Henry Hodgkins

3/8/22

As we retest the January lows, I think it is evident that geopolitical issues have unseated the Fed’s Monetary policy concerns as the number one issue for markets right now. An all out war is highly unlikely, but even a small involvement would cause already complicated Fed decisions to become more complex. It is already quite obvious that the Fed needs to raise rates and many, including myself, said they should have done sooner. However, that debate is pointless now. The new debates lie within how many rate hikes do we see in 2022? By how many bps? To what scale do we get involved in Europe? This quantitative tightening has the power to choke off the economy. Americans are already feeling the pain as prices skyrocket and consumer demand and savings rates retreat to more normal levels.

Time is not on our side. As consumer demand continues to wane, we run the risk finding ourselves in a stagflationary environment. We have had the luxury of the broad majority of consumers willing to pay elevated prices, but when that willingness runs out (and that already has started), we may get into the beginning of an economic recession.

Now, to the issue of conflict in Europe. In the case of war over Ukraine, the government will need to raise money. But where is it going to get it from? They cannot lower rates and they cannot print money in this environment, so financing a war will be next to impossible. I believe the government knows that - and so do the Russians. I believe that it was not a coincidence that Russia decided now would be the best time to strike. Economically, I believe that the United States is at its weakest right now, and thus will have the hardest time collecting the funds to assist in a war. Additionally, it is quite possible that we have hit peak earnings for U.S. companies and I think the market is ready for a reality check, whether we have a war or not. With so much technical damage done to the S&P, it is quite possible to head back to 4,100 or lower. (Shown by the purple line) Recently, we have seen the S&P hover around 4,300 (blue line), showing support around this level. I would also like to note the thick green candle on 2/24 in the small circle. This green candle shows the bounce off the intraday low of 4,100 its historic rise to end the day, never looking back. This gives me confidence and in my opinion it does feel like this market wants to head higher. Unfortunately, I just do not see a real catalyst for the broad market in the near future. However, this truly depends on the level of involvement of the US government in Europe. I think we could have a slow and steady recovery, decreasing inflation over time if we aren't forced to rapidly heat up our economy to fund a war effort.

As far as how this will affect companies, not only are we probably hitting peak earnings, but higher prices caused by inflation will likely stay if the government needs to keep their easy money policy. Inflation means higher input costs, causing companies to raise prices or lose profitability. Either of these will decrease earnings growth. This will directly affect what Price/Earnings ratio investors will be willing to put up with as companies experience slowing growth. This is why the selling has been so disproportionate to the high P/E names.

The biggest issue facing us right now is the fact that we cannot afford to finance a war. However, I do not think we are in danger of having a need to finance a war. The conundrum for the Fed is not a conundrum at all. I do not believe this market is going much higher anytime soon, but past levels of support are holding up. Going forward, I think the best opportunity for investors will continue to be in the energy trade, particularly oil. Commodities and materials will continue to do well and I think the slight pause in the financials is a great entry point for investors looking to add exposure. 1.7% on the ten year, negative real rates (see graph showing real interest rates) and $>120 for oil is ridiculous. I think we will see a seismic shift into financials, much of which I suspect will be coming from massive profits in energy.

(Real Interest Rates - 10 Year Treasury)

Sources:

Macro Trends

Yahoo Finance