Monday, March 27, 2023

Morning Note: Scenarios

In the following, economist Diane Swonk does a nice job of pondering present-day economic possibilities:
"Been thinking about scenarios that could erupt as a result of the period of high volatility and uncertainty we are in.
Humbled by the vast number of outcomes in a chaotic cycle.
More I read, the more I am humbled. Some scenarios float to the top: 

1) Federal Reserve’s working hypothesis seems to be that a little additional credit tightening, lags and the tightening due to recent financial markets events, will push us into mild recession with a consequential, but small, rise in unemployment. Inflation will cool, but at a glacial pace.

2) A more dramatic recession erupts with the Fed overshooting & unable to calibrate the tightening of credit conditions. There is no cliff event such as 2008, but large tail risks in the commercial real estate and longer term downside risks for urban areas.  Inflation cools but not overnight.
The pain is elongated and deeper than hoped with the Fed slow to cut rates rapidly. Markets clearly don’t believe this, but they also didn’t believe that the Fed was serious about how rapidly it was willing to raise rates to catch up.

3) A more abrupt and nonlinear tightening of credit conditions erupts. This could hit both demand and supply. Not a good combination, given the supply shocks we have already endured. A deeper recession erupts, exacerbated by a spike in uncertainty, which adds to a drag on economy.

Inflation comes down but not as rapidly as many market participants expect, because of supply side constraints. This is messier, as it could send signals that a more persistent inflation, or worse, stagflation, is taking root. Especially given lags in data. That may trigger more aggressive rate hikes and ugly period, which can morph into lots of ugly scenarios that extend to/complicate geopolitical tensions. This is a nightmare scenario for the Fed. as it means they will have failed on multiple fronts.

The Fed is at its heart a risk hedging entity, but the short term nature of that hedging can imbed longer term risks into the entire economic system. It also likes to learn from past mistakes only to make new mistakes. Would be nice if the Fed was needed less as primary tool to combat inflation. There are lots of policies that could better insulate the economy, including fiscal policy, which boosts productivity and insulates it better from inflation but we are not good on that front. (Understatement.)
4) Economy continues to chug along, losing steam slowly. Could we see, as one reporter asked me, “immaculate disinflation”. The economy stalls, but doesn’t collapse, and what was hot turns tepid with time, much like my coffee when I started to write this.  
Bottom Line: Lots of unknown unknowns…humility.

Open to other scenarios. My list keeps getting longer. Seems the largest fissure may be among those who are heavily leveraged with debt poised to soon reprice at much higher rates and those who have locked into ultra low rates and now on sidelines. (Eg Homeowners & big firms)."

Asian stocks leaned green overnight, with 10 of the 16 markets we track closing higher.

Europe's in rally mode so far this morning, with 16 of the 19 bourses we follow trading up as I type.

US equity averages are in the green to start the session: Dow up 230 points (0.71%), SP500 up 0.62%, SP500 Equal Weight up 0.77%, Nasdaq 100 up 0.37%, Nasdaq Comp up 0.43%, Russell 2000 up 0.90%.

The VIX sits at 21.23 down 2.35%.

Oil futures are up 1.91%, gold's down 1.62%, silver's down 1.40%, copper futures are down 0.66% and the ag complex (DBA) is up 0.49%.

The 10-year treasury is down (yield up) and the dollar is down 0.17%.

Among our 36 core positions (excluding options hedges, cash and money market funds), 28 -- led by Dutch Bros, VNM (Vietnam equities), OIH (oil services companies), EWZ (Brazil equities) and Disney, -- are in the green so far this morning... The losers are being led lower by TLT (long-term treasuries), GLD (gold), VGIT (intermediate-term treasuries), VWO (emerging mkt equities) and SLV (silver).

I highly recommend Charles Goodhart's The Great Demographic Reversal... The following comports with one of the underlying themes supporting our long-term inflation thesis (emphasis mine):
"...that the prior combined surplus of the personal and corporate sectors will in coming decades switch back towards a deficit. If so, again by simple arithmetic, the public sector will have to shift in turn from deficit to surplus. That will need to involve politically painful decisions to cut back on public expenditures or to raise taxes. Because that is more immediately politically painful (than rising deficit and debt levels), it will tend not to get done, at least not sufficiently to provide macroeconomic balance. The result is almost certain to be consistent and persistent inflationary pressure. We discuss at greater length the implications of these various demographic and macroeconomic trends for both future fiscal and monetary policies in Chapter 13."

Have a great day!

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