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“Putin Shock” — Financialization of Warfare Threatens “Risk-Free” Status of U.S. Govt. Debt — Can the Fed Thread the Needle Between Soft Landing and Disinflation? – Will Planned Rate Increases Achieve Sufficient Positive Real Rates to Lower Inflation? — Will Eroding Consumers’ Real Incomes Lead to Slower Economic Growth and Shift Away from National Brands? – Will Tight Labor Markets Lead to Higher Productivity? –Displacement and Replacement?

Date Posted: March 29, 2022

“Putin Shock” Underlines Eurasian Threat to Western World—U.S. Global Military Power and U.S. Dollar Reserve Status Go Hand-In-Glove

We titled our last commentary The “Putin Shock” Could Create Shocking Changes –  unfortunately, that proved too true. The “Putin shock” plus the pandemic changed our world for the foreseeable future. “The world has entered a new period of turbulence and change,” according to China’s President Xi. The Eurasian “alliance” between China and Russia creates a threat to the western world no matter the outcome in Ukraine. The “Putin Shock” will likely result in re-examining and increasing U.S. spending on military and cyber warfare equipment and systems. In addition, to remain the predominant global military power, the U.S. dollar must retain its reserve currency status — both go hand-in-glove. The “Putin Shock” will also force many European nations to step up their defense spending. To illustrate, the German army now maintains fewer tanks and helicopters than the Russians first lost invading Ukraine. Like the “fog of war,” fog also applies to our current economic outlook. This Commentary will attempt to look through the fog to potential challenges and, more importantly, resulting opportunities.

Fed Likely to Shift to More Aggressive Rate Increases — 50bps — Higher Real Rates Needed to Lower Inflation.

In March, the Federal reserve recently “firmed” its rate policies by raising the funds rate by 25bps — a seemingly dovish response to higher inflation rates. In reaction, some economists, such as Larry Summers, argued that making progress against inflation and dampening demand requires more substantial nominal rate increases to achieve 2-3% positive real rates. Then in a more hawkish speech, seemingly responding to Summers, Fed Chair Pro Tempore Powell indicated that, if the inflationary outlook calls for it, the Fed will increase the funds rate by more than 25bps and, if necessary, more than once. He indicated the Fed would move “expeditiously,”  implying a 50bps increase at its May 4th meeting. Other members of the Fed seem to be falling in line. At the same time, the relatively flat yield curve indicates investors expect the economy to slow (see Figure 1). Therefore, possible economic slowing would preclude the Fed from moving as aggressively on its current path of multiple funds rate increases.

Figure 1

U.S. 10yr-2yr Government Yields (Bps)

Source: Ryan Alm, Tradeweb ICE Closes

Fed Threading the Needle Between Soft Landing and Economic Weakness

Chair Powell remains comfortable that the U.S. economy shows sufficient strength, marked by tight labor markets and excess consumer savings, to continue growing and achieving a soft-landing despite rate increases. The Fed will be threading the needle to continue growth and bring down inflationary forces. Despite a likely series of funds rate increases, negative real rates could persist if inflation rates remain higher than nominal interest rates. This relationship would continue a less restrictive policy making it more difficult for the Fed to achieve its inflation goals.

Reduced Fed Balance Sheet — Quantitative Tightening (QT) – Reducing Commercial Banks’ Lending Capacity

At its March meeting, the Fed accelerated the timing for reducing its balance sheet —Quantitative Tightening (QT). In order to tighten, the Fed will reduce both its holdings of treasuries and agency paper assets. To offset that reduction, it will also bring down commercial bank reserves held at the Fed and carried as liabilities. Replacing the Fed’s government debt purchases, banks will then step up their purchases by using their excess reserves. By reducing excess reserves deposited at the Fed and increasing their holdings of government debt, banks will tighten their flexibility to lend.

Financialization of Warfare Could Threaten “Risk-Free” Status of U.S. Government Debt – Reducing U.S. Dollar Reserves Globally

In our view, sanctioning the Russian Central Bank (RCB) and Russian banks will likely prove to be the most important sanction — both currently and long term. Sanctioning the RCB roped off roughly $315 billion of Russia’s $640 billion in reserves. Absent those roped off foreign-based reserves, RCB’s reserves consist primarily of $135 billion of gold and $60 billion of yuan. The cost of insuring Russian government debt shot up, indicating a greater probability of default. Perhaps moderating that possibility, Russian oil and gas sales generate a weekly income of roughly $7 billion. In the private sector, Russian entities owe roughly $120 billion to international banks (see Figure 2). Financialization of warfare could lead, longer-term, to non-western countries ending their treatment of U.S. government debt as “risk-free” investments — removing its so-call “exorbitant privilege.” This possible shift would also reduce the size of U.S. dollar reserves globally. If so, it could lead to a broader interest in substituting cryptocurrencies and gold for dollar transactions. 

Figure 2

Banks’ Exposure to Russian Debt by Country — (US$ Billion)

Consolidated Claims on an Immediate Counterparty Basis (As of September 30th, 2021)

Source: Bank of International Settlements

Russia/Ukraine Provide Export Wheat to the World – Replacing Lost Production Should Benefit Suppliers to the Ag Industry – Higher Food Costs Could Stoke Increased Populism and Arab Spring Redo

Russia ranks as the top global wheat exporter, while Ukraine ranks number five (see Figure 3). Wheat harvested last summer continues to flow from Russia but at lower volumes. For the most part, exports from Ukraine trickle out. The key issue influencing global wheat supplies and, ultimately, food inflation, will be their summer harvest. That harvest will depend on how many of Ukraine’s farming towns and villages avoided being wiped out by the Russians. Ukrainian wheat exports flow out through Odessa — the nation’s commercial center. The Russian navy now blocks such exports. Assuming there will be no early end to the conflict, world wheat prices will rise further above the already 40% increase. With pressures to offset lost Ukrainian and Russian production and exports, companies supplying services, supplies, and equipment to the agricultural industry should benefit.

Figure 3

Russian and Ukrainian Wheat Exports ($ Billion)

25% of the World’s Wheat Exports

Source: Observatory for Economic Complexity, 2019, Al Jazeera

Inflationary Pressures — Consumer Real Incomes Erode – May Lead to Slower Economic Growth — Shifts from National Brands

The impact of energy and food inflation on consumers’ real income may prove key to economic growth. Figure 4 shows the trend of real disposable personal income — note the real income spikes from three stimulus programs in 2020-21. Figure 5 shows food prices rose 8.6%, or the fastest rate in 40 years. In the face of food inflation exceeding annual wage increases of less than 6%, consumers’ real purchasing power will erode. More specifically, consumers, particularly low-income consumers, will likely offset inflationary pressures by shifting their spending mix (see Figure 6). For example, consumers will likely move down from premium-priced to popular-priced branded products and, in many cases, shift to even lower-priced supermarket brands. In addition, they will likely purchase less. Despite excess savings, primarily at higher income levels, compressed real consumer incomes will likely lead to slower economic growth this year and next. It will also lead investors to focus on industries and companies less impacted by the erosion of consumers’ real purchasing power.

Figure 4

Real Disposable Personal Income ($ Billions — Seasonally Adjusted)

Source: Federal Reserve Bank of St. Louis


Figure 5

Food Price Inflation (% Annual Change)

Source: Axios

Figure 6

Inflation Impact on Shifts in Consumer Spending (% Change)

Source: Ipsos Coronavirus Consumer Tracker, Fielded January 4-5, 2022 Among 1,160 U.S. Adults

Long-Term Labor Shortages and Wage Pressures Lead to Technology and Digital Capital Investments — Improved U.S. Productivity?

The U.S. faces the slowest labor force growth in fifty years — likely bringing higher wage pressures for the long-term (see Figure 7). But, counterintuitively, wage pressures and labor shortages should lead to increased productivity longer-term. The answer to improving productivity with such labor shortages and resulting wage cost pressures will likely come from applying technology and digital solutions. Larger corporations will likely look to more entrepreneurial, smaller, companies to provide new technologies and digital services for improving their productivity. If not yet trading in public markets, then many of these entrepreneurial companies will be financed by venture capital.

Figure 7

Labor Force Growth by Decades — 1950’s-2020’s (% Growth)

Source: Bureau of Labor Statistics, Congressional Budget Office, Axios Visuals

Investment Conclusions

Equities — First Rate hikes — History shows equity markets should perform positively in the early stages after the first rate hikes. The S&P 500 rose at an average annualized rate of 9.4% during 12 past rate hike cycles. Figure 8 shows that to be the case except for the high inflationary period of the 70s; therefore, some caution seems appropriate with current higher levels of inflation. With that as a caveat, late-cycle stocks should continue to benefit.

Figure 8

U.S. Stock Market During Rate Hike Cycles – Annualized Total Return

Source: Truist Advisory Services, Reuters Graphics

Equities — Economic Slowing — “Putin Shock” — Displacement and Replacement — Global turmoil will likely accelerate an economic slowdown later this year and into 2023. The “Putin Shock” could lead to a rethinking of energy security and reliability and updating “green” planning. Those changes could result in expanded investments in the energy industries, including fossil fuels, “green,” and nuclear. Businesses servicing those industries should benefit. The growing security alliance between the two great Eurasian powers — China and Russia — will likely prove beneficial to companies supplying services and equipment in defense and cybersecurity. The “Putin shock” will also lead to a broad list of displacements and replacements. For example, uncertain wheat shipments from the Russian/Ukrainian “breadbasket” should benefit companies broadly serving the agricultural industries. No doubt the “Putin Shock” will speed regionalization — “near-sourcing.” In North America, longer-term, that will increase volumes for land based transportation—rails and trucking. 

Equities-Shortage of Growth 2023The possibility of economic slowing next year would lead to a shortage of growth investments. With growth in short supply, selective stocks that can produce above-average steady earnings growth and exhibit characteristics of quality businesses – including strong balance sheets and increasing dividends — could prove attractive.

Fixed Income and Alternatives — Whether inflation proves higher and lasts longer or not, interest rates will remain historically low for some period. With inflation materially higher than nominal interest rates, this combination results in negative real interest rates — inflation less nominal interest rates – for fixed income investors — eroding capital. Therefore, with both low nominal as well as negative real interest rates, long-duration fixed-income investments remain unattractive and should only be used to protect capital. For that portion of portfolios historically committed to fixed income securities, investors should primarily focus on a diversified group of alternative investments. In the aftermath of the “Putin Shock,” more than ever, alternative investments make sense.

Both the potential for increasing political and economic disruption from the “Putin shock” and a renewed outbreak of covid adds greater uncertainty than normal to these conclusions