Back on January 14, in “Something Wicked This Way Comes,” I wrote that “it’s becoming more difficult to shake the feeling that something bad is about to happen to the US economy, markets or, quite possibly, both.”
I penned that linked article on a Friday evening prior to a three-day weekend in the US. The S&P fell in seven of the next eight sessions, on the way to a shallow correction.
Fast forward a month, and it’s another Friday evening ahead of another long weekend for US traders. And here I am again, penning another ominous missive, albeit from an idyllic setting which belies everything that’s wrong with the world.
The headwinds markets faced a month ago haven’t disappeared or even dissipated. Rather, they’re significantly stronger — gale-force, even. Evidence that inflation is embedding itself across the US economy is everywhere except in long-run expectations, and one can’t help but wonder if that last pillar of support for whatever’s left of the “transitory” narrative might soon begin to crack.
When the article linked here at the outset was published, Fed officials were still calling three rate hikes in 2022 a “good baseline,” to quote Christopher Waller. Four weeks and some very bad CPI data later, and Jim Bullard was busy talking up 100bps by July, and suggesting it may be necessary to deliberately overshoot neutral in order to rein in inflation.
Although rate hike premium is coming out of swaps, it’s not because traders are suddenly feeling less anxious about the Fed. Rather, it’s because the risk-off trade tied to imminent conflict in eastern Europe is forcing the issue. The associated flight to safety is pressuring long-end yields lower, undermining any nascent steepening (figure below), and thereby exacerbating the poor optics for a Fed that needs a pre-liftoff inversion about like it needs a mortar shell in the head. 10-year yields ended Friday near the bottom of the weekly range at ~1.93%.
“The ongoing tensions related to the situation in the Ukraine have proven difficult to ignore; particularly as Treasury yields have now twice tested 2.06% in 10s and the level has held,” BMO’s Ian Lyngen and Ben Jeffery wrote. “While the flight-to-quality associated with the Russian question has been meaningful, the eagerness to push Treasury yields higher in the new year was always, at some point, going to run its course.”
Equities fell a second week (figure below), and flows are turning “recessionary,” as BofA’s Michael Hartnett put it. Although the shakeout in various manifestations of speculative excess may have mostly run its course, what’s (still) missing is an index-level purge — a cathartic capitulation that clears the deck.
Systematic de-leveraging has likely gone as far as it can go absent some truly harrowing episode that unleashes the risk parity kraken, but there’s certainly room for additional discretionary de-risking. And while last week’s inflows to global equities were the weakest of 2022, the cumulative haul over the first six weeks of the year matched that seen over the same period in 2021, a record year for inflows. Simply put: Those flows could reverse if a tail event comes calling.
On Friday evening, after the closing bell sounded on Wall Street, Joe Biden told the nation he’s convinced Vladimir Putin has decided to invade Ukraine. The US has gone to extraordinary lengths to preempt an incursion by bombarding the public with as much intelligence as it’s feasible to release, in an effort to undermine Moscow’s alleged plans to fabricate an excuse for war.
“We’re calling out Russia’s plans loudly, repeatedly, not because we want a conflict but because we’re doing everything in our power to remove any reason that Russia may give to justify invading Ukraine and prevent them from moving,” Biden said.
On Thursday, Antony Blinken regaled the UN Security Council with what the US believes are several false flag options under consideration at the Kremlin. Biden reiterated the risk of such an operation on Friday and categorically denied allegations that Ukraine is provoking separatists or otherwise engaged in activities that warrant a military response from Russia.
He didn’t mince words. “We have reason to believe Russian forces are planning and intend to attack Ukraine… in the coming days,” he said, from the White House. “We believe they will target Ukraine’s capital, Kyiv, a city of 2.8 million innocent people.”
While stocks would likely recover from any knee-jerk down trade, it’s difficult to imagine Wall Street making it through the first week of a Russian invasion without suffering serious losses during at least one or two sessions. That this is occurring with just weeks to go before the onset of a Fed tightening cycle, and at a time when Biden’s approval ratings are under pressure from the highest inflation in a generation, makes for a very challenging backdrop.
“While we anticipate the Ukraine will remain in the spotlight throughout the next several weeks, at some point the tensions will ease and the market will return to trading off Fed expectations, inflation data and the employment profile,” BMO’s Lyngen and Jeffery said Friday afternoon. The problem with that, for stocks anyway, is that Fed expectations arguably aren’t priced in quite yet. Even those of a sanguine persuasion are inclined to accept the possibility that US shares are vulnerable to additional modest de-rating.
Writing for The Economist earlier this month, Yuval Noah Harari suggested the direction of human history itself is at stake in Ukraine. “At the heart of the Ukraine crisis lies a fundamental question about the nature of history and the nature of humanity: Is change possible?”, he wrote. “Can humans change the way they behave, or does history repeat itself endlessly, with humans forever condemned to re-enact past tragedies without changing anything except the décor?”
It could be 1938 in Europe…again. I’m afraid that another week of risk-off market behavior may be the least of our problems.
I think it is unlikely, even if some on the Street wish it, that assets have mostly priced in the Fed’s actions.
I know, buy rumour / sell news. Sure, the “mechanical” valuation impact of higher expected rates can certainly be priced in; I think about 100 bps worth has been. But the real impact has, I think, hardly started to be reflected in prices.
There must be much more impact than not-even-ten points on SP50 and none at all on any inflation, employment, growth, or other macro measure – because if that is all there is, the Fed will have to do more.
As highlighted by H’s post on Zoltan’s latest, the Fed needs to make a significant impact on the real economy if it wants to be a proactive force in reducing inflation, which it must for reasons discussed here. That means stocks need to price in a significant impact on revenue, profits, growth, credit, etc.
Other than the uber-growth tech-web-ish names missing and getting duly plowed – hard to keep track of them all, but just read the list of ARKK holdings – where are all the stocks that are pricing in misses, guide-downs, cuts, and glum times? Or recessionary times, if you think we’re in for more than a “technical” recession?
I don’t track every report, of course, but aggregate measures of 4Q earnings reports don’t seem to show that. More pragmatically, (non-ARKK) stocks are getting slammed on soft reports/guides, so obviously softness is far from priced in, and whiffs are not even starting to be priced in.
I started pulling down equity exposure in 3Q21 (and boy did I rue that timing), by Dec was more defensive than any time since Dec 2019 (more rue-ing), and have been cutting exposure further on up days (and to my shame, on some down days too).
We haven’t even seen the start of monetary tightening by the Fed. The pandemic fiscal largess has not yet run out – e.g. all the money showered on states, many of which have been very slow to spend it. SP500 is not even in a correction. I do see some bargains in US stocks but they are either niche-y names (are not and cannot be market leadership) or have charts somewhere between ominous and falling knife.
I’m ranting. I need a drink. St Germain, tonic, and gin, I think.
ten percentage points, I meant to write
Harari is right
“Can humans change the way they behave, or does history repeat itself endlessly, with humans forever condemned to re-enact past tragedies without changing anything except the décor?”
This was most definitely a question I had to ask my vintage Magic 8-ball, as things of such importance require. After giving it a good shake the first response was “concentrate and ask again”. The second time I replaced the word can with will and stammered something about the foreseeable future, the response to that was “outlook not so good”.
Considering the show of unity Putin and Xi made at the Olympics, I think the bigger worry would be what will be China’s response if Putin invades Ukraine? If NATO challenges Putin will Xi help him?
Ukraine is not a NATO member, so why would NATO defend it?
How about because there are millions of innocent people there who help feed NATO nations and who have no culpability that would be a legitimate reason for them to be killed. Britain, France and others saw Hitler was going to annex Poland in the late 1930s along with several of its neighbors for the good of the fatherland but they did nothing. Should we send troops? No. Such efforts in the last 60 years have all led to tears. Should we bust their banks and resource sales. Sure if we can. Enough already.
Yup. Two combatants face off. One brings words to the battlefield and promises not to shoot. The other brings bullets, shells, jets, an armada, and allies while desperately looking around for a plausible provocation to open fire. Care to place a bet on who wins? Granted Biden has yet to drop the mighty F-bomb, but, it won’t affect the outcome much if he does. All demi-God Xi-lla has to do to help is say nothing. So there you go.
Or maybe NATO will just throw Ukraine to the wolves. Fiona Hill yesterday in the NYTime’s On Politics newsletter:
“Last night, I was at dinner with a European foreign minister and one of their under secretaries. And they were relating discussions that they’ve had with the Russians, where Putin’s told them bluntly that they can buy anyone they like in the United States or in Europe.”
Whatever the response, it will be bad for markets.
What is are the implications for investors, of a Russian invasion of Ukraine? I mean beyond the initial risk shock.
Maybe something like:
+ for some ag and metal commodities
– for their users
+ for inflation hedges
– for inflation sensitive
+ for defence
+ for oil, NG, LNG, renewable, nuclear (?)
+ for cybersecurity
– for (Russia-enabling) social media
Take a look at valuations of defense names … out of favor for years and 2023+ US / Euro defense budgets are not going to be down.