by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment begins with a discussion about why countries are ok with tight fiscal and monetary policy even when their economies are barreling toward recession. Next, we review what a possible reprieve in geopolitical tensions could mean for commodities. Finally, we provide our latest take on the FTX collapse and what it may say about risk assets.

 No More Cake: The prospect of recession has not encouraged policymakers to push through measures to stimulate the economy.

• Chancellor Jeremy Hunt revealed a budget proposal to raise over £55 billion through tax increases and spending cuts on Thursday. The plan includes increasing windfall taxes, pushing more people into the top tax band, and cutting household energy subsidies. Hunt’s heavy-handed proposal will reassure the market that the government is serious about maintaining sound fiscal policy as the country copes with elevated inflation. In his speech, Hunt admitted that the U.K. economy would shrink next year. As of this moment, the British sterling is down 0.7% against the dollar as investors are now concerned about the economy’s viability.
• In the U.S., equities are trading lower following comments by Fed officials suggesting that the central bank is not prepared to pause. After the October CPI report showed that inflation was falling faster than most anticipated, investors began pricing in the possibility of a Fed pause for early 2023. Fed Governor Christopher Waller has challenged this sentiment by emphasizing that one report does not make a trend, dismissing the possibility of an end to hikes. Fed tightening could make it more difficult for the economy to grow, and thus, raise the likelihood of a recession.
• These developments reinforce the view that governments are more focused on taming inflation than they are on promoting growth. A possible reason for this preference can be related to the low unemployment numbers. As demonstrated with the Phillips curve, there is a general trade-off between inflation and the unemployment rate. Theoretically, higher price levels allow firms to hire and maintain a larger workforce. As a result of higher employment levels, a recession may be less politically costly for policymakers, thus paving the way for hawkish policies. Although this could mean more monetary and fiscal responsibility among policymakers, it will also deny financial assets of additional stimulus. Hence, the easy money days may not be back for a long-time.

Remain Calm: Geopolitical tensions among major powers have cooled much to the relief of markets.

• China and Russia are relatively more sanguine, as both appear open to de-escalation while the global economy begins to slow. On Thursday, Moscow agreed to extend the grain deal with Ukraine. Meanwhile, Chinese President Xi Jinping was somewhat restrained in his comments during the G-20 gathering. However, he did chastise Canadian Prime Minister Justin Trudeau for leaking their discussions to the press. The latest developments have made investors more confident that tensions are easing. Equities sustained a brief rally following remarks from Xi and President Biden at the G-20, while grain prices fell following the announcement of the wheat deal. That said, it is unlikely that this optimism will last for long.
• The shift in these countries’ sentiments is likely related to the slowing global economy. On Thursday, economic data revealed that Russia fell into recession. New data showed that its GDP shrank by 4% from the prior year for the second consecutive quarter. At the same time, onerous COVID restrictions and a property market crash have made China more reliant on export promotion for growth. The weakness in their respective economies may have forced them to modify their stances. In the long run, these countries would like to become self-reliant, but they would like to do so at a moderate pace to avoid outraging the public. As a result, the path toward deglobalization is likely to be done at a plodding pace.
• Russia and China’s calmness won’t fool anyone. Western countries are determined to contain the two. On Thursday, Germany and France greenlit a project to develop fighter jets. The increased military spending reinforces our view that the aerospace and defense industries may have attractive investment opportunities, particularly for international firms. Yet, despite the West being undeterred, commodities appear to behave as if tensions have declined. One reason crude prices have softened is due to an increase in optimism among traders that geopolitical tensions are easing. If this trend continues, the drop in commodity prices should boost the global economy and reduce inflationary pressures.

 FTX Saga Continues: The fallout from the collapse of FTX has spilled over to other areas of the crypto market.

• Several crypto platforms have announced new restrictions on trading after FTX filed for bankruptcy. On Wednesday, Gemini exchange paused withdrawals from its interest-bearing Earn accounts; meanwhile, Genesis Capital Management halted new loan originations and redemptions. Crypto firms implemented these new limits to prevent a run on assets; hence, the move suggests a broader panic throughout the market. These stringent measures will undermine outsiders’ already shaky confidence in cryptocurrencies. As a result, cryptocurrencies will struggle to find newcomers, therefore making these digital assets less useful for portfolio diversification purposes.
• There are growing calls for more regulation and oversight of cryptocurrencies as the ongoing crisis has drawn comparisons to the fall of Lehman Brothers. The Security and Exchange Commission and the Commodity Futures Trading Commission are both vying for jurisdiction over the crypto market. The new legislation pushed by Senator Elizabeth Warren (D- Mass) would allow regulators to consider consumer protection, anti-money laundering, and protection of the climate from crypto mining. Although the concerns are not new, the crisis appears to give crypto regulation new life.
  • There is also talk about a potential crypto central bank run by Binance, though that may lead to other complications.
• There are no signs that the crypto meltdown will bleed into the broader financial system. However, the crisis shows how new asset classes created by ultra-low interest rates can lead to market bubbles. Central banks’ decisions to drop rates to rock-bottom levels meant market participants had to invest in risky assets in order to find yield. As a result, institutions created new financial products like crypto for investors looking to gain a positive return on their excess cash. When central banks began raising rates to fight inflation, investor returns moved away from risky assets and into safe havens. Thus, the recent market rout exemplifies how these innovations can struggle to survive in a normalized world. Although we are not expecting an imminent financial crisis, we do believe there is an elevated risk while the Fed continues its tightening cycle.

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