Climbing the Wall of Worry
August 22, 2022
With the slow days of August coming to a close, markets are watching nervously for the seasonally volatile month of September, especially around the options expiry on September 16th – there is much embedded muscle memory of painful ends to Q3 over the years – and are starting to adopt a certain ‘back to school’ mentality, where investors are forced to focus on the – not very attractive – fundamentals. As such, we thought it worth getting to the school-books a bit early and discussing a few of the ‘known’ issues (as well as a few known unkowns) that markets are likely to concentrate on over the next few weeks and months
This year has seen some significant headwinds for all markets, particularly those coming from de-leveraging and, as those headwinds fade, we see some stability emerging and a series of bear market squeezes that are hinting that the bear may be over and the new Bull can begin (see August Market Thinking). However, as markets sit just below long term moving averages trying to break higher, we should remember that Equity Bull markets are often said to have to ‘climb a wall of worry’, which is another way of saying that while a new bull market starts during a period when all the negatives are becoming obvious and ‘everyone’ assumes that they must go down further, such as now, if and when it does indeed bottom out, the early bull nevertheless moves in fits and starts as the short term traders in particular try to use the ‘noise’ to drive volatility.
Earnings, Inflation and recession.
The issues around the Cost of living crisis are what we would call in Rumsfeld speak ‘known knowns’ and are working their way relentlessly through the economies of the west in particular. For all the attempts by politicians to deflect blame, it is becoming increasingly apparent that the root cause is long term policy failure; specifically the triple zeros. The failed policy of Zero Interest Rates, that caused inflation in Asset Prices but not on the high street is now being used, equally incorrectly, except in reverse, to try and stop the high street inflation that is largely a function of the two other policy failures of the last decade – Zero Carbon and of course Zero Covid. The latter led to a dislocation in demand and supply that had already led to 7%+ inflation by January this year as a combination of cash injected directly into the economy (producing a very different demand response to cash given to Private Equity barons) met with a supply disruption caused by the foolish policy of sustained lockdowns. This, in turn, was exaggerated by the consequences of the obsessions with Zero Carbon that had become ever more extreme, imposing more expensive, less reliable and less efficient energy on western economies and which singularly failed to cope with the return to ‘normal’ levels of demand. In particular the European obsession with wind and solar ‘unreliables’ had created an unhealthy dependency on imported fossil fuels for baseload power. Nuclear – sadly neglected as a solution – can’t be spun up quickly enough when the wind doesn’t blow or the sun doesn’t shine, so imported gas, mainly from Russia, takes its place, with obvious consequences now that the US is insisting Europe bear the brunt of US geo-political sanctions on Russia. The fact that most European governments had neither filled storage, nor negotiated long term contracts, preferring spot prices is at best incompetence, but in reality borderline criminal negligence that won’t be explained away by blaming it on Putin.
The consequences of this triple policy failure are for prices generally to move to a permanently higher level – excess supply has been removed from the system and pricing power has shifted to the producer. But this is not the same as sustained annual inflation. More likely is a sharp hit to demand among consumers as the Central Banks compound their earlier error of failing to understand household balance sheets on the stimulus side, by now failing to understand them on the austerity side. Countries such as UK, Aus, NZ and the European countries known as PIIGS (Portugal Italy, Ireland, Greece and Spain) have all had housing booms and busts based around the fact that the household balance sheet is leveraged to short term rates (by contrast the US is fixed rate and refinanceable). Raising the cost of living (mortgages) to somehow deal with a high cost of living is, as the say an idea so stupid only an academic could believe it.
As to Recession, as noted, the US consumer is better protected from central bank failures, as well as arguably benefiting from Europe’s misfortunes (US exports of Gas, Guns and Grain all doing well, while the strong $ is keeping import costs down). Nevertheless, there is no doubt things are tough, but in terms of narrative management it’s interesting to note that WSJ tame Democrat economist Paul Krugman (and others) are desperately trying to convince us that there isn’t a recession (so long as you change the old definition of one), mainly it seems to avoid giving ammunition to critics of the Biden Administration ahead of the mid terms.
So far, the hit to earnings (another known known) hasn’t been as dramatic as some predicted, but, like the consumer, it’s all about balance sheets. The cash flow implications of badly structured balance sheets meeting liquidity constraints and negative operational gearing are now starting to bite and the leveraged buyout stories are unravelling rapidly, just as they did in previous tightening cycles – (Cineworld being the latest casualty), driving a shift to Quality.
Liquidity, redemptions and Politics – known unknowns.
Liquidity remains a key issue, albeit more of a ‘known unknown’ as we only tend to observe its effects after the event. While we suspect that the one way trend of deleveraging that dominated the first half is now over (for now at least), there is still a risk around redemptions and forced selling, which is likely to make this year’s poor performers (think mid cap tech) vulnerable to yet more selling. The ongoing drama around Tiger Global, Softbank and Ark (to name the three most prominent examples) is only the most visible part of the problem. Crypto is also a big unknown, specifically around margin calls and the risk of chain reaction failures from a liquidity event in the weakest link are part of the reason we would expect risk premia to remain elevated, ie we may have stopped de-rating, but that doesn’t mean a widespread re-rating.
The bigger risk factor however is likely to be politics – not least the political calendar coming up, not only the mid -terms in November, but the CCP conference in October and the Italian and UK selections of new leaders in September. There are also elections coming up in Sweden and Brazil and (largely off the radar at the moment) the election in Israel in November. The latter has already led to escalations in the Gaza strip and threatens to generate some meaningful tensions with Lebanon – and by implication (and by proxy) with Iran. The new twist is that this is due to the disputes over gas drilling in what Lebanon claims are its territorial waters – as if we didn’t have enough disputes over gas already.
As traders and investors return from the beach, they observe a fading of some headwinds as well as a technical set-up for markets to either hit resistance in the form of long term moving averages or to breach them and establish the base for a new bull market. As part of that they will be considering the Wall of Worry currently facing equity markets and trying to discern what is ‘already in the price’ and preparing scenarios for what might come next. In terms of ‘known knowns’, the negative fundamentals associated with the consequences of long term policy failures around the triple zero policy – supply shocks, vulnerable household and corporate balance sheets, poor energy infrastructure – are largely known, if not acknowledged by many. Less certain are the ongoing liquidity issues – although this is probably the area where uncertainty is likely to fall fastest. Probably the biggest unknown however comes from policy makers and the prospect of things going in widely different directions; will a (known) difficult energy winter force European politicians to urge negotiations over Ukraine? Will a post mid-term US government change its stance on international policy versus Russia and China? Moreover, what about other foreign policy arenas? How will it deal with the likely challenge to the Election result in Brazil by Bolsanaro, or indeed the prospect of a return of left winger Lula? What would it do in response to an Israel/Lebanon conflict?
Meanwhile, will Russia finally cut off gas supplies to Europe or a newly empowered Xi become more aggressive (if only on trade) in response to long term US antagonism? Will a new UK Prime Minister finally rein in the Green Leap Forward? A lot of known unknowns to think about….