We Don’t Know What We Don’t Know

For those of you who would prefer to listen:

These 2020s sure have been beyond eventful, don’t you think? And we’ve only entered year 4. Throughout history, we have faced inflation and economic slowdowns. We’ve experienced political and social division and unrest. We’ve also struggled through hot and cold wars. They just haven’t all occurred simultaneously; Until the 2020s. We are experiencing a unique environment with many cross-currents right now. The Market is navigating them all, like a long whitewater stretch with class 5 rapids. Those of you who know, know.

The American Consumer accounts for 70% of economic activity. That we know. Consumers are still spending. We know that too. But personal balance sheets are thinning. The savings rate is at multi-year lows. This week the CEOs of Home Depot and Walmart reminded us that we’ve not been in a situation like this where the Fed is raising at the rate that it has been. At what point does the spending stop? What’s the breaking point for the US Economy? What about the geopolitical issues that show slim signs of resolution? Corporate America is simply saying, we don’t know what we don’t know. But alas, we must keep moving forward. 

We’ve covered earnings, the economic slowdown, inflation and the Fed consistently for weeks. They’re all still materially relevant and a big part of the Market volatility. That’s not going to change anytime soon. Something we haven’t discussed for a bit is the war in Ukraine. This week marked the one-year point, a milestone celebrated by next to none. 

Presidents Vladimir Putin and Joe Biden gave dueling speeches ahead of the inauspicious anniversary of the war. The American President spoke from Poland, a day after making a surprise visit to Ukraine. Both speeches were well received by their audiences. Of course, they were also criticized by their adversaries.

Treasury Secretary Janet Yellen stated that Russia ending the war in Ukraine would be “the most important thing” for the Global Economy, which has suffered from the “weaponization of food and energy.” These words were spoken at a meeting of the G20 Finance Ministers in India. They were received around the time China caught the world’s attention by publishing a 12-point proposal to end the war. It was a busy week for geopolitics.

China will always act in its best interests. It’s no surprise that the 12-point plan was received with great skepticism. Of course, anything that would put an end to the war sounds like good news on the surface. But this proposed solution is probably not what the West had in mind. The United States and Ukraine, among other countries, don’t view China as an impartial mediator. Chinese President Xi seems to be seizing the moment to present himself as a global statesman. He is sending a message to a global audience that China is a neutral force for peace. This is a path to end the conflict without publicly telling Vladimir Putin that his conflict is not going well. China has clearly chosen a side in this conflict. The US and Europe aren’t happy that Xi is standing by Russia. 

To an extent, the war is perceived to be beneficial to China. China’s challenges are dimmed in the headlines as the West gets distracted and weakened from war. A weaker Russia also means lower Energy prices for China. Chinese-Russian trade has soared since the invasion of Ukraine. Beijing is now Moscow’s largest buyer of Oil, which is a massive percentage of Russian economic output. Since Russia has been blocked from doing business with the West, most of its auto and electronics imports now come from the East.

You may recall, China and Russia solidified their ties at a high-profile meeting between Putin and Xi ahead of the 2022 Olympic games in Beijing. This week, China’s top diplomat Wang Yi, described the relationship as “solid as a mountain” and building on its “no-limits” partnership. Does that mean China is providing support to Russia in this war? According to our sources, there is no evidence of “lethal aid,” but they don’t believe it’s been taken off the table either. Ukrainian President Volodymyr Zelenskyy rattled emotions when he warned that China allying itself with Russia would mean WWIII. The stakes are clearly high. 

Ukraine today, Taiwan tomorrow? Tensions were already simmering after the China spy balloon incident. It’s hard to dispute that it was an attempt to assess America’s ability to respond to a Chinese invasion of Taiwan.

If the US and China are in a Cold War, the opportunity for a mistake or misunderstanding is becoming increasingly dangerous. Something important to remember: China cares about its Economy. The Chinese government needs to provide prosperity for its people. China’s Economy suffered greatly with its Zero Covid policy. It’s now re-opening, which should bring a return to growth. It will be hard for China’s Economy to rebound this year if global growth continues to slow with uncertainty over the war. The conflict has also fueled increased tensions with the West, leading to everything from export controls on chipmaking equipment to increased Western diplomatic support for Taiwan. It’s been said that China is getting tired of the analogies being made between Ukraine and Taiwan and would like them to go away. One way for that to happen is for the war in Ukraine to end.

There’s also this, from one of our Washington sources: “Russia could be providing Iran with nuclear know-how in exchange for weapons. A nuclear-capable Iran is viewed as an existential threat to Israel and Saudi Arabia, and both may be compelled to take preemptive measures to prevent that from occurring. Such a conflict would disrupt oil prices.” Planet Earth is a complex place. 

Back to the Market: This week brought the biggest decliner on this young year. The S&P erased all its February gains in a single day. The Stock Market has a streak of 3 weekly decliners. The biggest issue: Inflation is not going away. The Core PCE (Personal Consumption Expenditure) index came in much hotter than expected for January. That crushed the disinflation momentum. The higher-than-expected number is not good for the Stock Market because that means the Fed has more rate hiking to do. The Market is now assigning a 73% probability of a ¼-point hike in March and an 88% probability of another ¼-point hike in May. It’s even pricing in a 27% probability that the Fed goes big with a ½-point hike next month.

The point is, higher interest rates and longer-lasting has become more likely. The 10-Year Treasury yield is back near the 4% level. The 1-Year yield cleared 5%. 30-Year mortgage rates are back near 7%. The last time those longer rates were this high was last Fall. That led to a slowdown in Housing and a Stock Market decline. A 7% mortgage buys a lot less house. That we know. Will it happen again? That we don’t know. But we think it’s likely. The corrective cycle seems unfinished in our work. We like bonds here. We are defensive on stocks here.

One of the biggest challenges of being a Market professional is you never have all the information. Doing extensive research and analysis provides signals and clues. We compare them to historical patterns and cycles to help anticipate future outcomes. We study success and learn from mistakes. We are quick to admit, we don’t have all the answers. We know full well we don’t know what we don’t know. Say that fast five times. But not knowing never stops us from studying and learning. Knowledge is power and the more informed we are, the better decision-making becomes. Even with a class 5 rapid Market in the 2020s. We’re all over it. 

Have a nice weekend. We’ll be back, dark and early on Monday.


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