Fed way too slow, way too late | Wolf Richter

“This most reckless Fed ever has had some kind of come-to-Jesus-moment late last year when it did acknowledge the problem it had set off. And now it’s trying to act way too slowly, way too late, and way too timidly to break up this spiral without causing the whole house of cards – the magnificent asset bubbles everywhere – that its money-printing and interest-rate repression created to come crashing down all at once.”

~ Wolf Richter, Wolfstreet

Never waste a good crisis

The Russian Federation has amassed a large army on the border of Ukraine and threatens to invade unless the US and NATO make concessions including the withdrawal of forces from Eastern Europe, securing Moscow a broad sphere of influence. There has been much hand-wringing in Western media: will Putin invade or is this just a ruse designed to extract concessions?

If we look past the uncertainty, it is clear that an increasingly over-confident Putin has entered a trap of his own making.

The West is faced with an ultimatum: either concede or Russian forces will invade Ukraine.

But every problem presents an opportunity.

The more aggressive Russia becomes, the stronger NATO gets.

Russian actions have united Western alliances, with even long-term neutrals Finland and Sweden, moving closer to NATO.  Both Finnish and Swedish presidents reiterated their right to join NATO in response to the Russian ultimatum.

Germany has long obstructed a stiffening of NATO defenses, increasing its vulnerability to Russian energy blackmail by shuttering nuclear power plants and supporting the Nordstream 2 gas pipeline across the Baltic Sea. But opposition is growing. A recent poll shows that the percentage of Germans who trust Russia has fallen by 11% over the past two years:

German Poll: Which Countries Do You Trust?

Concessions are unlikely, simply because there is nothing to gain from them. Concessions by the US would weaken NATO and encourage the Kremlin to make even more outlandish demands in the future. Concessions by NATO without the US would produce a similar outcome.

Russian invasion of Ukraine would be a strategic mistake.

First, invasion would be a flagrant act of war, removing the cloak of deniability that has covered Russian operations in the Donbas region. A formal state of war would increase the flow of Western technology and weapons into Ukraine as Western leaders are required to openly acknowledge Russian aggression.

Land invasions are costly in terms of both blood and treasure. The Russian army may eventually overrun the Ukrainians through the weight of forces and technological advantages. But Ukrainian armed forces have been in a protracted war in the East and are well-trained and equipped with modern anti-tank weapons, artillery and unmanned drones. The costs would be high.

Turkey’s Bayraktar unmanned combat drone

Turkey’s Bayraktar Unmanned Armed Combat Drone – Source: Ukrinform

Where the Ukrainians are at a disadvantage is in air defenses and vulnerability to long-range missile attacks. But that window is closing.

To stiffen Ukraine’s ability to resist, the United States and NATO have dispatched teams in recent weeks to survey air defenses, logistics, communications and other essentials. The United States likely has also bolstered Ukraine’s defenses against Russian cyberattacks and electronic warfare. (David Ignatius, Washington Post)

An air campaign would also achieve little without a follow-up land invasion.

Even if the Ukrainian forces are defeated, that is where the real problem starts. Occupation is a costly and morale-sapping exercise as the Soviets discovered in Afghanistan in the 1980s and the US discovered in Vietnam, Iraq and Afghanistan (they’re slow learners). An insurgency negates the occupiers’ advantages in air power and technology, leading to a drawn-out campaign with no outcome.

“You have the watches. We have the time.” ~ Taliban fighters in Afghanistan.

A Russian occupation force would require 20 combatants for every 1,000 Ukrainians, according to a formula devised by Rand Corp. analyst James Quinlivan in 1995. That would translate into an a required Russian force of almost 900,000, illustrating the impracticality.

We could expect a Russian occupation to be exceedingly brutal, along the lines of Syria, creating a humanitarian crisis and flooding the West with refugees. But that is only likely to harden resolve, marginalizing appeasers in the West, and increase support for the insurgents.

The cost of an extended Russian campaign would deplete the Russian Treasury, even without increased sanctions. It would also escalate opposition within Russia, spurred by the high cost in lives and deteriorating living conditions. The result would threaten collapse of the Russian state in much the same way as the campaign in Afghanistan led to the eventual disintegration of the Soviet Union.

Conclusion

The threat of armed invasion of Ukraine is a mistake. It is likely to strengthen resolve in the West and, if the threat is carried out, result in a long, protracted war in Ukraine. The cost in both blood and treasure would threaten to topple the Russian state.

Russian overconfidence has led them into a trap. Thinly spread across a number of conflict zones, they are vulnerable to an escalation in insurgencies wherever they have “peace-keeping” occupation forces: Syria, Belarus, Ukraine, Moldova, Georgia, and now Kazakhstan. The cost to the West would be low but would exact a huge toll on the Kremlin, depleting their military and already-vulnerable financial resources.

“Moderation in the pursuit of liberty is no virtue.”
George Crile, Charlie Wilson’s War: The Extraordinary Story of How the Wildest Man in Congress and a Rogue CIA Agent Changed History

S&P 500: Small caps diverge

The S&P 500 ($INX) remains bullish, with Trend Index holding above zero for over a year indicating tremendous buying pressure.

S&P 500

Narrow breadth is our main concern, with the Russell 2000 small caps ETF (IWM) diverging from the S&P 500 ($INX).

S&P 500 & Russell 2000 Small Caps

Conclusion

The market is growing risk-averse as the Fed starts to taper. But financial markets are still awash with cash.

M2/GDP

Buying is likely to be concentrated in the heavyweights.

Apple (AAPL), Alphabet (GOOGL), Amazon (AMZN), Meta Platforms (FB), and Microsoft (MSFT)

Small caps could possibly accelerate into a down-trend but reversal of large cap indices is unlikely with so much liquidity.

Omicron may be our best hope of taming the pandemic

Almost a year before Omicron appeared, Paul Ewald, an evolutionary biologist, predicted that the COVID virus would evolve in the direction of a highly contagious but less deadly variant.

Omicron is certainly proving more contagious than earlier variants.

Omicron Spread

Source: Bloomberg

But the hospitalization rate — for those above 30 years of age at least — is far lower than the earlier Delta variant.

Omicron Hospitalization Rate

Source: Bloomberg

The higher rate of hospitalizations among children under 9 may not be as concerning as it first seems:

Professor Mignon McCulloch, who is the Chairperson of the SA Paediatric Association, has urged people not to panic during her appearance on CapeTalk. Around 20% of new admissions for COVID-19 in Tshwane have been in children aged nine or under, whereas similar spikes have not been seen in any other age groups.

However, it doesn’t mean that Omicron is more dangerous, or even more deadly for children. According to McCulloch, it’s very likely that the children admitted to hospital are actually there for reasons other than the virus – and it is ‘coincidental’ that they have also tested positive for COVID-19 when checked by hospital staff. (The South African)

Evolutionary path

Earlier, researchers at the University of Exeter found that the most virulent variants of a pathogen may transmit the fastest, but tend to lose out in evolutionary terms to less virulent strains:

Pathogens have a single evolutionary goal – to produce more of themselves. “Virulence will evolve towards a level that optimizes their ability to transmit,” Dr Bonneaud said.

If the pathogen meets resistance to transmission — in the form of a recovered and immune or vaccinated host, or social distancing — then highly virulent forms die out with their host, and natural selection favors less virulent forms.

If there is no such resistance, the pathogen can kill its existing host at no evolutionary cost and will remain highly virulent…..

Paul Ewald, at the University of Louisville in Kentucky, said humanity had drawn a short straw with Sars-CoV-2 because it was both highly virulent and highly transmissible when it emerged.

Over time it is likely to reduce its virulence – in fact, that may already be happening, as reflected in falling mortality rates.

“I would expect it to evolve to a virulence that is very much like [seasonal] influenza,” Prof Ewald said in November last year.

“And containment measures, properly implemented, should accelerate that process.” (The Guardian)

Host mobility

Paul Ewald’s research focuses on the dependence of disease organisms on the mobility of their host for transmission. A patient (host) who is bed-ridden or dies is less likely to transmit the infection — unless the disease has another means of spreading other than personal contact/close proximity. A host with mild symptoms is far more likely to move around in the community and spread the disease.

If a disease organism is very dependent on healthy hosts moving around [and] contacting susceptible hosts, then we expect natural selection to favor extreme mildness in those disease organisms. If, however, the disease organism is not dependent on host mobility — for example, if the disease organism is transmitted by mosquito, or contaminated water, or because it’s durable in the external environment — then we expect that natural selection will favor high levels of harmfulness in those disease organisms…..

When we look at the population of disease organisms in any given area, we see both mild and harmful strains….. all we need to do is tip the competitive balance in favor of those mild strains.

We can look at the experience in South America and Central America as a kind of a natural experiment that allows us to evaluate these ideas. In 1991, cholera came into Peru and then quickly, within a couple of years, spread all throughout South and Central America. Some countries had clean water supplies, and other countries had contaminated water supplies. What we find is that when the organism invaded countries with clean water supplies, the organism dropped in its harmfulness.

In contrast, the organisms that invaded countries with poor water supplies — countries like Ecuador — evolved increased harmfulness over time. They’ve actually become more toxigenic. (Paul Ewald: Infectious Disease and the Evolution of Virulence)

Conclusion

We can use evolution to encourage diseases to evolve into milder forms that are not as harmful and also create resistance to more virulent strains. Use of vaccines, handwashing, masks and social distancing help to restrict more virulent forms of the virus and encourage milder versions like Omicron to take over, developing herd immunity.

Opening up populations to a pandemic — in the misguided hope of creating herd immunity — are likely to have the opposite effect. Unhindered transmission would encourage evolution of more virulent strains, with far higher hospitalization and death rates.

Acknowledgement

Hat tip to Macrobusiness for the images

Doug Kass | 50 laws of investing

Doug Kass wrote these 50 laws, incorporating many of Bob Farrell’s 10 rules, in an article in Barron’s. Doug is founder and president of Seabreeze Partners, with more than 45 years experience in financial markets.

  1. Common sense is not so common.
  2. Greed often overcomes common sense.
  3. Greed kills.
  4. Fear and greed are stronger than long-term resolve.
  5. There is no vaccine for being over-leveraged.
  6. When you combine ignorance and leverage – you usually get some pretty scary results.
  7. Operate only in your area of competence.
  8. There is always more than one cockroach.
  9. Stocks have a gravitational pull higher – over long periods of time equities will rise in value.
  10. Long investing generates wealth.
  11. Short selling protects wealth.
  12. Be patient and learn how to sit on your hands.
  13. Try to get a little smarter every day and read as much as humanly possible – an investment in knowledge pays the best dividends.
  14. Investors sometimes think too little and calculate too much.
  15.  Read and re-read Security Analysis (1934) by Graham and Dodd – it is the most important book on investing ever published.
  16. History is a great teacher.
  17. History rhymes.
  18. What we have learned from history is that we haven’t learned from history.
  19. Investment wisdom is always 20/20 when viewed in the rearview mirror.
  20. Avoid “first-level thinking” and embrace “second-level thinking.”
  21. Think for yourself – those who can make you believe absurdities can make you commit atrocities.
  22. In investing, that what is comfortable – especially at the beginning – is most often not exceedingly profitable at the end.
  23. Avoid the odor of “group stink” – mimicking the herd and the crowd’s folly invite mediocrity.
  24. The more often a stupidity is repeated, the more it gets the appearance of wisdom.
  25. Always have more questions than answers.
  26. To be a successful investor you must have accounting/finance knowledge, you must work hard and you have to be keenly competitive.
  27. The stock market is filled with individuals who know the price of everything but the value of nothing.
  28. Directional call buying, when consumed as a steady appetite, is a “mug’s game” and is often a path to the poorhouse.
  29. Never buy the stock of a company whose CEO wears more jewelry than your mother, wife, girlfriend or sister.
  30. Avoid “the noise.”
  31. Reversion to the mean is a strong market influence.
  32. On markets and individual equities… when you reach “station success,” get off!
  33. Low stock prices are the ally of the rational buyer – high stock prices are the enemy of the rational buyer.
  34. Being right or wrong is not as important as how much you make when you are right and how much you lose when you are wrong.
  35. Too much of a good thing can be wonderful – look for compelling ideas and when you have conviction go ahead and overweight “bigly.”
  36. New paradigms are a rare occurrence.
  37. Pride goes before a fall.
  38. Consider opposing investment views and cultivate curiosity.
  39. Maintain a healthy level of skepticism as you never know when the Cossacks might be approaching.
  40. Though doubt is uncomfortable, certainty is ridiculous and sometimes dangerous.
  41. When investing and trading, never let your mind dwell on personal problems and always control your emotions.
  42. ‘Rate of change’ is the most important statistic in investing.
  43. In evaluating the attractiveness of a company always consider upside reward vs. downside risk and ‘margin of safety.’
  44. Don’t stray from your investing and trading methodologies and timeframes.
  45. “Know” what you own.
  46. Immediately sell a stock on the announcement or discovery of an accounting irregularity.
  47. Always follow the cash (flow).
  48. When new ways of earnings are developed – like EBITDA (and before stock-based compensation) – substitute them with the word… “bullshit.”

Two Bonus Rules

  1. Favor pouring over balance sheets and income statements rather than spending time on Twitter and/or wallstreetbets.
  2. Always pay attention to what David Tepper and Stanley Druckenmiller are thinking/doing. (Trade/invest against them, at your own risk). 

Services inflation

A friend asked a question: “Our advanced economies are 70 – 80 % Services based these days; so will this make CPI inflation difficult to sustain if wages growth is not sustained.”

The answer is YES. Inflation is unlikely to be sustained if wages growth declines.

BUT wages growth is accelerating, not declining, both in the services sector and in the broader economy.

Average Hourly Wages Growth: Total Private & Services Sector

Wages growth is also not likely to decline while we have record job openings; 5.4 million in the services sector alone.

Job Openings: Services Sector

Employers are having to offer higher wages and sign-on bonuses to attract workers — the result of record high savings levels fueled by government stimulus.

M2/GDP

New COVID variant upsets markets

JOHANNESBURG — A new coronavirus variant has been detected in South Africa that scientists say is a concern because of its high number of mutations and rapid spread among young people, Health Minister Joe Phaahla announced Thursday.

South Africa has seen a dramatic rise in new infections, Phaahla said at an online press briefing.

“Over the last four or five days, there has been more of an exponential rise,” he said, adding that the new variant appears to be driving the spike in cases. (NBC)

Concern is focused on the rapid spread of new cases and the variant’s high number of mutations which could make the virus resistant to current vaccines.

The new COVID-19 variant, called B.1.1.529, has a very unusual constellation of mutations, which are worrying because they could help it evade the body’s immune response and make it more transmissible, scientists have said. South African scientists have detected more than 30 mutations to the spike protein, the part of the virus that helps to create an entry point for the coronavirus to infect human cells…..In comparison, the Beta and Delta variant respectively have three and two mutations. (Al Jazeera)

The UK suspended flights from 6 African countries on Thursday. (Yahoo.com)

The S&P 500 fell 2.3% on Friday, while declining peaks on the daily Trend Index warn of a correction.

S&P 500

Conclusion

There is a high level of uncertainty as scientists do not yet know how lethal — and how resistant to vaccines — the new strain is. Investors are being cautious and reducing risk. Expect a correction to test primary support but no bear market unless worst fears are realized.

Technology-critical elements

Technology-critical elements (TCEs) are elements for which a striking acceleration in usage has emerged, relative to past consumption, and which are critical to emerging technologies.

Wikipedia provides a useful list:

Rare-earth elements (REEs)

In atomic order:

Light (LREEs)

  • scandium
  • yttrium
  • lanthanum
  • cerium
  • praseodymium
  • neodymium
  • promethium

Heavy (HREEs)

  • samarium
  • europium
  • gadolinium
  • terbium
  • dysprosium
  • holmium
  • erbium
  • thulium
  • ytterbium
  • lutetium

Platinum-group metals (PGMs)

  • iridium
  • osmium
  • palladium
  • platinum
  • rhodium
  • ruthenium

Other elements

  • antimony
  • beryllium
  • caesium
  • cobalt
  • gallium
  • germanium
  • indium
  • lithium
  • niobium
  • tantalum
  • tellurium
  • tungsten

Retail sales, missing workers and the inflation threat

The October labor report shows hours worked were roughly unchanged from September and still 100K below the pre-pandemic high (5.25m). But GDP of 19.5 trillion is up slightly when compared to 19.2T in Q3 2019, indicating that productivity has improved.

Real GDP & Hours Worked

Monthly retail sales for September, on the other hand, were way above trend.

Retail Sales

People are spending Dollars they didn’t earn, courtesy of record government stimulus.

That is one of the primary causes of rising consumer prices (red below): when demand outstrips supply.

Average Hourly Earnings & CPI

A rising CPI in turn causes second run inflation through higher wage demands (green and gray above) if central banks fail to act quickly. They become embedded and difficult to dislodge.

The combined effect of the pandemic and government stimulus has had a profound impact on the US labor market. The economy added 5.8 million jobs in the 10 months to October, at an average of 580K per month. That rate is likely to slow as the economy reopens and enhanced unemployment benefits end.

We are missing 4.2 million employees, compared to the pre-pandemic peak of 152.5m jobs, and seem unlikely to find them, judging by the 10.4 million job openings in September. High levels of job openings are likely to exert continuing upward pressure on wages.

Non-farm Payroll & Job Openings

The missing workers — aided by government handouts — have either retired, quit their jobs to day-trade Tesla and crypto-currencies, or have re-assessed their work-life priorities. No doubt there will be a trickle back to the workforce — as day-traders encounter reversion to the mean and/or savings run low — but the Fed needs to reassess its full employment target. Failure to do so would leave interest rates too low for too long and allow second run inflation to become entrenched. The only way to then dislodge it is with the kind of drastic measures that Paul Volcker used in the early eighties, with the fed funds rate peaking at 20%.

Fed Funds Rate under Paul Volcker

David Woo: Prelude to volatility

The bond market had a heart attack last week. Rising inflation caused a massive back up in bond yields in the short end of the market. The market is now pricing in two rate hikes in 2022. The Fed will have to raise real interest rates in order to tame inflation.

Real interest rates are falling. The stock market is taking its cue from the bond market and is rising. Stock prices represent discounted future cash flows, so negative real interest rates make a big difference to earnings multiples.

The Democrats are determined to spend their way to a mid-term election victory, with a $1T infrastructure bill and $1.75T social spending, both light on tax revenue. The GOP will try to stop them when the debt ceiling issue returns in December but they don’t have much leverage.

Financial conditions will have to tighten a lot more in 2022. The Fed is way behind the curve and is going to have to play catch-up.

Conclusion

Inflationary pressures in the US economy are growing, while the Democrats plan a further $2.75T in fiscal stimulus which is light on tax revenues.

Long-term yields lag far behind inflation, with real interest rates growing increasingly negative. The assumption is that the Fed will tighten sharply in 2022 to curb inflation. We expect that the Fed will taper but is not going to rush to hike interest rates for three reasons:

  1. The Fed would be tightening into a slowing economy, with growth fading as stimulus winds down;
  2. High energy prices will also help to cool demand; and
  3. US federal debt levels — already > 120% of GDP and likely to grow further with proposed new stimulus measures — are a greater long-term threat than inflation. The Fed and Treasury are expected to work together to boost GDP and tax revenues through inflation, keeping real interest rates negative to alleviate the cost to Treasury of servicing the excessive debt burden.