Inflation came in hot this morning, as expected. And with the recent pop in oil prices, the next inflation reading will likely be in the double-digits (year-over-year).
With that, the Fed starts is inflation chase next week (beginning the rate hiking campaign). The European Central Bank began setting expectations for a similar plight this morning (telegraphing an end of bond buying and a rate liftoff).
Let's talk about Europe …
Remember, last week we looked at the euro, as the proxy for trouble in Europe. The common currency of Europe has been on the slide since the Russian invasion in Ukraine. And today, despite a hawkish ECB, the euro ended lower.
There are plenty of things to worry about in Europe. Telegraphing a tightening campaign to address the hottest inflation in 30 years, in the face of downgraded growth is one (thing to worry about).
Another, is ending the asset purchase program (by Q3) that has been the force behind maintaining stability in the sovereign debt market in Europe (i.e. ECB intervention/bond buying has kept countries like Italy, Spain, Portugal and Greece solvent since the days of the financial crisis).
The ECB ending its backstop of the weaker euro zone countries, alone, could create a dangerous spike in European sovereign bond yields.
This, as we are just in the early days of discovering what European (and global) banks are directly or indirectly exposed to Russian debt.
The risk environment had a huge bounce today. But don’t get too excited.
Remember this chart (we looked at last month) …
After two years of a liquidity deluge, we’re now seeing the effects of illiquidity on markets. Translation: The swings become exaggerated.
By this time tomorrow, markets will have digested another big CPI number. And as we’ve discussed, with oil prices gapping higher, people will begin to extrapolate out the next CPI print (for March). It will be bigger (likely, much bigger), not smaller.
On the Russia/Ukraine front: Headlines will continue to create confusion/ whipsaw in markets. Overnight there was (again) talk that a potential cease fire was coming, and perhaps a concession on Ukrainian territory.
The safe assumption: This won’t be a two-week war.
Back in 2014, when Russia annexed Crimea, the timeline was nine months, and the scale of global escalation is far greater this time.
With the above in mind (existing inflation + further commodity supply shocks, driven by geopolitical strife),dips in commodities prices (and commodity stocks) are a buy.
What’s not a buy? Bitcoin.
Bitcoin rallied today on an executive order from Biden to “ensure the responsible development of digital assets.” This followed a statement last night, in kind, by the U.S. Treasury.
This got the crypto-enthusiasts excited, as they assumed this meant the government is taking steps toward accepting and legitimizing private cryptocurrency. It’s precisely the opposite. As the executive order says, “sovereign money is at the core of a well-functioning financial system, macroeconomic stabilization policies and economic growth.”
The government wants to regulate away private crypto and strengthen their monopoly on money through a “central bank backed digital currency.” Remember, back in June of last year, Elizabeth Warren held a hearing on this. Warren made it clear that a central bank-backed digitaldollarwould “help drive out bogus digital private money (bitcoin, stablecoins, etc.).” This executive order starts the ball rolling, toward this goal — and a cashless society (not good).
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We get February inflation data on Thursday, which will show something close to 8% year-over-year increase in CPI.
That’s a hot number that will get a lot of attention. But that will understate the current environment, considering the price of crude oil is up over 30% since the end of February. With that, next month, when we see the March inflation data, it should be double-digits — maybe even something in the teens.
And that would mean a plunge in this chart …
This is the January report on real disposable income (inflation adjusted). As we know, driven by the covid-related government handouts (three rounds of stimulus checks plus an overly generous and prolonged period of federal unemployment subsidization), personal savings soared. Related to that, income spiked — as you can see in the chart.
Of course, now inflation is taxing not only that money, but all of your income (i.e. the blue line is going lower). Worse, by the time we see the February and March data incorporated into this chart, it will be falling farther, and likely knocked off of the path of the long-term rising trend.
That leads us to the next chart …
This is the spread between the 10-year and 2-year Treasury yields. This has declined to 23 basis points. When it goes negative (circled in the chart), recession has followed (between 6 and 24 months) all but one time dating back to 1955.
This brings me back to my July note of last year: “For now, we continue to ride the wave of asset prices. But the damage will come. First, from inflation and lower quality of life. And then, the economic decline is typically is triggered by the Fed. When the Fed finally, 1) acknowledges the hot inflation, 2) stops fueling it, 3) starts chasing it, and 4) ultimately kills it with higher interest rates, then the economic damage will come.“
We’re about to embark on step 3. And the Fed’s budding inflation chase would project a recession that would be consistent with the timeline from the yield curve analysis above.
That said, as we discussed last month, “if such economic disruptions (from Russia/Ukraine) unfold, we can be sure that the democrat-led Congress will quickly resurrect the “Build Back Better” plan to be rubber-stamped.”
So, if this unfolds as such, we should expect more fiscal-funded agenda spending, disguised as a “rescue package.” This fiscal profligacy would only reinforce the trend of devaluing fiat currencies, relative to hard assets (i.e. the commodities price boom).
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As we discussed on Wednesday, “if sanctions were placed on Russian energy exports, there’s no telling how high the crude oil market might spike.”
On that note, Pelosi launched a trial balloon last night, just as futures markets opened, saying that Congress was “exploring legislation to ban import of Russian oil.” Oil traded as high as $130 at the open.
This comes as the national average price for gas had already climbed above $4 a gallon. We’re just a nickel away from the highest national average price on record.
Importantly, this $4 has proven to be a psychological level that changes consumer behaviors. The record high was in 2008, and the national average sniffed around $4 again in 2011 and 2012.
What did consumers do? They pulled back. “Gas guzzling” SUV’s were dumped. They gave then the government in exchange for a check (“cash for clunkers”). And/Or they simply just stopped driving as much (as you can see in the graphic below).
Now, if high oil prices persist (which seems to be the highest probable scenario), it will hurt consumer spending (in at least some areas), but it also feeds into an already hot wage pressure situation, and it feeds into inflation expectations. The latter happens to be the Fed’s biggest fear (i.e. the “unanchoring” of inflation expectations).
With that, what happens when people start expecting the price of everything to runaway. They chase prices (higher, and higher).
That would push the Fed into the ring of a dog-fight. As we’ll see at the end of the week, inflation is already proving to be persistent, and steadily climbing toward double-digits. Remember, the last time the Fed was in this situation (early 80s), they had to move short-term rates ABOVE, the rate of inflation to finally bring it under control.
Despite all of the speculation about the dollar losing status as the world reserve currency … gold losing ground as the safe-haven … and Treasuries being penalized for reckless deficit spending, where does global capital flow when things really get dicey? The dollar. Gold. And U.S. Treasuries.
That's how we ended the week: Flight to safety.
Let's look at some charts …
With two valuation drivers at work (inflation and geopolitical risk) gold is back near $2,000, tracking toward the record highs set August of 2020.
And while gold typically rises, as the dollar falls, in times of global stress, they rise together. Here's a look at the dollar …
And the dollar chart is mostly driven by this chart below (a slide in the value of the euro)…
This is a key spot to watch (the euro) … where we may see some surprises bubble up in markets.
The 2013-2014 Russia/Ukraine conflict resulted in a sharp slide in the euro, involving sovereign debt risks and (related) exposure of European banks to Russia. This time, Fitch calls the bank risks limited (if not small). But there are typically secondary risks in these environments that can bite — like a hedge fund counterparty default, which could create a shock event for the financial system. Keep an eye on the euro.
A predicted-future climate crisis has led to policymaking that has created an immediate energy crisis.
Next up, looks like food crisis.
As you can see in this chart, food prices are near record highs already. This is a squeeze on the standard of living for rich countries. For poor countries, it's full blown crisis. This time it looks like an uglier, more widespread impact is coming.
Unfortunately, we know the energy input isn't improving anytime soon. Nor is transportation (from both energy and supply chain disruptions). Labor? Labor costs are just in the early to middle innings of an adjustment. We have a supply crunch in all three of these inputs.
What about fertilizer? Nitrogen, Phosphorous, Potassium: All higher, nearly double the cost of this input for 2022.
Now we add in a supply shock from Russia and Ukraine – which combine for a quarter of the world's wheat exports.
A year ago, oil was trading in the mid $50s. The national average on gas was $2.59/gallon.
Throughout the past year, we've talked about the glidepath to $100 oil (driven by anti-oil policies). And here we are.
Oil closed above $100 yesterday, and traded over $112 today.
With the Biden administration's pursuit of a "clean energy revolution," we've knowingly ceded control of the oil market to OPEC. And OPEC has every incentive to drive prices higher. As I said last year (and penned in a Forbes piece, here), Get Ready For $6 Gas.
Add to this, we now have the additional catalyst of a potential shock to an already undersupplied market. If sanctions were placed on Russian energy exports, there's no telling how high the crude oil market might spike.
With that, we've talked about the prospects of Biden going the route of price controls. It may be coming.
Remember, last night's State of the Union was all about "costs." He said the word "costs" as many times as he mentioned Putin last night.
He's already alleged price gouging from the domestic oil and gas industry and (similarly) called for an "investigation" into U.S. producers (for the audacity of making wider profit margins on higher prices, which is now controlled by OPEC).
Last month, Biden said he would be "coordinating" with major energy consumers and producers, and will be "prepared to deploy all the tools and authority at his disposal to provide relief at the gas pump."
These "tools" may come in the form of some sort of subsidy, at some point, but a subsidy would sustain the demand dynamic for oil. Apply that to a world that is undersupplied and underinvested in new supply, and the price of oil will continue to rise.
Oil broke above $100 today (trading as high as $106). No surprise, the last time oil was here was 2014, a few months into the last Ukraine/ Russia conflict.
What's different this time? The global economy is running about a percentage point hotter than it was in 2014. And today global demand is outstripping supply for six straight quarters.
Back in 2014, a large increase in global oil production was driven by a surprisingly strong and growing U.S. shale industry. So, back then at $110 oil, supply was growing. Today, it's shrinking, driven by global anti-oil policy.
Bottom line: While the price looks familiar, the supply/demand dynamic has been flipped on its head. We should expect much higher prices.
That brings us to the mid-March Fed meeting. What's the most scrutinized data point for the Fed? Inflation expectations. And what feeds into inflation expectations, like no other? Gas prices.
So the Fed will be facing another gut punch to the price pressure problem, while also facing uncertainty about economic shocks that could come from the growing conflict in eastern Europe. We have a higher prices and potential slowing growth scenario.
What will the Fed NOT do, in this environment? Surprise markets. The market is already pricing in a quarter pointratehike– which will officially end the pandemic induced "emergency policies." Jay Powell will testify before Congress tomorrow and Thursday, and will likely set the table for this outcome.
But the Fed's job to tame inflation will likely get a lot harder (if that's possible). Tonight, Biden's State of the Union will be a platform to pitch Build Back Better to the country, rebranded as an "economic relief" package (addressing rising "costs").
As I said in my Feb 24th note, the day Russia invaded Ukraine: "if economic disruptions unfold, we can be sure that the democrat-led Congress will quickly resurrect the 'Build Back Better'plan to be rubber-stamped." Adding a few trillion dollars in new fiscal spending as the medicine for the hottest inflation we've seen in forty years. Hmm.
Let's take a look at the fireworks in Russian financial markets today …
Below is a chart of the U.S. dollar vs. the Russian ruble. This is conventional way in it's quoted in the foreign exchange market (rubles per dollar). The orange line rising represents appreciation in the dollar/depreciation in the ruble.
Now, the white boxes in this chart above represent the start/end of the Russia/Ukraine conflict in 2014, and the start (November) of the latest conflict, to present, in the far right box.
Observation: If we look back at 2014, when Russia ultimately annexed Crimea, the damage to the Ruble was worse — about twice as bad as the current case (thus far). But it's early.
When the currency is collapsing (from a combination of capital flight and speculation), the central bank has to step in and become the buyer of last resort (defend the currency). But to buy rubles, the Central Bank of Russia has to exchange foreign currency, from their reserves. This is where it becomes dangerous for Russia. When the central bank is selling dollars and buying its own currency all day, every day to fend off speculators it can quickly bleed the country's currency reserves (a component of the country's global net worth).
With the above in mind, Russia ratcheted up short term interest rates today from 8.5% to 20%!
For any speculators now trying to short the ruble, they now have to pay an overnight interest rate of 20%. That will end a speculative rout quickly. That's precisely what the Bank of Thailand did to George Soros back in the late 90s, when he was trying to force a devaluation of the Thai baht. They chased him away by spiking the overnight interest rate. But they ultimately did give way to a big currency devaluation.
Thus far, the Russian central bank comes into this crisis with a larger war chest of foreign currency reserves (as you can see in the above chart) … and a customer, in China, that will probably be happy to buy all of the oil Russia will sell them (if the West were to go farther down the road of sanctions).
So, this confrontation building between Russia and the West probably won't be short-lived.
There has been plenty of attention given to Russia/Ukraine, and the swings in stocks over the past week.
Let's end the week with some perspective on global markets and asset prices, as we approach the Fed's official end of emergency policies (just weeks away).
In the graphic above, you can see commodity prices continue to rise. This is consistent with an inflationary environment, where the Fed has intentionally left themselves behind the curve, to let prices run hot.
But there is more to it. This a longer-term secular trend underway — a repricing underway of real assets, relative to financial assets.
As we've discussed over the past few years, commodity prices have been at historically cheap levels, relative to stocks. In fact, only two other times on record, have commodities this cheap: 1) at the depths of the Great Depression in the early 30s, and 2) in the early 70s (which was at the end of the Bretton Woods currency system).
Commodities prices went on a tear both times.
The last time commodities were this cheap, relative to stocks, a broad basket of commodities returned 50% annualized for the next four years – up seven-fold over 10 years.
Remember, we've looked at this chart many times …
Along with the deflationary forces of the post-financial crisis, commodities prices were flashing depression-like signals. We may not have recognized it so easily, given the buffer of trillions of dollars of central bank intervention (which manufactured sluggish growth).
Now, we have a massive government spending response (fiscal), inflation, a boom in commodities, and likely the early-stages of an aggressive economic expansion (finally). With that, the new bull trend in this chart above is in the early stages.
Consider this: Our Billionaire's Portfolio has 35% exposure to commodities-related stocks – and another 10% in asset heavy/ infrastructure related stocks. And in the face of this recent stock market decline, our portfolio is up on the year. It's a stock-picking market now (sectors matter, value matters, catalysts matter).
