This January has been the worst start of the year ever for the stock market, and specifically the market reaction to Fed Chair Jerome Powell’s Wednesday press conference is the worst in modern time with markets reversing to the tune of 3.5% (generally Powell’s press conferences get the worst market reaction… Ben Bernanke’s were the best). At the same time, the biggest invasion force mustered on the outer edges of Europe since the second world war stands ready for the battle cry.
If you are reading this on a Sunday morning, as prescribed, I’ll understand if you go back to bed and hide, it’s a depressing state of the world.
In this respect my intention is not to forecast where the stock market is going to go, nor on what day Russian troops will pour over the Ukrainian border (amongst other considerations it would apparently be considered bad form to eclipse the Winter Games in China, which takes us to late February – keep it close, but the 22nd is the day!), but to rather make the point that these two not unrelated events are stress tests, that reveal much about the world that is evolving before us.
Indeed, there are some common patterns. The first is policy mistakes.
The recent conversion of the Federal Reserve to a tightening stance comes after a decade of easy money that has conditioned investors and households that ample liquidity will continue unabated. Its no surprise then that asset prices and increasingly, consumer prices are extremely elevated. The Fed has many warnings that inflation was rising, and as recently as November officials were describing high inflation prints as ‘transitory’ (the latest inflation deflator released Friday, is at the highest since 1983). The Fed is now chasing its own mistake.
In prior years when the Fed had credibility (and its most senior officials were not dealing in the markets they oversee) a very hawkish tone by the Fed could be construed as the use of words to curb market exuberance rather than rate increases outright (more economically damaging). It is unlikely the case this time.
In and around the Ukraine, much is made of the tactical genius of Vladimir Putin. Without any special insight into how he operates (books like ‘Putin’s People’ and the ‘The Dragons and the Snakes’ help) the intention of his constant needling of the borders of Europe (from the border with Norway to angry Irish fisherman) is to gauge the reaction and readiness of NATO/European countries.
In this instance, even if we do not have a war, his actions are producing some interesting side effects – the readiness of Sweden and Finland to join NATO, the activism of small Baltic states, the dominance of American diplomatic power across Europe and the improving credibility of Tony Blinken, and the turning of even the most mild-mannering German politicians.
In that context, a full war on Ukraine might backfire badly on Putin, wealthy Russians and its economy.
The second, related element is the way in which the two events – the prospect of higher interest rates in the US and the threat of war in the Ukraine are exposing system vulnerabilities. Here are a few – energy distribution networks, Ireland’s lack of military hardware, the gearing built up in financial markets in the drive to ‘democratise investing’, groupthink in monetary policy, and German foreign policy, to name a few.
In finance, two vulnerabilities that may come into sight later this year are rising credit spreads and weaker housing markets. The euro-zone crisis and the policy reaction to COVID tell us that system vulnerabilities get stress tested until people adapt.
Thirdly, the geopolitical and market stress tests tell us much about the new world order that is forming ahead of us.
To start with geopolitics, in his annual and very long news address in mid-December, Vladimir Putin declared the certain end of a unipolar world, and the advent of a multipolar one. He will no doubt be delighted to learn that this letter agrees with these broad strokes but dismayed that we think Russia is too weak economically, financially, politically and in terms of its soft power, to carve out a Russian zone in this multipolar world.
A defining element of this multipolar world is the greying of the demarcation between soft and hard power and more pointedly, the idea of total war (attributed to a Russian general). This has been on full display in recent weeks, notably the use of press, PR and propaganda by Britain and the US, the prospect of financial and economic sanctions, the threat of massive cyber attacks and the use of energy supply chains as a pressure hold. In the future, places that are on the faultlines of the multipolar world (i.e. Taiwan, Hong Kong, increasingly Africa) will be subject to ‘total war’ style tactics.
An additional point, which always struck me hard whenever I visited Moscow or St Petersberg, is that at the friction points of the tectonic plates of this multipolar world, different countries have very different perspectives on the same situation – markedly so in the way Russia views the situation in Ukraine and beyond, and the way say that British military leaders do.
Finally, to markets, which also have Russia in mind (look at the gap between the Russian stock market and the oil price for instance). At the start of the year we wrote that liquidity would be the dominant factor in markets, and the tightening in financial conditions betrays this with US markets behaving in a way that we have only seen in severe economic crises (2001, 2009 and 2020). This is a concern because it signals underlying risks and threats ahead, and the possibility of further policy mistakes.
For my part, I do not think that the Fed will raise rates as much as the Fed itself and many investment banks think (4-5 times this year according to some forecasts). The key issue is what level prices need to fall to such that markets become less vulnerable to tighter liquidity, and in that context we might see a second dip before the end of March. At very least, the first week of February may be less stressful than January, for markets and geopolitics.
Have a great week ahead,