The Sleep of Reason
Big picture risk assessments today, and worries about the prevailing style of regulation - we look at where the next bank blow up maybe. Weâre assuming this will again be caused by regulators and their herding behaviour. On the upside, an improving medium-term market outlook. Also, dollar danger.
But before I beginâŠ
First of all, many thanks to those who replied to our sentiment survey, you are a cautious crowd! Over half (53%) sitting on the fence, alongside us. The largest directional group is bullish on equities (18%), but it is a pretty even bull/bear split with bonds, and quite a few equity bears too.
Regulatory Myopia and Declining Banks
Bank boards (and auditors) are still clearly confusing regulatory approval with sound banking, in the odd belief that excuse will wash, when they implode. In particular we worry about the vast amount of debt that is sitting on bank balance sheets, at below current market levels, and not in this case issued by governments.
We have notable anxiety about two areas, fixed rate mortgages and investment grade debt where, especially for the former, the numbers are vast. Perhaps the tightening steps to date appear so ineffective, just because so much of this old low-cost issuance, is only very slowly rolling off .
Big picture â the effect of long dated low-cost loans, with rising interest rates
This leaves cheap money in the system, funded by banks, that have to pay way more to keep funding these long-term deals. Theyâre doing this typically with short-term sources, like deposits. In sub-prime, asset finance, trade finance, consumer finance, none of it matters much, as they are pretty short duration. Which is where most people worry, because of default rates, we donât.
But in mortgages especially the regulator typically issues the future economic scenarios to banks, who then price (originate) and provide for losses against that projection.
If that projection is absurdly few rate rises, for a decade (as it was till fairly recently), it seems banks just follow obediently along. As a result, they have issued vast amounts of long dated, low cost loans based on false or unrealistic assumptions.
Those regulator driven economic assumptions/scenarios are key, and yet are lost in the detail. Each bank has to publish them if you dig deep enough. (Some are on p155-157 of the HSBC accounts, for example, if you have the stamina.)
Re-mortgages â what they contribute to our big picture
The other part is refresh rates, in a falling interest rate world, borrowers re-mortgage every few years, but in a rising one early redemptions virtually stop. So, the whole system gums up, without fresh liquidity. Regulators have not seen, and have no data, on such a âhigher rates for longerâ world. So, it is assumed that world cannot exist. While the key thing (still) on these scenarios is that interest rates are still assumed to be like rockets, straight up straight down.
Now if you assume that, there is some short term pain, but normal service resumes soon enough with no long-term issue. But is it realistic? It is a vast slow moving market as in this publication of the FCAâs mortgage lending statistics .
Inevitably the scenario dispersion used is small, indicating a regulatory finger remains on the scales. So, most banks take the Central Bank forecast as the middle way, with say 10% either side. All as at the historic balance sheet date. Last year they were nonsense even before publication, two months on.
That is aside from Hong Kong, where real economic models, with real outcome ranges are visible. For most markets you see a skein of twisted rope drifting laconically into the future, but on HK they produce an exploding ammunition graph, smoke trails looping everywhere.
To a lesser extent BP debt (a classic investment grade, big, global borrower) is a similar problem. It has half fixed, half floating issuance, but the fixed is at 3% with a fourteen-year average term and the floating at twice that, at 6%. Now someone holds that fixed debt, and if regulated it will have to now be held below par. Are BP going to prepay it? Despite the roar of cash coming in, why would they? It is stuck, unusable for 14 years, unless inflation (and rates) collapse as fast as predicted.
What else is driving markets?
The big upside drivers to us are, the end of COVID, the end of the energy spike and falling rates. The first two will help through 2023 and 2024. Rising rates are still hurting, but again 2024 and beyond  looks good.
While the biggest current downside driver is the recession, which will impact 2023, but again rebound in 2024. So, the issue is: will the rather timorous monetary tightening and anaemic reductions in the absurd fiscal overdrive, be enough to defuse all that good news coming in the next year?
Markets apparently think not.
We are particularly struck by the NASDAQ up 18% year to date, yet our tech bell weather share, Herald Investment Trust (HIT) is still (marginally) down YTD. So is this a bitcoin-type story (all about liquidity) or is it based on tech fundamentals? If the latter, then why is it seemingly glued to the US, and not translatable? Even failing to reach non-US holders of US companies.
For now, until the price of global tech shifts, I treat the US as a special case; growth is not back yet.
While the currency charts are unclear, it does also feel like the beginning of the end of the great dollar story, with sterling persistently ticking higher of late.
From: this page published by the NY federal reserve.
Thatâs a real danger for portfolios that thrived on dollar power last year.
We close wishing you a happy Easter break. We will be back with St George.
A RIGHT OLD TONKIN
About Influence â American and Russian, mediated by the Chinese
So, to start with what does worry us: That is the slide to a hot war with the powerful Eastern autocracies, fueled by the EU with Napoleonic tendencies, an old man in the White House and a curious sense of âcrusadesâ with no consequences.
For those with long memories of American imperialism, the latest drama even fits neatly as a modern Gulf of Tonkin, a key moment in the slide to war. In that case (south of Hanoi) the clash was naval not aerial but was still notable as one directly between the warring parties and not just their local proxies.
While elsewhere the pieces move, China can not let Russia fail, nor descend into chaos, their long-shared border must stay intact and secure. They no more want the US there than the Russians do. The first step after his confirmation as ruler for life, by Xi, was indeed to go to Moscow.
And the bitter battles in the Middle East of Persian against Arab, Sunni against Shia have cooled abruptly, under Chinese influence. The world once more understands that the US is the threat to peace and stability, not just their fractious neighbours.
For Biden it is an easy fight, the Pentagon so far has played a blinder, what can go wrong? While, for now, France is Europe, no other large state has anything like their stability, Italy is led by the unspeakable, Germany has free market liberals in a bizarre ruling alliance with Greens, Spain is wrapped in its own forthcoming general election, the UK both distinctly detached and under a caretaker government.
The UK budget said nothing, incidentally.
Main influences in France.
While the left in France, as the above photograph shows, are very alive to Macronâs ambitions, to add more territory to the EU, arrange more protectionism for French goods and to suck the labour force out of adjacent states to serve the Inner Empire. Just like Bonaparte tried (and failed) to do, with dire consequences for the French nation.
For all that, the domestic fracas in France (which makes our own strikes look rather tame) was inevitable. Raising (by not a lot) the pension age from 62 to 64, against our own 67 looks small, but it was a clear campaign pledge.
The absence of any minor party wishing to self-destruct, by supporting it in the French legislature, is no great surprise either. So, he has implemented it by decree and Macron has dared the opposition to now either remove his prime ministerial nominee, or shut up.
Banking On Nothing
So, what of markets? Well, the end of SVB is no great loss, it had several policies that had to implode if rates rose, especially on the lending side. It was painfully âwokeâ; I can tell you more about the Board Members sexual orientation, gender and ethnicity than their banking experience, the former just creeps into the end of their latest Annual Report, the latter was invisible to me.
SVBâs long list of ESG triumphs and poses (and it is long) at no point included not going bust. It did commit an extra $5billion to climate change lending, which I guess has all gone up in smoke now. Still apart from all being fired, the bank insolvent, the remnants rescued by the hated Washington mob, under investigation by the DoJ, all the rest of their âGâ was superb, and so, so, cool.
I donât see Credit Suisse as a danger, although it may be in danger. It has had an appalling run of misfortunes, with musical chairs at the top, but it remains a cornerstone of Swiss identity. To let it fold would be highly damaging and cause shockwaves in derivatives markets.
Influence on the markets
So, I do understand the Friday sell off (who wants to be weekend long with regulators on the loose). And we do understand markets needed to go down, after the big October bounce, indeed it was a key reason for our building up over 33% cash or near cash at the previous month end. We knew the winter rally was fake.
But I donât see this as much more. Retest of the S&P 500 October low? It should not be. I take a lot of heart from bitcoin soaring (63% YTD); if liquidity was short, that would not have happened.
But for all that, I donât like March in financial markets, too much is uncertain. So, this is more a time for cautious adding, rather than hard buying, but if we get to Easter (and hoping to be wrong on the Tonkin analogy) it does seem a better prospect.
Nor do I see how the various central banks can justify a pause in rate rises, at this point, but nor will they go in hard, that would be folly.
This Fed has made enough mistakes already.
First as Tragedy, then as Farce
This is turning into another unloved bull market, we look at why, and wonder if Chou En Lai was right about the French revolution. Lets start with inflation.
I chanced upon Paul Krugmanâs The Return of Depression Economics, written in 2008. Krugman is very much an establishment man, Keynesian to his socks and seeing the great failure of late 20th Century economics being the sudden lack of demand. He has other work and more recent books, but I will focus on this one.
IMF Remedies
He has particular vitriol for the way the IMF repeatedly used austerity in its many forms, as the antidote to all and any of the chaos created by a deflating bubble. So, taxes up, spending down and crush demand to stabilise a currency, to avoid the extremes of bank collapses.
In Krugmanâs world, it was more important to regulate banks, and it seems hedge funds, thereby stopping the sources of instability in the credit markets, and to then prop up demand.
Well, the echoes are there, current policy remains both IMF applauded austerity to save the currency, which is just what Hunt inflicted on the UK last year, and a desperate search for ways to pump up demand, to stop stagflation. Much as Biden is doing with the US and the amusingly called Inflation Reduction Act, and indeed the MAGA type, neo-Trumpian, protectionism now evident in the CHIPS Act. The rush to global rearmament should be just as effective.
All in the end versions of Keynesian demand creation â digging holes in highways to refill.
Echoes of Old Bubbles
Krugman is not indifferent to the bubbles this creates in the US stock market and US housing prices but would seem, like Senator Warren, to suggest whatever the question, more bank (and shadow bank) regulation is the answer.
It is odd as you piece together many establishment views, how this policy of âcreate bubbles, and then carefully regulate their deflationâ, but never cut demand too hard, is now the undeclared reality of mainstream economic policy at Western Central Banks.
Krugman is blistering on some old tropes, the Schumpeterian theory of creative destruction gets short shrift, which still lingers in the financial press in complaints about âzombieâ companies (which I have always found weird). Likewise, that global development is all about rigging resource prices, which haunts the walls of a million coffee shops and a fair few churches and is also (sadly) tosh.
So, he is not all bad.
The New Bernanke Put
Nor when you understand how deep his influence is, does this financial market seem so strange, because the Central Banks hope inflation is external (weather, politics, madmen fighting etc) so this will âmean revertâ in time. Alongside this sits a very wary take on destabilising currencies by interest rate differentials. The old guard real world elements break through occasionally (and have supporters, like the splendidly lucid El-Erian) especially with double figure inflation on the rampage, but they are not heeded for long.
Seen like that, while the stock market hates bubbles and inflation, it canât shake the belief that in some form the âBernanke Putâ is still in play.
In which case âhigher for longerâ on interest rates is a paper tiger, as rates donât cause recessions, regulatory failure and hot money flows do. In that world buying an overpriced but liquid US market and buying the dollar looks, to many, like low risk. Not to us.
Inflation control?
And yes, as we have long argued, this wonât control inflation, but it seems who cares? We donât need to fear the stock and housing bubbles deflating abruptly, as the Central Banks wonât allow that. Nor should we worry about rates, as Central Banks canât let them rise much more, without jeopardising their over-indebted host governments.
So yes, old hands may hate a rising market into an economic  slow-down, but they are it seems, just part of history.
What then to buy? Arms companies are not significant post ESG, the China trade is (we feel falsely) boosting already elevated resource prices, and travel companies are getting plenty of attention. Meanwhile areas of bountiful state subsidy (an ever-increasing list) are happy too. However, that is a fairly unattractive list. And are valuations in those areas still reasonable?
I can see why some investors just think playing around with Tesla options is the best bet (we donât).
Then as Farce, Modern Imperial Europe
Chou En Lai when asked about the French Revolution was of the view (it is said) that it was âtoo early to tellâ. I have been reading Michael Broersâ brilliant Europe Under Napoleon, an extended love letter to the EU, in favour of rational technocratic administration, with a deep-seated fear of the sans-culottes.
This seems to highlight so much of the French desire to see the EU as the Napoleonic Empire, without the bad bits. The terror of the rabble, the urban bias, the fetishism of one law, the desire to paint any opposition to EU autocracy as unspeakable - it all rather gels.
Well perhaps the parallels go too far, but in looking at the bizarre actions of the EU over Ulster it is tempting to see more than just childish spite. The resources thrown at half a dozen sleepy border crossings (reportedly 20% of all external border EU customs checks last year) made little rational sense. Even if not that bad, it was overkill.
So, I can half see why the DUP feel that getting rid of bureaucratic bullying is just appeasement, but looking at the litany of inconvenience to be scrapped, this does still feel like a win for all sides.
But as with markets, I suspect all the fundamental problems still remain.
The Scottish Play: Luck or judgement?
Three topics this week: has Sunakâs luck changed? Has Indiaâs bull run ended, and where is this much-discussed recession?
The Art of the Possible
Image from Wikemedia - by Neide José Paixão
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