Wobegon Contrarians: Markets Post Geopolitical Shocks
There is a simple and popular investment narrative that has emerged from the fog of the Russian invasion of Ukraine: geopolitical events are good buying opportunities for risk assets because the hit to sentiment is short-lived and the domestic (U.S.) economic impacts of these events have proven to be limited.
We published a version of this pop analysis, with many caveats, in last week’s chart update. To summarize, the analysis looks at the last 100 years of major geopolitical events and calculates average domestic equity performance before and after each event. The outcome is that returns tend to be better after the event than before it, in prototypical sell the rumor/buy the news fashion.
This conclusion is supported by the numbers on the surface, but we think this analysis is overly reductive, a bit crude and does little to address the unique and important considerations of today’s geopolitical events.
To be clear, we are not saying that current weakness in select risk assets can’t be bought (some valuations are becoming compelling) and that markets can’t rally from today’s levels in the near term. What we are saying is that we need a far more robust analysis of today’s market scenario before we can jump on the “bombs-drop equals back-up-the-truck” bandwagon (at the end of this piece we provide an update of key considerations and expectations for equity markets).
The reality is that most geopolitical events do not matter for markets because they simply do not impact the broader global economy in a lasting way. Most geopolitical events in the past 100 years have not caused a substantial destruction or re-allocation of resources (labor, capital, natural) away from the productive economy into, say, a war effort. And thus, most geopolitical events have not had a lasting impact on asset prices. For most events, sentiment gets jittery for a moment, but the economic machine motors on.
Of course, it would be aggressive to expect that something like a terrorist bombing of an embassy halfway around the world would cause lasting domestic economic damage, and thus there is little reason to expect that such an event would cause protracted domestic market weakness (of course there is always the risk of a butterfly effect where seemingly minor events, like the assassination of an archduke, can spark a global conflagration, like The Great War).
But the problem with the above analysis is that it simplistically treats all geopolitical events the same. Why would we weight the impact of WWII the same as the 1998 East African embassy bombings in order to divine the future path of today’s markets? The outcome of an analysis that weights all events equally risks providing false comfort that we can all be Lake Wobegon contrarian buyers in the face of every geopolitical event.
The key, and incredible challenge, is determining what geopolitical events don’t fall into that most category, meaning those events that actually do have a lasting impact on the economy and markets.
For example, how the Egyptian and Syrian offensives against Israeli occupied territories and the resulting U.S. arms support of Israel emboldened OPEC to institute the 1973 oil embargo. This sent oil prices skyrocketing and exacerbated an existing inflationary backdrop in the U.S., resulting in inflation expectations becoming unmoored. The aftermath of that one geopolitical event was a decade of weak equity markets and repressive economic efforts to contain this inflation. This outcome was probably not anticipated when the first shots were fired.
Also, the above analysis ascribes causality to these geopolitical events, blaming them for market movements when there were other factors at play that likely were of far greater importance. Of course there is the short term lurch lower in risk-appetite that often follows these surprise events, but the reality is that other factors, like liquidity or existing debt crises, were likely bigger drivers of markets in many of these scenarios.
The wrinkle here is that economies and markets are interconnected, so geopolitical events can spark changes in policy, liquidity, interest rates and flows that can be important for markets.
For example, the Fed responded to the tragic events of 9/11 by cutting interest rates from 3.5% to 1.75% by the December 2001 meeting. This sparked a 21% countertrend rally in the S&P 500 through the remainder of 2001. The success of this geopolitical “buying opportunity” soon faded, though, with the added liquidity unable to buoy markets for long given the overhangs of deleveraging fraught corporate balance sheets and valuation/positioning rationalization following the tech bubble. The S&P went on to fall another 32% to its bottom in September 2002. Of course, long term investors have still made handsome returns over the past 20 years, whether they bought during the post 9/11 slump, the late 2001 rally, or at the ultimate bottom in 2002.
The lesson in all of this discussion is that we cannot consider geopolitical events in a vacuum. We cannot simply extrapolate “average” performance experiences from the past and blindly hope for the best. We can’t all be Wobegon contrarians.
That brings us to today’s dreadful events in Ukraine.
We must look beyond the initial sentiment shock and consider the potential lasting U.S. economic and market ramifications (of course acknowledging the appalling humanitarian impacts that will certainly be lasting).
We think there are three main considerations for U.S. markets, with all three being deeply interconnected: the impact of sanctions on global liquidity, the impact of sustained higher energy and commodity prices on U.S. economic growth and the impact of financial market reactions and higher energy prices on the path of Fed policy.
Each of these items deserves their own treatment, which is exactly what we will do next week!
In the meantime, here is a summary of our key observations about and expectations for equity markets:
- The S&P 500 is now -9.8% YTD with a P/E multiple of 19x, down from 22x to start the year but still above the 17x 10-year average
- NASDAQ -13.4% YTD; P/E 26x vs. 31x to start the year and 21x 10-year average
- Russell 2000 -10.5%; P/E 21x vs. 25x to start the year and 24x 10-year average
- EPS growth expectations have been marked down to +7% for 2022 after companies issued cautious updates during earnings season
- Given decelerating PMIs and caution that consumer demand could be hit by inflation and slowing real income growth, we see fewer near term drivers for EPS revisions to move substantially higher (but would note that this could be a positive catalyst later in the year if estimates get cut too much)
- This lower EPS growth will not be able to offset P/E multiple compression like 2021’s 50% growth
- The trends of the S&P 500 and NASDAQ have deteriorated to start this year, and are now more neutral than they are bullish; we do not expect a return to the “up and to the right” unflinching bull markets of the liquidity abundant 2019-2021 years as long as the Fed is tightening policy
- The NASDAQ experienced a “death cross” on 2/18 where its short term moving average (50 day) crossed below its longer term moving average (200 day), a potential sign that there is growing risk of a further weak trading if a downtrend emerges
- As we described in detail in our chart update, equity indices are not fully washed out to levels seen at major market bottoms (2016, 2018, 2020), though sentiment has deteriorated close to contrarian levels where forward returns start to improve (in the deck we look at why today’s sentiment could be so weak and why there is still a lot of room for investor positioning to fall if this fear were to be fully reflected in portfolios)
- There are some areas of the market that have become oversold, but are now in distinct downtrends after recent trading; given heightened short interest we can see large countertrend rallies in these areas, but we would be wary of “bull traps” where the rallies fail at downward sloping trend lines; we continue to argue for reducing positions and selling rallies in liquidity sensitive parts of the market as these areas start hitting overhead resistance
- The Fed cares most about the movements in debt markets in order to ensure financial stability, so while credit spreads have widened, they are not at levels that would cause the Fed to act to step in and stabilize markets; this goes with our key expectations for risk assets in the coming months:
- We see markets stuck in this higher volatility, choppy sideways trading as the Fed begins to remove accommodation and then tighten policy
- There is risk of a bigger correction if liquidity tightens too quickly for markets to bear (the yield curve nearing inversion while the Fed staying hawkish has been the lethal combo for liquidity fueled markets)
- For the Fed to step in and stabilize markets, things have to get worse before they get better, meaning more market weakness is needed to get the Fed to pivot dovish, further complicated by inflation that is running at well over double their target
- Next week we will discuss how geopolitical events could impact the path of Fed policy
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