Could this mean peace in our time? Positive sounds about a possible ceasefire in Ukraine sparked a Tuesday surge in global stock markets, particularly in Europe. Oil prices took a dive, and ructions in the bond markets intensified. A Russian announcement that its military was cutting back activity around Kyiv and Chernihiv in the north of Ukraine to concentrate on the Donbas in the east sounded like a sign of progress.
However, the market reflex within hours was looking overdone. Western reaction was skeptical; an offer to stop hitting you in quite so many places is not exactly magnanimous, after all. And any deal is unlikely to do much to salve the economic damage. Sparing lives should take priority over the economy, and even arguably over weighty matters of sovereignty and the integrity of borders. That said, there are reasons not to get too excited about this peace process, or about any settlement that it might produce.
The first problem, unavoidably, is a parallel with World War II. When you compare someone to Hitler in an argument, it’s generally a sign that you’ve lost. Otherwise, you wouldn’t resort to hyperbole. But comparisons to Neville Chamberlain, the British prime minister who reached an agreement in 1938 that allowed Hitler to take Sudetenland, the German-speaking region of Czechoslovakia, might be in order. After proclaiming “peace in our time,” Chamberlain had to declare war on Germany within a year, after Hitler annexed the rest of Czechoslovakia and invaded Poland. There are arguments that history’s judgment on him has been too harsh, but no leader wants to invite comparisons to Chamberlain.
The similarities between the emerging deal over Ukraine and the one that Chamberlain struck in Munich are obvious. Russia appears to want to cement control over Donetsk and Luhansk and Crimea; as this map shows, that would involve peeling away from Ukraine the regions with the most ethnic Russians:
The map comes from a fascinating economic analysis of Ukraine and how its economy has shifted over the last decade, produced by Frank Neffke, Matte Hartog, and Yang Li of the Growth Lab at the Harvard Kennedy School. It tracks, in raw economic terms, the shifts in Ukraine — and suggests both why carving it up might have some logic, and also why it will be difficult to maintain economicpressure on Russiain any event. The following map tracks the number of business openings and closures from 2011 to 2020 (some of the area in question has been occupied by Russia or its proxies since 2014.) There has been a clear transfer of economic activity from the more Russian-influenced east toward the west:
Meanwhile, the effect of Euromaidan in 2014, when Ukraine ejected a pro-Russian president in what has variously been described as a color revolution or a CIA-backed coup, is clear from the balance of Ukraine’s exports. The share going to Russia plummeted in the early years of the last decade, while the portion going to the European Union increased significantly. Ukrainian integration with Europe was plainly happening and working far better in the west than the east:
Such fault lines suggest that some kind of division, along the lines of North and South Korea or Cold War-era Germany, would seem a plausible and pragmatic, if not desirable, outcome. The difficulty is getting there. Neither side wants to cede control of Donbas, and both have some reason to believe they can still win there. The region includes the devastated city of Mariupol and it is hard to justify a peace that allows Russia to keep it as a prize. Even assuming rationality on both sides (which isn’t a safe assumption), the route to a ceasefire and then a lasting peace looks hazardous. A lot is being asked of Ukraine, and there are pitfalls at each decision point. Can President Volodymyr Zelenskiyreally be expected to agree to neutrality while Russian troops remain in his country, or cede Donbas when the battle is ongoing?
The following flow chart comes from Christopher Granville of TS Lombard, who makes clear that the next two years will be difficult, even if there is goodwill (unlikely)on both sides. Ukraine will need to hold referendums in Donbas, and a national one on neutrality, and there will need to be security guarantees while they take place.
Can the West lift sanctions until these issues have been resolved? It’s difficult to see how, just as President Joe Biden’s controversial ad lib about the need for Vladimir Putin to fall shows that it will be hard to normalize relations with Russia without regime change. Granville warns that a year or so of a messy peace of “partial de-escalation” might “equally help entrench a stalemate in the struggle between Russian military actions in Ukraine and western sanctions.” He added:
The quickest hypothetical exit from this crisis would involve strangling Russia’s oil trade. But apart from this hypothetical solution also being very hazardous, our analysis of the relevant global political drivers (China, India) and domestic Russian economy concludes that it is practically unachievable. Welcome as today’s positive negotiating signals are, an early end to the global economic shock from this war and sanctions crisis is unrealistic.
That is the problem. Having imposed sanctions in the first place, it’s hard to see how the West can lift them for a long time to come. Even after any deal has been ratified by referendums, there will be the intractable issue of paying for the damage — though that may grow easier if Mariupol becomes a Russian responsibility. The longer the sanctions drag on, the more onerous they will also become for the sanctioning nations, making it harder to stay unified.
This chart shows the per capita exposure to investments in Russia of different countries. Beyond the oil issue, it will have a minimal effect on the U.S., but will be very painful indeed for some smaller European states:
The Kennedy School breaks down foreign holdings of companies in Russia into market-seeking investments (which aim to sell into the local market) and asset-seeking investments that try to exploit local assets, such as resources or low-cost labor. This chart shows the share of employees of foreign-owned companies in Russia that might need to be jettisoned in a write-off. The big economies of western Europe would take a far bigger hit than the U.S.:
Sanctions appear even more problematic for Europe if we look at their “asset-seeking” holdings in Russian companies that form part of their supply chain. This is also an issue for Japan and India, but not so much for the U.S. or China.
This doesn’t includethe over-arching issue of Europe’s need to wean itself off Russian oil, which a sullen peace settlement will not end. It’s unsurprising therefore that European consumers are greatly disheartened. Tuesday saw the publication of the first consumer confidence surveys in France and Italy since the invasion. Both experienced dramatic falls, while the Conference Board’s measure of U.S. confidence, released the same day, was little affected:
None of this means that the prospects for limiting the bloodshed and ending the war in Ukraine don’t look better than they did. They do. But we’re talking about hesitant steps at the beginning of a long process, while western countries have to live in the shadow of Neville Chamberlain’s piece of paper.
That makes what is happening in markets really rather startling.
Recession Is Coming! Buy Stocks!
We have inversion. Or we did briefly, anyway. For a few minutes Tuesday afternoon, two-year Treasury bonds yielded more than 10-year equivalents. The flattening of the yield curve had taken place with breathtaking speed.
Now, an inverted curve should, in anything like normal circumstances, be taken as a signal of a coming recession. In current circumstances, as I argued yesterday, it isn’t so clear. The amount of intervention in bond markets over the last decade dulls the signal. But recession risks are plainly increasing. To return to consumer confidence, mentioned above, there is an interesting recession indicator to be derived from the gap between the two best-known surveys, published by the Conference Board and the University of Michigan. Both are well respected, but they track slightly different indicators. The Conference Board’s is more weighted toward measures that tend to keep flourishing in late cycle, while Michigan’s tend to fall earlier in the cycle. The fact that the Michigan number has just dropped to an all-time high deficit compared to the Conference Board suggests very strongly that we are right at the end of the cycle (and therefore due for a recession):
If you think that chart looks familiar, you’d be right. As Matthew Luzzetti, chief U.S. economist for Deutsche Bank AG, points out, the spread between the confidence measures tends to mimic the spread between two- and 10-year bond yields. The sentiment emanating from bond traders looks identical to the sentiment revealed in the consumer surveys.
This is decent evidence that the inverted yield curve isn’t a deceiving indicator, and also suggests that inversion has further to go. We have a bond market that responded to encouraging geopolitical news by positioning for a recession. So,of course, stocks had a great time, particularly in the U.S. The FANG internet platform stocks have rallied by more than 25% since a low on March 24. Stocks in the rest of the world have also bounced nicely, though China continues to be an outlier:
As we’ve seen, there are reasons to think that the U.S. should be harmed much less by the war than the other developed nations. That should mean on a day of good news for peace prospects that the U.S. should underperform. Instead, the remarkable rally of U.S. stocks compared to the rest of the world continued, after only a very brief blip in morning trade. The turnaround in relative fortunes since the first news of the invasion, circled in the chart, has been remarkable:
Even more remarkable has been the calmness with which this has happened. The CBOE-VIX index, measuring stock volatility from the options market, unsurprisingly spiked immediately afterRussia’s attack.It reached another high three weeks ago. Then the VIX started to fall, and in the two weeks since the Fed unveiled its first rate hike in years, the decline has been almost linear. The “fear gauge,” as it is often known, is now significantly lower than it was a week before the invasion, when markets were priced on the assumption that there would be no war:
Volatility doesn’t normally subside in this kind of consistent and orderly fashion unless there has been a clear external catalyst, such as an election result. Usually, volatility is volatile. Data from Quantifiable Edges show that the VIX has now enjoyed a 10-day streak of closing 12% or more below its 10-day moving average. In other words, it has had an exceptionally smooth course downward. This is a record. There have only been three such nine-day streaks before, two of which came in the immediate aftermath of the presidential elections of 2016 and 2020.
Stock traders, in short, are behaving as though they were given a clear and emphatic reason two or three weeks ago to be confident that the market was going to be fine. It’s hard to see what that was, and it’s amazing that equities continued that streak on the day the yield curve inverted. Bond traders aren’t behaving like that at all. In the following chart, I rebased the MOVE index of bond market volatility and the VIX so that both were at 100 on the Friday in November 2020 that came immediately before U.S. networks decisively called the presidential election result, and the successful vaccine trials by Pfizer Inc. That was a big moment for risk appetite to return to stocks, and for volatility in bonds (which had been put to sleep during the worst of the pandemic) to be allowed steadily to rise.
Volatility in the two asset classes behaved much as might be expected for over a year, with growing anxiety in bonds sparking some jitters in stocks. But since the invasion, bond volatility has ratcheted up, while it has dropped significantly in stocks:
There is a raft of reasonable technical explanations for this. An aggressive central bank means that it’s time to get out of bonds and into equities, which are a better inflation hedge. This month’s Federal Open Market Committee meeting was hawkish, but not as much as it could have been, and the rally in stocks it sparked prompted asset allocators to start piling back into the equity market. Rebalancing flows from target-dated funds, which usually have to sell stocks and buy bonds at the end of each quarter, were much less than usual after the falls in stocks earlier in the quarter.
But putting all the technical weirdness together, it looks as though the contradictions that had built up in the market over the last two years, and in the decade before that, are being put under extreme stress by the double whammy of a newly aggressive Federal Reserve, and the worst geopolitical shock in decades. In broader perspective, it’s best to proceed on the assumption that this has been a technically driven bounce for stocks within a bear market.
More on the ties that bind. Yesterday I lamented the death of the necktie, and hailed the beautiful ties on Mexican themes produced by Pineda Covalin. It turns out that there is another maker of ties following the same concept, in Bangkok. The Jim Thompson ties, especially the ones with elephant patterns, are an accessible piece of Thailand worn by fans around the world. Both the readers and the editor of this newsletter rhapsodize about them.
I must say they look fantastic. I’m tempted to head to Bangkok at the first opportunity — such a great way to bring some color and individuality to the drab male dress code, plus an excuse to go to Thailand. Here’s hoping some other ancient cultures have a Covalin or a Thompson at their disposal. Does anyone know of any?