Despite heightened uncertainty, our central case of an inflationary macro environment that has experienced an additional inflationary shock remains. In effect this is the same market backdrop as pre the Ukraine-Russia war, only accentuated.
Three weeks after the invasion of Ukraine, global markets continue to be extraordinarily volatile. European bank stocks have rallied back 25% in 10 trading sessions, US front end rates have risen by 85bps having fallen by 45bps in risk-off dip in early March and this week Chinese internet stocks rose by 45% in 3 trading sessions, having fallen by 33% since the start of March.
This level of market volatility is similar to the COVID-19 crisis, and like that period, the impact of non-market variables (fiscal policy shifts, geopolitical risk et al) is significant. However, unlike COVID, there is not one shared global shock, but rather many factors working together to create exceptional macro uncertainty, and as this uncertainty rises and falls, the market experiences significant shifts in risk premium and large moves in asset prices.
This week there were three key drivers all of which are major themes by themselves.
1. Russia - Ukraine war
Our central case is that economically speaking, the war between Russia and Ukraine is primarily a European centric stagflationary shock. The depth of the growth shock will be driven by the duration and severity of the conflict, the level of energy and commodity price rises, as well as whether there is further escalation in terms of sanctions. This growth shock (and part of the inflation shock) can be mitigated by fiscal policy response, and it is notable that the low in European stocks occurred alongside headlines of the potential for a large EU fiscal response to the crisis. The tail outcomes of a broader military escalation work to increase the depth of the growth shock and peak of inflation risks.
Over the last two weeks, the market has priced an increased probability of a negotiated solution, and the risks of a near-term military escalation have fallen, with the US and other NATO allies being extremely cautious to walk the fine line between the aggressive military aid given to the Ukraine and steps that could lead to a direct military conflict (Fighter jets and no-fly zones). Furthermore, as noted above, fiscal policy response is potentially on the table, and sanctions on energy exports from Russia have not yet reached the most economically adverse scenario. Therefore, it is reasonable that risks to growth and inflation have fallen from the acute levels priced at the start of this month.
However, we would caution that the developments militarily have, if anything, increased some tail risks. The significant casualties experienced by Russia are being interpreted as creating a need for a negotiated solution. However, these losses have also led to a shift in tactics towards indiscriminate bombing of cities (Maripol, Kharkiv) which creates a much higher human cost, and with that, the risk that current NATO policy becomes politically untenable. Similarly, we are concerned that the use of WMDs is not inconsistent with this strategy, especially as Russian troop losses mount. The Ukrainian position, supported by weapon supplies from the West, is increasingly entrenched, and while there have been concessions on NATO membership, there has yet to be any concession on territorial integrity.
The bottom line is that the situation in Ukraine is likely to get worse before it gets better. The prospects for diplomacy have improved, but while the war remains kinetic and Russia continues to escalate, the risks in the tail remain which is why we retain hedges in FX (Short Euro and Polish Zloty) and European Credit.
Our subjective probability distribution is below
Scenario 1: Russia regime change
Probability: 5%
Trades: none currently
Scenario 2: De-Escalation / Peace deal
Probability: 40% (30% limited sanction relief, 10% significant sanction relief)
Trades: long EU financials, long KZT, paid real rates as inflation risk premium falls, paid the belly of EU rates
Scenario 3: Military escalation and sustained conflict
Probability: 40%
Trades: long commodities (oil and wheat), short EGP and commodity importers, paid front end US rates, paid Polish rates
Scenario 4: Military escalation beyond Ukraine
Probability: 15%
Trades: short Euro via options, short Polish Zloty, paid EUR ITRX CDS
2. The FOMC
The FOMC raised rates by 25bps as widely expected and released a hawkish set of forecasts in their Statement of Economic Projections. Specifically, the median dot for 2022 showed seven 25bp hikes, but nearly half the committee saw more than that number, implying a sizeable number of committee members who see the need for 50bp increments. Indeed, both Waller and Bullard stated as much on Thursday and Friday. Taken together with 3.5 hikes in 2023, the FOMC clearly signaled they want to bring policy into restrictive territory in the next 12 months.
Chair Powell in his press conference did not double down on the already hawkish message in the statement and dot plot, especially around 50bp increments. The equity market rallied and 5y real yields ended the week unchanged, having been 25bps tighter immediately following the FOMC statement and SEP release. While there were other factors at play to support the equity market, we would not point to the Fed as one of them. Clearly, this Fed sees the need to tighten policy, and they continue to rapidly change their policy stance to reflect a shift in their view of the tradeoff between inflation and growth, as evidenced by a restrictive forecast for the policy rate. The Fed remains significantly behind the curve, but they are catching up and the risk is skewed to higher rates, 50bp increments and a more aggressive balance sheet run down. We have reflected this in our book with shorts in Dec 22 Eurodollars, put spreads in Jun 23 Eurodollars alongside a paid 5y real rate position.
3. A new policy put from China
The developments from China this week are significant. In sum, our view is that the intervention of the State Council’s Financial Stability and Development Committee (FSDC), chaired by Vice Premier Liu He, was directly aimed at re-establishing a policy put for Chinese risk assets. Specifically, the council signaled increased macroeconomic policy support, support for the property market, more cautious, transparent, and incremental regulatory actions for China's internet platforms, and that policy steps would be taken to prevent delisting of Chinese ADRs.
This powerful intervention saw the largest ever single day rally in HKTech, which had a 7 daily standard deviation rally on Thursday, however from a macroeconomic and growth perspective, it is the delivered policy response that matters. Indeed, the risks to China's growth have deteriorated in recent weeks, as the Omicron variant has seen renewed lockdowns and a fall in mobility, and so the bar has been raised if policy makers want to turn the tide. Certainly, a shift to a more aggressive stimulus stance and an improved outlook for Chinese equities would certainly be a significant positive impulse for global growth and EM assets, but even the fact that there is a policy put in place does improve the skew of returns for Chinese assets. We have initiated a position in long Chinese equities, but are waiting for policy delivery to add to this position
Overall, uncertainty about the medium-term macro-outlook is very high, however our central case of a high inflation, high volatility environment has remained despite the geopolitical and policy events in the last number of weeks. We consider the war in Ukraine to be an accelerant to this broad inflation theme and our portfolio remains paid rates and long commodities. We consider the tail risk of a military escalation as adding convexity to this position, but it does open up a downside risk to growth which is why we retain hedges in FX and Credit. Our assessment in Q1 that the risks of war were real paid dividends with our Ruble options expiring well in the money, here again we are not discounting the risks of a scenario that nobody wishes to see but that may indeed occur.