Risk Commentary: Inflection Points; Predicting When the Wheels Come Off
Overview
All Institutional investment and risk managers face a dilemma: determining inflection points in various markets. This installment will discuss such and hopefully provide some helpful indicators.
Nearly all professional investment and risk managers have investment hurdles to meet (everyone has a boss) which is often expressed via an index or some other benchmark. The dilemma is that if one listens to the fearmongers, performance will fall short of targets. The adage that the typical economist has predicted 11 of the past 3 recessions holds true. However, being heavily invested when contagion fears hit is equally problematic. Hence, the trick is recognizing the signs of true distress and hopefully adjusting for such troubles.
Changing Landscape I: Monetary Policy
The Credit Crisis of 2008 massively changed the way senior government officials viewed investment risk and more importantly how to react to it. Perhaps the leading thinker during the credit crisis was Fed Chair Ben Bernanke who believed that during times of stress, the federal government had to intervene when the private sector exhibited weakness.
The upshot of such thinking was that during the 2008 Credit Crisis and to a greater degree, during the more recent Covid crisis, the federal government provided massive support in the form of injecting capital into banks, backstopping money market funds, buying corporate bonds, and even providing cash to qualifying citizens (hence the origin of the sobriquet “helicopter Ben”).
In Europe, the central bank went one step farther via its purchases of government debt resulting in yields turning negative. While many might criticize the actions of government officials, the reality is that the environment massively changed from prior periods. Of course, the result of the government largesse were massive deficits.
Changing Landscape II: Debt Burden
Now for the hard part: determining when market pressures overwhelm government intervention. To put things in perspective, most Western countries have seen a massive rise in their national debt relative to GDP as shown below.
Figure I: Global Public Debt
In the case of the European and United Kingdom governments, it is likely to prove difficult to both massively increase defense spending while maintaining normal levels of social spending, particularly when growth has been meager and the population has been aging. Defense spending goals of NATO nations are set to increase from 3% today to 5% by 2035.
The UK Starmer government tried to reach rather meager goals regarding a cutting of social spending and failed. With the curtailment of cheap natural gas and the downturn in the German and French auto industries due to China, the challenge is likely to be more daunting over the next couple of years.
Changing Landscape III: Promising Example
On the success side, Argentina under Mr. Milei appears to be the winner in the most improved category because of its massive cuts in government spending and focus on growth. Perhaps America can follow a similar approach, but it will take time for any results to manifest.
Changing Landscape IV: Crypto Disruption
As is often the case, technology has a nasty way of upsetting the soundest thinking. While still in the nascent stages, the crypto valuations are advancing at record pace with the U.S. providing some support with the recent passage of the Genius Bill.
“Stable coins” such as Tether (USDT) appear to be gaining traction, though remain a small portion of total crypto valuation and for the most part are tied to the dollar. These currencies are in total valued at ~$250B or ~6% of the total crypto market cap.
Our view is that there will be variations, with one being tied to a basket of Western currencies, perhaps with an over-weighting towards the most stable currency such as the Swiss Franc. If over time, such a currency gained traction, the extraordinary efforts of aggressive central banks might be tempered.
The most notable challenger for central banks remains Bitcoin, which is solidifying its position as the dominant crypto currency as it reaches ~59% of total crypto market cap (see figure III) and a ~$2.36T market cap.
However, problems with Bitcoin persist such as those listed below.
- Total transparency of transactions. Tools such as Chainalysis allow many parties (including non-governmental) to understand who is trading and how much in real-time.
- High cost to exchange. Trading Bitcoin can cost as much as 10 basis points. This hurts Bitcoin’s ability to serve as a means of exchange (though this fee is acceptable if Bitcoin serves as just a store of value). A solution to high fees is performing some transactions “off chain.” The lightning network is one decentralized “off-chain” trading tool.
- Price instability.
- Lack of institutional support. Crypto remains a fringe speculation for most institutional investors.
The decentralized focus of cryptocurrencies tend to disfavor services offered by legacy financial institutions which face relatively high costs of operation despite investor trust and regulatory oversight. The exception may be ETFs such as iShares Bitcoin Trust ETF.
Figure II: Total Crypto Market Capitalization
Figure III: Market Share of Crypto Currencies (measured by market cap)
Changing Landscape V: AI and robotics
The advent of AI and robotics means that the benefit of large labor pools is likely to shrink. However, China’s lead in manufacturing of sophisticated hardware (vehicles, drones, 6-axis robotic arms) and its ability to catch up in AI development is likely to translate to further strength in the next generation of robotics, particularly humanoid robots.
Watch for disruptions to the labor market, particularly for recent college graduates.
Inflection Points
Back to inflection points, the typical candidates for causing collapses are:
- Excessive risk-taking, including asset bubbles (often caused by perverse incentives or principal-agent problems)
- Failed regulatory oversight
- Political instability
- Fiscal mismanagement
- Exogenous shocks including war, refuge crises, natural catastrophe, and commodity price shocks
For the most part, investors are well attuned to look for indicators of a recession. While some factors are present, central banks’ new powers grant them the means to quell many firestorms. However, pay attention to the factor that eventually cost Marie Antoinette her head: food prices and availability.
“When Parisians stormed the Bastille in 1789 they weren't only looking for arms, they were on the hunt for more grain—to make bread.”¹
In Japan, there is massive sovereign debt and its car industry is under assault from China (see Nissan’s woes). Further, Japan faces pressure to spend more on defense to thwart the rising threat posed by China. The below chart is concerning:
Conclusion
Sophisticated institutional investors and risk managers need to have a nuanced view of ever-present risks to determine the best course of action. Evolving risks and counter-measures necessitate some deeper thinking for the best path forward.
Sources:
[1] https://www.history.com/articles/bread-french-revolution-marie-antoinette