Daily Comment (February 9, 2023)
by Patrick Fearon-Hernandez, CFA, and Thomas Wash
[Posted: 9:30 AM EST] | PDF
Today’s Comment begins with our thoughts on a report written by Seymour Hersh concerning the explosions that damaged the Nord Stream pipelines. We next share our view on the market’s switch in sentiment regarding central bank hawkishness. Next, we discuss the dollar’s rally to start the month and whether it can be sustained. Lastly, we provide an update on geopolitical tensions between the West and its rivals.
Nord Stream 1&2: Seymour Hersh, a long-time investigative reporter, released a blockbuster allegation overnight, suggesting that the U.S., along with Norway, attacked the Nord Stream pipelines. According to his report, U.S. Navy divers from the Diving and Salvage Center based in Panama, put explosives on the pipeline and were responsible for the damage. If these allegations are true, it would create a crisis. Arguably, this action would be a casus belli and could put the U.S/NATO into a direct conflict with Russia. Although, before we take the report at face value, caution should be exercised.
- Hersh is an 85-year-old investigative reporter who won a Pulitzer Prize in 1970 for uncovering the Mỹ Lai massacre. However, over the years, a good bit of his reporting has been discredited. He wrote a large piece for the London Review of Books that suggested the Obama administration’s account of the assassination of Osama bin Laden was essentially a lie. He faced strong criticism for that report, which relied heavily on unnamed sources. Later, he seemed to side with the Assad regime over chemical weapons, but the allegations he made were not entirely refuted either. Our take is that Hersh, at least at one time, was an important journalist. Over the years, though, his reporting seems to have become increasingly erratic.
- As we note, Hersh isn’t a crackpot, but over the years, likely due to his experiences in dealing with the U.S. military and intelligence agencies, he seems to have taken a position that the benefit of the doubt should go to foreign interests. Thus, there is a potential bias to his reporting. At the same time, even though there is a notable lack of sourcing in the report, there are solid geopolitical reasons for the U.S. to want to end Nord Stream.
- The age of oil has been difficult for Europe, mainly because the continent doesn’t have much oil of its own. Although Europe is blessed with ample coal resources, the superiority of oil as an energy source meant that without secure sources of oil, European dominance of the world was in trouble. Now, there is a bit of production available in Romania, and of course, after oil prices spiked in the 1970s, oil was extracted from the North Sea, but Europe was never going to achieve oil and gas independence. The European powers attempted to expand their colonial reach into the Middle East and Asia to acquire oil, but those areas were hard to secure. The Dutch lost the oil in Southeast Asia to Japan during WWII. Britain and France struggled to secure oil resources in the Middle East and North Africa and after WWII, when the U.S. fostered independence for European colonies, Europe lost controlled access to the oil in North Africa and the Middle East. Until the early 1970s, Europe was mostly dependent on the U.S. for oil. Not wanting to be fully dependent on Washington, Europe, and especially Germany, turned to Russia for energy. Naturally, this reliance on Russia wasn’t popular with the U.S. Consistently, American administrations have criticized Europe, and especially Germany, for their increasing reliance on Russian oil and gas. The Nord Stream projects were especially galling because they directly linked Russia to Germany.
- Thus, seeing the destruction of the pipelines, even if the Hersh reporting is false, is in American interests. That’s why this narrative will likely be hard to quash. It is natural to assume that if a party benefits from an event it might have had a role in causing it. However, that is about as far as this goes. It is quite possible that Hersh received this information from someone that would also benefit from increased tensions between the U.S. and Russia. And since no sources are named, it may not be possible to really prove anything here.
- We will continue to monitor developments and reporting around this issue. We doubt that we will see anything definitive on this in the near term, so the most likely outcome is that it won’t cause an escalation directly involving the U.S. and NATO against Russia. But we could see “tit-for-tat” actions, such as sabotage of LNG facilities, cutting of fiber optic cables, etc.
Not So Fast: Investors have finally begun to lose faith that central bankers are finished tightening monetary policy.
- Central bankers have pushed back on the notion that they are finished raising rates. Several Fed officials warned investors that the central bank still needs to hike rates to contain inflation. Some policymakers hinted that the interest rates might need to go up higher than previously anticipated to prevent services inflation from becoming sticky. Similarly, European Central Bank officials attempted to temper expectations that they were backing away from their inflation fight. European Governing Council Member Klaas Knot argued that the ECB would likely hike rates 50 bps in March and continue lifting its policy rate afterward. Fellow ECB policymaker Martins Kazaks went further and insisted that the bank lift rates to a level that “significantly” restricts the economy.
- The market responded negatively to the news that the borrowing costs would stay elevated for the foreseeable future. The S&P 500 closed lower Wednesday, with tech stocks leading the way. Meanwhile, swap rates suggest that investors are less confident that the Fed will cut rates this year, with some predicting that the central bank could actually push rates as high as 6.0%. The change in sentiment is not only related to Fed comments but also to recent data. Yesterday, a report showed that used car prices, which have been declining over the last few months, have started to rise again. Hence, there is palpable fear that talk of a pause or pivot may have been premature.
- Investors are trained to think that the central bank will come to save the day whenever the economy falls into recession. However, this time may be different. Monetary policymakers were not dealing with elevated inflation in the previous downturns, and thus the decision to intervene in the economy was less costly. Equities could be hit pretty hard if the Fed raises rates during a recession. That said, the economy still appears to have some steam left, and if inflation falls, holders of risk assets will likely be the biggest beneficiaries.
- Evidence suggests that much of the rise in stocks this year is related to short covering instead of investors returning to the market. The distinction is essential as options activity may not represent a broader sentiment shift.
Will It Last? After several months of decline, the dollar has shown signs of life following concerns that the Fed may be more hawkish than its peers.
- The U.S. Dollar Index (DXY) has been on a tear since the beginning of February. After declining 2.3% in January, the index is now up 1.6% to start the month. The bullishness for greenbacks is related to speculation that the Bank of Japan and the European Central Bank would be less hawkish than originally thought. Most of the rally is related to talk that European inflation may have peaked and that the BOJ approached Masayoshi Amamiya, a dovish candidate, to replace the outgoing Haruhiko Kuroda as central bank governor.
- However, there are signs that the dollar’s resurgence may not last long. The re-weighting of each country’s Consumer Price Index (CPI) has played a role in the inflation story this year. For example, German inflation fell to a five-month low in January; however, much of the decline was related to statistical tweaks. Hence, it is possible that changes could have the opposite effect. Additionally, there is renewed speculation that the Prime Minister of Japan, Fumio Kishida, could select Hirohide Yamaguchi, a hawk, as the new BOJ governor. As a result, it is still too early to tell whether the dollar is headed for another upswing.
- Much of the strong performance in international equities is related to speculation that the dollar will be in retreat for much of 2023. This view contributed to emerging market and European-related ETFs having their highest monthly net inflows in over a year in January. Meanwhile, U.S. equities have seen their first outflow since April 2022 within that same month. Although much of these flows are related to technical trends related to the dollar, better-than-expected growth in Europe and China’s reopening also played a part in the shift away from U.S. equity markets. That said, a sustained rally in the dollar, which we view as unlikely, could reverse those flows.
Ramping Up the Pressure: The West is tightening the screws on its adversaries as the group seeks to rein in China and Russia’s geopolitical influence.
- The U.S. and its allies are looking to provide more military assistance to Ukraine and other countries to help deter Russian aggression within the region. The U.K. and U.S. are weighing the possibility of sending fighter jets to Ukraine to help in its war efforts. Meanwhile, Washington has approved plans to sell Poland $10 billion in weapons, including 18 Himars rocket launchers. The moves are further evidence that the war in Ukraine will not only continue throughout 2023 but could, in fact, escalate.
- Meanwhile, China continues to find itself offside with the U.S. despite earlier attempts to thaw tensions. A group of G-7 countries is considering sanctioning the Chinese companies that supplied equipment to Russia for military purposes. Also, the ongoing row over the Chinese spy balloon continues complicating efforts to improve economic ties. Secretary of State Janet Yellen and her team of Treasury officials were scheduled to travel to Beijing later this month but were forced to cancel. Although tensions will probably smooth over between the U.S. and China in the next few months, we still believe that the countries are destined to decouple in the long run.
- Geopolitical risks remain elevated as tensions between the U.S. and China-led blocs continue to rise. The growing rift between the two sides may impact commodity prices and investment flows. Our research suggests that the U.S. will likely have the advantage in capital, whereas the China-led bloc may have the edge in energy-related goods and raw materials. This dynamic will likely lead to higher inflation in the long run. In our view, government regulation on capital and strategic manipulation of commodity prices will lead to greater inefficiencies and market volatility, thus, leading to higher prices. Hence, investing may become trickier over time.