Don’t Underestimate Central Banks and the fallacy of Craft Gins…

Blain’s Morning Porridge – April 24th 2023: Don’t Underestimate Central Banks and the fallacy of Craft Gins…

“Drunk for 1 penny, dead drunk for tuppence, straw for nothing..”

This morning: Markets are confused by rates, inflation and recession risks, wondering what central banks will do. The smart money gets it – Central Banks are on top of this, and have the fine controls to avoid crises becoming catastrophes. Meanwhile… why is my drinks cupboard full of craft gin?

Sometimes we just have to admit we just don’t know. The world is what it is and we struggle to understand it. We fret because inflation is what is inflation is, is pretty much what we know about inflation. Similarly, interest rates are what interest rates are, and panic that central banks will do what central banks do – with limited knowledge of the future and limited tools with which to influence it. The roll of strategists is to understand it all and opine what it all means for the market…. The excellent Robert Armstrong of the FT summed up perfectly this morning in his Unhedged column:

• “On Sunday I had a good laugh at a New Yorker cartoon. It depicted a man watching the news. The talking head is saying: “On Wall Street today, news of lower interest rates sent the stock market up, but then the expectation that these rates would be inflationary sent the market down, until the realisation that lower rates might stimulate the sluggish economy pushed the market up, before it ultimately went down on fears that an overheated economy would lead to the reimposition of higher interest rates.” The cartoon neatly captures the inanity of the rates down/stocks up narrative that dominates most market discussions today. But what is really funny is that Bob Mankoff drew it in 1981.”

When you put it that clearly, I think I have to accept my work here is pretty much done…. Except.. it probably isn’t.

Markets are never doing nothing. Smart investors dig deeper and try to understand it – which may be why US Hedge Funds are currently at record levels shorting the US Treasury market. Despite bank analysts saying rates will soon ease, hedge funds show little concern about potential recession, and reckon the Fed will keep hiking till it’s comfortable with inflation.

When it comes to markets, there are way to many things to worry about, and consider as indications of how the next trends play out. Consequences and implications are oft forgot, but they are the bread and butter of market strategy. The sauce is provided by guessing at the psychology of markets. No-See-Ums (what others may call Black Swan Events) can have enormous consequences on stability and confidence when they create the kind of chaos we saw during March’s bank shock, but in reality confidence stabilised quickly as Central Banks were seen to act quickly, effectively and decisively.

Over many years I’ve learnt markets tend to overestimate the threats and de-emphasise the positives. To illustrate; this week we will see European first quarter GDP numbers – they will likely show a small uptick. Yet, just one year ago we were all absolutely convinced Europe was about to plunge into economic catastrophe on the back of the Ukraine War, Energy Insecurity, and likely collapse of European unity in the face of the Russian Threat. Er.. nope.

Europe coped, energy prices are dropping and even the Germans are re-arming. The upside risk is now about how quickly and further the ECB will hike rates to address inflation, and because it’s the ECB (a central bank with the policy manoeuvrability of a supertanker), the market will now expect the Bank to get it wrong, or at least mis-time it.

Markets also underestimate Central Banks and what they have learnt.

The March banking shock; the quietus of Signature, Silicon Valley Bank and Credit Suisse, has much of the market commentariat predicting further doom and gloom; that further bank wobbles are inevitable, and the rot at the core of the bond market has also impacted asset management sector, sitting on massive unrealised bond losses that can only remain “hidden” if central banks ease rates to avoid a recession by boosting bond prices.

The belief we are heading into a recession, which will be exacerbated by consequential no-see-ums, central bank policy mistakes and the general noise, froth and panic that accompanies market instability, is widely held.

The key part is Central Banks. Give them some credit. They face multiple challenges – not just inflation. They are trying to unravel the consequences of the last 25 years of monetary policy – the current instability in global financial markets didn’t start in 2008 with the collapse of Lehman, but a decade earlier (and probably before that) with the bailout of Long-Term Capital Management.

Since then Central Banks have learnt how complex their roles are. Their responses to crisis have not been perfect – often playing catch up. But, in recent years they have quietly and competently kept the markets together – and come to grips with the consequences of their actions. Should the hoped for soft-landing threaten to turn into an economic crash, they have the capacity to quickly act with banking support and the kind of monetary interventions we’ve seen since 2008 (QE, Ultralow rates, Unlimited Repos) and through the pandemic (support schemes for business, repo facilities, and support for bounceback).

We underestimate what central banks can do – thinking the only tool they have is interest rates. Not so. But they don’t want us thinking they will step in to stabilise economies and markets should a crisis evolve or result from recession – to do so would immediately result in the market arbitraging their decision. The thing is.. we know they seek to engineer a stable growth economy, and have the tools to do so.. Place your bets accordingly.

It’s a bit like sailing a yacht..

Non sailors think it’s all about the rudder; the helmsman steering the boat in the general direction required by moving the tiller. New sailors tend to swing the wheel or jerk the tiller to point in the general right direction, with disastrous consequences for boat speed (the equivalent of growth.) Move the rudder too quickly and it acts as break jarring the flow of water across the rudder foil, thus slowing the boat. Hike Interest rates too fast and the economy stalls. The trick is movements of the rudder are subtle and merely guide the boat thru the water without disturbing the flow across it. The more seamless it is, the faster the boat goes.

Folk praise the helmsman for skillful handling of the boat, but it’s actually the sail trimmers, the guys focused on the optimal sail shape, that makes it go fast. It becomes more complex as the sail controls come into play, easing or tightening the sheets that control the mainsail and foresail. It is easier to turn a boat by adjusting the power in the sails rather than turning the rudder. Sails generate the speed – much as interest rates influence growth.

Then there are fine controls like the “Cunningham” (the sly-pig as we call it), the outhaul, the vang and half a dozen other things like barbour-haulers, halyard tension, leachlines, and other stuff to improve the flow of air generating life to speed the boat. As the windspeed picks up, the skipper can reef the sails, making them smaller. In a strong wind, small sails drive the boat faster than large ones. In recent years, central banks have increasingly learnt how to use fine-controls and reefing systems of finance in terms of repos to bail out banks, and how to stabilise the economy and growth with QE programmes. Their actions have consequences. Too much outhaul, or pig distorts the sail to the point the boat slows.

(Apologies for the lecture on sailing – but it’s my passion.)

There is a massive difference between what the markets see and the reality in the economy. Markets focus on higher rates are as a potential threat to corporate earnings, thus dictating defensive investments, while the economic reality is real-world firms cutting jobs, investment and expenditure to cope with the higher costs of interest rate hikes and massive energy and supply chain inflation. The difference between an analyst looking at a chart to determine what the Fed might do, and an economy facing a collective P.45 (the UK redundancy notice) is stark.

The trick for central banks is to steer the economy towards growth without the gains being hijacked (as they were from 2010-2022) by greedy markets. In many ways funds exploiting central banks are the barnacles that foul a boat’s hull, slowing it down – but I suppose finance generates its own ecosystem where every form of financial animal seeks to thrive!

Meanwhile… reflections of a weekend.. Too much Gin..

On Sunday morning my village received its first visit this year from Hampshire’s touring “Farmer’s Market”. Each week somewhere in the county is treated to the FM circus – taking over the town square, or in our case the foreshore car-park. It comprises 20 odd stalls, 3 of which are “craft” Gins, 3 others are drink related, a fudge maker, a baker, a nurseryman selling various plants, charcuterie makers, pre-packed venison, a vegetable seller, ice-cream, pies and vegan Cornish pasties – but alas no candlestick maker….

I missed it completely… I went for a swim in the river, then raced my dinghy (very badly in too much tide and too little wind), but She-Who-Is-Mrs-Blain invested in Gin, adding to our substantial stocks of mothers ruin. Craft Gin, of course, is one of life’s great marketing scams. Producers buy a tanker load of industrial spirit alcohol, (basically vodka), and flavour it with juniper and anything else handy to give it regional “credentials”, decant it into a pretty bottle, and flog it at ruinous prices.

As a result every Yachting haven and village on the South Coast of England – from the Isle of Wight to the Scillies – produces multiple competing spirits. We have lots of “craft” gins in our “holiday-booze” cupboard, alongside foolishly purchased Limoncello, undrinkable liqueur from Greece, and something yellowing from the mountains made from flowers unwisely acquired on a ski-trip. There are more bottles of gin in the yacht bilges than you can shake an empty Copa at. At least the gin gets drunk.

But what does the popularity of Craft Gin tell us? That folk are bored with the blandness of big brand Gin? (I can’t tell one Gin from another after the tonic and lime is added. Always lime please.. none of this nonsense about orange, grapefruit, passion fruit or such silliness.) Or that drinking local craft gin is an opportunity to boost and encourage local entrepreneurial flair? A chance to connect with the locality – drinking gin flavoured with seaweed and samphire (which we can’t eat because of sewage discharges) in which the Hamble River abounds? Or, Gin made from the clear chalk-steam waters of the Test – the finest trout stream on the planet? (Fortunately the gin did not taste of too much of fish..)

I suspect there is some proper economic work to be done here on the Gin explosion..

As the economy contracts and everyone whines about how expensive food has become, the unaffordability of restaurants, and food inflation, the masses turn, in Hogarthian fashion, to Gin. The cheaper, the nastier, the more of Aldi’s cheapo plonk will be sold. The middle classes splash out on essentially the same thing, but twice the price in a pretty bottle, and is playing the same escape from the drudgery of reality..  (Need to be careful what more I say her, Number One Son works in the Gin Industry… making a rather fine one…)

How many craft gins does the World need I idly wonder?

Five things to read this morning:

Project Syndicate                    The Overwhelming Case for Central Bank Digital Currencies

FT                                            Too much Fed Liquidity has led to a whack-a-mole world of problems

BBerg                                      Hedge Funds Place Biggest Ever Short On Benchmark Treasuries

WSJ                                         First Republic Earnings Report to Shed Light on Depth of Bank Crisis

WSJ                                         Tech Billionaires Bet on Fusion as Holy Grail for Business

Out of time, and back to the day job…

Bill Blain

Strategist – Shard Capital