Geopolitical Developments: A Mask Of Short-Term Optimism Helps Investors Get To The Weekend
Worsening news on the economic front and dreadful news on the Ukrainian front is being papered over as global investors approach the weekend. The sensibility now engulfing the markets is that a hard landing is within sight but once we land it will be all signals go to prepare for the eventual return to flight. Consequently the markets are rallying into a Friday and taking a week of bad news in stride. 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), but my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought several positive factors for US stocks. The US yield curve is falling and in the current context that is bullish. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there was also one negative factor across global asset classes. Copper is pointing to declining global GDP expectations. Expect the S&P 500 to be rise moderately over the next few days before collapsing as the bears retake control going into month-end.
Since the Russian invasion the markets have fallen with high volatility, and yet the mood among global investors has vacillated between bewilderment and resignation over the recession that’s certain to ensue. One of the reasons the market has been both volatile and seemingly orderly is the muted risks of financial contagion. Russian banks could fail and lead to disruptions in global dollar markets, but that disruption would likely be temporary, if it happens at all. Inflation can lead to global labor unrest and food shortages could compound that stress into a new Arab Spring, harming EM banks already struggling to pay back dollar-denominated debt. But the largesse that world leaders gave the middle and lower classes during the pandemic is a strong foundation for worker complacency. Shortages, strikes and protests can harm the global economy, but more salient is the inflation-fighting of the Fed as a result of the invasion and the excessive stimulus payments, and the impact a recession would have on global confidence and peace.
As former Fed Governor Dudley recently remarked the prospects for a mild recession are strong precisely because the Fed intends to raise unemployment and both banks and shadow banks are in good enough shape to stand that. Consequently a mild recession ensues for the normal reason of dropping demand from both consumers and the businesses that anticipate falling sales. A long and deep recession like that of 2008 seems off the table, so markets are taking bad news in stride.
But the high intraday volatility reflects the complex currents driving global investors, and in this complexity lies uncertainty over how the leverage engineered by the Fed since the pandemic will work itself out as the world heads into recession. Crypto nonsense is part of this, but the limited participation by both retail and institutional investors in this imaginary asset class means the odds of contagion are small, even if it heads to zero. But other sources remain.
Reuters notes “An indicator of credit risk in the U.S. banking system may be showing signs of stress, as the Federal Reserve's aggressive rate hike path ratchets up expectations of economic pain. The so-called FRA-OIS spread, which measures the gap between the U.S. three-month forward rate agreement and the overnight index swap rate, increased to 29.55 basis points on Thursday, its widest since May 23, according to data from Refinitiv. The measure was at -11.66 bps earlier in the week. Widely viewed as a proxy for banking sector risk, a higher spread reflects rising interbank lending risk. Spreads on five-year credit default swaps (CDS) of JP Morgan, Goldman Sachs, Morgan Stanley, Citigroup, Wells Fargo and Bank of America peaked to fresh two-year highs on Thursday. Some strategists are concerned that these might point to "stress under the surface".”
The US and European banking systems will likely weather the storm, but not so all Asian banks. Contagion starts with a weak link falling and the stronger links getting run over in a flight to safety, and that is a possibility due to the ongoing malaise in the 3rd largest economy in the world.
Risk.net notes “Plummeting mark-to-market valuations battered The Norinchukin Bank’s capital adequacy in the first quarter, highlighting the lender’s outsized exposure to market vagaries compared with its Japanese peers. Common Equity Tier 1 (CET1) capital fell 14% to ¥7 trillion ($52.2 billion) in the period, after accumulated other comprehensive income (AOCI) – which primarily includes paper gains on fair-value securities – shrunk by almost half, from ¥1.7 trillion to ¥984 billion.”
I see the fears of contagion as real and the actual risk of it as minor, and for that reason I see another leg lower in the bear market and a bottom happening at that point. A recession is nearly upon us but I don’t see it as mirroring the GFC, largely because financial contagion is more a fear than a likely scenario.
My current positions are a large cash position, Goldman Sachs (GS), 3M (MMM), Pfizer (PFE), Starbucks (SBUX), Titan Machinery (TITN) and the levered ETF UPRO.