Tumult and Tail Risk

Tail risk can be loosely understood as what happens when you catch a tiger by the tail. Russia, for example, is now in the grip of deep tail risk, in danger of losing more than they ever hoped to gain by going to war. And because, for the last 120 years Russian destiny has repeatedly entangled the rest of the globe, so are we. 

Rumors of war mixed with rising inflation began unsettling the markets in February, 2022. Russia invaded Ukraine on Feb. 24, playing the nuclear card as air cover for a relentless campaign of indiscriminate bombing of populated areas, cities, and towns, killing hundreds, probably thousands of civilians.

The U.S. market dropped 5% to -15% off the January high and bounced around between -10% to -15% until mid-March, holding its breath hoping the war wouldn’t expand into the rest of Europe or escalate to an unwinnable nuclear exchange. Not since the Cuban missile crisis has the nuclear black swan been seen so clearly in the wild. 

The Fed held its mid-March meeting, raised the Fed rate +0.25%, Russian tanks were bogged down, and the Ukrainians were fighting back. The market took a breath and gained back 8% in a week, now just 5% off its all-time high. If the war stays in its current confines, with the Russian economy wrecked by sanctions and Ukraine’s by bombs, the combined impact of both on the global economy will be limited, just 2% of global GDP (World Bank data). China, for example is 17.3% of the global economy, and the U.S. 24.7%.

The market has its eye on the petro supply chain, since Russia provides 40% of Europe’s natural gas and 27% of its crude oil, and on the agri supply chain since Russia and Ukraine provide 30% of the globe’s wheat. There will be knock-on effects on the global economy from an extended war—a significant uncertainty. So, -15% may not yet be the bottom.

But the market has turned its short-term focus back to the U.S. economy. The job market is strong, with unemployment at 3.6% just above where it was before the pandemic. The bond market is repricing bonds lower in the wake of the Fed’s first quarter-point overnight rate increase, with the 10-year Treasury note now paying 2.4%–2.5%, a rapid +0.80% increase since Mar. 1. 

Still, with inflation at 7.9%, and with the market pricing the next ten years of inflation at 2.4%, there is concern on the one hand that the Fed is moving too slowly and that continuing high inflation will spark a stagflation recession, while on the other hand, there is concern that moving too quickly will choke off growth. Either way, a soft landing in the economy and the labor markets looks as difficult to navigate as a Russian off-ramp out of Ukraine. 

A week after the Fed meeting, Fed Chair Powell was already repositioning: “The expectation going into this year was that we would basically see inflation peaking in the first quarter, then maybe leveling out,” Powell said. “That story has already fallen apart. To the extent that it continues to fall apart, my colleagues and I may well reach the conclusion that we’ll need to move more quickly…The risk is rising that an extended period of high inflation could push longer-term expectations uncomfortably higher.”

Longer term, the current crisis in Ukraine is the source of great uncertainty. It underlines a swing away from the globalism that rose up in the 80s out of the ashes of the old Soviet bloc. Détente gave way to perestroika and to glasnost, and McDonald’s spread around the globe along with dozens of other global brands. Global supply chain efficiency supported ever lower unit costs and inflation fell to historically sustained low levels in the advanced democracies. Computers and other goods got more powerful and cheaper every year. Since 1989 we’ve enjoyed 30 years of a golden age of globalism.

But many without advanced skills were left behind by automated manufacturing and the offshoring of low-skilled labor. An angry nationalism has been gaining traction in advanced democratic states, a swing to the right that is struggling to dismantle the consumerist free-market world emblemized by the European Union. The Trump administration reversed decades of global initiatives, pushing trade protectionism and nearly walked away from NATO, straining ties with old allies it recast as economic adversaries.

Thomas Friedman’s “Golden Arches” theory, that countries which have developed strong ties to the global economy—symbolized by having McDonald’s franchises—would not risk their economic well-being fighting wars with neighbors, has been blown up by the war in Ukraine. For the record, Russia has 847 McDonald’s outlets and Ukraine 108, though how many remain after all the bombing is not known.

One hundred and seventeen years after the First Russian Revolution, Russia’s outsized sense of destiny has once again led to a global tipping point. Together with the after effects of the COVID-19 pandemic and the barriers it created between and within nations, the war in Ukraine announces that globalization may be at an end.

What’s next? The so-called peace dividend is vanishing. The $773 billion fiscal 2023 defense budget, up 3.8% from 2022, calls for $130 billion in research and development, an all-time high, $56 billion in air power, $40 billion in sea power including nine more battle-force ships, and $12 billion of Army and Marine fighting vehicles, among dozens of readiness and modernization programs. There’s also a 4.7% pay increase for military and civilian personnel. All this without a significant bump-up arising out of the current war. Stay tuned for that.

But there will be other pressures from the fall of globalism besides increased military readiness. The longer-term impact is uncertain, but less global interconnectedness could lead to higher supply chain costs, rising labor costs, rising inflation, lower growth, earnings and innovation, currency disruptions, the bulking up of inventories, and pressure for more protectionism for on-shore investments made at higher costs. As Atlanta Fed President Raphael Bostic put it, expect a shift from just-in-time to just-in-case inventories. 

Investors are as uncertain about the future as the future itself is uncertain. The two year/ten year Treasury yield curve has inverted twice in the last week, with two year Treasury bonds at 2.42% paying a higher yield than ten year Treasuries at 2.41%, an unnatural regard for long-term credit that typically precedes a recession. 

The message? Investors can’t see clearly more than a short way down the road. Whether that will slow down the markets as earnings season gets underway in a week or so and prevent a massive pile up remains to be seen.