Overextrapolating

Humans have a tendency to think about the present and extrapolate it into the future.  In the investment world, this tendency is reinforced by month to month performance tracking of hedge funds, mutual funds, etc.  No one wants to lose money in the short term, which leads to herd behavior and short term thinking.  When the herd is running away from stocks in a rush, driving prices lower, fund managers can't pretend like they are managing their own money and just hold their positions and wait for the storm to pass.  They have to worry about short term performance, about losing too much money because that could lead to redemptions.  So they have to sell some of their holdings, just to slow the bleeding, even when they don't want to. 

The war in Ukraine is a perfect example of an exogenous event which has made investors revise their global view and overextrapolate.  Not only about the economic side of things, but also the geopolitical side.  Economically, now most expect the war to cause inflation to rise and growth to slow, especially in Europe, due to the side effect of Russian sanctions.  Geopolitically, suddenly people think there is a pre World War II setup where you have the Allies and Axis powers, getting ready for war, this time with US/EU/Democracies on one side and Russia/China/Non-democracies on the other side.  

I disagree with that view.  But I feel like I am in the minority, with most people now expecting more wars and conflicts between the 2 sides.  There is a lot of inertia when it comes to geopolitics.  Especially when the current situation is close to the equilibrium.  The overwhelming advantage that the US/EU/Democracies have from an economic and military aspect makes it a lopsided contest, and Russia and China know this.  Sure, they are nuclear powers but before nuclear weapons are used, financial/economic warfare through sanctions and restrictions will be leaned upon, and those heavily favor the side with the bigger total economy and the one with the global reserve currency.  It only took a couple of weeks and the Russia economy is already in free fall because of the sanctions.  Holding the financial levers in a global war is a huge advantage.  

After financial/economic war, then comes a hot war using conventional weapons.  That also gives a big edge to the Democracies due to the US investments in the military. Technologically, from a militaristic standpoint, the US is the best. You can say what you want about incompetence in the US government, which is valid, but the US military through massive spending and investment over the past few decades has put them clearly at the top.  Its not a force that Russia and China want to antagonize into a world war.  There is a clear deterrent effect of the US military buildup which prevents a hot war between superpowers from getting started.  

I see some of the 15 minute geopolitics experts who are opining that because Putin gambled and invaded Ukraine with bad information, that Xi will do the same thing with China.  They are 2 very different countries.  Historically, Russia has started a lot of military conflicts.  China has not.  China has usually been on the receiving end of other countries' aggression.  Unlike Russia, which has some imperialistic ambitions, China seems more concerned about its economic position, and ensuring that it has a steady supply of natural resources to keep growing to become a first world country. 

So what about all the talk about China invading Taiwan?  China invading Taiwan is different than Russia invading Ukraine in the sense that there is no way the EU/US will put on heavy handed sanctions on China like they did to Russia.  It would be suicidal, because of the amount of Chinese exports that they depend on for their economies.  And the difference between China invading Taiwan and Russia invading Ukraine is that Ukraine is right on the border with EU countries that are also NATO members.  That immediately rings alarm bells for the EU and its allies.  Taiwan has no such borders.  And most countries don't even recognize Taiwan diplomatically as a country, like they do with China.  And with Xi set to be reappointed as Chairman for life this coming fall, I don't expect any risky moves like a Taiwan invasion before then.  So if it does happen, it probably happens in 2023 or later.  

We are getting some headlines about Russia and Ukraine making progress in peace talks.  Its the rational outcome for both parties.  Only through a peace agreement will Russia be able to get the West to lift sanctions, winning the war and occupying Ukraine is losing economically and politically.  Putin is not crazy, like many think, he just has bad information from incompetent sycophants who tell him what he wants to hear.  If he knew what would have happened before the invasion, he probably wouldn't have invaded.  So clearly taking an off ramp before his economy goes even further down the toilet is the rational choice.   

As for Ukraine, if they don't reach an agreement with Russia, they'll have to probably withstand another couple of months of artillery bombardments with the West making token donations of weapons and aid until Zelensky and his government get taken out by Russia, dead or alive.  Any deal that isn't totally egregious is better than doing nothing and eventually losing the war.  Ukraine cannot win the war militaristically.  They are totally outgunned, outmanned.  Sure the Russians also are taking significant losses, but their military can bleed for quite a while before they run out of manpower and firepower.  Ukraine cannot win a war of attrition, they just don't have the capacity.  

Of course, if neither side is willing to compromise to get a deal, then wars continues, but the pressure on both sides is building with each passing day to make a deal.  The alternative is worse for both sides.  

We have an FOMC meeting today, I see that many are expecting 25 bps and a hawkish statement and press conference.  So the bar is a lot lower than the last meeting, when many were still not so sure about Powell's stance.  They know now that he's taken a hawkish turn, so the expectations are more aligned with reality.  I actually think the FOMC meeting isn't that important right now, its not really a variable, its a constant and that is 25 bps for each of the next 3 meetings, taking the Fed funds rate to 0.75-1.00% range.  After that, it becomes a variable again.  I don't put much weight on what Powell says because he seems locked in for the next 3 meetings, and the balance sheet runoff is probably going to start either in June or July.  

The market cares about the war much more than this FOMC meeting.  Hedge funds have not been derisking like this (near spring 2020, early 2016 levels of net equity exposure) just because they think the FOMC will be hiking rates for the next few meetings.  Its from the unknown and economic doomsday scenario that they picture with a long dragged out war where Russian sanctions eventually result in much higher energy and food prices, and thus lower overall global growth.  

Still holding long, see some stiff resistance at SPX 4400, and strong support around SPX 4150-4200 area which has held the last few times down.  Bond market weakness is a definite negative, but I'm not sure how much of that is selling ahead of the uncertainty of the FOMC meeting, and how much is from a view that inflation will remain higher for longer due to the side effects of war.  If it is more the latter, that's not a good sign, because I expect commodity prices to be quite high for longer even after the war is over.  That's the biggest fly in the ointment for the stock market bull case.  But despite that, I still see a market that's oversold enough and de-risked enough to rally for 1 to 2 months from these levels.  A bear market rally of sorts, a counter trend rally that surprises a lot of investors. 

Of course, if you get peace and Russia leaves Ukraine, that event itself would get the animal spirits flowing for at least a few weeks, if not months.  I still view this as the middle of the topping phase, I don't expect a protracted downtrend until more rate hikes are behind us and investors are more complacent.  Right now, so many are cautious out there because of the war that when the war ends, a lot of money will be put into stocks, and its going to take more than a week or two, considering how much the funds seem to have sold down.