Albert Edwards summons the bears

The always entertaining Albert Edwards of SocGen: 

For all the Fed’s newfound bravado and bluster, we know by now that any attempt to ‘normalise’ interest rates will end in elephantine pivots, pirouettes and ignominy.
 It’s certainly been a lively start to the year for investors as they take another look at the Fed’s tardy rediscovery of its inflation fighting zeal – prompted in part no doubt by President Biden’s slumping popularity in the polls as voters suffer from the current cost of living squeeze.
 For all the reams of verbiage written about the coming year I think the bond market has it about right. Namely that despite the Fed seeing ‘neutral’ fed funds at around 2½% they’ll struggle to get rates above 1½% before the financial markets chop them off at the knees.
 Bill White of the OECD has been one of the few mainstream economists to identify (decades ago)that the Fed and other central banks are trapped by their own actions and lack of foresight to predict the malevolent consequences of those actions. We explained a few weeks ago how their policies were driving even higher levels of inequality – and hence underconsumption – which, in their own misreading of the situation, warranted even more monetary stimulus.
 Successive debt-financed recoveries, underpinned by super-loose monetary policy, havedriven a wedge during tightening cycles between what monetary policy is necessary for the economy and what overvalued and over-leveraged financial markets can tolerate.
 Whatever the intentions of the Fed to ‘normalise’ interest rates with respect to this economic cycle (having admitted they might have got behind the curve on inflation), the financial markets will simply not allow it. To illustrate just how the Fed has lost all touch with financial market
reality, I saw that as part of the latest bout of muscle flexing, the Fed floated the idea that they should re-commence Quantitative Tightening in 2022 (auto-pilot anyone?). Simply hilarious.
 To be sure, just as in previous cycles, no-one knows how much tightening the financial markets can tolerate before breaking point is reached. I don’t know and the Fed despite its myriad economic models doesn’t know either. But it won’t take much for the wheels to fall off.
 Since the late 1990s, every debt-fuelled recovery has triggered bizarre examples of excess. We previously identified central banks inflating the mid-2000s housing bubble to ‘compensate’ the middle classes for losing out on their share of the national income pie. ‘Grade inflation’ in universities is really just another meaningless sop to the middle classes – but in this case it creates an excess supply of intellectually underemployed and hence resentful ‘elites’.

In the UK, 40% of 18-year olds go to ‘university’ and a third of those get top degrees. Nuts!

I’ve been doing this job for almost 40 years now and still things can surprise me, especially with regard to the misallocation of capital when money is free. In this cycle many have noted with incredulity the proliferation of shell Special Purpose Acquisition Companies (SPACs) as an example of excess. But when money is free people are always willing to pay top dollar for next to nothing. Some of the more esoteric examples deserve mentioning however, if for nothing else at least to have a good laugh about how ridiculous things have become on the back of free money.

Amid the global gas crisis Forbes (no less) highlights former star of reality TV show “90 Day Fiancé” (whatever that is!), Stephanie Matto’s venture into the gas business. Forbes writes, “In this case, the gas business was not selling gasoline but rather selling her flatulence in a jar for about $1000 apiece. Matto described this jarring business that she claimed was bringing in around $100K.”

In a mirror image of the stretched global supply chains trying to keep up with inflated demand, Stephanie also attempted to increase supply (beyond 50 jars of farts per week). The Metro newspaper explains how “she recalled how she consumed three protein shakes and a huge bowl of black bean soup in one day, before feeling that ‘something was not right’ with a pressure in her stomach that moved upwards throughout her body. ‘It was quite hard to breathe and every time I tried to breathe in I’d feel a pinching sensation around my heart,’ she explained. ‘I thought I was having a stroke and that these were my final moments.’”

Stephanie, who hails from Connecticut, landed in hospital, and has had to abandon her previous lucrative career in gas supply. But with oceans of free central bank money still floating around in the ether, she is squeezing the last gasp of air from this idea. For the Metro reports “her clients will no longer be able to own the physical jar of Stephanie’s gas, but they will be able to purchase them as digital artworks on the blockchain. You might say that Stephanie, much like her career, is having a second wind.”

I simply don’t know where to start in analysing this apocryphal story. But it epitomises the bizarre entrepreneurial opportunities that surely only exist when central banks misprice money. We’ve seen such openings at the top of every bubble and good luck to Stephanie for taking advantage of it and quickly adapting her business model. Unfortunately, I might hazard a reasonable guess that this might be one of the businesses that, in Warren Buffet’s words, is found to be swimming naked when the monetary tide goes out. It’s a great story of the extreme consequences of QE and the misallocation of capital. But hey, it’s fun while it lasts – as long as you don’t end up in hospital.

Rip Van Fed has finally woken up and decided it’s time to stop the fun. Yet as Gerard Minack shows below, the markets don’t really believe the Fed can ‘normalise’ rates anywhere close back to the 2½% the Fed themselves postulate is ‘neutral’. Markets think we’ll see 1½% tops!

Certainly, in terms of the transitory inflation story – or ‘former’ story as the Fed has designated it – there is good evidence that supply constraints are easing quite rapidly in some areas.

I might be convinced that history will repeat itself and the financial markets will be blown to smithereens as the Fed tries to ‘normalise’ rates. Yet, there are voices suggesting that the flattening yield curve seems to be sniffing out that the economic cycle may be near its end.

“What!” I hear you shout, surely this economic cycle has only just started? But after the shortest recession on record, following on from the longest economic cycle on record, there might be too much anchoring by investors on the concept of long resilient economic cycles. This cycle may yet prove to be unusually fragile to the lightest of Fed touches.

Certainly, the flattening of the yield curve (showing 30y-10y in the chart below) is consistent with the sort of shortfall in consumer confidence expectations (vs current conditions) that immediately precedes the end of the cycle. David Rosenberg has calculated, using a variety of indicators, an 80% probability that a recession might start by mid-year! David Rosenberg is a man who knows his economic onions and that sort of warning should be taken seriously.

But perhaps the biggest risk I see at the moment is complacency – as measured by low spreads and volatility. I was looking back at something my Credit Strategy colleague, Guy Stear wrote back at the end of 2016 about how the markets were ignoring the then rise in political uncertainty.

Guy wrote back then, “There are lots of reasons for caution, but the biggest is political uncertainty.

This is a notoriously intractable concept, yet three brave academics in the US called Baker, Bloom and Davis (BBD) do put a number on it in a website called” Guy noted back in 2016 in the left-hand chart below that unlike 2008 and 2011, when the correlation between ‘Economic Policy Uncertainty’ and credit spreads was very close, something odd was happening. Indeed, what Guy spotted was a secular break in the relationship between credit spreads and political risks (see updated right-hand chart below). The markets don’t care!

This high level of market ‘complacency’ in the face of political uncertainty is not just a feature of the credit markets. Gerard Minack has aggregated the implied volatility of a variety of equity, bond, FX and commodity markets. He finds that although we are not at the single digit lows we saw just ahead of the last recession, we are still well below normal. Indeed prior to the 2018 Powell Pivot, the current 13 level of complacency was just about as extreme as we ever got!

I was chatting with one of my colleagues (let’s call him Jerome, because that’s his name), and we agreed that after everything we have experienced since 2008, any portfolio manager should probably contemplate allocating a non-zero share to catastrophic hedging. There is simply too much linear thinking out there!

I asked Jerome for some examples of the sort of thing he’d been reading aside from the usual geopolitical risks and he even had me worried. Aside from the risk that the next pandemic will come sooner and be more deadly than expected (link), the unfolding water crisis seems to be an important theme. Whether in Germany with the Rhine waterway drying up (link), or in Brazil where drought is likely to push commodity prices sharply higher (link), or indeed near to home in western USA (link), drought is a big issue. Then you have the unfolding collapse in gulf stream currents and its dire consequences on food production (link). And returning to our originaltheme, some interesting models predict a lot more political and social turbulence in the coming decade in large part as a result of the ‘excess’ elites problem (link). As they say, choose your poison!

Houses and Holes

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