Escalation And Expansion

By Peter Tchir of Academy Securities

Escalation and Expansion

It isn’t often that one title can encompass geopolitics, the economy, and markets, but “escalation and expansion” covers all three quite well this week.

Escalation and Expansion – Geopolitical

By the time that you read this, the situation may have shifted dramatically, but Friday night’s SITREP – U.S. Commences Retaliatory Strikes is great background in any case.

I went with “Escalation and Expansion” this week, as General (ret.) Marks used the phrase on several of our calls and I thought that it captures the risk better than just “escalation.”

The conflict in the Middle East could escalate, it could expand, or it could do both. As of now, the risk of both occurring is real.

On the flip side, another phrase you are likely seeing (or hearing) more frequently is “escalate to de-escalate.” The theory is that if the U.S. escalates and flexes its military might, then Iran and the “proxies” may back down. In addition, the fear of an ongoing and strong attack phase from the U.S. is enough for the adversaries to back down. That hope could be accompanied by back-channel messaging pointing out that this was retaliation (the proverbial “eye for an eye”) and if no further provocation is given, then the U.S. can step down its efforts.

Without a doubt, the “escalate to de-escalate” strategy would be best for the U.S. and its allies, as well as markets and the global economy.

What remains to be seen, as of the time of publication, is whether that’s how Iran and/or the proxies see it. Maybe they want to challenge the U.S. further? Maybe they doubt our commitment? General (ret.) Ashley often points out a famous quote in our meetings. To paraphrase the quote (which isn’t his; he just references it) – the enemy used to respect us and fear us, but while they still respect us, they no longer fear us. That could be put to the test in the coming days.

If we see de-escalation:

• Not much will happen. Shipping won’t return to normal. Maybe if there is some multinational truce reached, we could see that, but I’m not even sure how that could be done logistically with entities like Hamas or the Houthis. De-escalation is better than the alternative, but it is no panacea for global trade or the region. It would just take the region back to where it was a few weeks ago.

If we see escalation and expansion, or “retaliation for the retaliation” by Iran and/or proxies, two things will be crucially important for the impact on the economy and markets:

• Does Iran’s production and sale of about 3.5mm barrels of oil a day get put in jeopardy? That number comes from sources in the energy sector who have proven right time and again, which is why I use it as my base case for Iranian production and shipments. Brent crude, the best measurement for current Middle East fears, has backed off in price terms. It is back to $77 a barrel from $83 last Friday. It was at $90 in September (before the conflict) so a price of $90 seems easily reachable if the escalation and expansion of the conflict occurs (dragging the U.S. and Iran into more direct conflict).
• What does China do? While the most obvious thing to think about is oil, it makes sense to think about how China might respond.
• At Academy Securities, the working assumption (based on an overall assessment from our Geopolitical Intelligence Group) is that China may have had advanced warning of Russia’s invasion of Ukraine and gave Putin “tacit” approval at the very least. Our working assumption is that China, like much of the rest of the world, was surprised by how ineffective the invasion was, and is likely unhappy that the war is ongoing. Nonetheless, they have continued to purchase Russian commodities and have not done anything publicly to demonstrate that they want Putin to end the conflict.
• The events in the Middle East are very different. No one in the Geopolitical Intelligence Group thinks that China had any knowledge or forewarning of the attacks in the Middle East. China was as surprised as anyone else. While China is buying Iranian oil, there is no indication of any involvement (tacit or otherwise) in the ongoing conflict. Having said that, if we see much more of a direct U.S./Iran engagement, will it be difficult for China not to “take sides”? Will they come down hard on Iran? Boycott oil? Or will they continue “business as usual” with Iran even as the conflict escalates and expands? The take from the Geopolitical Intelligence Group is that China would come out in a way that supports global trade (i.e. against the proxies), but that is barely consensus and certainly not a universally held opinion. For what it is worth, I lean towards a “business as usual” case, but I am influenced by my own theory that we are in the early stages of a transition from “Made in China” to “Made by China” where they do not need to care as much about trade with the U.S. and even (to a lesser extent) Europe.
• Whatever China does (in the event of escalation and expansion) will shape the geopolitical, political, and economic landscape for the foreseeable future!

Hopefully, it doesn’t come to the escalation and expansion case, as cooler (or more cautious) heads prevail, but if it does, China’s reaction could be more important than whatever oil does, though the two will go hand in hand to a large extent.

Escalation and Expansion – Economic

The STUNNING Job Report on Friday could signal a massive shift in how I think about the economy. Even in our instant reaction, we felt obligated to write “if it is true” because the report seemed too strong to be true. It defied some other data like the ADP report, the JOLTs quit/hire rates, etc. January is notoriously difficult to estimate the “seasonal effects” which could come into play. Unable to work due to the weather may have played havoc with the wages. I’m not the only one who seems to question the validity of the report. You can find some interesting take downs, some focus on the ongoing shift from full-time jobs to part-time jobs (published in the Household survey), and the potential over-reliance on the birth/death model.

My view is that the job report was stunning, but I’m skeptical of its veracity. Certainly, if it is an accurate representation of the job market, we may have to skip all the “landing” metaphors and call it a trampoline, or something else that propels us higher as we touch down.

We have had some “surprising” data recently. The Citi Economic Surprise Index touched 0 in the middle of January, but a string of “surprising” data has pushed it higher!

As you will see in the chart below, that was after a steady decline in this index. The index is always fascinating because it reflects the data relative to expectations. As we start seeing a decline in the index, it is usually accompanied by analysts reducing their forecasts. The index rarely bottoms or tops out due to the absolute level of the data, it is because expectations have become too optimistic or pessimistic.

So, a chart like this tells me that we could start seeing economists ratcheting up expectations! If the data keeps outperforming, the natural reaction (certainly from a “consensus” point of view) is to increase your forecasts. That can propel markets higher as that change in sentiment in economic outlook will translate into increased bullish sentiment.

I doubted some of the “surprisingly” good data.

• GDP is “old” by the time we get it.
• Consumers spent.
  • But they used credit cards and pushed outstanding consumer credit back above trend lines, dispelling the idea that we are “just getting back to normal” on credit.
  • Sales seemed to be earlier and more aggressive than usual, so some of the spending may have been demand that was pulled forward, leading to disappointment in the coming weeks and months.
• Jobs. If anyone believed in ADP, the Household survey, or even the JOLTs quit and hire rates, then the job market would look as blasé as I think it is.

In any case, I need to revisit all the recent data and decide if I’ve been too negative on the direction of the economy. I haven’t been super bearish on the economy by any stretch of the imagination (mild slowdown, very industry specific, and somewhat rolling/regional rather than all at once/national), but I certainly wasn’t betting on escalation and expansion!

This is the first time in months that I’ve felt the need to step back and see if I’m not giving the economy enough credit! I think that I have it right, but after the streak of surprises and a stunning (if you believe it) job report, it would be malpractice not to rethink my stance. More on that is coming up as we start the week.

Escalation and Expansion – Markets

“Magnificent” is a massive understatement of Meta’s performance on Friday. The stock added just under $200 billion to its market capitalization in a single trading session! If a trillion-dollar company jumping 20% in a day isn’t escalation, then I don’t know what is!

The Nasdaq 100 gained about 3% in 2 days! Again, that seems like “escalation” to me! Having said that, it is only up 0.7% since Thursday January 25th which is a little less eye-popping.

Unfortunately, at least for an overall perspective, we haven’t seen true “expansion.” While the S&P 500 has done a bit better than the Nasdaq 100 for the past week or so, the Russell 2000 continues to underperform and was down on the week.

If economic growth is escalating and expanding, should the stock market be too?

We got the escalation, at least in some stocks, but the expansion to a broad market rally, like we had from mid-November to mid-December last year, hasn’t really returned.

While it is impressive that a mega-cap (I think $1 trillion is mega-cap territory) can jump 20% in a day, it is also somewhat disturbing as it seems frantic (yes there were all sorts of likely reasons, from buybacks, to dividends, to internal growth, to cost cutting, etc.), but I can’t get it out of my thick skull that 20% for a widely followed company (or $200 billion) seems atypical of what you would expect in a “normal” market. Not saying to fight it, just saying it is weird.

I have not been a fan of the so-called “laggards” for some time with the exception of commodities and commodity stocks which are meandering along.

I highly recommended CRE and regional banks for much of last year, starting in April after the mini “banking crisis” created great value. That stopped again, in late December, and I cannot decide if last week’s sell-off is a great buying opportunity or not. KRE, a Regional Bank ETF, dropped over 9% from Monday’s close to Thursday’s close. Part on the Fed and part on renewed fears of the health of smaller banks.

If the recent spate of good data can be trusted, this is a buying opportunity! If problems are only manifesting themselves now as loans mature or need to be rolled over (as we are seeing in some recent announcements), then it is too early to wade back in. I continue to believe that 2024 will be the year of Work from the Office, which will support CRE in many locations. The Fed is done hiking and even if I’m right on rates (10s to 4.3% and then 4.5% with 2s versus 10s going back to positive spreads), CRE can do well. Big banks (and many of what people refer to as “regional” banks, which are also pretty darn big banks) will do well and come out not just unscathed, but also with new opportunities.

Basically, if I believed the economic data, I’d have to be pounding the table for expansion across all equities, but I cannot quite get there. Maybe I should, but I cannot, at least not today.

Bottom Line

I’m not convinced that the economy is about to take off, but I am re-evaluating that – URGENTLY!

Having said that, I still like credit. Yes spreads are tight, but I think that credit (corporate, structured, munis, etc.) should be heavily overweighted in any fixed income portfolio.

Still in the higher yield camp, but that was all over the place this past week.

I hope you enjoy the new delivery/formatting that Academy has instituted for the T-Report! It is a work in progress, but hopefully it allows you to receive and access our content more conveniently!