Hope really is not a strategy......
Why the re-opening bullwhip effect of 2020 = capital market volatility in 2023
January has been a pleasing start to the year for markets – as highlighted by the asset performance table.
It’s also been a pleasing start to the year for our advisory portfolios – returning on average a little over 4.5% roughly in line with the average wealth manager portfolio, albeit at a much lower level of risk for the MBMG portfolios, as was evidenced by their far greater resilience and far lower propensity for loss last year than the average wealth manager portfolio.
However, we find it hard to be overly optimistic, even though during January many of our portfolios recovered the ground that they had lost during the traumatic preceding 6 months:
The idea, popularised by Yale Hirsch of the Stock Trader’s Almanac that “as goes January, so goes the year” is extremely unconvincing in 2023. We hope that it’s proven right but as James Cameron observed, “Hope is not a strategy.”
While this might give an impression of standing still, that would actually paper over volatility that our portfolios haven’t previously exhibited and for which we can find no comparable historic parallel. Conditions have given rise to the bumpiest conditions that we have experienced….and I’ve been in the world of banking and investment for over 35 years.
Even the ECB warned that cross asset correlation assumptions and volatility expectations are looking treacherous in the prevailing environment.[1]
In other words, while we might be ending up in a broadly acceptable destination, the journey to get there is involving far greater swings to the upside and downside than is precedented in portfolio data. While many market participants seem to be ignoring this, we worry that you can only do so at your peril.
We have previously seen periods when particular asset classes, such as stocks have exhibited far greater volatility than last year but not when the combination of broad asset classes has produced such violent outcomes at a portfolio level.
Even at the height (or depth) of the Global Financial Crisis (GFC) and the collapse of Lehman Brothers, when stocks plunged, treasuries and gold and even the Dollar Index, not only remained relatively stable but produced countervailing gains to offset stock losses:
The chaos that we all recall of a time when America, as Timothy Geithner once told me, was “melting” limited to risk assets and the financial system that relied upon them as collateral. It wasn’t a series of highly correlated wild swings in the value of all assets of the kind that we’ve experienced in the last year or so and which is showing no signs of abating.
When the prices of pretty much all assets pop higher at a much faster rate than within historic parameters (as has happened in January and in October and November last year), nobody minds too much. But they should. Because there’s a very good chance that it could presage an equally dramatic fall in the prices of pretty much all assets.
It could of course be the launch pad for an asset price ‘moon shot’ but right now, there’s really no reason to believe that’s going to happen.
What appears to be the case is that policymakers orchestrated the biggest co-ordinated shutdown of human activity in history in 2020, creating a potentially even greater problem that far exceeded their capabilities to control and since then they have mismanaged the resulting challenges – creating a tidal wave of consumption ebb and flow that overwhelmed the shuttered supply chains and transmitting the well-documented bullwhip effect from a logistics issue into a structural financial and economic one that has determined inflation, output, interest rate policy and cast huge shadows over security and energy policies.
We created this graphic some time ago to help explain the concept of intertemporal dislocation as it relates to the lockdown and post lockdown periods:
It’s dangerous, as policymakers are discovering, to simply think of capacity in terms of volume and to disregard the element of time.
A factory that can produce 100 widgets a year can sell and deliver 100 widgets a year. But it wouldn’t be able to make them all on a single day. At least not right away. They can deliver 100 on a single day in a year’s time (assuming that they have no other commitments in the meantime) but they can’t deliver 100 today.
The above example assumes that in the 6 months ended June 2019, the widget maker sold and produced 50 widgets. Similarly in the following 6 months it did the same. In the first 6 months of 2020, the factory was furloughed and produced and sold no widgets. But in the last 6 months of 2020, it received orders for 75. In the normal course, the factory would be unable to produce these and any measures to increase capacity (overtime, double or triple shifts, investing in additional machinery, buying goods in from competitors, renting additional production space), would all usually imply additional costs, which are passed on through inflation (because presumably all widget suppliers are in the same or similar boats and unable to satisfy short run demand). 2020 was a poor year for the widget manufacturer in that it produced 25% less than it had the previous year and incurred greater costs in doing so – and was only able to partly pass these on, judging by the data that S&P 500 companies’ margins have declined every quarter since the middle of 2021.
Higher prices don’t always equate to higher profits; in the last 2 years they have largely been an organisational (or disorganisational) premium paid by businesses and individuals to cover the costs of decisions inflicted by policymakers faced with the admittedly extremely challenging situation of a global pandemic.
The second bite of the bullwhip is that in reality, most businesses don’t then simply resume a recognisable trading pattern.
It’s likely that following the surge in demand in H2 2020, that the first half of 2021 would have been weak before a renewed surge in the second half, a pattern that would by now have become embedded and would only very slowly regularise.
It seems that the bullwhip is feeding into capital market trends and prices.
Policymakers made a real mess in 2020.
They surpassed that in 2021.
By last year, they had become an existential threat to human life.
Don’t fight the Fed.
But don’t ignore them either.
Above all, don’t rely on them. The uncertainty and volatility facing us all in 2023 is largely a consequence of policy mistakes. We shouldn’t assume that policy makers will suddenly acquire competence. But we can’t even rely on them to always get it wrong either.
However, the damage, severe though it is, that economic policymakers can cause is nothing compared to the potential planetary destruction that geopolitics can unleash and tragically, there is no reason to have any greater faith in the architects of foreign policy than in the bungled purveyors of economic policy.
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