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G&T: Guns & Tinned food

(This post is not investment advice - do your own work before taking any position)

Love will win in the end.

It might be the love between a giant, irradiated cockroach and the skull of the last human.

But it will win.

-Frankie Boyle

After the recent Jackson Hole meeting (who invented that name?!) I don’t think that’s an over the top statement. The equity market music appears to have well and truly stopped - unless of course you’re Jerome Powell who’s dancing a jig on the smouldering and irradiated ruins of many a portfolio.

I find myself in a place of some concern for markets. Liquidity is thinner than the veneer of respectability surrounding Boris Johnson. Just about everyone I speak to is sitting on tons of cash or lies in wait, with both transaction count and net exposure sitting close to zero (your author included). Such thin liquidity magnifies market movements, making a drastic move more likely.

Rates are firmly on the ascent. If you followed Jerome Powell’s speech at Jackson Hole, you might have noticed he quoted former Fed governor Volcker, a man who showed inflation (and the economy) all the mercy of a Greek tragedy with a rather aggressive series of rate hikes.

The strange thing about the current rising rates environment and its attempt to calm inflation is that rate rises probably won’t solve the immediate causes of said inflation. Interest rates are meant to affect inflation by reducing consumers’ and businesses’ propensity to buy things because they have to spend more on mortgages, car finance, credit card payments, and debt. However, this particular flavour of inflation is not being caused by people buying too much stuff, it’s caused by lingering covid-related supply chain disruptions and war in Ukraine (and its affect on energy prices).

These two factors are causing consumers and businesses to spend more money on energy, anything that contains a semiconductor, and anything that is transported from its point of origin to their premises. In other words, it’s a supply-driven phenomenon. The way you solve this problem (ideally) is by increasing supply.

This is not the approach being taken by The Fed and other central banks (mostly because they control money supply, not semiconductors and oil supply). They are trying to combat this by making everyone pay more for debt which reduces demand. This is designed to slow economic growth and perhaps cause a recession. In turn, this should damp inflation. However, this remains a demand side solution to a supply side problem - which is not likely to be ideal even thought it should ultimately work (in an extremely simple example: 20% energy inflation coupled with 18% consumer goods deflation evens out to 2% inflation).

So far, this post has read a little bit like the book of Revelations. The final act of this play concludes with humanity ruled by a cannabalistic warlord who spends his days roaring for fresh meat while playing a three-note national anthem on a ribcage xylophone (I assign a 1% probability to this scenario). But I’m not exclusively negative on markets. I can see a variety of scenarios.

The G&T scenario (which I think is ~66% probable) is: rates rise, consumers (already struggling under the weight of high energy bills etc) are hit with higher mortgage/credit card/car payments that crimp their spending on all but the essentials - with disastrous economic consequences. Businesses are similarly affected - which kicks off a wave of redundancies and makes the issues consumers face even more severe. The default cascade commences with credit cards, followed by cars and finally houses. After a painful (and probably lengthy) recession, supply chains normalise, leverage falls and prices return to more normal levels. I do not believe this is priced into markets.

The Goldilocks scenario (20% chance): central banks get rate rises just right. Demand is tempered enough that inflation falls back to 2-3% without a severe recession. The war in Ukraine ends and energy prices return to normal. I think this would lead to a modest rally in equity markets.

The final scenario (14% chance): central banks don’t raise rates fast enough. Inflation coupled with a tight labour market kicks off a wage-price spiral (which becomes a self-fulfilling prophecy). Inflation is high for a time, but returns to a typical 2-3% upon the end of the war in Ukraine, the (almost inevitable) semiconductor glut and a more balanced labour market. I believe this would be modestly negative for equity markets.

I know I’m being a bit doom and gloom here, but I still see opportunities to make money - admittedly, these are mostly on the short side, but the opportunities remain.

Alternatively, just buy guns and tinned food and remind yourself that one way or another, love will win in the end.

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Henri Klimek
Henri Klimek
Sep 18, 2022

Which of your scenarios do you think current oil prices of $85.11 pbl (11% below pre-Russo-Ukraine War levels) are pricing? Especially given Russia will likely cut supply in retaliation (I give 63% probability) and OPEC could reduce supply to keep prices high (I give 32% probability), and China could swiftly do away with their zero covid policy in 1Q23 (72% chance for me) to increase economic output as it won't meet the premier's mandate at its growth current rate - all of which should result in an uptick in demand/reduction in supply resulting in a much higher price (in my opinion) despite the lower price. Given these potential outcomes, I think the markets, if pricing these events efficiently, are pricin…

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