Image: It is not hard to see why Russia wants to control Ukraine. It is one of several buffer countries that the Soviet Union used to insulate itself from Western Europe.

• Stocks and bonds fell during February as investors reacted to interest rates creeping higher and the Russian invasion of Ukraine.
• January's inflation came in well above 7% on a year-over-year basis. We still expect some higher readings until the end of 2022 as rent and food inflation is digested.
• Commodity markets all rose as the market tried to figure out if Russian sanctions would result in energy shortages.

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Table 1: Performance update

February markets continued to weaken as stimulus programs expired and the impact of inflation lowers the effective spending power of the consumer. Widespread inflation in wages, food, shelter is affecting everyone. Even so, the Fed continued holding rates at zero and continued its last little bit of quantitative easing. The Russian invasion of Ukraine may disrupt energy and financial markets in Europe, pushing the region into recession. The geopolitical effects of pandemic, stimulus and war are overwhelming the normal rhythm of the economy.

Key Interest Rates Move Higher

Interest rates continue to inch higher. Remarkably, all interest rates in the United States remained relatively stable in the face of 7% inflation and a paralyzed Federal Reserve.

There is a giant tug of war between the forces of deflation and inflation here in the United States. On the inflationary side we have a Fed that is still stimulating, rapid economic growth, rising wages, rising rents, and consumers flush with cash. On the deflationary side we have temporary stimulus programs winding down, a Fed about to raise rates, a slowing economy, a decline in inflation adjusted spending, and ongoing supply chain disruptions.

It is unclear how the Russian attack on Ukraine will affect the US. The Chinese are certainly watching the US reaction closely because they want to take Taiwan in exactly the same way. Taiwan is a key part of the global technology supply chain because they produce 60% of the semiconductors used in the world. A Chinese invasion of Taiwan will severely affect the global economy and drive-up inflation. The Russian invasion of Ukraine is less important to the global economy but will affect oil prices. Watch the tit-for-tat escalation of sanctions; there is a chance Europe talks itself into an energy crisis and recession.

Figure 1: Recent history of 10-year and 2-year Treasury bond yields

Markets Weaken on Higher Interest Rates

There is a connection between higher interest rates and financial asset prices. In general, when rates rise, the value of the asset falls depending on several factors. For assets like stocks, when rates rise, but earnings rise faster, sometimes the stocks can resist the higher rates. For bonds, however, the relationship is much more mechanical. Higher rates almost always mean lower bond prices.

In the following diagram you can see the reaction of many asset classes to higher interest rates. In particular, those companies with high valuations and poor earnings are most affected by the new interest rate regime.

Figure 2: Risky Assets Do Poorly In Rising Rate Environment

What Will The Fed Do?

The big question is how high will the Fed raise interest rates? If we compare key rates like consumer price inflation, Federal Funds rate and the US 10-year Treasury Bond yield, it is obvious that rates could go much higher.

Whether the Fed is stimulating or restraining growth is a function of the relationship between short-term and long-term interest rates. The Federal Funds rate must be compared to a long-term Treasury bond interest rate to evaluate the Fed's policy. When short-term rates are below long-term rates, the Fed is stimulating growth. When short-term rates are above long-term rates, the Fed is restraining growth.

Here is a brief matrix that creates a framework for thinking about Fed policy. Remember, today inflation is 7%, 10-year Treasuries are 2% and the Fed Funds rate is zero.

Table 1: Fed Policy, Federal Funds Rate and US 10-year yields

The Likely Result 0f Various Fed Choices

Now let's add the wrinkle of actual inflation. If interest rates are held below inflation, this is generally considered stimulus that will promote more inflation. So, even if the Fed raises rates to 5%, if inflation is 7%, they are still promoting a stimulative policy

It is unlikely inflation will remain at 7%. There are very high inflation numbers from rent that have not made it into the data and the economy is decelerating. These effects offset one another to a certain extent. Policy makers are hoping the current inflation is transitory but are acutely aware of the pain inflicted on the economy during the 1970s to break the behavioral cycle of inflation.

We won't really know what Fed Chairman Powell will do until his nomination is finalized in the Senate. There are now 5 Fed nominees waiting for Senate confirmation. Many of them have stated that inflation is the top problem to be solved. It should be an interesting year as these folks take charge.

Table 2: Possible Impact Of Various Fed Policies

Russia, China, and Inflation

How quickly we have forgotten about the pandemic, masks and vaccines. Yet, the inflationary impulse created by pandemic policies is still ripping through the global economy. Politicians are complaining to central bankers to do their jobs and fix inflation: the voters aren't happy.

In the US, Europe and Japan, central bankers have their overnight rates at zero. There is little room to cut rates to answer a war-time emergency. That means any geopolitical problems caused by Russia and China can't be easily offset with monetary policy. What kind of problems, you ask? That is an interesting question.

The global community has placed limited sanctions on Russia for invading Ukraine. While NATO is talking tough, the fact is Germany and much of Europe are heavily dependent on Russian oil and gas to run their economies. Sunday, the US and EU announced that the Russian central bank will not be allowed to access their dollar and euro reserves to conduct business. Russia, your move. Russia may say, fine, we'll just turn off the energy we supply the Eurozone. Good luck running your economy without energy!

China is closely watching this because they want to take over Taiwan. Just as Russia may turn off the lights in Europe, China may deprive the world of semiconductors by taking over Taiwan. Good luck building PCs, phones and cars without those chips!

These concepts are the key link between geopolitical problems and inflation. The Fed can print money, but they can't print oil, food, or semiconductors. They key lesson of the 1970s was that lowering demand through recessions was required to suppress inflation. In the 1940s, the solution to excess inflation was outright shortages of food and oil. Both options will be extremely unpopular but not unprecedented.

Our leaders are playing a very dangerous game with shrewd opponents.

The Lehman Scenario

Western leaders of the US, Germany and UK are putting together sanctions to punish the Russians. One of these sanctions closes off Russian bank access to western financial markets. While painful for the Russians, our fearless leaders have not thought through the consequences of these policies.

Our different national economies are held together by trade and financing arrangements. Germany buys oil and gas from Russia, sending cash for the product. Russian companies borrow from western banks, sending interest and principal payments back to service their debt. By blocking the financial plumbing with sanctions, the leader of western countries risk triggering another Lehman bankruptcy scenario where the failure of one critical counterparty can take down the financial system. Do you remember how gracefully Lehman failed in September 2008? It was neither graceful nor pretty.

Today, banks and corporations across the world are calculating how much they will lose in a worst-case scenario. Historically, when losses are large, corporations have traditionally cut spending and employment to compensate. A rational exercise in risk management triggers an economic slowdown if everyone is incentivized to do it at once. This is the new risk that has cropped up in the last 2-3 days.

The economy is slowing, the risk of heavy sanctions is rising, valuations are high, and the Fed is about to raise interest rates. Expect the markets to be choppy and sloppy over the next few months.

We are happy to discuss our research and what it means for your situation. If you have any questions, please call me at 281-402-8284.

Sincerely,

Rob and Chris

Robert J Lloyd, CFA^®

President and Chief Investment Officer

Lloyds Intrepid Wealth Management

1330 Lake Robbins Dr., Suite 560

The Woodlands, TX  77380

281-402-8284

Robert.Lloyd@lloydsintrepid.com

www.lloydsintrepid.com

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