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Eric Peters - april 2022

Hope all goes well…

“My massive bias is to believe things always work out okay,” said Simplicity, walking Occam’s Razor. “But today somehow feels unique, and when I look at supply and demand in oil, grains, base metals too, there’s an undeniable tail risk here,”

he said, having analyzed the fundamentals of such things over a long career. “Without a perfect North American growing season, there will be shortages, perhaps we’ll have them even with perfection, it’s too early to be sure.” And Simplicity paused, sharpened by decades of trading markets that oscillate wildly in times of great uncertainty as producers, consumers and speculators struggle to balance supply and demand. “It’s critical to size your positions small enough so that you don’t discover you’re trading a 3-year perspective with a 3-day stop-loss.”

Overall: “One thing is certain: To be effective, the Fed will have to inflict more losses on stock and bond investors than it has so far,” said Bill Dudley, former Fed President, saying bluntly what his active-duty central bankers barely dare whisper.

“Market participants expect higher short-term rates to undermine economic growth and force the Fed to reverse course in 2024 and 2025 - but these very expectations are preventing the tightening of financial conditions that would make such an outcome more likely,” explained Dudley, scratching the surface of the disquieting predicament the Federal Reserve now finds itself in. And because the world’s developed-market central banks adopted US policy in recent decades, the Fed’s quandary is now a global phenomenon. “This would mean hiking the federal funds rate considerably higher than currently anticipated. One way or another, to get inflation under control, the Fed will need to push bond yields high and stock prices lower,” Dudley said. Cooling an over-heated, capacity-constrained, hyper-financialized economy, in a time of deglobalization and war, without first tightening financial conditions is proving rather difficult. Like all complex problems, this one took decades to create. Back when the US economy had less debt and leverage, when financial assets had lower valuations, and when wealth was less concentrated, the ups and downs of the real economy drove financial markets. In such a world, the Fed quite easily used conventional rate policies to influence our behaviors to achieve their objectives. When those became less effective, they introduced unconventional policies, and forward guided their intentions to become highly predictable. The effect was the hyper-financialization of our economy. Now, with such high levels of debt, leverage, valuations, and wealth-concentration, it is financial markets that drive the real economy, not the other way around. We have never experienced a modern economic cycle that looks anything like this. And Dudley may be right in his prescription. But if it is one thing, it is certainly not certain.

  • One River’s Head of Research, Marcel Kasumovich, published a terrific piece titled, “The Dollar is Dead... Long Live the (Digital) Dollar”

Rate of Change: “Looking back on the 1970s, you find 3 distinct inflationary cycles,” said the CIO.

“Inflation first peaked in 1970 at just over 6%, then backed off,” he continued. “It peaked again in 1975 at around 12%, declined, then made a final push to nearly 15% in 1980.” That was it. “In the first two cycles, equities fell when inflation rose, and rose when inflation fell,” he said. “Then in the third cycle, inflation went up and for some reason equities did too. I don’t know why. But maybe it’s not only about inflation, but also the rate of change of inflation.”

Autarky: “What’s the really fancy word for it?” asked the CIO, annoyed that he couldn’t recall it.

I simply shrugged, quite happy to keep it simple. “Anyhow, screw it, it’s some word that refers to nations which strive to become self-sufficient, economically independent,” he said. “There will be a move toward that for the years, decades probably. What the hell is that word?” he asked, sighed. “But the thing is, not every country can become self-sufficient so as much as everyone will want to if they need to, hardly anyone can, and that’ll slow the whole process.”

Autarky II: “This is really driving me nuts,” said the CIO. “But I’m not going to Google it, I’ll remember the word,

it’s right there, I can just about touch it,” he said. I had already found it but didn’t want to rob him of the pleasure. “What’s more likely to happen will be a shift toward trade blocks, unions of like-minded nations, partners, allies.” I was tempted to suggest such a world would be bifurcated, but that word is a bit much for me, and besides, I was pretty sure that meant two-worlds, when in fact there could be three or more. “This word is driving me crazy.”

Domo Arigato: “The age of optimization and maximization is over,” said the CIO.

“It will be replaced by a resurgence of manufacturing, and Japan is filled with such companies,” he said. “Japanese equities have been penalized for years because they employed inadequate financial engineering.” Now they’re comparatively cheap. “With the weakening Yen, Japan’s minimum wage priced in US dollars is the cheapest in the G-7,” he said. “The percent of Japan’s workforce near the minimum wage is high. And the real exchange rate is back to where it was in 1975.”

The Grind: “Neither side is talking, negotiating, they’re participating in a television event,” said the CIO from London. “The US and UK appear to be supplying enough weaponry to ensure that in the end, there will be few Ukrainians left,” he said.

“And Ukraine’s only viable strategy is to provoke a war between the West and Russia, which is the one way for them to ensure Russia’s destruction,” he said. “And Russia believes that if it can drag this out, acute global food and energy shortages will fracture national alliances that might appear durable today.”

Anecdote: “The hope is that these cracks will turn into chasms,” said Dr. Mitesh Patel of Imperial College, Faculty of Natural Sciences, Department of Physics.

“And eventually we will see some spectacular signature that not only confirms that the Standard Model has broken down as a description of nature, but also give us a new direction to help us understand what we are seeing and what the new physics theory looks like.” He’d just announced the results of a series of particle collisions that reveal the sub-atomic W Boson is heavier than predicted. “If the results are verified by other experiments, the world is going to look different,” he said. “There has to be a paradigm shift. The hope is that maybe this result is going to be the one that breaks the dam.” Despite our magnificent scientific advances, we still barely know how the universe operates.

We will all live and die, having existed within a reality we hardly comprehend, or perhaps entirely misunderstand. It is as exciting as it is humbling. And then there is the role that chance plays in the complexity of human interactions. In a game of chess - a two-dimensional board game with just 32 pieces and 64 squares - there are 288bln different possible positions after 4 moves each. There are more possible chess games than atoms in the observable universe. Human relations have many more dimensions than a board game. With 8bln players and 195 nations interacting with a chaotic climate and ever-advancing technology, the range of outcomes is infinite. We develop standard models to make sense of economics, politics, society.

But unlike physics, such models are not constrained by set rules, immutable physical laws - just probabilities, tendencies, nothing more. And right now, the probability of extreme outcomes is rising. Inflation, economics, geopolitics. The tendency toward paradigm shifts is evident, underway.

Deglobalization, multi-polarity. New models will emerge, they always do. And the risks and opportunities in the transition will be unlike those we’ve observed in many decades.