The volatility will continue until morale improves
Over the prior weeks, we’ve seen huge volatility in markets, but for once in a very long time, what we observe is no longer a case of “numba go up” or “numba go down”. Rather, we’re starting to see significant dispersion in performance in markets: the turbulent undercurrents of rotation despite the apparent calm of major indices remaining close enough to all-time highs.
We started the year with a rather simple hypothesis: that inflation was running out of control, and the ability of central banks, particularly the Fed, to control inflation and inflation expectations was increasingly limited. As it has been in cycles past, the Fed playing catch-up is never a pleasant sight to watch. Our base case was that this time, the catch-up is so long delayed that it might be severely out of sync of the cycle to the extent of being pro-cyclical.
Put differently, whereas central bank policy was meant to be a stabiliser (calm things down when they get too hot, nudge activity up when the economy is down), it may now be doing the reverse: easing into a recovery (as has been the case over the past decade, and especially the past year), while potentially tightening into a slowdown.
At the same time, we’ve had the great fortune of being able to listen and read to the thoughts of some of the sharpest minds in finance of our time: from Credit Suisse’s Zoltan Poszar whose series of notes touching upon the nature of money and the oft-taken-for-granted real economy quite literally gave us chills while reading them, to listening to various discussions from other subject matter specialists about the moving parts in segments of the market less familiar to most equity investors – rates, credit, liquidity, fixed income – often to our peril.
Notwithstanding the effort it takes to write our newsletters every week, the benefits of putting ideas and narratives down in writing are substantial: it helps to synthesise thoughts and ideas that would otherwise be floating around into a coherent narrative. In some cases, we seek to rethink/reframe some of the models we’ve used before in response to new inputs.
And on the subject of making sense of markets, there is without doubt too much to succinctly pack into a single post. But it’s worth a try: much of what will come will include ideas and concepts we’ve written on before, on which we build more analysis and consideration.
As always, opinions are welcome - especially if you disagree.
Inflation: transitory, peak or permanent?
Of all the complex issues and metrics that come from economists and “finance people”, none matter more than inflation. Sure, we can talk about spreads and basis, implied volatility and gamma hedging, but at any given time, these concepts matter of a relatively small subset of the general population.
But when it comes to generalised consumer price increases, the increasing cost of food, fuel and life in general matters to everyone – the point where it becomes political. As we and no doubt many others have observed, everything is getting more expensive. But not only that, supermarket shelves are starting to look rather bare.
The general narrative being pushed through the media is that this is all Russia’s fault. Culprit no. 2 is Covid, which has caused severe disruptions in the global supply chain. But notwithstanding all of that, it was transitory (then it wasn’t), and now it is high but will peak soon™.
To facilitate this peak in inflation, the Fed along with most other central banks around the world including the ECB (with the BoJ being the main exception) has signalled and seemingly started on a path of tightening. The hope is that with this tightening, at least according to the traditional Central Banker’s Playbook, raising rates will drain liquidity out of the system and reduce price levels. Yes, it will hurt, but the Fed is supremely confident of engineering a “soft landing”, against the odds of their track record (certainly not one of successfully doing so).
At this point, we need to call upon our trusty economics textbook diagrams, because sometimes, classical economics makes perfect sense. We’ve moved what was previously included in this section into an appendix at the bottom of this note, for anyone who’d like to relive the old days of classical macroeconomics lectures.
A hiking cycle to tighten aggregate demand might help to bring price levels down, but if demand isn’t overflowing, one has to ask if tightening is the right policy – or if there is actually no alternative route that the Fed can take.
Furthermore, take a look at the state of capacity expansion in the entire industrial complex, and we may quickly conclude that the reverse is actually true: from copper mines to oilfields to agricultural production, the base of productive capacity has actually been stagnant, if not shrinking over the past decade or so.
The picture is similar everywhere but this chart in Alcoa’s most recent investor presentation is a snippet of what has gone on in the Aluminium space. Stocks have been falling over the past decade, while capacity continues to be shut down.
The narrative is similar with every commodity producer, hard and soft. Furthermore, the ongoing conflict in Ukraine deals an added blow to aggregate supply of wheat and potash, fanning the flames of supply shortages.
But the shrinking of Aggregate Supply is not limited to physical commodities. The labour force isn’t growing either, for various reasons including perhaps some structural ones – tasting freedom of not having to work in the office in a post-COVID world isn’t something that can magically disappear. No surprise then that in the US, the labour force numbers haven’t exactly made the most enthusiastic comeback:
It sure doesn’t help when governments are starting an unhealthy habit of dishing out free cash either.
Ultimately, going back to the demand question, one cannot help but ask: if demand was so great that businesses were struggling to cope with too many customers (first world problems!), why would they not just pay up higher wages to get the staff they need?
The Fed cites tightness in the labour market and continued elevated wages as signs that the labour market is strong. But why can’t the gap close? Or could it be that businesses don’t feel justified in paying up on higher wages because the reality is less rosy than it seems?
Putting all of this together, we get to a worrying conclusion: that central banks are using a demand-side solution to address a supply-side problem. Of course, the same end goal (lower inflation) can be achieved, but with very different impacts on GDP.
Tightening into already-tight supply hits GDP much more than simply tightening to cool off overheated demand. The problem is the Fed how has a dual mandate of BOTH growth (GDP) and inflation.
Push has come to shove, and either way, something has to give.
Inflation was certainly not transitory, and it’s unlikely to be permanent. But whether it’s already peaked and whether coming off that peak will be a pleasant experience is a different story.
Constraints on monetary policy
But let’s zoom out for a moment to the even-bigger picture. Full credit to Zoltan Poszar’s writings for the impetus to think about the concept of the nominal vs the real economy.
As mentioned above, his recent writings are essential reading, and the visceral effect of giving us chills is noteworthy to say the least. We will nonetheless try to summarise the idea, though at risk of not doing it full justice: printing money to stabilise the nominal economy is easy; but you can’t magically hit a button and print copper, iron ore, aluminium, oil, wheat or corn. Most importantly, you can’t hit a button and print time.
There are two layers to this idea. The first is the shortage of physical commodities, which we’ve touched on above. Monetary policy cannot solve supply constraints because these constraints aren’t issues that are solved by throwing lots more money at it. In contrast, throwing much more money around exacerbates the issue.
In some way, this also reveals the fundamental flaws of top-down monetary distribution flagged up by critics of QE years ago: the money that’s printed flows through the banking system, and unfortunately banks being profit-seeking (and rightly so) are unlikely to direct those new funds to higher risk borrowers who are ironically the ones that need credit the most. The result is a concentration of surplus credit accessible to those who need it least – we touched upon this when we wrote years ago asking where did all the money go.
In short, solving issues in the nominal economy is easy. Bank run? Print more money; Short on working capital? Print more money. Collateral issues? Print more money, swap for collateral. Problem solved.
In contrast, in the real economy, it’s a different story. Shortage of copper? Sure, start prospecting a new mine, spend 5-10 years of capex and hopefully revenues come in 10-15 years. Shortage of grain? Well, we missed planting season, nothing we can do there. Can’t print money to wind back time.
This takes us to the second level of thinking: that money can’t buy time, but time burns money. Almost every financial invention operates on the principle of drawing the future into the present (or vice-versa), circumventing the linear flow of time (at a cost of some discount rate) with respect to returns.
Specifically, we need to think about how in the relentless pursuit of “efficiency”, powered by the financialisation of everything, the whole world transformed itself into a “just-in-time” system. The concept of antifragility (and hence fragility) best articulated by Nassim Nicholas Taleb comes into play here: more efficiency = more fragility, and we’re seeing that fragile system being smashed before our eyes.
A confluence of factors that have been in play over the past decade have now put us in a position where a delay in a “just-in-time” world translates into disruptive ripples in an interlinked global supply chain. We saw that in the early days of COVID, although the effect was subsequently muted because everyone was locked in and couldn’t go out and place demand stress on supply chains. That is quickly changing – not just because of everyone going back out, but everyone going back out in a different manner.
Optimised systems naturally don’t have redundancy, but redundancy is flexibility. It turns out we have none, and this lack of flexibility is causing tightness in the physical markets for everything, translating back into tightness in financial markets: deliveries take longer, payables and receivables are stretched, balance sheet consumption increases, capital gets tied up for much longer, return on capital falls.
“Just-in-time” is now becoming “Just-in-case”.
At its very core is the notion of time, the one thing central banks will never be able to print.
Together, time and physical markets are already causing a tightness that is unrelated to monetary policy, with consequences that monetary policy is unable to fully control.
There is “Inflation” and there is Inflation
The final thought here is something that might be labelled as “semantics”, although in this case they are critical.
The textbook definition of “Inflation” involves a situation with “too much money chasing too few goods.” This is the situation in which we are told we find ourselves, the solution to which is some degree of tightening, and it’ll all go away.
But while we feel a set of effects that correspond to this textbook definition (i.e. higher and rising price levels), it is clear that the drivers of this increased price level have nothing to do with “too much money”. Ask the average household if they have “too much money” and you’d risk getting a slap on the face.
Most importantly, the sequence of events that have led to these inflationary symptoms have been in motion for a very long time. Recent events have exacerbated it, but they certainly were not the root cause.
And perhaps there is also “Inflation!™“, the meme which we are sold that says there is a bad guy out there which is causing all of our problems.
Which leaves us with a rather worrying conclusion: if Fed policy isn’t the right policy for addressing the rising prices that we are experiencing, what is?
Is there even a way out? On one hand, hiking runs the risk of a procyclical tilt into recession; on the other, not hiking (or even easing) will only serve to send inflation on an even more violent spiral. The stock market bulls would argue that that’s great, since equities will serve as an inflationary hedge in such circumstances.
Perhaps, but it is hard to see how we’d put the narrative of out-of-control inflation back into the bottle now that it’s out in the wild, not when the effects of that inflation are being viscerally felt around the world. Ultimately, we face a scenario where regardless of whether a tightening happens by the hand of the Fed or through persistently high prices, the accompanying demand destruction comes to pass anyway.
Until then, the beatings (from market volatility) will continue until morale improves. And the real world may get rather ugly.
Appendix - The Macroeconomics bit
At this point, we need to call upon our trusty economics textbook diagrams, because sometimes, classical economics makes perfect sense. We’re going to borrow this diagram which we found on google to demonstrate the point:
Raising rates essentially reduces the availability of credit going around the economy, thereby reducing the ability of consumers and companies to borrow and spend. The effect that the above narrative (rate hikes = lower inflation = all problems solved) has comes about as shown in the left panel of the above chart. Aggregate Demand (AD) is reduced as the curve shifts from AD0 to AD1, thereby reducing GDP (an engineered recession, a “soft landing”) from Y0 to Y1, while reducing the price level from P0 to P1.
Now think carefully about whether this is truly the case. Are we truly in an economy where demand is overheating, in which everyone is swimming in huge wage increases, massive wealth and therefore so affluent as to be borrowing and spending too much?
Every central bank narrative is running along the same lines: supply chain problems are causing inflation. And they’re right, which means the situation that we’re facing right now is that depicted in the right side panel: Aggregate Supply (AS) is being reduced, thereby leading to an increase in price levels despite no change in Aggregate Demand. Sure, hiking rates would bring AD down as per the scenario before, but the double whammy impact on Real GDP would be two-fold – the impact from the right side panel PLUS that of the left side panel when higher rates come into play.
The caveat to add to these simplified models is that there is a time lag, reflected in the diagrams containing both LRAS (Long-run aggregate supply) vs SRAS (short-run aggregate supply). In this case, the LRAS is to the right of the SRAS curves, suggesting that there are near-term constraints that prevent AS from reaching its full potential in the short run.
One can only wonder if we are facing a reality where our LRAS curves are actually to the LEFT of the SRAS curves, as decades of supply rationalisation and closures mean that the time lags mask the extent of the supply destruction that has already happened.
When we say that the circumstances that have conspired to create our status quo today have been years in the making, we aren’t exaggerating.