What Financial Markets Are Telling Us: Mistakes By Putin May Find An Echo In Mistakes By American, European and Chinese Policymakers

The US and Europe persist in treading cautiously while Putin’s irrationality causes devastation in Ukraine, while the markets look on in the vain hope nothing drastic will happen in consequence. The volatility risk premium points to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), while my technical reading of key stocks in the S&P 500 is bullish. Yesterday's cross-asset action brought one positive factor for US stocks. The action in major currencies indicates the $US is weak. But there was also one negative factor across global asset classes. The US yield curve is rising and in the current context that is bearish. Expect the S&P 500 to trade within the range set in early March until a steep decline sets in later in the month.

The equity markets are telegraphing mild concern over the economy and the Fed’s hawkish pose in response to current inflation. Equity volatility derivative indices such as the VVIX and SKEW show little panic and limited hedging by global investors, while volumes in the equity cash market have been only slightly higher than normal. This is consistent with what the economic data have been showing through March, namely a slowdown in the economy across regions and sectors while inflation remains high. Expected equity volatility (as measured by the VIX) had been high until yesterday while actual historical volatility has remained high, suggesting there will be a significant slowdown in the American economy but not a recession.

But the fixed income markets tell a more complicated story. Expectations of inflation continue to be anchored in the 2.50% range, with medium-term inflation above 2% but longer-term inflation close to 3%. This combination of slowing growth and modest inflation suggest the Fed should be measured in raising interest rates and reducing its balance sheet, yet the Fed has been hawkish and even featured a dissent of James Bullard yesterday (voting for a 50bp hike), and this has pushed bond market volatility to very high levels. Factor in volatility and it’s clear the global bond market sees a possibility of a policy mistake that pushes the US into recession, but relatively little concern for the situation in Ukraine other than its impact on inflation. The strong $US and volatility in the Chinese Yuan point to fears of a global recession and mistakes by Xi Jinping in handling the property crisis as he focuses on finessing China’s position on Ukraine.

Here I differ strongly from the market consensus and fear not only a Fed policy mistake but that Putin’s delusions will reverberate into global growth and cause earnings estimates to fall steeply. Estimates began falling two weeks ago but still point to high single digit profit growth this year. I see valuations declining significantly as estimates come down, and the S&P 500 falling to at least the 3700 region before bottoming. The key won’t be the Fed, but how quickly Putin is eliminated. The longer it takes for his inner circle to act the deeper the global economic slowdown and the harder it will be for the Fed to raise interest rates and risk a recession in the US.

My current positions include a large cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO.