Geopolitical Developments: The Russia Problem Persists And The Federal Reserve Is Contributing To It

Strangling the Russian bear is the overriding objective of the free world but uncoordinated government leaders are making it a long bout that will cost the world dearly. The recent spike in equity volatility mirrors this dismal state of geopolitical affairs. The volatility risk premium points to a higher market over the next few days, but my technical reading of key stocks in the S&P 500 is bearish. There is one negative factor across global asset classes. The action in currencies signifies $US strength. Expect the S&P 500 to fall over the next few days.

The Fed is taking away the punch bowl despite the party emptying out on fears of war across Europe and worse. While the motivation of Fed Governors hinges on egos and vanity above objective criteria, these governors can count on both history and a selective reading of the current economic context to justify their hawkishness. This makes it impossible for Biden to pressure them to lay off, and the result is currency depreciation around the world and the attendant stagflation that drives down confidence.

The Fed still bears the scars of the 1960s & 70s, where serving political masters who wanted low interest rates caused inflation and subsequent attempts to rein in prices were middling and unimaginative. It took the overpowering Fed Chairman Paul Volcker to bring prices down, largely by shocking the world with new monetary techniques and enduring the wrath of common people who found their livelihoods diminished by the harsh recession Volcker engineered. Today’s Fed are colorless technocrats in the vein of Alan Greenspan who can’t communicate confidence like Volcker and who would rather not risk a worsening inflation environment and so are blissfully ignoring geopolitical and economic realities as they push for positive real interest rates. Since Biden and most Americans can remember the malaise of the 1970s the Fed can have its way and let the rest of the world deal with the consequences.

The current economic context isn’t supportive of such hawkishness but the Fed will point to strong consumer and business balance sheets as reason enough to hike rates and take a little short-term pain for supposedly long-term economic health. S&P notes “The median interest coverage ratio — a measure of a company's ability to repay its debts calculated by dividing earnings before interest and taxes by the cost of its debt-interest payments — for nonfinancial companies rated investment-grade by S&P Global Ratings was 8.0 in the third quarter of 2021, according to the latest data published by S&P Global Market Intelligence. While this was down from 8.4 in the previous quarter, it was up from a pre-pandemic level of 6.0.”

Consequently rates are going up and bond market volatility is rocketing, while inflation expectations for the long term still hover around 3%. Currency volatility is back as well, feeding into equity volatility and equity-like securities in the high yield bond market. S&P notes “In recent history, rising corporate bond spreads have dealt setbacks to the Fed's plans. The Fed halted policy tightening in early 2019 after corporate credit spreads widened by 50 bps, eventually cutting rates when the pandemic arrived, while a spike in spreads in the aftermath of a rate hike in late 2015 delayed further increases by 12 months…” But this time “The Federal Reserve will likely forge ahead with its plans to hike interest rates despite wider credit spreads.”

The geopolitical impact is stagflation as the $US rises and raises the cost of imports for everyone but the US, which simultaneously lower global economic growth. At a time when the basic liberal order needs to persevere and get nations like India and China onside the Fed is pushing stagflation on these nations, making it likely impossible for Biden to choke off Russia quickly and thus end the War in Ukraine. China has seen its currency fall like a knife as a host of factors conspire to bring the economy down. The impact on Chinese firms is tangible and reflected in the recent equity market fall. CNBC notes “China’s inflation dynamics implied a continued margin pressure on Chinese corporates...”

Coordination is difficult across nations but impossible when the US can’t coordinate its political and monetary authorities. The consequent is more bloodshed in Ukraine as Putin holds onto power, with a rising threat of nuclear war as the Russian military takes historic casualties. This isn’t in the Fed’s bailiwick but the signs of dark times ahead are reflected in equity volatility and plain for everyone to see. I expect lower lows as we work our way to a solution to the Russia problem in the months ahead.

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.