By Michael Every of Rabobank
More swings in geopolitics, more Fed histrionics, and more market hysterics: yet for equities, any time is ‘Peace in our time’ time: there is no reality-denying, can-kicking delusion they cannot embrace, imbibe, snort, or main-line. Allow me to soberly unpack another volatile day, and the *very* volatile days to come.
Yesterday started with the new ‘normal’: bond yields higher, even if 2.50% in US 10s was a line in the sand, and curves flattening; commodities bid; and stocks saying in times of high inflation and war, they provide a safe haven. Then wild claims started flying around: “Russia to wind down operations around Kyiv!”; “Mutual trust!”; “Ukraine can join the EU!”; “Zelenskiy and Putin to meet!” Suddenly, Neville Chamberlains on trading floors everywhere were waving pieces of paper.
The most immediate impact was in oil and the commodity complex, which was hammered. That saw bond yields reverse their earlier spike. Equities then decided that as well as being a safe haven against inflation and war, they would thrive with less inflation and peace. Then oil prices went back up again on a US inventory draw-down. But it didn’t matter: US 10s closed 12bp lower from their intra-day peak at 2.40%, while 2s only dipped 11bp and, briefly, the 2s-10s curve inverted. We had already seen other parts of the curve invert, but 2s-10s is a key recession indicator: with the kind of inflation and supply-chain backdrop we have, more so. Yet that didn’t bother stocks.
US consumer confidence showed expectations falling to 76.6, lower than during Covid, with lower earners the most despondent. That didn’t bother stocks. Poor people don’t spend money, right?
A Bloomberg article by former New York Fed President Dudley said: “The Fed Has Made a U.S. Recession Inevitable: Jerome Powell is far too optimistic about the chances of a soft landing.” That didn’t bother stocks. What does a former Fed president know?
Current St. Louis Fed President Bullard said he favored a Fed Funds rate of over 3% by the end of this year. That didn’t bother stocks. Who is Bullard anyway?
Philadelphia Fed President Harker stated inflation was at unacceptable levels and he wants to see a series of “deliberate, methodical” rate hikes, with 50bp steps not off the table. That didn’t bother stocks either. Apparently it doesn’t matter that we are only one 25bp hike into an aggressive hiking cycle and the curve is *already* inverted: Fed, shmed - we have peace in our time!
On that peace, look up the Russian military doctrine of ‘maskirovka’ (deception). Yes, it’s as old as the hills and not exclusively Russian, but not all armies embrace it as openly as Russia’s does, even if they sometimes do a rubbish job of it: recall the 150,000 troops now swarming over Ukraine were supposed to just be on a “training exercise?” Stocks don’t.
We do see a fighting pullback of over-stretched Russian forces from Kyiv, which from day one they never had the manpower to take if they faced serious urban resistance, which they do despite the US trying to airlift President Zelenskiy out at the start of the war. However, those Russian forces are pulling back to the eastern front to try to encircle 80-100,000 Ukrainian troops holding the line there. They are not going home to buy stocks, even if the Moscow stock exchange is open again.
Imagine what the suddenly pragmatic and all about “mutual trust” Russian negotiating position will be if that encirclement succeeds: and how bloody the fighting is about to get in Ukraine’s agricultural and industrial heartland as they try. Stocks can’t.
A ceasefire has still not been achieved, and neither the US nor the UK are taking Russia seriously yet. Former Russian foreign minister Kozyrev says: “This could easily be a manoeuvre to buy Russia time to regroup and then hit has hard as they can.” Former Finnish president Hendrik tweets: “Analysts say it’s little more than a tactic for regrouping. Why would you take seriously *anything* Russians say?” Ukrainian intelligence alleges Russia is concealing a mass mobilization of combat reserves and conscription of Chechen convicts to replenish its fighting forces. President Zelenskiy says: “Ukrainians are not naïve…Of course, we see all the risks. Of course, we don’t have a reason to trust the words of representatives of a country that wages war against us.” Stocks do though.
Yes, we have a potential peace positive in the status of Crimea reportedly being kicked into the long grass for 15 years. Ukraine can remain neutral, outside NATO. It might even be allowed to join the EU. But it insists on inviolable security guarantees from the UK, Turkey, the US, France, and Germany that will force them to defend it - a de facto NATO Article 5. It wants this passed into legislation so there can be no repeat of the 1994 Budapest agreement that was supposed to protect it in exchange for relinquishing its nuclear arsenal. Moreover, Ukraine won’t accept territorial losses in Donbas. Why should it surrender access to the Sea of Azov or the Black Sea, or its industrial and agricultural base: to placate Moscow, or stocks? Kyiv also insists on a referendum to cement any deal‘s legitimacy: how does one hold one during a war with millions of refugees; and how would the fired-up population vote?
However, there is no Damascene conversion underway in Russia. Its Duma just proposed a bill that would only give ethnic groups the right to obtain citizenship if they speak Russian, and envisions adding the definition of "state-forming people" for ethnic Russians and "representatives of Belarusian and Ukrainian peoples that are related to the state-forming people."
Yet President Biden’s huge gaffe in talking about regime change, walk back, and walk back of the walk-back, disquieted parts of the Western alliance: as such, it would suit Russia to try to look like the more reasonable party again. Indeed, one can see how Russia could now try to split the West again. France and Germany may welcome any opportunity to deescalate: President Macron doesn’t seem to be able to go more than 48 hours without calling the Kremlin. Stocks will love it.
By contrast, Poland, the Baltics, the UK and US will want to keep up the pressure on Russia. The Atlantic’s ‘Don’t Let Up Now’ perhaps reflects D.C. thinking:
“Nothing in Russia’s pronouncements or behaviour suggests that the long-term goal of the Putin regime has shifted from the desire to subjugate Ukraine, replacing President Volodymyr Zelenskiy and his subordinates with a quisling government and eliminating the country’s independence in all but name. Indeed, the apocalyptic rhetoric of Russian news commentators and senior civilian leaders suggests that the war’s aim has not changed. The giddy aspirations of February 24, though, have encountered the realities of the battlefield. Delusions are often modified by the sight of hundreds of burning vehicles…
Thus, the West should support Ukraine by extending only limited promises of sanctions relief to Russia, and it most definitely should not reward Moscow by lifting them entirely should Russia accept a status quo ante cease-fire. And even when official sanctions are lifted, it makes sense to discourage Western companies from doing business there by every means possible.
This sounds harsh, and it is. But there is another Clausewitzian truth to be faced here, that war is a contest not just of armies but of societal wills, and the West must aim to break Russia’s societal will through the grinding up of its army and the devastation of its economy.”
Indeed, if sanctions on Russia are removed with no concrete security guarantees in place for Ukraine, what stops this happening again with better logistics from the Russian side? Stocks won’t like that thought: but luckily they seem to believe everything Putin says - and nothing the Fed does.
Meanwhile, look at the biggest picture to really see ‘Peace in our time’ dynamics. The White House’s proposed defence budget sees a headline increase of around 5% in nominal terms, but real terms decrease. At a time when supply-chains are the front line in the New Cold War and maritime power is vital --which the stand-off in the Black Sea and Sea of Azov underlines, as does the potential threat to Taiwan-- the US Navy is being downsized. The budget proposes decommissioning 24 ships, 11 of which are less than a decade old, together while adding just 9. The outlook, according to some analysts, is that the 298-strong Navy is heading for around 280 by 2027, and perhaps 240 in out years. Up to 10,000 sailors may also lose their jobs. By contrast, China is building ships at a frenetic pace.
Wasn’t weakness projected by the West a contributing factor to this war in Ukraine? If so, what signal does a fading US Navy project in a fragmenting world? And as another military analyst pointed out years ago out, if the US gets dragged into a war on the relative scale Ukraine is facing, it would also find its stock of military assets would be rapidly depleted – it has no spare capacity to ramp-up production to replace them at the rate they would be lost. In short, the US would have only a narrow fighting window before, like Russia, it would have to rethink its tactics, strategy, and perhaps even willingness to escalate.
How many allies will the US need to bring on board to compensate for its relative loss of power? We see AUKUS – but defence spending in Australia and the UK isn’t high enough either. We see The Quad – where Japan and India are spending more, but India is not a given in the US camp given its relations with Russia. We see Europe realising it must rearm – but with the risk of political or bureaucratic delays. Worse, given how long it takes to build military power, which regions will the US have to retreat from to focus their attention where they see it matters most? Look at the Sunni Arab-Israeli military alliance emerging precisely because of that shift – even as Middle Eastern energy begins to matter even more to many. This all matters for markets, which rest on politics, which rest on power, which ultimately rests on the military.
If the US wanted to spend more on the Navy, how could it afford it? Grow faster? How, without structural reforms that are anathema to Wall Street? Make money from its maritime military control? Monetizing in an inflationary environment where the US no longer controls supply chains? If anyone can do military MMT, the US can… until it can’t because the rest of the world walks away – which, circularly, revolves around US military power! Look at what is happening to JPY as the BOJ carries out Yield Curve Control. Or, inversely, by trying to slow down China’s rate of growth, so it can’t afford to build so many ships? Anathema to Wall Street again: but capital outflows from China have accelerated since the Ukraine war started.
For now, the US, and the Eurodollar, are hegemons – as underlined yesterday. Russia is weaker, not stronger, after attacking Ukraine (even if a wartime, largely untradable RUB even more jerry-rigged than CNY is almost back to its pre-war level against USD). Many say China has also been warned off any moves on Taiwan. Yet if you want to look further ahead, look at the US military budget and its capacity to sustainably project military power against an economic peer, not a militia or weaker emerging market. But then again, why worry about any war when anytime is ‘Peace in our time’ time for markets?