"Quantitative Easing" or QE, may be a more familiar concept to readers, since we have been experiencing some form of QE (monetary stimulus) since the Financial Crisis of 2008. QT is the opposite. The Fed first tried to reduce its balance sheet back in 2018-2019. The stock market had such a hissy fit that the double-digit melt down that ensued convinced the central bankers to back down in their attempt to normalize their balance sheet. By the end of 2018, the Fed was allowing $50 billion/month to run off its balance sheet. Market turbulence erupted almost immediately and by March 8, 2019, the Fed under Jerome Powell, turned the money spigots back on and reversed the easing that "no longer seemed necessary." The crisis was over, and so was QT.

 

The problem, however, is that investors have become accustomed to the low interest rate environment that the Fed engineered through asset purchases and low interest rates. It has become an essential prop holding up equity values, which have climbed higher and higher.

 

Every time the Fed has sought to drain liquidity from the banking system, the stock market has reacted by staging a Taper Tantrum. There was one in 2013, another in 2019 and we are in one now.

 

Fast forward to the coronavirus pandemic when the Federal Reserve Bank bought a massive $3.3 trillion in U.S. Treasuries, and $1.3 trillion in mortgage-backed securities to support the markets. Those Fed purchases have not only contributed to the massive gains in the stock market in 2021, but also contributed to the present explosion in the inflation rate.

 

On April 6, the FOMC minutes of the Fed's March 15-16, 2022, meeting became available. The notes showed deepening concern among members that inflation had broadened throughout the economy. Most policymaker were prepared to raise interest rates in May by 50 basis points and continue these half-percentage-points hikes in coining policy meetings.

 

They also supported a second try at reducing the Fed's holdings of Treasury bonds. Up to $60 billion per month of U.S. Treasury bonds will be sold as well as reducing $35 billion per month in mortgage-backed bond holdings. That is nearly double the Fed's QT program from 2017 to 2019. By reducing the balance sheet, while moving the short-term, Fed funds rate higher in 50-basis-point increments. The Fed is again taking away the punch bowl for equity investors.

 

The news may have shocked most investors, but unfortunately it was part and parcel of why I have remained relatively bearish throughout the year thus far. Will investors double down on dumping equities or will they calmly go to the slaughter ahead?

 

I fear that an even worse sell-off may be ahead of us sometime in May 2022 when the Fed begins implementing QT.  The stock market has been practically straight down most of the week on news of this plan. I advised readers last week that the stock market had become too "frothy" after the bear market rally of last month. I wrote that we could see a pullback to "between 4,400-4,500 level on the S&P500 Index." We have accomplished that, and I am now looking for a relief rally that should continue for a week or two. After that, we face earnings season and the next Fed meeting. Strap in.

Defense stocks have soared since the outset of the Ukraine-Russian conflict. That is a typical reaction to geopolitical strife. Frequently, investors bid up the sector only to sell these stocks once peace returns. This time may be different.

 

Vladimir Putin has put the world, and specifically Europe, on notice that he is bound and determined to resurrect the formal might of the USSR, no matter how long it takes. His actions have caused a sea of change in Europe's decades-long freeze on defense spending. Germany is a prime example of what analysts believe will be the beginning of a new era of inflated European defense budgets.

 

In February 2022, Chancellor Olaf Scholz argued before the German Parliament that the invasion "was a turning point in the continent's history." In order to prepare his country for this new reality, he immediately doubled Germany's defense budget from 47 billion euros to 100 billion. Several European Union (EU) members are planning the same thing. Finland, Sweden, the Netherlands and the UK have been first to declare their intent to beef up defense spending and more countries are expected to follow. The intent is to raise defense spending by NATO members to more than 2 percent of GDP.

 

And while the Ukraine War is serious enough to goose spending for planes, tanks, drone, rockets and such, the shooting war simply adds to a long list of mounting hostilities in an increasingly dangerous world. The threat of China and its ambitions to annex Taiwan, North Korean missiles, incessant warfare in the Middle East, rebel movements in Africa, and regular instances of cyberwarfare have kept defense spending high throughout the last several years, at least in the U.S.

 

The U.S. defense budget has been stable and rising given the quantity of perceived threats. As a result, the defense and aerospace sector have been quietly outperforming the market's returns for the past eight years or more. Thanks to the pandemic, and resulting supply chain issues last year, the industry experienced reduced production, but with the down swing in coronavirus cases (at least in the U.S.) production is getting back to normal. Most Wall Street analysts are expecting government defense expenditures to rise from about 2.8 percent to a range of 3.5-4 percent in the next few years.

 

From an investment point of view, the defense stocks move in cycles; roughly gaining for 7-8 years, underperforming for 2-3 years, and then growing again for another eight years or so. From 2020 to 2022, the industry underperformed, thus setting investors up for what could be a spate of outsized gains.

 

If we look back during the last 20 years of U.S. involvement in the Middle East, defense stocks such as L3Harris Technologies, Northrop, Lockheed Martin and Raytheon gained respectively 1,399 percent, 866 percent, 800 percent and 509 percent compared to the S&P 500 Index advance of 297 percent from 2001 to August 2021. I am not cherry-picking results either; most defense stocks have had similar returns.

 

Obviously, government spending is the largest customer of defense companies. At least 19 members of Congress (or their families) are personally invested in defense contractors, and some of them sit on congressional committees that regulate defense policies. I will avoid the obvious conflict of interest issues that this might raise and just remind readers that politicians on both sides of the aisle have good track records in investing in stocks that they can influence.

 

All indications are that the war in Ukraine is moving to another phase. Military experts expect the war will continue and may evolve into a protracted war of attrition. The China threat is not going away, and now that most western nations are rethinking their defense spending, it appears that we may be starting on a new multi-year cycle for defense stocks.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.

Speculation is not quite rampant but it's getting there. Volume is tailing off and the short covering that has boosted this market higher is fizzling. These are signs that beg for a nice sharp pull back that is overdue.

 

As I have been suggesting (hoping) over the last two weeks, negotiators from Russia and Ukraine are making progress. Investors are beginning to hear more positive statements from both sides. A combination of factors are pressuring negotiators to cut a deal that would be acceptable to both heads of state. I expect that to happen soon.

 

Remember that we are now approaching planting season in the Ukraine. The spring thaw will also make mobility difficult for the invading forces. The Russian army seems to be pulling back in some areas but bolstering its forces in others. I suspect that has more to do with the Russians' strategic intent to capture and hold areas that contain Ukraine's most valuable energy resources.

 

The stock markets' "fear" trades have already begun to dissipate as evidenced by the slide in oil prices. The red-hot price rise in wheat and fertilize stocks are selling off, and gold is faltering as well. But notice that all this good news on the geopolitical front during the past week has not moved the overall averages up by much. That is a tell-tale sign to me that the good news may have already been discounted and it may be time to take some profits on some of the gains we have enjoyed recently.

 

Of course, the flattening of the yield curve, which inverted for a brief time on Tuesday and Thursday, March 29-31, had the bears jumping up and down. A flurry of bearish commentators lined up to solemnly predict the curve will invert further and a recession is right around the corner when it does. What is an inverted yield curve, you might ask, and why is it so important?

 

According to Investopedia, "An inverted yield curve occurs when short-term debt instruments have higher yields than long-term instruments of the same credit risk." An inversion is the first sign that the long-term growth prospects of the economy are in trouble and have preceded every U.S. recession in the past 50 years. Typically, a recession has followed in the two years after an inversion of this measure.

 

However, before you leap into the lifeboat, remember the same thing happened in August 2019. I warned readers at the time not to jump ship, because I believed the condition was temporary. It was, and I think this time around the same thing may happen. If, over time, all the short term, versus long-term, debt instruments — one month, three-month, one-year, two-year, five-year, versus 10-year, 20-and-30 year — were to invert, well then that would be a horse of a different color. We are not there yet.

 

But my optimism concerning the longer-term prospects of the economy doesn't necessarily translate into the short-term prospects for the stock market. I believe that the financial markets are still not out of the woods. This relief rally off the lows is a bear market bounce in my opinion. It has further to go, but a day or two of pullback next week would be helpful. Unless the S&P 500 Index closes between 4,400-4,500 today (Friday, April 1), I expect next week we will work off some more of this froth.

 

Sometime in late April or May, we may see a return to the bottom once again. Why do I believe that when the latest data show unemployment dropped to 3.6 percent? A combination of persistent inflation, a slowing economy, expected tepid corporate earnings, and an even more hawkish Fed will simply be too much for the markets to take on board.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.