7 March 2022 - Playing the Russian Roulette



Equity markets fell again last week, with Europe feeling the heat. Eurozone shares fell on average by 10%, while the Swiss and the UK markets managed to lose “only” 5%-6%. The US markets fell by 1.5% on average, but Nasdaq was weaker again, falling by almost 3%. Asia also performed much better than Europe with 2% drops on average. In terms of sectors Oil companies continued their ascent, while our favorite defensive sectors such as Healthcare and Real Estate finished the week almost unchanged, which is a miracle in such a negative environment.


The US started thinking about using the “bazooka”, as reports are saying that an official ban on Russian oil is in the cards. These news have sent oil prices soaring to new decade highs, making the European open this morning a nightmare again. However, our understanding is that Russian oil was effectively already “banned” from the market, which led to the rally above 100$/barrel in the first place. It is not clear how Europe will react to this, and of course, what Russia is thinking as a counter-attack. The situation continues to be very fluid, and Russia has probably decided to go “all-in” and occupy Kiev soon, although the third round of negotiations are supposed today.


The ECB meeting on Thursday will be very closely watched, to gauge any change in tone (again). The minutes of the February 3rd meeting were published last week and revealed the hawkishness that was also evident in Mrs. Lagarde’s press conference. Many members expressed concerns about inflation (and oil was 30% lower back then) and there was an overall mood for abandoning the negative rates within next year. Of course, this was the sentiment one month ago, which now seems like a lifetime. The undoubtful impact of the military conflict on consumer prices and the eventual economic slowdown creates a “cocktail” that no central banker wants to have: stagflation, or in other words recession with high inflation. This scernario, however, carries a very small probability at the moment.


In the US, the FED’s Chairman, Mr. Powell, preannounced the first interest rate increase for 2002. This will happen next week and despite the ongoing turmoil in global markets, as he publicly committed, while his proposal is for 0.25%s, instead of the speculated 0.5% until some weeks ago.


The labor market data in the US for the month of February were spectacular. The non-farm payrolls were announced at 678’000 vs expectations for 400’000, but most importantly average wages did not increase, and previous wages data were revised downwards. This places a temporary stop to the “runaway wage inflation” theme that had spooked the markets, before the war in Ukraine and takes one inflationary force out of the equation for now.


Government bond yields moved lower (prices higher), as they present one of the best “safehavens” in this environment. The 10-year yield in the US moved down to 1.70%, but the market is also watching the difference between the 2-year and the 10-year, which has now dropped to just 25bps. If this falls to below zero, the market will start to discount a recession in the US , a scenario which now looks almost impossible. However, as mentioned before, a recession with high inflation is very negative for long term government bonds and they will stop being a “safe-haven”. It is better to avoid them.


Gold is finally rallying towards 2000$, as there is a run for commodities globally, but nobody knows how this will end. Last time we had a similar run, at the height of the Eurozone crisis in 2011/12, when the region would fall apart according to the theories circulating back then, it fell later like a stone, and it took the metal almost 10 years to regain those levels.


The EURUSD is trading below 1.09, as investors are also rushing for the US currency and not for the Japanese Yen, as tradition holds.


Charts of the Week


As we are experiencing a 10% drop for the S&P500 from its highs, which touched almost 15% one week ago. It is valuable to remember that during most bull markets corrections are more frequent than people can perhaps remember. The above table summarizes some interesting statistics. A correction of 5% or more happens almost three times every year, while a correction of 10% or more happens every one year and a half. We have a correction of more than 15% every three years and a much bigger correction of 20% every five years. The largest correction of 20%+ happened two years ago in March of 2020, so to have such a magnitude again in 2022 has a low probability, but of course not zero. The average duration of corrections of about 15% is usually 6-7 months, but we have now reached it in less than two. The size and the speed of the correction prompts to a big (short-term) rebound when the situation improves.



This is the chart of the EUR High Yield bonds spread against the “risk-free” yield, that of German bonds. The higher this spread is the higher the actual return to investors is. Having been cautious on high yield since September of last year when this spread was close to 300bps, we now see that this is approaching the 500bps, which was the high of 2018. We have long argued, before the conflict in Ukraine that 2018 resembles 2022 in the sense that the FED tightened its monetary policy significantly that year which caused turmoil in financial markets. The current levels of spreads in more simple words means that the EUR High Yield bonds of short duration (2-3 years) are offering an almost 4% return to investors. If the blue line moves again lower as it is expected, bonds will rise in value making the potential return higher. Of course, a major crisis like in March 2020 will make spreads explode even higher, but this usually lasts for weeks if not days.




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