wknd notes: We Demand Of Our Leaders

“Are you watching Ukraine’s President?” asked Jackson, in uniform, Facetime. We all are - the whole world. And I wonder how Zelensky’s remarkable behavior will inspire our children as they come into their own, forming ideas about how they’ll lead their lives, set the bar for themselves, and what they will demand of their leaders, as they build a better future for us all. “Zelensky is what real leadership looks like. Genuine. Inspiring everyone around him, his entire nation, even when he and his family are in real danger, fighting a far stronger adversary,” said my oldest, one of the 132-million 20-year-olds on our little planet.

Marcel Kasumovich, our head of research, published a thoughtful piece on digital assets, shifting correlations, deleveraging, and the place for such investments in institutional portfolios [click here].

Overall: “We will cause the collapse of the Russian economy,” said France’s finance minister, Bruno le Marie, international sanctions raining on Moscow like carpet bombs on Kharkiv. No doubt Bruno is right. Wars cause economic devastation, particularly in nations that lose. But they inevitably diminish our collective prosperity and well-being in ways few appreciate at their offset. Were we more aware of this fact, there would be far fewer conflicts. My alma mater estimates the post 9-11 War on Terror cost the US $8trln, which perhaps coincidentally is the rough size of the Fed’s balance sheet. The Afghanistan portion cost $2trn. Would that war have been America’s longest had politicians asked voters to fund it through tax hikes? The 7,000+ brave children we sent to fight but who never returned, and the 900,000 foreign dead, can no longer ask that question. But we can. Anyhow, it is easy to fund wars against weak adversaries in a time of structural disinflation, expanding globalization, economic optimization, hyper financialization. But that time had passed even before Ukraine’s war broke out. Structural disinflation allows governments to freely experiment with monetary magic. During inflationary periods, however, such alchemy comes at a steep cost -- in the extreme, we collectively realize money is an illusion, a mass delusion. The Russian central bank just discovered that $388bln of its $643bln in reserves are inaccessible. That’s because most reserves are deposits and securities held by Western central banks and institutions. This leaves Russia with $135bln of gold that Western dealers won’t touch, and $85bln of Chinese securities that Beijing’s state banks won’t trade. So Russia’s central bank has just $30bln in paper foreign currency with which to sustain the illusion that the ruble is real. It is hard to overstate how desperate a financial position Moscow now finds itself in. And on Saturday, Putin said, “These sanctions that are being imposed are akin to a declaration of war, but thank God it has not come to that.”

Week-in-Review (expressed in YoY terms): Mon: Ruble collapses (down ~20% on the day) as west enacts SWIFT sanctions and restricting the CB from deploying its reserves / Russia CB hiked rates to 20% and imposed capital controls (banning foreigners from selling securities in Russia), ECB’s Panetta “ECB stands ready to act”, minimal progress made as Russia/Ukraine officials meet on Belarus border, Zelensky repeated request for Ukraine to be fast tracked into the EU, Biden approval rating falls to record low, ECB’s Rehn says should fully assess implications of war before hiking too soon, Spain CPI 7.5% (7%e), Poland CPI 4.4% (3.4%p), India 4Q GDP 5.4% (5.9%e), Mexico unemp 3.71% (4.24%e), S&P -0.2%; Tue: Russia says it will continue until goals are met / 40mi long convoy approaches Kyiv, Ukraine auctions first “war bonds”, BTPs outperform on potential later end to QE, Italy CPI 6.2% (5.5%e), German CPI 5.5% (5.4%e), S&P -1.5%; Wed: Russia says ready to resume talks, Powell guides to 25bps hike in March but open to 50bps in the future, Biden closed US air space to Russia, China to suspend major activity in Moscow, Biden delivers state of the Union/ vows to control inflation, BOC hikes 25bps as exp, wheat extends to highest since 2008, EU nat gas prices set all-time high, Germany unemp 5% (5.1%e), EU CPI 5.8% (5.6%e) / Core CPI 2.7% (2.6%e), S&P +1.9%; Thur: MSCI and FTSE to remove all Russian stocks from indices, Moody’s and Fitch cut Russia to junk, Powell admits to running scenario with crude at $125/barrel, Turkey CPI 54.44% (52.5%e) / PPI 105.01% (103%e), Swiss CPI 2.2% (1.8%e) / Core CPI 1.3% (0.9%e), Hungary hikes 75bps (50bp exp), Italy unemp 8.8% (9%e), EU PPI 30.6% (27.3%e), EU unemp 6.8% (6.9%e), US unit labor cost 0.9% (0.3%e), US init clam 215k (225k exp), US serv PMI 56.5 (56.7e), US ISM serv 56.5 (61.1e), US factory orders 1.4% (0.7%e), S&P -0.5%; Fri: Russia takes over largest nuclear power plant in Europe causing a fire which is claimed to be “under control”, US NFP 678k (423k exp) / unemp 3.8% (3.9%e) / AHE 5.1% (5.8%e), Fed’s Evans sees 1.75-2% as “closer to neutral”, EU ret sales 7.8% (9.2%e), S&P -0.8%.

Manufacturing PMI (high-to-low): Switzerland 62.6 ( previous month 63.8), Netherlands 60.6 (previous mth 60.1), US 58.6 (prev 57.6), Sweden 58.6/62.2, Germany 58.4/59.8, Austria 58.4/61.5, Italy 58.3/58.3, UK 58/57.3, Greece 57.8/57.9, France 57.2/55.5, Spain 56.9/56.2, Canada 56.6/56.2, Czech Republic 56.5/59, Norway 55.9/56.3, India 54.9/54, Poland 54.7/54.5, Taiwan 54.3/55.1, Vietnam 54.3/53.7, South Korea 53.8/52.8, Hungary 53.2/50.9, Japan 52.7/55.4, Indonesia 51.2/53.7, South Africa 50.9/50.9, China 50.4/49.1, Turkey 50.4/50.5, Singapore 50.2/50.6, Brazil 49.6/47.8, Russia 48.6/51.8, Mexico 48/46.1, Hong Kong 42.9/48.9. Services PMI: Sweden 68/68.6, Ireland 61.8/56.2, UK 60.5/54.1, Spain 56.6/46.6, US 56.5/51.2, Germany 55.8/52.2, France 55.5/53.1, Italy 52.8/48.5, Russia 52.1/49.8, India 51.8/51.5, China 50.2/51.4, Japan 44.2/47.6.

Weekly Close: S&P 500 -1.3% and VIX +4.39 at +31.98. Nikkei -1.9%, Shanghai -0.1%, Euro Stoxx -7.0%, Bovespa +1.2%, MSCI World -1.3%, and MSCI Emerging +0.0%. USD rose +44.8% vs Russia, +5.0% vs Sweden, +3.1% vs Euro, +3.0% vs Mexico, +2.8% vs Turkey, +1.5% vs South Africa, +1.4% vs Sterling, +1.2% vs India, +0.8% vs Ethereum, +0.4% vs Chile, +0.1% vs Indonesia, +0.1% vs Canada, and flat vs China. USD fell -3.9% vs Bitcoin, -2.0% vs Australia, -1.7% vs Brazil, and -0.6% vs Yen. Gold +4.2%, Silver +7.4%, Oil +26.3%, Copper +10.1%, Iron Ore +15.4%, Corn +15.0%. 5y5y inflation swaps (EU +28bps at 2.11%, US +14bps at 2.60%, JP -9bps at 0.62%, and UK +3bps at 4.03%). 2yr Notes -9bps at 1.48% and 10yr Notes -23bps at 1.73%.

Feb Mthly Close: S&P 500 -3.1% and VIX +5.32 at +30.15. Nikkei -1.8%, Shanghai +3.0%, Euro Stoxx -3.4%, Bovespa +0.9%, MSCI World -2.7%, and MSCI Emerging -3.1%. USD rose +26.7% vs Russia, +4.1% vs Turkey, +1.6% vs Sweden, +1.0% vs India, +0.2% vs Sterling, and +0.1% vs Euro. USD fell -6.5% vs Bitcoin, -6.2% vs Ethereum, -3.0% vs Brazil, -2.7% vs Australia, -0.8% vs China, -0.8% vs Mexico, -0.3% vs Canada, -0.3% vs Chile, -0.1% vs Indonesia, -0.1% vs Yen, and -0.1% vs South Africa. Gold +5.8%, Silver +8.6%, Oil +10.7%, Copper +3.0%, Iron Ore -10.4%, Corn +10.6%. 5y5y inflation swaps (EU +2bps at 1.87%, US +3bps at 2.55%, JP -4bps at 0.65%, and UK -1bps at 3.94%). 2yr Notes +25bps at 1.43% and 10yr Notes +5bps at 1.83%.

YTD Equity Indexes (high-to-low): Brazil +19.9% priced in US dollars (+9.2% priced in reais), Colombia +16.3% priced in dollars (+9.3% in pesos), UAE +14.1% (+14.1%), Chile +14% (+7.7%), Saudi Arabia +13.2% (+13.1%), South Africa +6.3% (+1.9%), Indonesia +4.4% (+5.3%), Thailand +2.8% (+0.9%), Singapore +2.4% (+3.3%), Malaysia +1.9% (+2.3%), Argentina +1.8% (+7.2%), Philippines +1.2% (+3.1%), Canada +0.2% (+0.8%), Turkey -0.2% (+7.2%), Norway -1% (+0.5%), Mexico -2% (+0.1%), Australia -3.2% (-4.5%), Taiwan -4.2% (-2.6%), China -4.7% (-5.3%), Israel -5.2% (-1%), HK -6.6% (-6.4%), New Zealand -6.7% (-6.8%), UK -7.5% (-5.4%), India -8.7% (-6.4%), Venezuela -8.9% (-12.8%), MSCI World -9%, S&P 500 -9.2%, Japan -9.4% (-9.7%), Portugal -9.7% (-5.9%), Korea -10.9% (-8.9%), Russell -10.9%, Greece -11.7% (-8%), Switzerland -12.6% (-12.2%), Czech Republic -14.1% (-8.4%), Spain -14.4% (-11.4%), Denmark -14.4% (-11.4%), NASDAQ -14.9%, Belgium -16.3% (-12.8%), France -18.7% (-15.3%), Netherlands -19.2% (-15.8%), Germany -20.4% (-17.6%), Euro Stoxx 50 -20.6% (-17.3%), Italy -20.7% (-17.9%), Ireland -22% (-18.7%), Poland -23.2% (-15.7%), Finland -24.1% (-21.4%), Austria -24.2% (-21.5%), Sweden -24.4% (-17.9%), Hungary -26.7% (-20.7%), and Russia -41.1% (-34.8%).

Crack: “Finance doesn’t live in a vacuum,” said the Plumber on all fours, looking beneath the sink for the origin of a little leak. “There is no tidy scientific controlled experiment. The knock-on effects from sanctions in Russia are a stark reminder. European banks crashed more than 30% in the past three weeks, including a steep 19% decline last week. Credit default spreads are widening sharply in response. The strains emerging in European banks are tied partly to US dollar funding markets. Russia’s acrimonious exit from the financial system is not a spectator sport. It raises risks to broader financial instability.”

Crack II: “Interbank borrowing costs have jumped relative to overnight interest rates, surging to 35bps at the 3-month tenor from 5bps earlier in the month,” mumbled the Plumber, flashlight tucked between his teeth. “This is on-par with past warning signs of global strain: 2008 ahead of the financial crisis; 2011 into the European crisis; 2016 ahead of the global recession; 2018 in the repo shock; and 2020 into the pandemic. Market participants are on high alert,” explained the Plumber, my go-to-guy whenever the global financial pipes start to creak and bang.

Crack III: “Is it the next Great Financial Crisis?” asked the Plumber rhetorically. “No. Fighting yesterday’s war is futile. The GFC, like the Great Depression before it, was “Great” by way of incompetence more than shock. The role of the US dollar in the global financial system was poorly understood. The response was to build tools to repair this blind spot – the Fed was the central bank to the world, not just the US. It was very different from past experiences. Dollar funding crises in emerging markets were opportunities to instill orthodox economic programs in exchange for US dollar financing; this was a tell-tale signal for the private sector to buy EM equity assets at a steep discount.”

Crack IV: “But in the GFC, the numbers were implausibly large for a such a strategy,” explained the Plumber, no one better in the world. “New tools were needed and the Fed’s cross-currency swap line with foreign central banks was arguably most important. It brought the USD discount window to foreign banks through foreign central banks. And last week, the Fed cross currency swap lines were drawn, quietly appearing in Fed weekly balance sheet data. European banks need US dollars, and they are getting them from the Fed via the ECB. They couldn’t into the GFC because the tool didn’t exist.”

Crack V: “The shortfall of US dollar funding comes at a time when reserve balances with Federal Reserve Banks – excess reserve liquidity in a former name – are $3.9195bln,” said the Plumber, surprising me by not calculating it to the nearest penny. “This is a staggeringly large number, near record highs. Excess reserves would rarely rise above $10bln before the GFC, a time when reserve scarcity drove efficiency in funding markets. No more. The trauma of the GFC led the Fed to build tools to ensure a GFC repeat will not happen.”

Crack VI: “But that doesn’t make today’s tightening in credit conditions irrelevant, and it will be much harder to see a proactive policy response now,” said the Plumber. “Inflation is the big difference between past funding squeezes and the current one. In past periods, inflation was a footnote on the list of policy concerns for the Fed. Now, it is the headline act. President Biden declared “getting prices under control” as the top priority in his State of the Union address last week. And inflation expectations, rising sharply since the European conflict, are taking their cue from a shortage of energy and commodities, not the shortage of US dollars in global funding markets. This is different. It will limit the Fed pivot and move the “Fed put” much deeper out of the money.”

Anecdote: “Just a couple things today,” I said at One River’s internal risk meetings. “The first is an observation. Of the many Russia and Ukraine experts who dedicated decades to the study of the region, Putin, other key players, not even one expected this outcome,” I said. “Rarely when it comes to geopolitics does that happen. And when it does, it means we are entering a period of extraordinary uncertainty. So, while it is always important to approach markets and our portfolios with a great degree of humility, it is utterly critical to do so now. Don’t fool yourself into believing you can war-game this out. No one can, not even the key players, it is far too complex. People often like to say they have open minds. But the truth is very few people are capable of processing rapid change of this scale. Their thinking is anchored to the recent past, a decade, two at most. This applies equally to investors and political leaders. Therefore, we must remind ourselves that very few people who are interacting with markets and determining policy are capable of fully internalizing the range of new possibilities we must now consider. At one end of the spectrum of outcomes is a coup that replaces Putin, followed by an ending of hostilities. At the other is a nuclear conflict. There are many other possibilities we have not even considered. And during this period, assume that we will have to process information that is wildly inaccurate, intentionally deceptive, truces that come and go, cyber warfare, biological too, random volatility, etc. Our portfolios and risk management should reflect this – both market and operational risk. The second thing to keep in mind is that often in periods of great change, some very odd market behaviors appear, and these can foreshadow powerful trends that will soon emerge. The Yen is particularly weak when it would normally be a safe haven. The Chinese Renminbi is stable when it would typically be weak. Emerging market equites are surprisingly steady, Asia too. Stay attuned to unusual market divergences, prices that move in counter-intuitive ways. They don’t always lead to great opportunities, but they are the places to start looking.”

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management           

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.