So goes the infamous (and slightly bastardised) version of Jack Nicholson's speech in A few good men.
Yes, he was talking about the truth, but lets not fixate on that for the moment.
Since 2009 we have undergone the single largest financial experiment in history. I will leave it to others to plot the actual origins, but for now we will use the financial crisis as our starting point for this story.
From that moment, we saw central banks around the world in a largely coordinated way, take interest rates down towards zero, crushing the yield curve, and moving investors up the risk curve.
At the same time they started buying huge amounts of debt. They became the market in government debt and by proxy in Investment and High Yield.
Like the lowest block in a game of Jenga,everything is stacked atop.
That dual action has lifted risk assets to all time highs, and largely in a straight line (on various relative measures we are still below 2000 on growth stock metrics). The ultimate expression of this risk-on, has been the explosion of the speculative assets, crypto. NFTs. (I am not saying there is no value in these assets, but we are a long way from seeing the winners, and unpicking the regulatory hurdles — something their prices do not correctly reflect).
But now — now we find ourselves facing inflation.
What’s interesting is that inflation is something we’ve been ‘looking for’ for years, (Japan — decades). As recently as last year, Jay Powell was talking about letting inflation run hot in the near term to get the average rate back up.
Well, we have gotten what we wanted. Through a combination of massive monetary debasement, covid, supply chain issues, geopolitcally enforced nearshoring, and a desperate bid to slow carbon emissions.
Inflation is here. We wanted it.
But now what?
As we can see from the various investment bank commentators we see a huge split on expectations for interest rates. The bond market is telling us little will happen, the 5Y5Y is telling us little will happen, but the Fed and at the extreme end JPM and GS are telling us we need to hike, more quickly to get this inflation under control.
Central banks are fractured in their response.
BoE has left port, with 2 consecutive hikes — likely driven by a knowledge that post brexit sterling could be in for a rough ride if too closely tied to other bigger currencies. The Fed is due to ‘launch’ next month, and the ECB having been stuck in the traps, has now said it too will start to tighten in 2022.
So what now?
Well, it depends. Is inflation exploding as most commentators believe? in which case central banks are already way behind the curve, and this will lead to large political pressures as wage growth will lag cost of goods, and people will start to feel poor. This belief might well lead to CB’s to follow GS advice and speed up the hikes (either via jawboning, or action).
A quick series of rate hikes would, in my view be devastating for risk assets.
For 10 years we’ve been in easy street, but for over 20 we’ve lived with a fed put, an implicit knowledge that the fed wouldnt allow ‘too much pain’.
That put might now need to be repriced. We might need to see a large correction in equity markets, as risk resets. Growth to value, long duration to short, HY to IG, IG to sovereign. and gold. Assets will flow to safety quickly and in a disorderly manner. Credit markets have been intermittently creaking with liquidity issues, will come under tremendous strain.
In my view, the Fed is trapped on this angle. It cannot run hot, the ship would go down as the floating device of trust finally bursts and the financial mirage is laid bare.
However its not clear to me that the Fed knows this, or that the politicos know this, so we might need to prove it.
This is my base case, that the Fed talks up action to counter inflation and this talk causes some painful ruptures in asset prices, forcing a reversal.
The alternate path is that the Fed never gets a chance, as with growth seeming to slow, the spectre of stagflation rises again, causing indecision and a need to maintain support.
These are wildly different paths, but they lead to three conclusions:
- Volatility is here
- Single stock/single asset picking will outperform benchmark investing
- We can’t handle inflation.
Good luck!
