Risk unwind, supply chains and the Ukraine

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MR. MICHAEL CEMBALEST:  Good afternoon, and welcome to the Eye on the Market podcast.  This is Michael Cembalest.  A couple weeks ago, we issued a piece on cryptocurrencies and the blockchain.  It’s called The Maltese Falcoin.  You can find a link to it in today’s piece, or you can get it from the people you talk to at J.P. Morgan.  In this Eye on the Market, we’re going to look at the fact that the markets have had a lot of negative news to digest in a pretty short period here.  After pricing in less than one Fed hike last September, the markets now expect between six and seven hikes over the last year.  I can’t remember the last time over three months the markets went from expecting no hikes to expecting six or seven.  And some people are arguing for a 50-basis-point hike and not just 25. 

On top of that, the U.S. supply chain situation hasn’t really resolved itself as fast as some of us had hoped.  And now we have the situation in the Ukraine that the markets are adjusting to as well.  And there are a lot of issues here related to European energy dependence and a possible U.S. sanction bazooka with a very wide range of impacts.  So we’re going to take a look in this note at global equity indices, which are down 3 to 10% this year, and the fact that a lot of the global fixed income indices are down 3 to 4% as well. 

So let’s start by talking about some of these market risk unwind measures.  The first chart in today’s piece is from the Global Market Strategy Group in the Investment Bank at J.P. Morgan.  They estimated the implied credit in overweight, in other words the overweight the credit positions in corporate bonds, high yield bonds that investors have.  And it’s at a very high level, and it’s just beginning to unwind.  We all knew that this day was coming, and now it looks like it’s finally here.  This one can be laid at the doorstep of the Fed for engineering the longest period of negative real interest rates in probably 150 years.  In any case, the unwind of this fixed income credit overweight has a long way to go. 

The equity repricing I think is a little bit further along.  Stocks that were heavily favored by retail investors have come crashing down.  Valuations on the S&P have fallen let’s say three multiple points from their peak levels, although they’re still on the expensive side.  On the NASDAQ, the average stock is down to around 40% from peak levels, with a lot of the stocks down 70% or more.  And we’re really seeing some carnage in SPACs and renewables and fintech and things like that.  If we get a 50-basis-point Fed hike in March and some additional equity market capitulation, that could represent a reasonably attractive equity market entry point.  And we might be getting closer to one now, even without that. 

The good news for investors is that the impact of rising input costs on profits, sorry about the noise, the impact of rising input costs on profits might be overstated.  ‘Cause one of the things that we’re following is how are all of these rising labor, commodity, and interest costs going to affect margins and revenues?  Over the last 70 years, there’s been a remarkably close connection between rising costs and rising revenues, in part because one person’s rising costs are somebody else’s revenues. 

And it’s amazing when you look at this, and the same thing holds for rising SG&A expenses and revenues, the link is pretty strong as well.  And what that tells us is that rising costs by themselves don’t result in lower profit margins and poor equity returns.  If you look over the last few decades, equity market returns are almost identical regardless of the level of wage growth that was going on, in part because wage growth pushed up aggregate corporate revenues as well. 

So the more important question is whether a recession’s coming.  And that’s way more predictive of a deeper and more sustained route in equity markets.  And on that front, I don’t see a recession in the cards this year.  I still think GDP growth is going to be around 3%.  Production is still struggling to catch up to higher levels of consumption.  And the latest capital spending surveys that we see are still pointing in this direction. 

Now of course in the near term, a Ukrainian invasion could be very destabilizing.  A lot would depend on what kind of sanctions get adopted.  The U.S. is apparently talking about some pretty severe ones, export controls to prevent countries, other countries from selling products with U.S. content to Russia, which is essentially the Huawei penalty, putting Russian companies and individuals on prohibited transactions lists, particularly for U.S. banks, prohibiting U.S. securities firms from either underwriting or even transacting in Russian sovereign debt, blocking Russia from the SWIFT payments network.  And then trying to further delay the Nord Stream 2 pipeline. 

The full imposition of all of this, of these sanctions could be pretty disruptive, at least in the short term, given the likely Russian retaliation in terms of energy supplies.  I’m a little dubious of Europe’s ability to withstand a protracted two-sided sanctions war here.  Russia exports a lot of energy as we all know to Europe.  And the latest numbers we’ve been tracking is that Europe produces around the same amount of oil and gas for itself as it imports from Russia.  That probably is the biggest difference, of all the ways of describing differences between the U.S. and Europe, energy dependence is maybe the biggest one.  And just to reiterate, Europe is as reliable on Russia for its energy as it is on itself.  And so with that kind of backdrop, I think it’s right to wonder how assiduously Europe would stick to any kind of protracted sanctions war with Russia. 

On the Ukraine itself, last weekend I reread an essay that I had saved from 2014 in Foreign Affairs magazine from John Mearsheimer at the University of Chicago.  And you can kind of tell where he’s going where he says the Ukraine crisis is the West’s fault, the liberal delusions that provoked Putin.  It’s an interesting read; I didn’t agree with all of it.  You probably won’t agree with all of it.  But it does lay out some facts that are important to understand.  The story begins with the Clinton administration’s NATO enlargement in the 1990s, an amount of enlargement in terms of land that was larger than aggregate French, German, and Italian land mass combined.  So this was a large enlargement to the East. 

And for those of you that remember George Kennan from college, where we all studied him, he was an architect of the post-war policy of containment of the Soviet Union, when this NATO enlargement began happening, Mearsheimer quotes Kennan as saying, and here’s a quote, “I think the Russians will react quite adversely to this, and it will affect their policies.  I think this is a tragic mistake.  There was no reason for this whatsoever.  No one was threatening anybody else.”  And then ten years later, NATO announced that Georgia and the Ukraine would become members.  The Russians made it clear at the time that certain red lines had been crossed, the Europeans and the U.S. ignored them, and then here we are. 

So the bottom line is that since the 1990s, there’s been this battle between liberalism and realism in the Western foreign policy circles on this whole question of the Ukraine.  And depending upon what happens now, particularly since the West has made it clear that it will not militarily defend the Ukraine, the realists might turn out to be right.  And that’s why Mearsheimer had concluded in his essay at the time that some kind of Finlandization of the Ukraine would be a better outcome for all sides.  If you don’t know what Finlandization means, it means what it sounds like.  But you can look it up, and there’s a lot of history to it. 

We have an appendix this week on supply chain conditions.  They are still pretty tight.  There are some signs of modest improvements from peak levels.  But whether it’s whole issue of the notorious container ships in LA and Long Beach, as we have discussed before, some of the worst-run ports in the world, or you’re looking at container freight rates, or you’re looking at global manufacturing delivery times, air freight rates, shipping rates, demand for trucks, the supply chain delays are alive and well, unfortunately.  And it looks like it’s going to take a few more months for them to settle down.  We thought they would start really settling down by May or June, but I was hoping for a little bit more progress on some of these things than we’ve seen so far. 

The last topic this week is a dilemma that I want to share with you.  So here’s the dilemma.  What should I do when a research firm, I read a lot of research, probably 1,000 to 1,500 pages of research a week, what should I do when a research firm whose work I generally respect and also pay for starts writing irresponsible and unsubstantiated COVID stuff?  And it’s like The Invasion of the Body Snatchers movie from 1956.  You have normal people.  They’re walking around, and all of a sudden the pods get them, and they become crazy. 

The latest episode involves one of the research firms that I often cite their work in the Eye on the Market.  In a recent research note, one of their principal authors argued three things.  Number one, COVID vaccines probably don’t work well.  And that all the data that we’ve been showing on higher hospitalization and mortality outcomes from unvaccinated people, that data is unreliable because unvaccinated groups are not comparable to vaccinated groups.  Why, you may ask?  Well, according to this logic, a lot of unvaccinated people are frail and sicker.  They have cancer and heart conditions that prevent them from being vaccinated even if they wanted to be. 

I am not making this up.  He’s actually arguing that the cohort composition differences are so huge that they render all of the data that comes from the CDC and the other health organizations around the entire developed world, all that stuff is useless, and all of those health agencies are wasting their time sharing this information. 

Now this is of course nonsense.  The unvaccinated people in the U.S. are not generally frail and sicker and older.  They’re younger people whose decisions are driven according to all the studies, by lack of trust in government, lack of trust in the vaccines, they don’t think they need the vaccines, and then concerns about myocarditis and other side effects.  And in the U.K., people get vaccinated and boosted in order of their age and vulnerability.  So the vaccinated group is more frail and elderly than the unvaccinated one.  So that’s probably why when I showed this to some people I know at Scripps Research Institute for Biomedical Sciences, they said that their claims were patently false and unsupported by the data. 

There was another line of, the second of the three.  Well, since it’s hard to measure flu vaccine efficacy, that means COVID vaccine efficacy figures are not reliable as well.  And in retirement homes, it’s only the healthy ones that get the flu vaccine and the weakest ones don’t.  So therefore the deaths are disproportionately higher in the weaker third.  I reached out to some people that I know at the La Jolla Institute of Immunology.  They just described this line of thinking as silly.  There are very few people for whom COVID vaccines are not recommended.  And by the way, doctors generally do recommend the flu vaccine for frailer adults.  The flu vaccine is not very immunogenic, which it has no adjuvant, which is why the efficacy numbers are so low.  And it’s so very well tolerated by the aged and frail.  So the unsupported facts and assertions just keep piling up.

And then the third one, the third thing that this particular author pointed out was well, if COVID vaccines work so well, why are COVID mortality rates so much higher in the developed world than in the developing world, whose vaccination rates are so much lower?  If you can use Google, which everybody knows is a search engine, it would take you all of five minutes to see why this comment is so poorly informed.  The death rates in a lot of emerging market countries have been much higher than normal.  The overall death rates in the country, not the COVID-reported ones, but the overall death rates. 

And according to most demographers who spend their lives looking at this, these elevated overall death rates are picking up COVID mortality that the country health agencies are unable to identify.  And there’s been tons of research on this.  And we have a chart in here that shows total mortality versus reported COVID mortality.  And of course, the big outliers are mostly emerging market countries where the health agencies are strained and unable to accurately track the COVID deaths.  So all I have to say about that is if you’re asking why the EM world has much lower death rates, despite lower vaccination, all that shows is that you don’t understand basic pandemic research two years into the pandemic. 

And so what am I going to do about their research now?  I’ll probably still read it since it’s generally pretty good.  But my unquestioned confidence in their work is gone.  And any personal relationships with their researchers are probably gone too, as I find that as I get older, my personal world is shrinking.  I distance myself from people on the far right.  I distance myself from people on the far left.  And now I’m distancing myself from people who use garbage facts and sloppy research to push an agenda.  Life is too short for that.  Anyway, thank you very much for tuning in this week.  And I look forward to speaking to you all next time.      

FEMALE VOICE:  Michael Cembalest’s Eye on the Market offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of J.P. Morgan Asset and Wealth Management.  Michael Cembalest is the Chairman of Market and Investment Strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers.  For more information, please subscribe to the Eye on the Market by contacting your J.P. Morgan representative.  If you’d like to hear more, please explore episodes on iTunes or on our website. 

This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments Incorporated.  Views may not be suitable for all investors and are not intended as personal investment advice or a solicitation or recommendation.  Outlooks and past performance are never guarantees of future results.  This is not investment research.