A Week of Reflection
It has taken a week to process the unspeakable acts of last weekend. Despite the lessons of history, we are always shocked at man’s ability to be inhumane. We pray for and support the Jewish community and Israel. We pray for the many innocent victims of the past week and the weeks to come. We pray that the men that instigate these events are held to account by a power much greater than ourselves.
“Our most basic common link is that we all inhabit this planet. We all breathe the same air. We all cherish our children’s future. And we are all mortal.” John F. Kennedy
Investing in a Dangerous World
We certainly hope that this conflict can be contained, but we are realistic enough under these extraordinary circumstances to expect a wider conflict that will require U.S. participation in some way, shape or form. If Iran is dragged in, who knows what could result. Our base case is for a wider conflict to develop.
Wall Street is still talking about Fed actions, the pace of inflation and economic growth, but in reality, the developing war in and around Israel over the coming months may have more to do with how financial markets react than any economic statistic. In a span of hours, the world has changed.
Wars create uncertainty and angst and when that happens, there is typically a ‘flight to quality’, and that implies Treasury bonds will do relatively well. But there are also caveats.
- We enter this period with a very high Federal debt level and a very large current account deficit.
- War typically brings inflation, due to the associated deficit spending to finance a war.
On the surface, Treasury bonds could go either way, but the reality is that if we move to a war time stance, The Fed will be the buyer of last resort if markets are unwilling to buy, in other words, we return to QE yet again. With Treasury bonds already short term oversold before the crisis in Israel, longer term Treasuries appear particularly attractive now, especially the inflation protected bonds (known as TIPs). We were of the opinion that inflation was not going to go away as easily the Fed would desire and the crisis in the Middle East only extends those concerns.
If the government drives down interest rates as a means to finance a war, other bonds will also tend to rally, but they will not have that inflation protection and are exposed to have those price gains eaten away by inflation.
We were still quite convinced that a U.S. recession was in the cards, but if this conflict escalates (as it appears to be doing) that recession could well be cancelled. We don’t mean to sound cold, but wars are generally good for stocks. After the initial shock of war brings down market valuations, the government spending increases can drive economic growth and inflation (see the U.S. in WWII). Stocks are more resilient in war time than you might imagine, especially those critical to a war machine – oil/energy, industrials, particularly defense, & technology. This war, if fought, will likely be different than any war before it and technology will play a critical role.
War will typically create supply disruptions of commodities and that can send prices on a wild ride. The key commodity is oil, but there are many others that can be easily affected. Gold, also a safe haven asset, would also be expected to perform well.
The Bond Market Balks
The Treasury auction calendar is heating up as massive deficits need to be funded and the Market is not reacting well evidenced by several very poor auctions this week. Bond investors might finally be reacting to concerns regarding the level of the Federal debt as well as growing budget deficit that totaled $1.7 trillion in the fiscal year just ended on Sept 30. If that were not enough to cause the bond market to pause, the CPI and PPI data this week were less than encouraging as consumer inflation and intermediate goods inflation both ticked up again.
Watch the Treasury market. Ex the Middle East crisis, the Fed has been walking a very fine line to bring inflation down and avoid a recession. Up until now, markets were content to just follow along, but now markets are starting to flex their muscles and tighten financial conditions on their own. The risk of a financial accident is growing, but the Fed is not helpless to respond. If they are forced to intervene in markets, the reason for the intervention won’t really matter. It will be back to QE and much of the work done over the last several years to normalize policy will be negated. Back to the drawing board
What We’re Reading
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