Inflation and Cold War Risk Escalate as Russia Plays Chess in Ukraine

The 39 year high on inflation has nothing to do with Russia, yet the risk of a Cold war leaped higher today on the news of Russia invading Eastern Ukraine that triggered significant US and European sanctions. The news is increasingly fluid with regard to the growing Russian Bear rising up along the Ukrainian border. Russia is legendary for its Chess prowess as well as their geopolitical gamesmanship. For almost 3 months Russia has been building its forces around Ukraine with an implied threat of usurping all of Ukraine and increasing fear amongst all non NATO states on its border. Feeling emboldened since their painless acquisition of Crimea from Ukraine in 2014, Russia pretends to demand that Ukraine agree to “never” be a part of NATO, allied with the West. Putin likely intended to take only a portion of Ukraine at this time, hoping to avoid the maximum banking system punishment by the West. Our assumption has been that Putin’s original intent was annexing Eastern Ukraine, the Donbas and Luhansk regions and adjacent regions, which their proxy army can with clandestine assistance from Russian soldiers and equipment. Sanctions are ratcheting up, but until Russia is shut off from the US dominated SWIFT financial system of global payments and energy funding, they can keep escalating their annexation efforts and rely upon China for banking and trade shortfalls. While we don’t expect a major advance at this time, should Russia continue its advance onto the rest of Ukraine, it would appear that future diplomacy will fail. The US and Europe are historically feckless in the face of superpower aggression, so it will be interesting how well they play Putin’s game of brinkmanship. In our opinion Biden and Europe must doggedly follow through toward their powerful counter measures to weaken Russia’s long term vitality and perhaps more importantly to set a precedent to deter the rising aggression of China as both countries are increasingly transparent in their goal of dominating the world militarily and economically. Our understanding is that Russia has already been assured by China that it will buy any petroleum that Europe curtails and that it will bring Russia into the Chinese financial payment system that both countries desperately want to replace the Dollar dominant SWIFT payment system. Punishing sanctions will be observed by China as they contemplate continued hostility toward neighboring countries and to eventually invade Taiwan. With their world leading semiconductor technology and symbolism for world Democracy, capturing Taiwan would be far more devestating to the global order than Ukraine. Thus far, inflation risk to petroleum and industrial metals markets has been mostly unaffected by Russian or Chinese threats, but there is risk that an errant chess move will trigger full scale Russian fighting that causes markets to panic short term and further inflate global supply chains. While it would be a precedent setting geopolitical travesty if the West fails to impose maximum long term financial punishment on Russia for this annexation, it would be calming for commodity market prices if the West implements maximum sanctions only temporarily. Diplomacy is likely to begin soon and quell energy fears short term, especially with Iran coming on line next week.  Highest inflation risk commodities from this conflict are Oil, Nat Gas, Nickel, Wheat and neon gas for semiconductor chips. The US and europe will need a economic world war type of posture to become more self reliant after decades of increasing reliance upon Russia and China for our survival.

Even without Russian and Chinese military aggression, supply chain based inflation is a major concern for the markets. For the past year, as core inflation (CPI) rose to almost 4 decade highs of 6% in January, the inventory shortage of cars and trucks reached a new extreme. Dealer lots have never been leaner. Many ponder the reason for the persistent shortfall of supply that is temporarily elevating CPI . Demand for computer chips needed for today’s electronic vehicles is often cited as a reason for slow production, which has led to a shift to used car sales to supplement unmet demand. Of course that’s a bit simplistic as Government handouts and mandates have reduced labor supply, which is also a major factor in slow Auto production and a lack of materials. After the recovery began from the Great Financial Recession of 2008, it took over 4 years before labor rebounded to pre Recession levels. At the current pace of adding 6 million jobs a year, it will have taken about 2 and a half years (Q3 2022) before employment returns to pre Covid levels and Q1 2023 to reach historic trendline labor growth equating to full employment. Supply chain inflation should abate significantly as we approach these milestones. By creating Trillions of Dollars out of thin air, artificially stimulating record consumption during Covid while restricting the return of labor, the Government caused supply chains to experience record delays and corresponding inflation. Using the Automobile sector as an example, it can be seen in the chart below that vehicle sales rebounded sharply with Government stimulus in 2020, but without the labor and parts to produce more cars we had a rapid drawdown of inventories.

This low level of vehicle manufacturing and loss of new car inventories triggered an aggressive Dealer quest to sell more used cars to alleviate some of the excess customer demand. Consequently, used car prices rose a whopping 85% over the past year and even new car prices are being reported sold above sticker price. If vehicle production could increase, sales would follow. Normally after almost two years of recovery we would see normal labor supplies, but due to Government mandates and major disincentives to work resulting from financial handouts, vaccine passports and masks, it caused millions of workers to stay home. Historically, used car prices don’t affect the CPI, but this past year it has added 1%. When rising production meets softening demand by late 2022 or early 2023, the used car component in CPI may actually have a mild deflationary impact upon the CPI.

While the word Transitory has been dropped from the Feds lexicon, replaced by growing concerns of long term spiraling inflation, the current 39 year inflation rate peak is inspired primarily by unusual factors of the Government response to Covid that led to supply chain inflation that has many transitory elements. Automotive production will not remain depressed forever and thus used car prices will eventually collapse. Another example is the record high shipping rates that will normalize as Asian and US ports become fully open post-Covid and the rapidly falling global personal savings pool slows consumption of physical goods. Nothing cures high inflation like high inflation. Semiconductor chip makers around the world are building advanced fabrication facilities that will explode production over the next few years. This will ease the Auto and high tech supply chains over the next year. As the virus threat subsides and labor returns, supply will rise while demand moderates. This will normalize supply chain inflation and bring the core PCE back under 3% and core CPI under 4%.

The 20 year hgh in wage inflation is also frequently hyped as a sign of a sticky – not transitory – inflation spiral. In this cycle of record labor shortages with an amazing 11 Million job openings in the US, it’s understandable that wage rates are rising rapidly. While labor rates are not directly measured in the inflation data, they morph into inflation as businesses have to raise their product cost to maintain profit margins that are being severely impaired by rising employee expenses. What is more interesting in this recovery cycle is that low wage, low skilled younger workers are seeing a much more rapid rise in incomes as compared to the highly educated and more skilled worker. This unusual phenomenon during a recovery reflects the extraordinary shortfall in Service sector workers. These jobs require less training and skill, but can’t be automated or performed remotely as many higher skilled jobs can. Eventually, leisure and hospitality workers will fill the 2 Million person shortfall along with other labor starved sectors that will adapt with higher productivity. For now, inflation persists, rates must rise. However, peak base effect inflation is on our doorstep over the next few months with significant CPI moderation over the next year. This assumes the escalation of Covid restrictions are reversing and geopolitical military conflicts regarding Russia and China don’t create even more supply chain delays and energy shortages long term. 

Inflation and rising rates are a concern for stock investors until the Fed actually starts raising rates in March, but over the next few months the worsening credit fears over inflation should begin to peak. In Q1 we have outlined ahead of time the expected seasonal trends, cycles and technical indicators that are tracing out as forecasst with recent escalation by Russia supporting our techncial outlook.

Russia is an economic flea vs China or the US and even their inflationary threats to the energy and metals supply chain should be brief, with the potential to have a deflationary impact should a Russia/China trade war with the West ratchet higher due to the current conflicts. The stock market woes in Q1 should approach their nadir in March and form a base which will eventually lead to modestly higher prices by year end led by Japan, emerging markets, cyber security and the service (travel) sector. The past two years have been about earnings and multiple expansion that was artificially stimulated by Central Banks and Governments. This year is about the withdrawal of artificial consumption and contraction of valuation multiples in a rising rate environment. Price to earnings ratios continue to fall with SP 600 Small Cap Index valuations already back to levels seen at Bear market lows. In January we outlined 2 major support target zones for the expecte Q1 correction near SP 4200’s and 3800’s. Currently we remain defensive until the 2nd or 3rd week of March, with potential downside risk in the 3800’s on the SP 500 Index. From wherever the Q1 lows complete, the continued earnings expansion trend as the service economy reopens, can allow stocks to grow into attractive valuations for investors as the year evolves. Our cycle forecast expected a correction into important lows in late January and March, followed by a rally into late April with a more important Bull trend peaking in the third quarter.

 

 

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