TUE 15 FEB 2022
For those not familiar with the term, an “armchair general” is someone who portrays themselves as an expert on military or strategic matters despite having no actual experience in the military. There are parallels with the “armchair virologists” who have mushroomed since the start of the pandemic in 2020.
While I have personally spent time in Moscow with key advisers to the Kremlin, I can safely say that I have no idea how the current episode in Ukraine will play out. However, what we do know is that similar episodes in history have often contributed to emotional selling that can create opportunities to purchase distressed assets when other investors become forced sellers. As an aside, Vladimir Putin’s speciality at the KGB was “conspiracy theory.” The most plausible strategic reason for the threat of aggression is to extract concessions, to protect the gas export market in Europe or for his own domestic audience.
What we also know from the previous episode in 2014, is that it remained largely idiosyncratic to Russian and closely liked assets. Indeed, the spill over into broader credit risk has been modest (so far). European high yield spreads have widened in line with US high yield spreads. In contrast, the additional risk premium on Russian sovereign credit appears more idiosyncratic (chart 1) compared to the general spread widening in 2020.
Similarly, the volatility in the RUB appears similar to the recent widening in broader implied equity volatility (chart 2). However, our sense is that the rise in equity volatility has more likely been driven by the impulsive rise in short-term interest rate expectations and the recalibration of beliefs on liquidity and broader financial conditions which include dollar strength against emerging market currencies.
To be fair, the correlated impact of the current episode is the rise in oil and energy prices more broadly, particularly for Europe. As we have noted in the past, energy prices are relative – producers gain at the expensive of consumers. Or stated differently, higher energy prices not supported by strong final demand are a tax on households. Moreover, energy prices tend to be correlated to headline inflation and inflation expectations, especially in the context of correlated global supply side constraints and much greater breadth in consumer prices since 2021 (note the Cleveland Fed’s Trimmed mean inflation measure last week which highlighted the breadth of inflation at the highest level since the 1980s).
On the positive side, and as we noted last week, the 16th Eurodollar contract implied yield and 5 year 5 year forward breakeven inflation is still well anchored just above 2%. Put another way, the current inflation shock has not impacted longer term inflation or neutral rate expectations (yet). On the negative side, there is a greater fear among some market participants that the implied hikes priced into the fixed income markets and flattening/inversion of segments of the yield curve suggest that the Fed is about to commit a major policy error; tightening into a deteriorating growth environment.
In addition to the signal from the yield curve, there has been a meaningful deterioration in consumer confidence (and expectations) which has coincided with or contributed to the recent weakness in equity prices via a reflexive feedback loop. However, as we have noted in the past, consumers do not always spend their confidence (note the period in 2011 and 2012 when retail sales remained firm despite recession-like expectations – chart 3).
As we have noted before, the real damage from higher rates tends to occur later in the cycle when tighter policy flattens/inverts the curve. In conclusion our sense is that it is probably too early to be too pessimistic on growth and profits as the economy reopens. In this region, China has also pivoted to easing credit and Asia trades at a material discount to the United States following material underperformance last year. In most episodes caused by idiosyncratic factors, indiscriminate selling is an opportunity to take on. The most important element of the current episode, is persistent inflation, the rise in short term interest rate expectations and withdrawal of liquidity. The assets most are the most expensive and levered entities with weak free cash flow. The key question is not why equities have fallen, but why they have not declined by more. Our sense is that the balance of risks is still to the downside into March.