“People only accept change when they are faced with necessity, and only recognise necessity when a crisis is upon them”
Jean Monnet, Memoirs (1976).
An economic crisis can mask a financial crisis. While all eyes have been focused on the inflation trajectory and recession risk, the rise in rates seems to be acting like a slow and silent poison that continues to seep into financial players’ balance sheets. That is, until the loud cracking sounds snap the central bankers back into their role of lender of last resort.
UK pension funds must have been relieved when the 30-year rate fell back down after the appointment of a new finance minister and the scrapping of the government’s indefensible fiscal plan. But we came very close to a large-scale shock.
This scenario could have provoked a domino effect: hit with massive and intensifying margin calls, pension funds would have then found themselves with no liquidity, forcing them to sell a wide range of securities in a hurry. This is in part what happened. An interest rate shock was transformed into a financial panic, transmitting risk to market counterparties. To top it off, UK real estate funds would thus have been unable to meet redemption requests and would have suspended trading. This would have been the cocktail for a financial crisis that echoed the dynamic money market fund crisis of the summer of 2007.
What warning signs can we take from these recent events? First, the fact that every change of regime reveals the weaknesses of the previous regime. The last regime was characterised by the search for yield "at any cost" and the difficulty of accepting a downward adjustment to return expectations, in the face of low rates and zero inflation. The sharp rise in rates has wrong-footed all players that have accumulated significant leverage or rashly given up on liquidity.
Second, the fact that every market regime is also coupled with a school of thought and a belief system. One of the tightly held beliefs in the previous regime was the central banks’ unwavering support of private-sector and government actors.
Another was the idea that the central banks made debt sustainable; debt in which institutional investors were forced to play an ongoing role. Yet central bankers remain focused on fighting inflation and, to retain their credibility (and that of their currency), they must not give in easily to governments that are tempted to wield fiscal leverage with the help of monetary policy. But macro-financial risks can quickly call this into question and jolt central banks back into their general firefighting role.
As a result, at the beginning of every financial crisis there is renewed hope that the monetary authorities will pick up the tab and that international institutions will nurse the most vulnerable back to health. That is the secret hope of the market: that the crisis will become so bad that the Federal Reserve (Fed) will be forced to pivot. This fails to take into account the stance of a central bank whose credibility is at stake, and which is all the more determined to keep full employment and inflation from weakening.
Every crisis has generally a capitulation phase that offers exceptional investment opportunities, when extreme pessimism leads to irrationally low valuations. We have maybe not yet reached this point, but it is likely imminent. One lesson learned from previous crises on this point is that they sometimes resemble seismic shocks, with repeated shocks and successive upheavals. 1992 before 1993. Mexico before Asia. Bear Stearns before Lehman. Exiting a crisis without purging or overhauling the system can prove to be short-lived.
All this to suggest that it might be better to sell the relief rebound than to be too quick to believe in a year-end rebound that may not happen, despite the glaring opportunities. Resilience and patience have definitely been necessary throughout this very challenging year, but a very positive year for return assets could be on the horizon.
Monthly House View, 24/10/2022 release - Excerpt of the Editorial
October 28, 2022