War and Bad Energy Policy Makes a Difficult Situation Even Worse

We don’t write that often about markets because The Prickly Pear is not a financial publication.  However, we appreciate that our readers, like the public generally, are being squeezed by the worst inflation in a generation and are being buffeted by very uncertain financial markets.

Our main concern remains the country and the future of our children and our grandchildren. But financial affairs embrace both political and personal concerns.  It is difficult for a nation to do well if its people are not doing well. In addition, it is hard to help your family when you are broke.

In our past few pieces, we suggested some broad themes about 2022 were likely. First, we felt it would be a “risk-off” year. That is to say, things that had been working so well and attracting risk money such as stocks, cryptocurrencies, bonds, and real estate, would be in for a rough go of it. We would have a corrective phase.

We also suggested that the classic 60% stock and 40% bond asset allocation strategy would not work because stocks and bonds were likely to go down together. Thus, bonds would not be providing the diversification and protection they historically have. That has certainly turned out to be true.

We also suggested that cryptocurrencies would not provide diversification and that governments were likely to move against them. Governments do not want to give up their monopoly on controlling money, nor will they tolerate much in the way of financial privacy. Cryptos have been highly correlated to stocks and governments from Canada to China are cracking down on them.

We recommended reducing exposure to stocks and bonds, increasing substantial holdings in cash, and adding a bit of gold.

Although pointing out that we so far have been basically correct might appear boastful, we are not. In fact, we know from painful experience that markets can be fickle and unpredictable and can make idiots of us all. But the trends we were worried about have just been considerably made worse by the uncertainties of war and that compels us to write more on the subject. 

Most of our observations were based primarily on a change in the monetary regime. There has been well over a decade of extraordinary easy money policies pursued both on the fiscal front by Congress and the monetary from by the Federal Reserve. Many markets are now quite addicted to cheap credit, speculative juices have been flowing in the extreme, and many markets seemed to have the look of mania about them.

But with inflation running this hot, it would appear the Federal Reserve would attempt the impossible: increase rates enough to cool off inflation, but not raise them enough to tank the economy. Likewise, the excessive and wasteful Federal spending would probably peak, especially with Republicans likely to take back both the House and Senate.

In short, the monetary flows supporting the rapid appreciation of various markets were going to be reduced, likely creating monetary addiction withdrawal symptoms. That is what triggered our caution.

Thus far, most of our general predictions have come true, and sad to say, we think there is likely more to come.  Yes, in the short term, the stock market is getting quite oversold and due for a bounce. The strength and duration of that bounce will tell us more about the rest of the year. How that process works out will define the difference between a correction and a bear market.

So far, most major stock indices are in “correction” territory, that is losses of 10-20%. Many individual stocks have lost a lot more as the market indices have been held aloft by a handful of giant tech companies. We have not yet entered bear market territory, which is much greater in both time and extent. Typical bear markets will pull equity prices back 50%, and sometimes even more than that.

So far this year cash has done fine, gold has modest gains, while energy and energy stocks have been the big winner.

While the FED continues to prepare the markets for rate increases, so far, they have not delivered.

But the markets are moving in anticipation and interest rates are nonetheless rising, the yield curve is flattening, and credit spreads are widening. All are typical preliminary signs of credit stress.

This process of cooling off inflation caused by both monetary excess and supply chain issues caused by the idiotic response of governments to Covid would by itself present quite a challenge to the FED and to the markets.

Then along comes Russia and the invasion of Ukraine. Since inflation is at least in part caused by the Democrat’s war against fossil fuels, sanctions against a major energy producer, while entirely justified, can only make matters worse. The Administration has countered that they plan to make up the energy deficit they have created, by accelerating “renewable energy.”

There is simply no way realistically to expand the very small contribution renewables make to world energy in a short period of time, and it is very questionable if it is technically possible long term.

Europe, especially Germany, has drunk the Cool Aid of the “green movement” and is very vulnerable, closing down their remaining nuke plants just like the geniuses in California. Electricity costs have been skyrocketing.

The Biden energy policy is almost a guarantee for soaring energy prices, creating an additional serious problem for the world economy. Money that goes into the gas tank is money not spent on clothing, ball games, or orthodontics for the kids. As energy and labor costs soar, it now risks a profit squeeze on business hardly helpful to a stock market already in distress. And because Biden is shutting down domestic production, the benefit of those energy revenue streams goes to all those wonderful people in the Middle East.

By acting almost immediately against the  Keystone XL Pipeline, he in effect suppressed Canadian production. By targeting U.S. producers, we in the U.S. are producing less. By vetoing the gas pipeline from Israel to Europe, he made Europe more vulnerable to Russian energy, just on the brink of war.

You could not design by intent a worse energy policy.

The Administration and its fans do not seem to understand that oil and gas go far beyond just fueling cars and heating homes. There are basic materials for fertilizer and plastics, and thousands of other things we buy all the time. It does not matter how many Chinese solar panels you erect if oil is needed to make plastics and gas to grow food.

Food prices are likely to be impacted in two ways.  First, fuel and fertilizer are major costs for farmers.  Secondly, Ukraine is a big food producer, especially of grains.  This can only add upward pressure on food prices.  For the poor, food and fuel are often their biggest costs.  A food squeeze only makes inflationary pressures worse.

An oil price shock could plunge the country into recession just as the FED is raising rates. This has the potential of making the FED interest hikes pro-cyclical. In short, the FED could make what would be a soft patch into recession because the economy will get the triple shock of inflation, interest rate increases, and an energy crisis. Financial flows are international and supply chains are integrated. Sanctions may indeed be necessary but they come with a cost both to us and the Russians.

The Russian/Ukrainian conflict and the accompanying economic sanctions could wreck credit flows, cause central bank issues, foreign exchange turmoil, and various other maladies that could further disrupt the international economy.  We are long past the time when the U.S. economy ran pretty much on its own. It is now thoroughly integrated with international trade.

The worst case would be for Europe or the U.S., or both, to get directly involved in the war. While we doubt that will happen, there are many economic tripwires being hit that don’t involve direct military contact.

The personal experience we have had with recessions and bear markets is you just can’t know in advance where all the difficulties could show up. For example, a slow down in the economy hits the tax collections of state and local governments. A bear market in equities can harm households, retirement funds, public and private pension funds, and consumer spending. A bear market in stocks can create negative wealth effects and change consumer psychology as well. A slow down in the economy will expose the excesses in debt that may range from housing finance to the junk bond market. Default rates could rise.

And, with interest rates just barely coming off zero, it is not like the central banks of the world have a lot of ammunition to fight in the next recession. How much water do the fire trucks have left?

As far as fiscal stimulation goes, the same thing can be said. We have just had a huge surge in deficits just to satisfy the Democrat political agenda. If the Republicans take over in Congress, it is unlikely they will be willing to spend if the economy slides into recession. Besides, we are not sure how much more in the way of global deficit spending the markets can take, nor is anyone else.

While there is no sign of recession evident right now, they do typically follow a course of interest rates hikes, a burst of inflation, political turmoil, and an energy crisis. Professionally, we cut our teeth on the 1973-74 bear market, and there are a lot of things that appear similar to that era.

We don’t envy Jerome Powell at the FED. He faces record deficits, soaring inflation, and now disruption from a war that was hardly on anyone’s radar. Does he hold off on the interest rate increases that have been so widely publicized?

If he does that, will the markets interpret that to mean the FED is too fearful to tighten and thus has chosen to let inflation run? That too will have profound consequences.

The FED rate increases are expected to start early next month so we should be getting some answers soon. But as mentioned before, rates in the marketplace have already increased and are impacting decision making.

To reiterate: threading the needle between inflation and recession would have always been a tall order to fill. When we add to that the confusion of war, massive deficits, distortions due to Covid policy, and terrible energy policies, the risks of policy error and unintended consequences go up considerably.

That makes for a difficult and uncertain investing environment. We would still say prepare for a risk-off year.