Market Pulse: Tit For Tat
In 7 minutes, let's discuss (1) the tit for tat geopolitical conflict that's putting the market on edge and (2) how to navigate this perilous market landscape.
Below are still frames from the 1948 Looney Tunes animated short “Bugs Bunny Rides Again”. The short is set in a Western town that’s being terrorized by the volatile gun-wielding Yosemite Sam and Bugs Bunny is the only one that’s brave enough to challenge him.
Yosemite Sam and Bugs Bunny engage in a classic gun duel and both of them threaten each other with increasingly larger revolvers.
Six shooter!
Seven shooter!
Eight shooter!
Nine shooter!
Ten shooter!
Sounds similar to a particular situation of great import happening in the world right now? Yup, the ongoing Israel-Iran tit-for-tat spat. I think this is the market’s current defining narrative.
It’s a perilous time to invest. Let’s dive in.
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For the sake of brevity, and also to distance this issue from the heightened emotions of the overall situation, I’m going to refer to Israel as ISR and Iran as IRN.
On April 1st, ISR bombs the IRN consulate in Damascus and kills several consulate staff including two senior IRN generals.
In retaliation, last weekend, IRN sent 170 drones, 30 cruise missiles and at least 110 ballistic missiles at ISR. This was a historically momentous event; it’s the first time IRN directly attacked ISR.
Yesterday, ISR returned fire on IRN, firing missiles at targets deep in IRN.
The markets have been trading on the news of these attacks. The prevailing fear, of course, is that a major kinetic conflict starts between the two regional superpowers. This conflict will most likely pull in the global hegemons sponsoring each of the regional superpowers, the US and China/Russia respectively.
Last Friday, a day before the IRN attack, the S&P 500 sold off by 1.8%.
The S&P 500 sold off another 2% in overnight markets last night when ISR retaliated against IRN yesterday. The volatility spike as a result of this news was so large that it even forced Robinhood to disable trading on their overnight markets.
We’re not geopolitical experts but from how the market is behaving around news coming from the region, it’s clear that if the conflict between ISR and IRN escalated, it’d spell incredible trouble for the global economy.
In line with this narrative, the market sectors are rotating like there’s an impending major war afoot.
Here’s the SPDR sector ETF momentum map for the past week.
Energy continues to make broad and dramatic moves up and to the right. It has been moving like this since mid-March after Russia banned gasoline exports for 6 months.
What’s worrying is that Materials and Industrials are now also following its lead. I realize that I’m at risk of sounding like a fear-monger by saying that all 3 sectors are important for war but this must be mentioned.
At the same time, Technology and Communication Services, two sectors with a heavy concentration of high-growth companies, are rotating the other way around: down and to the left.
The 10,000 ft Narrative
This ongoing market sell-off that accelerated last week started exactly when Q1 ended and Q2 began on April 1st.
Coincidentally (or maybe not, excuse me as I put on my tinfoil hat), April 1st was also when ISR escalated the conflict with IRN by bombing IRN’s Damascus consulate.
We are now in a broad market sell-off.
The two major factors troubling the market right now are:
Fears of war, as mentioned above.
A broad-based retreat in liquidity:
Capital inflows to the US weaken (looking at you, China and Japan) when the US dollar spikes and the US dollar has strengthened significantly after the hot March CPI report
The Bank of Japan is finally dipping its toes into tightening monetary policy (aka printing less money). Less money-printing in Japan means less liquidity in the US financial system
A $245 billion reduction in total t-bills supply this quarter. As we touched on in a previous Market Pulse issue, t-bill issuance is net-additive for liquidity and so when t-bill supply shrinks, liquidity falls as well. In contrast, in the previous quarter, total t-bill supply expanded by $442 billion.
In addition, a falling total t-bill supply means that Money Market Funds will want to allocate more money to the Fed ON RRP facility.
More money in the ON RRP is more ballast for the financial system and if fiscal spending spikes again, the US Treasury can tap into a larger Fed ON RRP balance to fund the spending (by issuing more t-bills in the future).
As such, a falling t-bills supply is bad for the short-term but good for the ensuing quarters.
We see here that the ON RRP balance is stabilizing at $400 billion and I expect it to grow by a couple hundred billion dollars by the end of the quarter.
Fin
So what happens now?
One thing that should be of particular interest to every market analyst is what happens next between ISR and IRN.
For this, one has to understand the mindset of both superpowers. Here’s what I think.