Required Reading - Risk Checklist (January 2022)
It is the time of year when anyone serious about risk mitigation reviews the various threats to operations and where possible, evaluates means of offsetting risks.
Likely events with Moderate to High Impact:
Inflation – By most traditional measures (CPI and PPI), inflation is running in excess of 7% annually. While the normalized level might be a bit less, it is clear that “transitory” is a misnomer.
Comment: The dilemma facing the market is that the normal process for quelling inflation is likely to cause turmoil in the market and undermine some of the initiatives the current administration has been undertaken in stoking the economy. Using the past as an indication of the future, under ex-FED chair Volcker, 10-year interest rates were 100 bps above the inflation rate to slow the economy and break inflation. Translating that to today’s levels, rates would need to rise over 6%, which would be disastrous for the economy. https://www.egan-jones.com/insights-risk-commentary/newsletters/
Rising Interest Rates – The FED is now talking tough and is likely to act tough, via a couple of rate increases, but the increases are unlikely to be sufficient to quell inflation. The FED’s actions are likely to be constrained by politics; both the current administration and Progressives are likely to continue to favor low interest rates. Of interest are the comments of Chinese President Xi Jinping’s in Davos Monday requesting no interest rate increases: “If major economies slam on the brakes or take a U-turn in their monetary policies, there would be serious negative spillovers. They would present challenges to global economic and financial stability and developing countries would bear the brunt of it.”
Comment: From our perspective, a rate increase of more than 150 bps is unpalatable and politically disastrous, particularly given the current makeup of the FED. Hence, we can probably expect a rise in FED rates near 100bps. Adding to the complexity is (i) the massive balance sheets of the central banks and (ii) the dovish view of other central banks such as the ECB and BOJ. We do not expect a rapid unwind of central bank balance sheets in the near future.
Continued Covid – If the disease was man-made, if it was intentionally released, and if the motivations for releasing it remain, then we can assume that despite the apparent tepid noxiousness of the Omicron variant, we can expect additional contagions in the future.
Comment: Whether all the above is accurate or not, at some point, the Western governments are going to be forced to confront the cause of the infections and address them. Watch for this to be a flashpoint during the mid-term elections.
Ukraine Turmoil – Putin believes it is in his interest to threaten Ukraine either because of weak domestic Russian conditions or the perceived weakness of the Western states, or both. Furthermore, the US’s tortured exit from Afghanistan probably bolstered Putin’s efforts.
Comment: Putin has been at the table longer than any other world leader and probably views his hand as fairly strong. If Western Europe does not provide succor, expect a curtailment of natural gas deliveries, and Biden’s threats appear to be hollow. Trump was perceived as trigger-happy, but with little support from the EU, whereas the current administration appears to be the exact opposite in both areas. Watch for a face-saving way to provide something to Putin.
Taiwan Turmoil – Xi Jinping is set on integrating Taiwan and has been encouraged by the non-response to his crackdown on Hong Kong. Xi appears to have consolidated his power and is on track to become a life-time ruler. While the use of force is a possibility, there are numerous other means for Xi to achieve his objective with the most likely being something similar to Hong Kong with the election of a pro-China legislature and a crackdown on dissent. Given the fact that Taiwan has been and remains a strategic location for the manufacture of computer chips, this item remains a major concern.
Comment: This problem is broader than Taiwan as it impacts the West’s strategic footprint in Asia. The trust in the US has been pressured by the tortured exit from Afghanistan.
Climate Concerns – The issue is now main-stream and federal regulators are pushing banks and other financial service firms to integrate such analysis in operations. The upshot is likely to be that major carbon emitters are likely to face shallower and more expensive capital sources.
Comment: The climate focus appears to be institutionalized. The challenge is establishing a credible framework for making such decisions.
Regulatory Scrutiny – The current administration has stepped-up enforcement efforts with the result that many larger firms are likely to face stiffer fines and restrictions on M&A efforts.
Comment: This item is likely to be irritating but unlikely to have a major impact; firms adjust.
China Slowdown – The Omicron virus is highly transmittable, and it is hard to imagine that China will escape its reach.
Comment: Lower growth is manageable.
Supply Chain – A variety of industries have been disrupted by difficulties in obtaining supplies. The problem is exacerbated by port bottlenecks, but the problems are more widespread.
Comment: We expect the problems will be alleviated over time. Furthermore, some of the inflationary pressures might stem from supply shortages.
Labor Supply Shortages – The government has paid people not to work, and they haven’t. While many will return to the workforce as the COVID threat eases, many will not as they have retired or become accustomed to minimal commutes.
Comment: We expect the problems will be alleviated over time as schools reopen and support payments ease. The shift to automation will help at the margin, but with the retirement of baby boomers, the problems will remain.
Petroleum Prices Increases – While the auto headlines are all about the shift to electric vehicles, the reality remains that the bulk of vehicles remain dependent on petroleum. Hence, with the partial opening of the economy, petroleum prices are elevated.
Comment: Difficulties in balancing supply and demand exacerbate price swings. While the typical response is an increase in fracking, expenditures on hydrocarbon production are out of favor and therefore the elevated prices are likely to persist.
Lithium, Cobalt and Nickel Shortages – As a result of the focus on carbon-neutral policies, the demand for electric vehicles is likely to create shortages in the raw materials for batteries, thereby increasing prices, and forcing manufacturers to develop alternatives.
Comment: Alternatives take time and money to develop. Expect a continuation of the problems.
Currencies – While currency movements are hard to predict in the short-run, in the long-run movements are typically a measure of the change in relative productivity of a country’s workforce. With the rise in interest rates in the US compared to Europe, the dollar might gain relative to the euro. A more convoluted picture is presented in the case of some other markets. India’s and Russia’s central banks have been diligent in raising rates and might partially escape the normal path of turmoil when the US increases interest rates.
Equity Markets – Markets have been and will continue to be under pressure from rising rates.
Crypto – The critiques have long stated that cryptocurrencies have no inherent value, and they are correct. However, what is missing is the convenience factor; the block chain makes it far easier to transact business and convenience is, in many cases, critical. Just as people are willing to pay steep prices for food and drink in airports or stadiums, the convenience offered by crypto creates value.
How we can help
Egan-Jones Ratings Company started providing ratings in 1995 for the purpose of issuing timely, accurate ratings. EJR is a Nationally Recognized Statistical Rating Organization (NRSRO) and is recognized by the National Association of Insurance Commissioners (NAIC) as a Credit Rating Provider. EJR is certified by the European Securities and Markets Authority (ESMA) and recognized as market leader in Private Placement ratings. EJR also provides independent credit rating research, Climate Change / ESG scores, and Proxy research and recommendations.
Prospective clients have often asked how we can help them and what areas we consider are particularly
strong. In response, below are the areas worth reviewing:
Private Placement Ratings – assisting investors access private markets via ratings on private placements.
Subscription Ratings – we have had a strong track record in providing early, accurate independent credit
Climate Change / ESG Scores – an assessment of entities’ current and prospective scores.
Independent Proxy Research and Recommendation/Voting – assisting fiduciaries in fulfilling their voting and record-keeping obligations.
Egan-Jones rates a wide variety of private placements:
Aircraft Lease and Loans
Airline Lease Back
Credit Facility/ Warehouses
Credit-Tenant Loans (CTLs)
Middle Market Lending
Real Estate, REITs
CRE Loans, Other
Direct Lending Funds
Mixed Strategy Funds
Real Estate Funds
Structured Debt Funds