Blain’s Morning Porridge Dec 14th 2021: 2022 Outlook – Politics will be a worry, but Credit will be the Big Risk
“Reader, suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.”
This morning – Let me present a list of things to worry about next year. Inflation, US and China growth, Stagflation, Central Banks, Stocks, Climate and Equality, etc, etc.. But the big risks will be the consequences of US Politics and a Liquidity Meltdown in the Credit Markets.
As promised yesterday, ahem, my outlook for 2022: I can state with some certainty that 2022 will begin very early in January and go right through to the end of December….. Otherwise, take your pick from the following:
I’ve got a number of main themes..
- Inflation will not be transitory – it will grind away at savings as wage demands, labour shortages, supply chain instability, and energy costs undermine the global economy.
- Two economies matter – the US will do relatively well. China is going to suffer from major energy dislocation, deepening the global supply chain crisis. Europe – really? UK – please…
- There is a moderate probability of stagflation – recession plus inflation.
- Central Banks have limited choices: destroy the global economy long-term by doing nothing to unwind monetary distortion, or destroy the global economy now by normalising interest rates. (Basically..)
- Stock markets are not at record levels because of productivity gains or soaring earnings, but because money has been overly cheap and central banks accommodative – fuelling the rally. Mean reversion is not a risk – it’s a rule.
- Credit spreads don’t reflect current real risks, which will magnify as rates rise – Credit Markets are my number one pick for a chronic liquidity crisis.
- Too much easy money and minimal returns have fuelled massive speculation, financial asset inflation, crushed returns and is generating a pensions crisis.
- FOMO and social media pressure reached a crescendo with retail desperately gambling on meme stocks and praying that crypto will make them rich. Hope is never an investment strategy.
- Politics – especially in the US – will have major consequences for markets.
- Regulatory risk in terms of tech and finance are substantial.
- Climate change is now recognised as a major risk – policy makers will act.
- Inequality is an even larger risk – policy makers are unlikely to act.
Let’s start with the big known unknown: Dysfunctional US Politics.
Back in January 2021 we started the year wondering if Donald Trump would actually exit the White House. He did, but left the US bitterly divided and fractional with 70% of his party convinced the election was “stolen”. The Biden administration has singularly failed to pass any meaningful legislation – and the Republicans haven’t had to do much, letting the Democrats beat themselves. There is no Democratic party as such, just different interest groups sailing in different directions.
The Republicans (at this stage) look certain to win both houses in the Nov mid-terms. That’s going to be the big political theme of the year on markets: just how badly Biden will fail and the Republicans are set to benefit.
If a united purposeful Republican party wins, then that’s a good thing? Well… it would be if it wasn’t likely to confirm a succession of voter-registration “laws”, consolidation of electoral power, and gerrymandering of seats designed to ensure the minority US party retains a majority of power. The party remains in thrall of a vengeful Trump setting its agenda, with moderates being forced out. There will be rising fears the failure of the left in the US is pushing the world’s most important economy towards long-term right-wing protectionism and global disengagement.
If we see the US morphing towards a one-party “democratic-state”, or even a Trump dynasty, markets will probably embrace it, looking forward to tax breaks, subsidies and protections, and a push-back on anti-oil and climate change programmes. Long-term the consequences of a shift to an isolationist right-wing US on geopolitics will be immense. It’s not a pretty vision. All China and Russia have to do is…. wait.
Last year I correctly predicted the global economy would stage a swift recovery from the Pandemic lockdowns, but that supply chains were troubled (brought into focus when a container ship blocked the Suez cannal), and inflation would be a rising risk factor through the year. I pointed out Billionaires got $1.9 trillion richer in 2020 on the back of recovering markets. They did it again the year just past. No political party is yet serious about addressing income inequality.
We’re heading into a very uncertain year for the global economy and markets in 2022. The fiscal consequences of the pandemic spending bailouts are mixed; on one hand government largesse avoid collapse and actually strengthened fundamentals, but the consequences include soaring wage demands, while rising debt levels terrify many investors. Inflation/Stagflation and renewed Covid recession are also known unknowns.
One immediate issue to deal with will be a winter energy crisis. Markets are vastly underestimating just what higher power prices are going to do to corporate earnings and growth across the globe. Europe is particularly vulnerable, the numbers coming out of China may be even more scary – power outages and serious industrial dislocation (caused by rising prices and their unwise attempts to bully Oz), could rapidly send renewed rounds of supply chain chaos around the globe, triggering a host of consequences.
The dearth of financial asset returns has focused investors on now ways to generate alpha on the investment spectrum. That’s always a risk – new risks require new skills and experience to manage. Some of the return strategies are founded in common sense; generating high returns from negotiated private and structured assets, (equity, debt and hybrid). However, although hopes and dreams seldom pay out, inflated hopes and expectations from “disruptive” technologies, right across to wildly speculative conflabulations like cryptocurrencies and NFTs which few folk understand, but which everyone expects to get rich from – will likely still dro\ive markets in 2022.
Never forget – it’s not what you know about markets and expect that matters, but what the market believes that matters. The market is just a voting machine – and if the voters are daft, then prices might be daft, but the price is the price is the price. As the well known saying goes; the market can remain irrational longer than you can remain solvent. But even daft markets revert to mean stupidity over time. You can speculate and win in the short-term. In the long run, returns are mean reverting and smart long money generally wins.
So… some quick thots on two dominant other trends likely to set the story of 2022:
The risk of Policy Mistakes
There is a significant risk parts of the global economy could tip into Stagflation triggered by further Covid induced slowdowns and/or policy errors by central banks and governments raising taxes, austerity spending and overly aggressive tightening too early. Policy mistakes will remain a major fear through the new year.
The big risk for the year? Credit
At its core the credit market is broken. Credit Spreads no longer reflect real risks – they gave up doing so sometime after Central banks took over being the market. Now they simply reflect misperceived relative interest rates vs other financial assets. Ultra-low rates have distorted the business cycle – allowing failing firms to survive longer. The market sees lower default rates as positive signal of corporate resilience rather than a signal of something fundamentally wrong. (There you are, my Big Short trade: sell mispriced credit…)
When the whole market is missing debt fundamentals like the capacity to repay debt, the strength of future earnings, and resilience (ie, all the old-fashioned stuff about lending to firms with effective management with a high propensity to repay lenders), then it’s time to be betting against them.
Default risks look to be relatively low, but Zombie overleveraged firms that have beggared themselves via stock buybacks and are now clinging on due to absurdly low rates will clearly suffer as rates rise, and face financing risks in a diminished liquidity environment.. (Which will occur as rates rise.)
But if you want to sell credit… who will buy? Regulation means there is no market making, and if central banks stop buying, the smart money will already be out. The market will go offered only. Anyone left in will find liquidity as rare as an ice-cube in hell.
And on that happy note…. There are a host of other topics I need to cover like energy transition, climate threats and change, growth, the taming of ESG, and many more. I will write about them all in the porridge through the coming year…
Next few days might be Porridge scarce as I’m travelling…
Five Things to Read This Morning
New Yorker – Lina Khan’s Battle To Rein In Big Tech
BBerg – Washington hasn’t learned the real lessons of the China Shock
BBerg – Saudi Oil Minister says Global Production Could Plunge 30% This Decade
FT – The Return of Inflation: crunch time for the ECB
WSJ – This was the year investors and busines put big bets on climate
Out of time, back to the day job then off to the airport..
Strategist, Shard Capital
Thanks for the overview. Clarity and common sense are in short supply, and I value them when I find them.
Merry Christmans and a Happy 2022 ( oh well )
APpreciate it.. I intend to have a very merry holiday.. and then spend January working it off! (Dry January is on the cards..)
Thank youf ro this mornings porridge Bill. Stand out comment for me at 30 who probably over thinks was, “In the long run, returns are mean reverting and smart long money generally wins.” Maybe close my eyes for a few years? Thanks again.
Good god no man.. Never close your eyes in markets.. but understand that speculation is speculation, and long-term investment is a strategy. At your age you should be “mixing” it up a bit… put some money into a sensible bucket, some into a risk-on bucket.. and even play a little in the madness of crowds.. Heck, I am twice your age and I do own about £300 of Crypto now… I think and know its ponzi risk, but as long as there is a greater fool its still worth something!
Central bankers have been giving away money since 2009. We have an inventory, built up over 12 years, of companies that can’t clear the hurdle rates which should be imposed by a properly functioning debt market.
These zombie companies are feasting on the trillions of (borrowed) dollars provided by a Congress intent on buying votes. The end result will be ugly.
While I admire the latest generation’s dedication to social justice, wait until they live with stagnation and realize they are responsible for rebuilding the economy AND paying off the debt.
They are going to be really pissed!
Your analysis of the US political landscape is pretty grim, but I can’t say it’s entirely unlikely either, with all the best will in the world I hope your wrong.
There are some bright spots in the crypto space, much like the early days of web it’s hard to pick the winners, and some of the obvious candidates today are likely to be the myspaces and yahoos of tomorrow. While there’s no shortage of what are basically Ponzi schemes, there are some distributed ledger techs out there that provide decent utility outside speculative investments if you look at the business model behind them .. those are more likely to become the eBay’s and Facebooks of the future.
The part on shorting bad credit makes sense m, but what does that mean for small players .. not just minnows, but plankton like me. Do we just wait around for the tide to go out and CFD short the ones who aren’t wearing pants, or keep buying well managed cashflow happy stocks into the dip or what ? No wonder real-estate is looking like the best option for a safe haven despite its effervescence.
Bill, as a fellow member of the Dundee Diaspora (born in Dundee, raised and live in America) it is good to see someone attempting to apply the common sense we grew up with to what are insane credit and equity markets. Unfortunately, our natural instincts (skepticism, distrust of too much success, inability to paper over obvious market dislocations) put us at a disadvantage today.
Bitcoin, equity valuations, Treasury spreads, gold and silver prices, etc. The list goes on. Free money has turned many fools into rich men, and there is nothing sane people (like the ones who read your website) can do in the face of the tsunami of nonsense currently washing over us.
I have worked in finance for the last twenty five years, mostly at commercial banks but also at non-bank lenders. The disparities you often refer to are more evident than even you or many of your readers know. And much risk is concentrated in a sector that operates under the radar of the average citizen.
My focus of concern is, like yours, the credit markets. The good news is that US commercial banks are actually in decent shape (loan-wise). I was in the belly of the beast in 2008, and went overnight from running a leveraged loan origination team to working on distressed credits for a large US bank. I thought my bank was too big to fail at that time, until I watched Wachovia ($800BN in assets) swallowed like a guppy by the problem real estate loan whale.
Fortunately my institution made it through, and did so for two reasons. First, we decided not to enter the subprime mortgage space. My bank still did its share of dumb loans. Developers in Florida were a particular challenge, and often a black hole of large losses. But we avoided stepping on that particular land mine. Subprime took down players much larger than my bank.
Second, we moved relatively quickly to lop off our gangrenous limb of bad loans, cauterize the wound and nurse ourself back to health over time. Speed, decisiveness, and ruthless realism are friends of a lender with a problem loan.
During that time I took over a half-finished $40MM yacht with a large construction loan. We funded the remaining $20MM in construction on the theory that a half-finished boat was a $20MM loss, but a completed $40MM boat might only be a $10MM loss. The theory proved correct, and we actually got out whole. But the decision process gives you a sense of where banks were at the time.
US commercial banks learned from their 2008 mistakes (the mistakes actually took place from 2002-2007 but that is a topic for another day). Balance sheets are stronger, they don’t do nearly as many dumb loans, they watch loans more carefully, and they act more quickly and decisively than they did in 2008.
The first wave of bad loans in that time scared the banks, and often led to slow responses. This was mostly because people were still under the assumption that normal rules applied and maintaining relationships was paramount. By early 2009, it was obvious that survival was the priority, and that promises from borrowers (that did not involve cash infusions) were worthless. Things changed once that reality sunk in.
US banks are battle hardened now (mostly) and the institutional knowledge gained from that period seems to be firmly embedded in the consciousness of the people that run and work at these banks.
There will be dumb stuff that happens, no doubt. Bank stock prices will crater like last time, and some banks will undoubtedly fail. Other lines of business might prove fatal to an otherwise decent lender. And this time the size of the problem might just simply dwarf any ability to respond. But I am of the view that US commercial banks are as ready as they can be to deal with the problem loans that are coming.
But while I feel OK about US commercial banks, I am much less sanguine about other sectors of the market. In particular, my view is that the vast majority of lending risk lies in the private equity (“PEG”) and non-bank lender (“NBL”) sectors.
I refer to them as “sectors” but in truth the PEG and NBL spaces are symbiotic and joined at the hip. The explosion in capital available to PEGs and NBLs is not readily visible to those outside the finance space, and the nuances of how these players operate is even less apparent. What becomes apparent, however, is their portfolios are built on sand, and the efforts they undertake to offer above-market returns to their investors will have devastating consequences for the global economy in the future.
If your readers are interested I will post more on these markets, with details and examples. It is a part of the market that is opaque and contains within in it almost unlimited levels of potential destruction.
Fascinating read. Would be more than interested to read more!
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