Blain’s Morning Porridge – May the Fourth Be With You, 2023: Opportunities are all about confidence, so what fears will a record Gold Price trigger?
“These are not the droids you are looking for…”
This morning: Don’t assume inflation is licked, don’t assume interest rates will stop rising, don’t assume there aren’t further bank failures to come, don’t assume politics and society will cope well, but don’t assume it’s all end of the world. In periods of financial uncertainty there is opportunity…
Happy Star Wars Day…
Start the day by wondering what gold hitting a record price of $2081 last night might mean. I can’t think it’s a positive sign of market harmony or a predictor of good karma. What’s that large extra moon with the big lasery-looking cannon pointed at us doing up there?
Yesterday the Fed raised the Fed-Funds rate to 5-5.25%, the highest rate since the beginning of the Global Financial Crisis in 2007. Much of the market has chosen to read Fed Head Jay Powell’s “policy is tight” comment as a dovish signal rates will shortly start to trend downwards as inflation comes under control. However, in the face of a still relatively robust economy, strong employment, still rising core inflation, and a global economy adjusting to new and tight supply chains, the inflationary drivers remain strong. Pay closer attention to what Powel the said: “we are prepared to do more if greater monetary policy restraint is warranted.”
With all the scientific rigour we could muster, we set up a quick office sweepstake on when the Fed will start to cut rates. Many of my colleagues believe the Fed is now done tightening. Some believe the first cut in rates will come as early as Q3, pointing to employment as a lagging indicator. Some cite the Fed’s dot-plot, others what the market is saying about forward rates.. (Huh, what does the market know – it’s just a voting machine… reflecting what traders want to happen, not the actuality!)
Me? I reckon it could be Q3 2024 till we see the Fed start to ease, although that would clearly trigger a furious political reaction as too close to the US elections. I still see enormous issues to work around on “sticky” inflation in terms of employment, wages, and supply chains (everything from accommodation to zebra pattern rugs remains disrupted), as the world adjusts to a new China/West relationship and crashing consumer discretionary spending. Deflationary bust, recession, recovery or Stagflation – you choose.
Central banks are under increasing political pressure to create growth/avoid recession – but, repeating the mistakes and consequences of the QE age by easing too early simply triggering another market party with low interest rates triggering a financial asset binge – would be a massive error. (Unless it’s done with full knowledge and cleverly… which since it will involve politicians.. I doubt.)
Central Banks do not want market instability – which is bad for economic confidence, and would fuel recession – but they desperately desire efficient markets to ensure the arteries of capitalism deliver capital to the businesses that need and can use it. Critical to that is setting the right real interest rates – but these are still negative: less than inflation. Everyone writes about yield curves. Fewer talk about real rates.
As I’ve written many times, Central Bankers are very aware that since 2009 capitalism has been hopelessly distorted by a speculative everything bubble. A primary consequence of that is the plethora of zombie firms, holding productivity down and filling economic niches other firms could more profitably fill. Failure is critical for the success of capitalism. A second is firms using cheap money to replace equity with debt (share buybacks) rather than building new productive capacity or investing in future product. These, and other issues, like the fact the US stock market rose 280% from 2010-2022 when the economy grew a mere 40%, highlight how central bank cheap money skewed markets.
Not everything is end of the world though.
Let’s quickly try to defuse one ticking UXB: US Banking Apocalypse! According to the professor of banking at Stanford University 2,315 US banks are about to go insolvent as their assets are worth less than their liabilities. Let me put on my best BBC weatherman accent and assure you there no hurricane approaching…. Ahem..
Yes, US Banks are sitting on substantial mark-to-market losses on their bond books. They bought these bonds at 100% pre Fed-hikes, but following the fastest series of interest rises in US interest rate history bond prices have notionally fallen substantially, say to 70%, more than swallowing capital reserves. This infers a similar scale of losses across their lending businesses – although most banks will have hedged mortage and lending rate rises, although not the underlying credit risk, hence the rising concerns about commercial real estate.
However, most bond portfolios in banks are “held-to-maturity”, where the bonds will redeem at 100% and will continue to pay interest. If the bank faces a liquidity shock where it may have to sell hold-to-maturity bonds, that could crystalise a real loss – a potential solvency event. They can pledge them as collateral at 100% to borrow money at the Fed to cover such a loss.
The problem is banking is all about confidence, and that is why the market is increasingly concerned about which US bank is next against the wall. A liquidity event occurs when depositors panic and pull out their money, forcing banks to scrabble for money, by selling bonds which creates real losses. If they can avoid these losses via the Fed.. they technically survive, but as First Republic demonstrated, the reality is shareholders are wiped out when the compromised bank is forced into a firesale to a larger bank because depositors have lost confidence. I suspect PacWest and the rest are in a queue.. Its ….. called “rationalisation”…
My chum Mike Hollings commented yesterday: “if people are worried about a banking crisis, they are worried about the wrong thing… like panicking about a barracuda when swimming with great whites…”
So, what should we be worried about? Recession in the form of deflationary bust or stagflation. I worry about the latter.
Somewhere near the top of my list is Social Cohesion. In times of crisis the burdens always fall disproportionally on the weakest in society. That is clearly happening now as governments panic about debt, cut back spending, while inflicting higher taxes and wage austerity on populations finding their wallets battered by energy, food and core inflation. Strikes and industrial discontent range on a scale from (1) mildly miffed to (10) somewhat annoyed in the UK, and from (1) burn police cars to (2) burn everything in France. Folk apparently don’t strike in the US – they vote instead.
Periods of Social instability breed populist politics. Le Pen is leading French opinion polls. Farage is appearing more in the UK, and then there is Trump in the US. Populism is typically bad politics and makes bad situations worse… When political confidence slides, a nation’s Virtuous Sovereign Trinity of bond sustainability, currency strength and political competence will wobble – its been happening re the dollar since 2016.
Also on my list of concerns is Shadow Banking – how much of the debt burden once originated and held by banks is now held within the shadow banking system, (which is nowhere are exciting or evil as it sounds). If banks face a massive asset/liability mismatch because of how quickly interest rates have risen, then the same must be true for the fund managers lending direct… surely? We know about the crisis in banking because they are highly regulated and subject to multiple stress tests (smaller banks, less so.) We know less about the position of funds invested in less liquid assets like corporate bonds, junk debt and private lending.
These assets will have moved in line with the underlying collapse in the benchmark bond markets, but are also highly illiquid. While a treasury bond issues in 2021 at 100% may now be worth 70% on the liquid bond market, a private bond today is only worth whatever the next buyer says it worth – which will be considerably less than 70%. Spice up the scale of the problem with the reality many funds buy private debt on leverage..
My day job is in “Alternatives”, creating assets for private debt and hybrid investors. I focus my efforts on understanding how the cashflows work, and how solid they are to understand exactly how the returns accrue to the investor, providing mitigation for concerns on the payment of interest and principal, and company value in hybrid bonds. I might write about some examples of such bonds next week – if we get the time..
Most Alternative investors are actually very good – specialised in their subjects, highly focused on the risks they face and how to manage them. Many benefit from working in smart, nimble firms, that can act quickly to mitigate risks, rather than follow the rather bureaucratic processes of the banks and institutionalised funds. The most successful independent investment firms demonstrate the advantages of regulation light, decentralised smart thinking. Clearly they will become massive targets for the regulatorcracy!
In periods of market crisis – as now – that’s when the smarts, experience and the nimbleness to act fast to sieze opportunities is at its best. I’m placing my bets on the smarter shadow banking players..
On the other hand, no matter how good the best investor on the planet is… no one is perfect. When the next no-see-um strikes… (I wonder if the Empire ever got round to fixing the exhaust on the Death Star..?)
Crashing minor/major chords..
Five things to panic about this morning:
Out of time and back to the day job
Strategist – Shard Capital