Weekend Reading #188

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This is the hundred-and-eighty-eighth weekly edition of our newsletter, Weekend Reading, sent out on Saturday 1st October 2022.

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What we're thinking.

With global rates gyrating like a teenager on Tik-Tok, it's no surprise that equity prices are being thrown around like a toy ship in a hurricane. The most important factor for any “CFA” trained analyst when doing a valuation is “what is the discount rate?” And whatever anyone may tell you, the answer right now is that no one has a clue. There is no greater uncertainty that this and markets as we know do not like uncertainty. When we get closer to the answer to this question, we will be closer to getting to stability. But from the way things stand, it doesn’t seem like we are anywhere close.  

We have to of course also mention what transpired in the UK over the past week: from a collapsing GBP to a full-on market intervention by the BOE, things really got heated up here. As the events of the week unfurled, what looked like a U-turn on the BOE’s part (QE AGAIN?!) was eventually revealed to be a market intervention to prevent a cascade of margin calls from none other than pension funds. 

As it turns out, the custodians of the retirement savings of millions of people have been taking on quite a bit of leverage (euphemism intended) to help juice up those pension returns, with none other than gilts as the collateral. Triggered by the UK government’s ostensibly profligate “mini-budget”, as gilt yields started to pop, pension funds were facing margin calls from their brokers to the extent that Lehman actually was mentioned in a quote to the FT: “It was not quite a Lehman moment. But it got close.” Asset manager Blackrock was even reportedly threatening to halt trading in certain funds at one point, somewhat reminiscent of BNP Paribas freezing some of their funds back in 2007. 

The bind that the BOE finds itself in – between bailing out the pension funds and the financial system vs trying to bring inflation down in the face of growing popular dissatisfaction – is one that arguably all central banks face, especially in the developed world. The government is of course also in hot water, with Labour grabbing a huge opinion poll lead as a result of this. Whitehall probably needed a reminder that making fiscal policy is different when one is no longer the global economic hegemon, and the markets were prompt in providing that reminder. 

Is this the end of the trouble? Probably not. If anything, this could well be the beginning of other tremors to come. As is always the case, crisis hits where it is least expected. The banks will probably emerge unscathed, but for a hit to earnings, thanks to some serious overcapitalisation, thanks to the regulators continuously fighting their last battle. Where could the real damage come from? Time will tell, but the same combination of factors always show themselves: illiquidity and leverage. 

Finally, there’s the matter of the US dollar. We’ll leave everyone with this thought: that the USD is essentially now the world’s definition of “cash”. Fed policy is domestic, but surplus USD gets circulated into the offshore lending system (the “eurodollar” system, not to be confused with euro/dollar FX) which ultimately determines how everything from supply chains to working capital is financed. Trade operates on USD, regardless of where one is, with a few growing exceptions – but it is the exceptions that make the rule. The only difference here is that while domestic monetary policy determines the tightness/looseness of a domestic money system, an offshored lending market determined by the willingness of USD holders to put their dollars at risk for a yield is a different matter. If corporates and individuals, irrespective of country of domicile, decide that hoarding dollars is the way to go, then there won’t be any surplus dollars in the system, and there’s nothing the Fed or any central bank can do about it. Indeed, if you’re looking for a “decentralised” dollar system, it’s already here: it’s called the eurodollar system. Everyone’s already using it. So, the question is: how much pain is tightening eurodollar liquidity going to cause? 

What we're doing.

The CAIA Association’s London chapter hosted its first in-person event this week since the start of the pandemic and so I decided to head down to the iconic Lansdowne Club to enjoy an evening of cocktails and discussions on the state of the hedge fund world and private equity market. Whilst there, I chatted to a whole host of people from across the industry, with prominent discussions as one could imagine centred around the state of the UK economy and the ongoing decline of the Pound. HS

What we're listening to.

My listening was a bit below par but I really enjoyed Daniel Negreanu’s chat with Lex Fridman. I don’t watch live poker or follow the pros as much as I used to, but I do remember him as a skinny kid from back in the early 2000’s when poker had its breakout period on TV. Today he has a luscious beard and has clearly been gyming for a while. Turns out he has become one of the greatest players of all time, not only for his success but for his longevity. The two chat about the emotional rollercoaster of trying to play consistently. They talk how the game has changed and how the newer generation is impacting the game. But most of all they just talk about poker – strategy, hand recollections, stories and it’s a helluva lot of fun.  

Stan Druckenmiller has been in the media over the past week first chatting with Alex Karp and Palantir, then on this podcast with David Novak and then finally at the CNBC Delivering Alpha conference. It's unusual for him to be so active but as he said at the Delivering Alpha conference, even though he promised himself he wouldn’t go on TV again at the start of the year, he has felt compelled to speak up given the craziness of how he sees The Federal Reserve making decisions. He has been quoted before as saying that he thinks Jay Powell is the worst Fed chairperson in history. The podcast with Mark Novak was great as it focused a bit more on his journey and his career and philosophy rather than as much on investment related things. As with the recent Palantir chat, this one once again is a great listen. DC 

Jim Bianco is one of the veterans of the fixed income market that has a history not just of thinking deeply about the drivers of the market, but also has a knack for explaining the result of that deep thinking well. Furthermore, despite his “traditional” finance background, he’s proven himself to be open to learning about new developments in the market, even showing up for a podcast with Bankless to chat about DeFi. This recent podcast that he did on Macro Voices was one of those that helped to articulate ideas that we were struggling with finding the right words for: talking about how inflation is not going away, Jim drills straight down to the heart of the matter, that what COVID and the lockdowns did was accelerate trends that would’ve taken decades to play out and made them happen in 2 years. These trends – of working from home, of government-mandated lockdowns, of supply chain fragmentation to name a few – were gradually already taking form, but left to their own devices would have perhaps taken 2 decades to come into play, giving us time to work out how to deal with them. But the speed with which they manifested now leaves us in a situation where the future has been brought to the present, but no solution has yet been found. The outcome: the end of an era of persistently low inflation, something we’ve taken for granted our entire lives. EL 

What we're reading.

Every now and then the order of the Chinese political theatre throws up some weird stuff like this week’s apparent coup attempt which as one would expect was pure conjecture during a quiet period while Xi Jinping quarantined for a few days after a trip. It just so happens this week I also finished reading Kerry Brown’s short biography on him simply called Xi – A Study in Power. Brown is Professor of Chinese Studies and Director of the Lau China Institute at Kings College here in London and has written a number of books before (none of which I’ve read). The book is a nice, whistlestop summary of Xi’s path to power, although the real personal insights into Xi as a man remain elusive (and not by coincidence I'm sure). But what it does make clear is that Xi has been preparing for power his entire life. His every move was carefully scripted beginning particularly with his time in charge of the Fujian province. His messaging has been clear all along – the strength of the party, consideration for the environment and most importantly his obsession with not getting caught out by the many trappings of power which can be used against someone of his stature. Whether he believes in the party and in the environment and all the themes he has emphasized for so long or whether it's what he wants everyone else to think he believes is a different story. But I found good insights to layer onto all the other pieces of the puzzle that is Xi Jinping. 

My go to source for truth these days when it comes to news is the Common Sense substack. Founded by Bari Weiss, its grown into a new-age, news and opinion publication with more and more journalists joining. The title of the publication is just perfect because in today's world all I really is to read someone’s take which is based on basic common sense. This week’s edition featured a bunch of great stuff. This piece on why AI can never produce real art got me thinking a lot. Often I’ll be thinking about something in the news and wish that I could read a take that just didn’t have a bias or an angle and them bam Friday arrives and there it is. This week’s one was a piece on new Italina PM Giorgia Meloni. It’s nigh on impossible to find anything on the internet that isn’t a binary view on whether she is “fascist” or “not fascist” so I heaved a sigh of relief when I was directed to this piece which answered a lot of my questions. The answers however, are not quite black or white. DC