The “Guns of February” that boomed across Ukraine have added another strand to the complicated web global central banks have spun for themselves. In the mere ten days since the invasion began to the time of this writing, the entire calculus has changed for geopolitics, inflation and global finance. Wall Street pundits have been falling all over themselves to produce forecast scenarios for clients regarding the implications of the Ukraine war for the markets and economy, but the truth is that nobody has any idea how this is all going to play out. One thing that does seem sure, however, is that the tenuous trading and diplomatic relationships the west has had with Russia have been swept away and are being replaced with a new paradigm of animosity and conflict.
Central banks, and in particular the U.S. Federal Reserve, had been facing multiple challenges to their missions before Ukraine was invaded, and now even more so. The Fed and their global cohorts have spent the last thirteen years weaving themselves a web focused on artificially suppressing interest rates, facilitating massive increases in debt at all levels, and providing a seemingly endless fount of liquidity to financial markets. This merry-go-round of perpetual stimulus was happily accepted by investors, who bid up the price of stocks, bonds and real estate to unsustainable levels, inflating the third financial bubble of the 21st century (2000, 2008, and now). Sadly, the Fed, which has been instrumental in creating the bubble, is now caught in a web of their own making.
Inflation is the key predicament facing the Fed and their friends. The consumer price index (CPI) has now risen by 7.5% in the last twelve months, while the producer price index (PPI) is up a whopping 12.5% over the same time. This is now feeding into wages. The Atlanta Fed’s wage growth tracker posted a 5.1% rise in January, and the highest reading since 2001. One employer has upped the ante: retailer Target announced they would bump starting pay in the most competitive job markets to as high as $24 an hour, more than triple the federal minimum wage. Social Security recipients and pensioners will get a near 6% increase in benefits this year, far above the 1.65% average increase of the last 10 years.
One behavior the covid experience made clear is that when you give consumers more cash, they spend it. Stimulus payments of 2020-21 circumvented traditional monetary policy by putting money directly into consumer hands, a necessity when interest rates were already near zero percent. This was a real-world experiment with what economist Milton Friedman called “helicopter money,” and as Friedman theorized, would result in inflation. Higher wages and cost-of-living bumps will have much the same effect, at least until the next recession.
The Fed has fiddled while the flames of inflation have burned, but has reiterated they are committed to begin raising rates despite the potential recessionary fallout of the Ukrainian war. Indeed, the war has served to reinforce the upward trajectory of key commodities such as oil, aluminum, coal, and wheat, and we should expect these to feed through to consumer prices for the near term. With the CPI at 7.5% and 30-year Treasury bond yields at a mere 2.3%, the gulf between reality and monetary policy is huge. The Fed has a lot of catching up to do to close this gap, thus we expect we are in a long cycle of rising interest rates.
It is not hard to see the reasons for the Fed’s dithering on rate hikes. Their “quantitative easing” (QE) policy was originally a temporary rescue measure back in 2009, but has evolved into one of the stickiest strands of the monetary web. QE’s intent was to boost asset prices to stave off a deflationary decline and keep banks solvent. In this goal they were enormously successful, as stocks, bonds, and real estate have had a tremendous run on the back of artificially suppressed interest rates. Profits at Goldman Sachs, Citigroup, and Morgan Stanley have rarely been higher. But that asset inflation has also brought about a commensurate rise in debt, both on corporate balance sheets and in margin debt taken on by investors.
To deal with inflation, the Fed will need to raise interest rates and markedly reduce the pace of QE liquidity. It is the latter policy that spooks Wall Street, as markets have become addicted not only to the continual flow of cash into the financial system, but also the knee-jerk monetary injections the Fed has provided any time stocks prices have wobbled. Cutting off the flow of liquidity risks toppling the edifice of over-inflated assets at a time when the Fed will be hard pressed to run to the rescue again. This could create a reverse “wealth effect” whereby falling asset prices cause people to “feel” poorer, and hence pull back on their spending. In the battle over stock markets and inflation, it’s still an open question with whom the Fed will side: Wall Street or Main Street?
Another entangling element of the monetary web is that the Fed has little to no stimulus power left to counter a recession. They squandered the opportunity to raise interest rates when times were good, and the economy was well positioned to absorb higher rates. Now, with rates still hugging the zero boundary, they can’t lower rates in the traditional way to stimulate borrowing. That leaves only further QE as the primary monetary tool. But can QE be effective with inflation climbing and becoming more entrenched? Investors, who cheered QE over the last decade, may now view more QE as further fanning the fires of inflation, pushing bond yields even higher than otherwise. The Fed’s toolkit looks woefully empty.
Finally, the Ukrainian war has prompted the west to weaponize finance. Knowing that armed confrontation with Russia is impossible without risking a pan-European war, the NATO-plus alliance has decided to torpedo the Russian economy. Finance is one area where the west can deal from a position of strength. Russian bank assets have been frozen, strict restrictions placed on dealings with the Russian central bank, Russia has been kicked out of the SWIFT global banking facility, and Russian securities have been suspended from trading making them nearly worthless, as investments and as collateral. The rapid and cooperative imposition of sanctions shows that the west was prepared for the worst-case result of Putin’s early saber rattling.
The Fed’s job, and especially that of the European Central Bank (ECB), has become more entangled as a result of this weaponization. A key phrase above is “as collateral.” We live in a financial world that is, of course, globally connected and has become even more so with the advent of technology that allows easy movement of funds around the globe, with the result that international lending has grown into a multi-trillion-dollar (daily) business. But remember that one bank’s asset (loan) is another bank’s liability (borrowing), and the key to the system functioning is the expectation those liabilities are repaid. Up until February 23rd, this was a valid expectation. Now with their assets frozen, Russian banks have no way to repay their liabilities, and no hope they’ll be able to for the foreseeable future. Further, any collateral western banks may have required to secure a Russian loan is rapidly becoming worthless. Thus, while the sanctions have seen the Russian economy fold like a house of cards, there are probably follow-on effects for western banks that aren’t obvious yet but likely to become apparent soon.
As banks begin to suffer defaults from these Russian borrowers central banks are likely to revert to their role as lenders of last resort to the banking system. This means creating more liquidity to keep banks solvent, which is just another form of, you guessed it, more QE. Funding stresses are already becoming apparent in the global money markets, so we expect a coordinated central bank announcement of new liquidity programs any day now.
Thus, the intractable problems of the Fed and their peers becomes clear: they must tighten monetary policy to begin to curb inflation, and they must keep policy loose to help cope with the fallout from financial sanctions. How they thread that needle is anyone’s guess, but it does indicate that the calm era of limitless QE is coming to an end.
How is the ordinary investor to cope with these uncertainties? The financial media is nearly useless in answering this question as they seem to be focused more on the price of gasoline and which Russian oligarch’s yachts have been seized. Wall Street pundits are no better, as they are falling over themselves trying to handicap the market bottom, or parroting their defunct advice to “buy the dip.”
We are in a bear market, one that has been masked for months by the strength of the major indices that are dominated by the index heavyweights such as Microsoft, Apple, and Amazon. We are also in a war from which Putin will not retreat—he is committed to an all-out takeover of Ukraine. Moreover, we have the price of a key commodity, oil, leaping higher (closing at $115 as of this writing).
These are not the conditions that lend themselves to quick resolution. Investors have become conditioned over the years to “buy the dip” and the Fed has accommodated them by opening the monetary spigots every time Wall Street’s billionaires began their whining. With asset valuations still at stratospheric levels, inflation and interest rates rising, investors should resist the urge to leap into the market simply because it has gone down. If Putin’s war coincides with, or indeed is the catalyst for, the financial bubble bursting, stock prices can go down a lot further than people think.
Investors should bear in mind that while the indexes are declining, under the surface there are securities that are bucking the trend. Passive index investing works great when conditions are “lifting all the boats” in the financial markets, but not so much under current conditions. Thus, now is the time to consider individual issues or sectors that are holding their own during this market stress. It may be areas that have defensive characteristics (e.g. food), pay an attractive level of income (i.e. dividends), or have unique characteristics that benefit from the moment we are in (e.g. oil and gas).
More specifically, with all the “junk” advice swirling around, we recommend investors keep an eye on two key breadth measures we often feature in this newsletter. The first is the NYSE advance/decline (“a/d”) line. The a/d line takes the number of advancing stocks minus declining stocks and adds that value (positive or negative) to a running cumulative total. In bull markets more stocks go up than down in a day (or week) and so the chart rises, and the converse is true in a correction or bear market. Currently, both the daily (shown) and weekly a/d lines are on a sell signals, indicating that downward price action predominates at the moment.
The downtrends of the daily and weekly a/d lines are now well established, and that is enough to call this a bear market. As such, investors should exercise patience before making aggressive commitments on the buy side. When the daily a/d line (and especially the weekly a/d line) eventually give buy signals, then that will be the time to broadly add to stock positions. Until then, investors should assume any rally is a counter-trend rally within the context of a larger decline. The one thing investors are unprepared for is a bear market that lasts many months, or dare we say it, a couple of years. The a/d line is one of the best tools to use to let the “message from the markets” guide your decision-making.
The second barometer that is key to watch is our old friend, the NYSE Bullish %. This measures the percentage of stocks on the NYSE that are on “buy” signals, using the point-and-figure method. Like the a/d line, the NYSE Bullish % rises in a bull market, and falls during corrections as a declining percentage of stocks are able to hold on to buy signals. Oversold low levels, and attractive buying levels, occur with the NYSE Bullish % below 30%. Currently, it stands at 45.1% and looks to be headed lower. Moreover, the Bullish %s for the S&P 500, Nasdaq 100, and small- and mid-cap indexes are all in bearish patterns, underscoring the pervasive selling that is dominating the markets right now. Again we urge patience in buying—when there is this much consensus among the Bullish %s it reinforces the idea of a broad decline, and these measures can go a lot lower than people think (in 2008 the NYSE Bullish % got down to 6%).
Not all is bad news for investors, however. We’ve pointed to the euphoric behavior witnessed in 2021 as a clear indication that risk was high, and a conservative stance was warranted. The low-risk time to buy would come when fear stalked the markets, and media stories were dominated by negative headlines.
Recent action has gotten us part of the way there. The combination of resurgent inflation, rising interest rates, and now the Ukraine war has demolished the sunny and complacent attitudes of just a few months ago. Advisory sentiment, as measured by Investors Intelligence, has seen a dramatic reversal from mid-2021. Bullish advisors now comprise only 29.9% of the survey, while bearish advisors have risen to 34.5%, the first time the bears have outnumbered the bulls since 2020. As the chart below shows, the best buying points occur when the bull-minus-bear calculation is negative (more bears than bulls). This is an indication that fear is rising among advisors, a necessary condition for a long-term bottom. Remember that major market lows can take many months to form, so sentiment can stay negative for quite a while before the market turns positive.
While we still see too many bullish or buy-the-dip headlines in the financial press, we believe this bear market will last long enough that it’s only a matter of time before we see stories advising investors to “sell everything” and get out of stocks. When that moment comes you’ll know a truly low-risk moment has arrived.
There are no easy answers for investors today in the wake of the Ukrainian invasion. For our part, we can only proceed day-by-day to protect clients’ assets. Putin’s actions, though, have long-term consequences for commodities and financial markets, and have turned post-Berlin Wall geopolitics on its head. This is a watershed moment for western liberal democracies, and we hope and pray we can achieve some stability and peace before there is a cataclysmic loss of human life. Regrettably, current behavior on the part of Russia does not look promising for this goal. Putin will not stop until he is stopped, and so investors should be prepared for difficult times ahead.