“The Big Crunch”
We have long forecast “The Big Crunch”. This is a moment of lucidity when policy-makers and the market realise that previously undreamed of monetary policy easing has failed to address the slow burning growth crisis of the global economy. This is assumed to be a period of juxtaposition: when growth would remain slow both cyclically and secularly, at a time when the practical and political limits of monetary policy are being actively considered. Even worse, The Big Crunch could entail the next global downturn coinciding with these increased concerns of monetary policy impotency.
“Non-linearities and the gravity well of deflation”
Deflation is an outcome the saps economic vitality at the macro and micro-level. It is an outcome that feeds on itself, as falling prices complicate consumption patterns and investment decisions and thereby weaken aggregate demand, which in turn adds to the persistency of price declines. A duel equilibrium problem confronts policy-makers. They can impellent a sufficiently ambitious and appropriately coordinated policy mix to raise global economic and income growth, or in the case of many key economies they risk seeing the descent into deflation. Escaping this latter outcome is far harder that avoiding it. Deflation can, somewhat floridly, be viewed as a gravity well and policy makers need their economies to grow fast enough to avoid falling below the Event Horizon.
In a world of high leverage and slow growth and a background drumbeat of downside risks to inflation, it has never been more important for investors to embed convexity considerations into their portfolios. The potential for or risk of (depending on one’s positioning) non-linear market moves are manifold. This is a backdrop that allows for no Shibboleths: yields can move far below zero; selected financial markets can become instruments of policy rather than expressions of collective valuation assumptions; the bar to defending currency pegs can increase. All of this takes place during a period when regulatory regimes are sapping liquidity from financial markets and where the interplay of technology and styles-based investing strategies is creating an increasing profusion of momentum based trading activity. Liquidity air-pockets can ensue and extreme right and left tail opportunities/ threats abound.
Our investment philosophy
Regular readers of Des’ research will be familiar with these core themes and the consequent investment thesis:
- Government bond yields where credit considerations can be assumed to be marginal will fall far below levels assumed by market expectations.
- “Risk assets” will be buoyed by the provision of central bank liquidity, by the “portfolio reallocation effect” of low yields being increasingly forced by policy and where a secular decline in the pricing power of labour helps corporate profitability. However, the slow-burning growth crisis needs to be addressed for lofty valuations to be sustained. A re-pricing of equity and credit market remains a persistent threat, that needs to be closely assessed.
- Emerging markets remain acutely vulnerable as they bore the lion’s share of global re-leveraging in the post-crisis world of loose monetary policy, but have been subsequently exposed by the failure of global growth to recover sufficiently. The problem is made more acute by China, which in our view remains the third leg of the global financial crisis: first, came the bursting of the US housing market and the securitisation and derivitisation related blow to the world financial system; secondly, the Eurozone ceased to be a stable currency area when credit considerations started to impact the borrowing cost of non-core countries; thirdly, a weaker global economy is even less able to absorb the surplus industrial capacity created by China’s investment and credit driven growth model, particularly when a secular slowdown in Chinese growth is softening the country’s domestic demand.
We are not perma bears looking only for a left tail skew on asset returns. Within a secular trend, cyclical dynamics can diverge. Policy formation can also become more (or less) effective. When appropriate we will highlight opportunities to long risk assets, and may even consider short gamma strategies. However, we will be analysing economic and market themes through the analytical framework of our macro world-view. This will be critical in helping investors avoid mistaking liquidity risk for market risk and in helping them be on the right side of event shocks.