance of representative democracy proved to be a mirage. The Chinese Communist Party owes Bin Laden a debt of gratitude. The 9/11 attacks brought forth the wrath of the US on the Taliban regime and Bin Laden's organization in Afghanistan. In a moment of hubris, the US followed this up with an attack on Iraq with the goal of regime change. Afghanistan defied multiple attempts at re-imposition of the writ of the state by the US and its Afghan allies. Regime change in Iraq proved to be a complete disaster. The US had blundered into Iraq and the genie of communal strife was out of the bottle. A fire had been lit whose embers would be fed by the opposing power centers of Iran, Turkey and Saudi Arabia. The frail states of the middle east with few if any durable institutions eventually came apart. The US spent the next 15 years in the Middle East muddling its way from one crisis and one failed nation state to another. It was all consuming and the cost to the US exchequer was in the trillions of USD.

This involvement on the part of the US gave the Chinese Communist Party the time needed for China to execute a plan for growth along every imaginable axis, the likes of which the world may never see again. One important axis was that of its armed forces. It is clear the Chinese armed forces are on a trajectory to achieve parity with the US over the next decade or so. More importantly, China has become the workshop to the world and a manufacturing power that eclipses Japan, Germany, and the US. By virtue of its population, resources, and manufacturing prowess China is now able to dominate much of East Asia and increasingly South Asia. Obama's Asian Pivot proved to just talk and little action. The TPP was supposed to be the hallmark of the Asian Pivot. With the TPP on the chopping block, US credibility is further eroded and China is in a position to pick up the pieces in terms of new Asian allies.

As President Trump takes office, it is clear that the US electorate has limited interest in fighting foreign wars. Trump was elected to set right the domestic economy and bring jobs and growth back to the US. Trump has said multiple times that allies need to pull their weight and cannot expect the US to continue to shoulder the burden of their defense. By the same token, the US cannot unilaterally withdraw from defense alliances without destabilizing the balance of power.

There is another major constraint on US actions. It is the US role as the preeminent power and the policeman of the global commons. This enables the USD to be the global reserve currency and allows the US to run the huge trade deficits because the rest of the world craves USD's. The Euro faces an uncertain future. The Yuan could be buffeted if China is unable to slowly deflate its own real estate and financial bubbles. The Yen has lost relevance as Japan's demographic decline continues. Basically, there is no serious claimant to the role of default currency, just as there is no serious claimant to being the peacekeeper of the global commons.

US strategy post WW II has been based on avoiding the emergence of a peer competitor on the global stage. While Japan emerged as a formidable economic power, its foreign policy was guided by the US and it posed no military threat to the US. European resurgence after the war made NATO much stronger than the Warsaw Pact. The Cold War took a heavy toll on the Soviet Union and eventually led to its demise. Which in turn led to the uni-polar moment of the early '90's.

The US needs to focus its resources. This is not a new realization. The Obama administration has been trying to extricate itself from the quagmires in Afghanistan and Iraq. Political disunity, religious factionalism and sheer incompetence on the part of the Iraqi army has forced the US to go back in to take on ISIS. The US avoided boots on the ground as most of North Africa descended into chaos. It has intervened selectively in sub-Saharan Africa and East Africa. The US has kept an eye on the badlands of Pak-Afghan region since its straddles some of the most virulent breeding grounds of Islamic fundamentalism. But the Obama administration has had to do this while keeping Russia in check in the Ukraine and along the frontiers of NATO, as well as on opposite sides of the civil war in Syria.

What the Trump administration needs to do is arrive at some sort of a modus operandi with Putin. An arrangement that freezes conflict in Europe and allows some sort of formal partitioning of Syria could be important elements of this. This enables Putin to save face by keeping the Assad regime in power in Western Syria. This is not a new Sykes-Picot agreement that we are talking about. Just a cessation of hostilities in the Middle East that posit the US and Russia on opposite sides.

Russia and the US can also co-operate when it comes to fighting Islamic fundamentalism in Afghanistan and Central Asia. Leaving Turkey, Iran and Saudi Arabia to squabble over Iraq, Eastern Syria, and the Arabian peninsula will lead to the power of all three being sapped over time. The Saudi regime is the weakest of the three Muslim powers, but it has always counted on Pakistani and Egyptian army reinforcements in times of need. Egypt is likely to come to the aid of the Saudis as Pakistan has problems on its own frontiers and will likely be reigned in by China. The US and to a lesser extent Russia would play the role of balancing powers in the Middle Wast to ensure that no one power emerges victorious and for that matter no two powers unite to take on the third power.

A grand bargain with the US and Europe will allow Russia to supply adequate energy to Europe if Middle Eastern oil supplies are disrupted. Similarly North America will be self-sufficient when it comes to energy supplies. The grand bargain with Russia will also allow the US to focus on Asia. If the US is not able to reassure Japan about its alliance, it is very likely that Japan will become a nuclear power in short order. This will also lead to South Korea acquiring nuclear weapons. The only way for the US to prevent this is to re-engage with its Asian allies. The US can elect to supply energy to its East Asian allies as Middle Eastern oil supplies come under a cloud.

The major impact of an unstable Middle East will be felt by the Asian giants India and China. China has never deployed its troops in battle after the brief border war with Vietnam in 1979. With its newly upgraded navy and army, it is quite possible that China will be tempted to fill some of the void left by the US in the Middle East, if only to secure energy supplies. A Chinese intervention in the Middle East may have a very similar outcome as the Russian intervention in Afghanistan. Considerable stress on the budget and significant backlash against the Communist Party as body bags start coming home. This will be a drain on China, and over time China will cease to be a peer competitor to the US.

We are on the verge of a US foreign policy that will be driven by realism as opposed to an impulse to spread democracy and capitalism. Here are the main areas of engagement:

1. A grand bargain with Russia allows for the US to draw down forces from Europe and also allows Russia to move resources from defense into social programs. Russia needs to deal with its own demographic decline.
2. Withdraw from the heart of the turbulent Middle East while still staying on the periphery to influence outcomes. Let Turkey, Iran and Saudi Arabia fight for influence and balance one another without allowing any one or two from becoming dominant. Its is clear that the Middle East needs to find its own path to conflict resolution. Outside powers only complicate matters. 
3. Redeploy key forces to Asia to keep allies from acquiring nuclear weapons and also from aligning with China. As a frenemy, allow China to get involved with the Middle East to protect its own energy supply sea lanes. Taking on this role will feed China's perception of itself as a global power. However, this will also sap Chinese power over time.
4. Ensure the economic rise of India and Indonesia as a long term balance for Chinese power in Asia. As demographic decline comes to China, this will be reflected in its economic and military power.

If the US is able to manage these foreign policy changes, it will continue to the be indispensable nation on the global stage well into this century.

The Trump campaign was fueled by resentment of the white working class. There are many campaign promises that will need to addressed. These are tactical matters that will need to be dealt with while pursuing the larger goals outlined above.

• Expect to see moves that will include browbeating US corporations to bring jobs back to the US as part of repatriating funds that have been parked abroad. Recent Carrier deal is a sign of things to come.
• NAFTA will be tweaked on the margins to placate Trump's voter block. But NAFTA is not going to be renegotiated from scratch. Expect some sections of US-Mexico border to be further controlled with walls/fences, but no new Great Wall will be coming up.
• A new detente with Russia can play well in the context of some of the identity politics that we have seen emerge this election.
• ISIS will be bombed by both Russia and the US. As the US withdraws, Turkey, Iran and Saudi Arabia will be forced to fill the unstable void. Terror attacks in the US and Europe will not stop any time soon.
• Partial withdrawal from the boiling cauldron that is Middle East will also be accompanied by strict limits on immigration from the Middle East.

The pieces on the chess board are well laid out for the US to execute a major changes in its foreign policy. The main leverage for the US vis-a-vis other major powers is demographics. All other major powers are facing demographic decline or already dealing with it (Japan and Russia for example).

Demographics can be destiny if you play your cards right.