To The Moon

This month, stocks are up nearly four percent and bonds are down four percent. Those seem like normal returns, but it's not often that there is an 8 percent difference between stocks and bonds in four weeks, especially when the bond market is falling so sharply. Such a move usually coincides with a stock market bottom, as in 2002, 2009, 2011 and 2020. The prospect of economic recovery then causes both interest rates and the stock market to rise; it is a real buy signal. In the four cases mentioned, this was preceded by a sharp fall in the stock market. That is not the case now. Shares are currently less than four percent below the all-time high of November 17, 2021. In January of this year, the stock market still went down as a result of the rise in interest rates; now the stock market is rising as interest rates continue to rise. The main reason for this move is the apparent belief that the U.S. Federal Reserve will do everything it can to fight inflation. In May, the Fed will raise interest rates by 0.5 percent and probably by another 0.5 percent in June. Each subsequent meeting will then add a quarter so that the policy interest rate in the United States will stand at 2.25 percent at the end of this year. The bond market reacts spooked, but the stock market is remarkably positive as if there were no war in Ukraine, including the accompanying oil shock. Rising interest rates have a major impact on the economy. In the case of both stocks and bonds, rising interest rates cause the value of future cash flows, and therefore the total value, to fall. The only difference is that companies are much better able to pass on inflation, whereas with bonds the cash flows are fixed from the start. Inflation is therefore the great enemy of bonds. Furthermore, higher interest rates make it more expensive to finance a house, for example. Companies looking for financing have to deal with higher credit spreads on top of rising interest rates. Since the early 1980s, bond yields have fallen continuously, but every time interest rates rise as sharply as they have in recent months, a financial problem reveals itself not long afterwards - a real sell signal in that respect. Consider the years 1987, 1994, 2000, 2007 and 2018. Each time, the financial problem forced the Fed to cut interest rates. The difference with said previous years is that then inflation was never a problem. Now inflation is, thanks in part to the coronavirus and Vladimir Putin. The reason the stock market is rising last month is that there is no alternative, even for the money flowing out of the bond market. Part of it, therefore, goes almost automatically to the stock market. In doing so, the market is ignoring important developments. For example, the economic impact of the war in Ukraine increased sharply last month due to the heavy sanctions. This is reflected in the sharp increase in oil prices last month. There is a good chance that certainly in Europe, monetary policy will soon be determined by geopolitical factors and not by interest rates. A further rise in oil prices would mean that inflation could remain high for much longer. Inflation expectations rise as a result and the Federal Reserve responds with faster interest rate hikes. This picture would not change if the war in Ukraine ended tomorrow. Rather, the fact that the US president is pushing for a changing of the guard in the Kremlin is a dangerous escalation. All wars cause more inflation and the one in Ukraine is no exception in this respect. And this is at a time when inflation has already risen sharply as a result of corona. As a result, this war will have the same effect as the oil shocks of 1973 and 1979. Only in 1973 inflation in the United States was 7.3 percent, now 7.9 percent, and unemployment was 4.6 percent compared to 3.8 percent today. In October 1973, the Federal Reserve raised interest rates to 11 percent, doubling from the beginning of that year. The U.S. government budget deficit - despite the war in Vietnam - was 1 percent of GDP then, 12 percent now. The big advantage now is that energy is a much smaller part of the economy than it was in the 1970s. Still, getting current inflation under control will not be easy. Fed President Paul Volcker needed a positive real interest rate of 5 percent in the early 1980s to do so. That would mean at current inflation rates that the Fed's policy rate would have to go to the 13 percent range. Thus, the picture of the financial markets can change in just a few weeks. Oddly enough, the consequences at the portfolio level are not as great as many would think. A logical reaction might be to sell everything, but when inflation is a major risk, there are few alternatives besides equities. Of course, there are alternatives outside the stock market such as residential real estate. Even private equity offers better protection against inflation than listed equities. The best returns are achieved even when there is a recession. In the stock market, inflation will increase the divergence between countries, sectors and currencies, but after the initial shock, wars are, on balance, good for equities. War is first and foremost an economic struggle that requires a lot of innovation and adaptability. This time, additional investment is needed in the energy transition, new supply chains, defence and food security. On top of this, countries and regions are investing in various areas of self-sufficiency, even though more should already be invested due to the tightness of the labor market. Equities, therefore, remain the favorite, but savers and bondholders are the losers, given the still extremely negative real interest rates.