What comes next? Markets are mean reverting, are you prepared?

Blain’s Morning Porridge (Part 2) Oct 14^th 2022 – What comes next? Markets are mean reverting, are you prepared?

“Do you expect me to talk? No, Mr Bond, I expect you to die!”

This Morning:. “Well, that was a fun week… but the UK’s travails are the tip of the iceberg of market pain facing the global economy. More political, geopolitical, liquidity and leverage driven crises are coming as markets reverse out the QE era. Don’t Panic!”

Yesterday morning I wrote about dysfunctional UK politics and conflict within and without the Bank of England – this is the follow up note I promised, but failed to deliver.

The last few weeks highlight just how damaging bad politics are for markets. The volatility we’ve seen in Gilts highlights just how damaging political incompetency can be. It hurts when the UK apparently ranks way below Italy in terms of financial stability. However….

• The first brutal reality of the current markets is the UK will just be the first domino to fall. The UK is not the only nation facing political fracture, and the multiple challenges of uncertain markets.
• The second brutal reality is that in periods of financial instability, the laws of leverage, liquidity and subordinated risks are immutable, and they will seize any opportunity to exacerbate a crisis.
• The third brutal reality is the War in Ukraine, the Energy Spike, Inflation becoming long-term (rather than transitory), the Pandemic, broken global supply chains, and the ending of China’s role exporting deflation (as the cheap manufacturing centre of the globe) have all come together just as the costs of a decade of global monetary experimentation mistakes have come due for payment.

All these strands are coming together as we shape up for a potentially cataclysmic finale to the 30 year Bond and Stock boom. Anyone for the last few choc ices?

Recession will be deep and painful in Europe, less so in the US.  The only thing likely to weaken the mighty dollar will be the Fed being in a position to pivot to a more dovish policy on interest rates ahead of Europe and the UK – which looks less likely to happen anytime soon.

In the face of looming Financial Götterdämmerung, it’s a very good time to recall one of Blain’s key market mantras:  “Things are never as bad as you fear, but never as good as you hope”! All good parties come to an end. Inevitably we wake up with a minging hangover, swear never to do it again, and don’t till the next weekend.

Therefore I am not going to go dystopian-prepper, defeatist, or particularly negative but the reality is markets are mean reverting, and the mother of mean reversions is probably upon us. Be ready, be prepared, and be aware. There may be a couple of bear trap rallies to come.. but beware. We are not done correcting yet.

I am confident we still have a number of crises points coming that will roil markets in the next 6 months: an EFT liquidity crisis will probably occur, Corporate Earnings will disappoint, Default Rates will rise as Zombie companies tumble, couple of banking crashes, while we will see a host of real leverage margin events and liquidity crashes pummel overall sentiment.

Each of these wobble points will be inflict more pain… but you just need to grin and bear what is coming.

One of the major themes of 2008-2022 was how ultra-low distorted bond yields forced investors to juice returns. There were only two ways they could do that:

• Take on leverage – multiplying the risks, and/or
• Yield Tourism down the Subordination ladder – taking on more risky equity like investments (ie a bond buyer buying equity to improve returns..)

In times of low returns, it’s tempting to use leverage to juice performance. But increased leverage increases liquidity risks. Liquidity is how easy it is to buy or sell a security. In times of market stress liquidity and leverage conspire to block markets. We’ve seen it so many times before. When markets stress, the more risky a market is the more illiquid it becomes. Or you can picture liquidity risk in terms of the New York Stock Exchange: There are 27 doors marked “Entrance”, but only one very small one that says “Exit”.

The good news is there will be some fantastic investment opportunities occurring as markets correct and prices over-react. Some are already upon us.

And…. it’s nice to finally be right! I’ve been warning about the inevitability of QE reversal ever since The Fed stepped in to buy US Mortgages back in 2008 – the beginning of the Quantitative Easing miracle cure that is now reversing, and crushing markets in its wake.

It’s going hurt. Maybe on the scale of the 1930s, but the thing is… it has to happen. The decade plus consequences of Quantitative Easing, Ultra-low-rates, Debt mountains and insane speculation will thump Western Economies as they unwind. Institutional Investors, Hedge funds, Family Offices and Retail will all suffer.

But the sun will come out the morning after. The survivors will be pulling their buying boots on sometime next year I expect.

What’s the trigger?

Kami-Kwasi Kwarteng’s disastrous not-a-budget sinking of UK financial stability will be little more than a footnote in the history books – much like Lehman. He will go down in history as the Gavrilo Princip of his generation. His ill-judged, tone-deaf (and apparently un-advised) nonsense on September 23rd was the shot that precipitated the Great Financial Meltdown 2022-24. Other nations will likely to see their Virtuous Sovereign Trinity rocked as rotten aspects of the three-legged stool of financial stability: competent government, stable currency and sustainable bond markets, are exposed.

To be blunt – the UK has just exhibited extreme political complacency, but our debt position and national finances are not actually that bad. Other nations face crisis as well.

Across Europe the effects of Energy instability and the failure to understand what Putin was up to is only now becoming apparent in economic and political terms. This is especially true in Germany where the Coalition can only succeed if it embraces “reality”. Elsewhere in Europe social tensions are rising on the back of inflation and energy, and as Italy shows that can trigger political outcomes that bode ill for stability. I reckon the ECB will cope, but at a high cost.

China’s growth has plummeted on the back of Covid policies reinforcing Xi’s accession to the Jade Throne – autocracies seldom result in growth… more paranoia instead and that bodes ill for geopolitics.

And who knows what might happen next in ‘Merica. Mid-terms could see massive political gridlock, perhaps setting the agenda for Trump Part 2 (small chance I now think..) Given half a chance, Trump will make Kwarteng look a bonafide financial genius, and Liz Truss a global statesperson of stature. He will unravel the West and Nato.

The good news is I’m hopeful Global financial authorities will cope – we need to stop demonising Central Bankers and Financial Regulators. They are imperfect, but necessary. if they have the time to understand, acknowledge and mitigate the risks, and are prepared to act imaginatively to minimise the consequences with pragmatic interventions and policy, then perhaps the scale of the meltdown can be averted.

What worries me is just how muddy and dirty the market is likely to get as unscrupulous politicians prioritise their survival over financial common sense – by trying to pin the blame entirely on the financial sector and its institutions. I am seriously concerned the collegiate solutions agreed between that avoided the GFC in 2008 will not be repeated as Politicians – like Kwarteng – try to pin the blame on Bankers.

So what about the immediate market threat?

LDI market

Chronic instability in the Global Pensions industry is being overemphasised. It is solvable. The problem is a solvable problem becomes a crisis very quickly if not addressed. Full marks to The Bank of England for acting fast.

Liability Driven Investment is a perfectly acceptable financial investment strategy. Pension and insurance funds with long term liabilities aim to generate the returns they need to meet liabilities 30 years down the line with leveraged investments. Over 30 years there is are bound to be constant volatile moves in the price of these assets. At maturity we know governments are going to reliably repay the underlying bonds, thus there should not be anything to worry about… (except counterparty risk and leverage.)

While interest rates have been distortedly low – under QE – investors had to improve returns to meet their liabilities, converting a 2% Gilt yield to a 6% return via leverage and financial engineering.

Bank of England Governor Andrew Bailey’s solution to the LDI (Liability Driven Investment) crisis is pragmatic. It makes no sense for these Long-Term Hold-to-maturity transactions to be marked to market on a daily basis. We need to stop treating them as short-term liquidity instruments. Pension funds should not be in the position of being forced to sell gilts to meet margin calls because of a chaotic gilts market.. that just makes it worse.

Undoing regulations is a fraught and time-consuming business, but the same effect could be achieved by encouraging the pension and insurance funds exposed to crippling margin calls to simply borrow the money from The Bank instead of having to sell assets into chaotic markets via Repos (repurchase agreements).

But only banks can access repos. Using the underlying trades as collateral for Repos is not a major risk issue: the underlying credit on the deals is the UK, thus the credit risk is limited to however the counterparties have structured the trades. We have to acknowledge systemic risks in banking now extend into the shadow banking sector which includes the real money pension and insurance firms.

The EU and The Bank identified the weakness in LDI many years ago… but nothing was done to mitigate the apparent risk. Now Holland is also facing an LDI crisis. The sudden LDI crisis in UK pensions is a great example of the consequences effect and how regulating for the last financial crisis will not solve the next.

Podcast: Liquidity Risks in The Bond Market

Myself and some chums from the office discuss the recent crash in the UK government bond markets, which has exposed the lack of liquidity in financial markets, with some significant cracks in the system starting to show. Cracks in financial markets have formed, what is likely in store for us with the ever-growing financial instability, and what investors should be considering for their personal wealth.

Five Things to Read This Weekend

Bberg – The Rich are Living in a Different World

Times – Netflix offers £2 discount to watch with ads

FT – Hopes of US FED Pivot fade on alarming inflation numbers

WSJ – Inflation and the Mid-term elections

New Scientist – Bacteria and catalysts recycle waste plastic into useful chemicals

Out of time, back to the day job, and have a great weekend…

Bill Blain

Strategist – Shard Capital