What Kabul means for U.S. markets

Babies razor wire

By David Nelson, CFA CMT

Friday’s feel-good rally wasn’t enough to keep the major indices from slipping into the red for the week. The tragic scenes in Kabul, mounting foreign policy challenges for the President along with a wave of economic data less than ideal proved too much for stocks as investors dialed back exposure.

While there is a very real human and political cost to the events unfolding in Afghanistan the market and economic implications for investors can’t be ignored. With an evenly divided Senate and a narrow majority in the House the Democratic economic agenda always faced an uphill battle. A $1.2 Trillion bipartisan infrastructure package along with a $3.5 Trillion Democrat only spending plan will be that much tougher as the news cycle in Kabul continues to suck up the oxygen in the room.

House returns from recess


Speaker Pelosi is facing party infighting as 9 centrist Democrats led by Rep. Josh Gothheimer (D-NJ) have signaled they will not vote for the larger package unless the bipartisan infrastructure bill is put up for a vote first.

Scenes of Afghans falling from planes and babies being handed over razor wire replace images of crumbling infrastructure and electric vehicle charging stations. I find it difficult to believe Washington will be business as usual when the House returns from recess this week.

Stocks love money and anything that upsets what has already priced in forces investors to reposition or at the very least hedge their bets. Very defensive action this week with Healthcare and Utilities putting in the best returns with Energy, Materials and Industrials bringing up the rear.

Reversion to the mean is a bitch

Source: FactSet

Even before last week concerns were starting to mount as reflected in the charts above. Almost upside down to the first part of the year Utilities hardly a risk on asset leads the way. Reversion to the mean? Perhaps or maybe, some gathering fear that along with a challenged economic agenda some pre-conceived notions about a market friendly Fed are starting to unravel.

Investors today understand all too well that monetary policy has been a driving force in equity returns for the last decade. The Fed’s mission has been to eliminate the business cycle and smooth the way for risk assets and of course to a large degree they’ve succeeded.

1st half of the year

Source: FactSet

The first part of the year was a risk-on pro-cyclical stock rally with large cap secular growth taking a back seat. Out of the gate Q3 has largely turned that dynamic upside down with defensive sectors like Utilities leading the pack. Not exactly a risk-on setup.

Mounting inflation in everything we consume from the pumps to the grocery has an increasing number of voting members in the FOMC leaning toward a Taper. As such, the time frame is being pulled forward.

Even if the above proves true we’re talking about an event that will take close to a year to unfold. Initially the Fed will move from $120 Billion in monthly purchases to perhaps $105 Billion reducing periodically by $15 Billion at each meeting. I see little chance the Fed will do anything with the Balance Sheet and will likely opt to let it unwind over the next couple of decades.

Fed Balance Sheet – Still Going

Source: FactSet

I spent most of this post discussing the geopolitical an economic backdrop for U.S. equity investors but outside the U.S. the rest of the world is dealing with its own concerns. With the exception of New Zealand and Denmark almost every market in the world ended the week lower. Asia Pacific led by Hong Kong’s near (-6%) drawdown last week pointed right to China and their continued regulatory crackdown.

With earning’s in the rear-view mirror investors will need a new catalyst to drive sentiment. On the heels of last week’s retail sales miss and other economic data starting to slip any news on COVID and hospital capacity will likely be a market mover.

Source: FactSet

Last week Goldman rattled the markets by baking modest cuts to their Q3 GDP outlook. The good news is that they added back to Q4. Investors understand that we are at peak growth and peak GDP. The question isn’t that we’re starting to slow but what are we slowing down to? This is the conversation that will drive equity returns in the weeks and months ahead.