John Authers

Dangers of a ‘Pulp Fiction’ Moment in Ukraine

One of the best moments in “Pulp Fiction” comes when Samuel L. Jackson is questioning a hapless victim and breaks off to shoot someone else in the head. “Oh I'm sorry, did I break your concentration?” he says.

In the same way, it’s very easy for what now looks like the possible imminent invasion of Ukraine to break everyone’s concentration. There are very good reasons why it should. Many established certainties of the world order would be scrambled by such an event, while in markets it is reasonable to assume that such a shocking incident would lead to lower bond yields once more, and higher oil prices.

So, to guard against the risk that we’re all about to have our concentration broken by a Tarantino-esque shock in Ukraine, here are a few of the issues that are already easy to miss amid what have been a dramatic few weeks on capital markets.

First, it's always important to keep an eye on the credit market. Higher rates would logically lead to some kind of problem with solvency, and so it’s encouraging that to date the spreads of high-yield bonds compared to Treasuries remain historically low, even though they’re back up to their highest in some months. It is hard to discern any serious angst in the credit market at present.

Turning to inflation, the issue of the moment is that unless Vladimir Putin decides to break our concentration, an analysis by the Institute of International Finance demonstrates that the return to inflation of the last few months has been driven by prices in goods, even though services make up a large part of the basket in the US these days.

A chart produced for the new newsletter by Andreas Steno Larsen shows that the acceleration in goods prices has been driven almost entirely by demand. With services demand now approaching pre-pandemic levels, there is a chance that inflation itself will begin to normalize.

One of the points that could easily be missed is that the inflation problem in the euro zone, and particularly Germany, is growing fast in severity. Using the IIF's measure of how generalized rising prices have become across the economy, we see that Germany now has a much more serious problem than it had a decade ago and leads the euro zone. Even though there appears to be far more slack in the European economy, a real risk exists that the European Central Bank will be forced into tightening monetary policy earlier than it hopes.

Another issue to keep in mind, despite the distractions, concerns corporate profitability and the potential political effects it could have. As Dario Perkins of TS Lombard shows, the crucial difference between the last two decades and the 40 years before them, at least as far as monetary policy has been concerned, has been in companies’ pricing power. Over the last 20 years, a better deal for workers has not been passed on into higher prices. In the latest earnings season, plenty of firms have been happy to report the ability to raise prices, and this helped limit the damage to share prices over the last few weeks. But on the face of it, this isn’t good news for the inflation outlook. For investors, the risk is that what companies give by being able to extract higher profit margins, they’ll also take by forcing higher rates and lower earnings multiples.

On the subject of the earnings season, perhaps the single most important trend to emerge is that companies are markedly less optimistic for the future. My Bloomberg Opinion colleague Jim Bianco said companies are suddenly guiding more bearishly than they’ve done in a decade. It’s been easy to miss amid the excitement over inflation, not to mention the possibility of war in Europe and the continuing pain of the pandemic. But it would be wise not to ignore.

If worse comes to worst in Ukraine, then we will all be forced to contend with a new and more dangerous reality. The effects on bonds and commodity prices could certainly affect the economic dynamics in the West. But it’s just as well not to let an invasion break our concentration completely.