Geopolitical Conflicts, Commodities, and the Securities Markets
When discussing recent headlines, it is difficult to avoid a mention of the conflict in the Middle East. It feels insensitive to examine the economic ramifications of such a conflict when it so clearly involves great human suffering which is by far more important than securities markets. Unfortunately, markets discount everything including wars and investors often wonder how such events could affect their portfolios. To that end, I will limit the scope of this examination to help our readers understand the economics of geopolitical conflicts.
Hamas carried out an attack in Israel on October 7 and as can be seen in the charts below, the markets have not yet reacted strongly to the conflict. The vertical line in the charts represents October 9, which was the first trading day after the attacks. While the major indices have been down since then, they are pretty much on the previously existing trendline. While oil prices are up, they haven’t made new highs.
Major US Stock Indices – 1Yr
Spot Oil Prices, Daily – 1Yr
To oversimplify, the stock market is most likely to react to any geopolitical conflict if it is perceived to have the potential to impact the supply of, or demand for, commodities. In the case of Ukraine there were concerns about wheat and natural gas. In the case of the Middle East, the concerns are usually centered around oil. Oil prices are reflected in the costs of most goods because it impacts the cost of transporting goods and other commodities. So surging oil prices could be a catalyst for lingering or even increasing inflation which could have an impact on interest rates.
This is an evolving situation and may change from the time of writing to the time of publication. Unfortunately, at the time of writing, there has been recent news of fighting in Lebanon (ABC News) and Syria (the Hill) as well which could indicate a widening conflict. If the conflict were to broaden and lead to damage of significant oil infrastructure, that could certainly be the cause of a surge in oil prices. For humanitarian reasons more so than financial ones, I hope the situation does not escalate further.
What’s going on with the US Money Supply?
Over the last year or so I have seen the US money supply (M2) referenced a few times in alarmist tones, the most recent of which was this article in the WSJ Opinion section. The M2 money supply is “the U.S. Federal Reserve’s estimate of the total money supply including all of the cash people have on hand plus all of the money deposited in checking accounts, savings accounts, and other short-term saving vehicles such as certificates of deposit (CDs)” (investopedia). The article makes the claim that “the money supply has been contracting for 18 months, and soon, after the overhanging extra money from 2020-21 has been used up, spending will plunge and inflation will fall, not simply to 2%, but below—and perhaps even into deflation in 2025.” The article also points out that “between July 2022 and August 2023, the M2 supply contracted by 3.9%, the most extreme contraction since 1933.” If you look at the 18 month M2 graph (below) with that in mind, it seems alarming.
M2 Last 18 Months
However, if you expand the chart out to the maximum time frame (below) it becomes apparent that not only is the M2 money supply historically elevated, but it also blasted off in 2020 as a result of unprecedented fiscal stimulus and monetary policy easing, completely changing trajectory from the trend it was on from roughly 2010-2020. Now admittedly the trajectory has changed over time, M2 growth has been accelerating since 1959, and charts can only tell us what has happened, not why or whether it makes sense. It’s a fool’s errand to try to predict anything from a chart and a single data point. However, the rate of change certainly looks out of the norm from the rest of the historical data. It is possible that this is the new trajectory, but it’s also possible that an artificially inflated money supply is just now moving back in line with the previous rate of growth. The bottom line being that adding context to the claim changes the perception. This isn’t to dismiss out-of-hand the notion that M2 money supply is an important economic indicator, it may very well be. We may see unemployment increase, but that would be from historically low levels. The real point is to ask if the data truly supports the headline claim of “another black Monday” around the corner.
M2 1959 – Present
The Federal Reserve interest rate decision meeting is coming up.
The Federal Open Market Committee is meeting again October 31 and November 1 to discuss interest rate policy and so I am compelled to comment on it once more. The overwhelming expectation is that the federal funds rate will not change at this meeting and this message was reinforced in a flurry of Federal Reserve speakers over the last few weeks. As of the time of this writing the markets are betting that the Fed is done raising rates and that there will be two or three rate cuts in 2024 beginning in June, but those expectations are always subject to change.
There has certainly been a significant amount of bond market volatility of late with the 10-year US Treasury yield flirting with 5% for the first time in a long time. Keep in mind that when bond yields go up, bond prices go down. There are several factors that could explain rising bond yields. For one, the Federal Reserve isn’t just increasing the federal funds rate and holding it high. They are also shrinking their balance sheet, which means they are not acting as a buyer of bonds in the market and are, in fact, allowing bonds to mature without purchasing more. With the Fed being a major player in bond markets, the absence of this buyer is resulting in falling bond prices. In addition to that, the Treasury is issuing debt (selling new Treasury securities) to finance operations. This means that supply is increasing even more while demand is not following suit. Add to that some foreign entities selling Treasuries for various reasons and the back and forth of safe haven buying and selling as investors variably brace for worsening geopolitical tensions, and then reverse those expectations, and you’re left with an unusually “exciting” bond market.
The good news for bond investors, despite the volatility is that bonds are paying a decent income once again after many, many years, and the Federal Reserve Chairman himself has admitted that interest rates are at a “restrictive level” which would indicate that they will come back down at some point in the future. Nothing is ever guaranteed in the markets and new information and events could change that outlook, but when interest rates fall, bond prices rise. So, if we really are approaching peak rates and the federal funds rate is at a restrictive level, then bond investors potentially have price appreciation baked in and get to enjoy a decent interest rate for the time being.
Is bitcoin finally an uncorrelated asset?
To end on a lighter note, I had a recent discussion with a friend who brought to my attention that the first ever bitcoin spot price ETF is nearing fruition. Then only days later a headline hits my inbox that Bitcoin Hits $35,000 for First Time Since 2022 on ETF Optimism and I couldn’t resist a quick explainer.
For those who want to invest in bitcoin there are essentially 2 options. They can buy the coin directly on a crypto exchange or through a broker who offers this service and store it in a digital wallet, or they can buy a bitcoin futures ETF (Investopedia). Technically there are other options like bitcoin ATMs and P2P networks, but let’s keep this simple. The problem with buying bitcoin directly for many investors is that it requires a degree of technical knowledge that might be prohibitive such as setting up a digital wallet and maintaining sufficient security. A lack of technological expertise and proper security procedures increases the risk of direct ownership of bitcoin. Major players in asset management have been pushing for bitcoin ETFs for a few years to allow more investors to access investment in bitcoin without needing to own the coin directly. Asset managers would like to offer a spot price ETF, but currently the only bitcoin ETFs on the market are futures ETFs. A bitcoin futures ETF is a pooled investment vehicle which doesn’t own bitcoin, but rather owns futures contracts on bitcoin and uses these futures contracts to attempt to track the price of bitcoin. By comparison, a spot ETF would own actual bitcoin giving clients more direct access to the actual price of bitcoin (ETF). Investors in a bitcoin spot ETF still wouldn’t own bitcoin directly; they would own shares of an ETF that owns bitcoin directly. Regardless, this would mean potentially increased demand for bitcoin as the universe of potential investors would expand to anyone with a traditional brokerage account.
One of the claims of bitcoin bulls is that it can be an uncorrelated asset, meaning that it isn’t tied to the performance of traditional investments like the stock market. However, for quite some time the price of bitcoin has largely tracked the performance of tech stocks and the Nasdaq Composite Index. In the chart below it’s clear that the price of bitcoin often moved in the same direction as the Nasdaq with a couple of exceptions over the last three years. One of those exceptions has been year-to-date 2023 with the Nasdaq lifting off with the help of the Magnificent Seven tech stocks while bitcoin traded somewhat flat. Recently the Nasdaq has been on the decline and bitcoin price has surged. The recent surge in bitcoin price could be attributable to excitement about the launch of one or more bitcoin spot ETFs. However, viewing this as a signal that the positive correlation between bitcoin and tech stocks is breaking down in a sustainable way may be a bit presumptuous. If a bitcoin spot ETF does launch it is possible the infusion of more capital into the bitcoin market would buoy the price of bitcoin for a while, but that doesn’t fundamentally change anything about bitcoin. At the very least it is too early to call whether the lack of correlation in 2023 is a sign of things to come.
Bitcoin Price and Nasdaq Composite Index – 3Y
What do attention-grabbing news headlines really tell us?
The purpose of this exercise of examining attention-grabbing news headlines is to engender a skeptical attitude in readers. There are always news headlines, and they almost always focus on disasters, sensationalism, and creating fear and anger because that’s what gets clicks and keeps eyeballs on screens. To find sources that focus on good news, one must actively seek them out. Our attention is a commodity that is constantly being traded. The problem for the average investor is that taking these headlines seriously can lead to knee-jerk reactions that leave investors worse off in the long run. As Dylan pointed out in this newsletter a couple of weeks ago, individual investors don’t have the same investment goals or time horizons as investment managers who focus on quarterly performance and the ultra-wealthy who have so much wealth it’s practically an abstract concept. The real valuable financial advice is not attention-grabbing or exciting. It’s boring and has been effective over the long run. Have a plan, update your plan regularly as life inevitably changes, diversify, save, budget, and have conviction that all this hard work will pay off in the long run. I’ll end today’s newsletter with one more bit of good news on the state of American wealth. The recently released Survey of Consumer Finances showed that real (inflation-adjusted) American wealth grew between 2019 and 2022 and that America has made progress on wealth equality.
DISCLOSURES: This newsletter may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss to the investor. Investment strategies, philosophies, and allocation are subject to change without prior notice. This newsletter is intended to provide general information only and should not be construed as an offer of specifically tailored individualized advice. While H&R believes the outside data sources cited to be credible, it has not independently verified the correctness of any of their inputs or calculations and, therefore, does not warranty the accuracy of any third-party sources or information.