Know when to take risks, and when not to

‘Providence protect idiots’ Otto Von Bismarck once exclaimed. I’m never quite sure what the direct intentions of the Almighty are. Bismarck, a Prussian Prince and one of the great leaders of the 19th century, might have had a more direct line of communication with the powers that be than I do.
But I’m relatively certain that liquidity not only protects from bad decisions, but also emboldens those who succeeded once to take even worse ones.

The problem is that the opposite isn’t true. Scarcity of liquidity doesn’t mean scarcity of bad decisions. And as liquidity is about to become much scarcer than it already is, even genuinely thoughtful action may fail to produce good results.

Despite last week’s rate pause by the Federal Reserve, the global interest rate environment remains considerably hawkish. The American rate-setting body may have paused for now, but a poll of its members known as the ‘Dot Plot’ suggested that two more hikes may be in store for American consumers by the end of the summer. Jerome Powell, the Fed’s Chair, suggested that there may be two years before rate cuts. Those rate hikes will continue to work through the economy for about a year after they have ended.

Meanwhile, the European Central Bank raised its key interest rate by a quarter point and is further draining liquidity by letting its emergency loans expire, which would require Italian banks to go to the markets for funding. The Bank of England, meanwhile, is preparing for another possible 1% rise in interest rates.

Rising rates is a simple mechanism, aimed at squeezing mortgage holders and incentivising saving instead of spending. But other tightening is taking place too. Commercial banks are tightening lending standards. Borrowers can still find alternative sources of financing but have to offer even better terms to private and shadow lenders. PIMCO, a global asset management company focusing on fixed income, described private debt conditions as some of the best they have ever seen.

Central banks are removing all the stops to stem the inflation wage-price spiral. What’s on the line is not just prices, but, much more importantly, the public’s belief that they can be trusted to bring price growth down to 2% in a timely manner. That belief, according to a poll by Ipsos, is now at an all-time low.

Policymakers are emboldened in their course of action, by the rally in equity markets, overall financial stability and a benign economic slowdown, as opposed to a possible crash. In other words, they can afford to focus on inflation because they don’t see significant risks building up elsewhere.
So how can investors react to this environment?

For one, they must remain vigilant for bad decisions. Just because we have high rates, doesn’t mean that everyone understands that risky behaviour is a bad idea.

Kwasi Kwarteng thought that a bold spending plan in the midst of an inflation fight that would surprise markets was a good idea. It cost him his job and made his boss the shortest-lived Prime Minister not to have died in office. The executives of SVB thought that its ok to spend a year without a Risk Officer. The Board of Credit Suisse, which felt that the bank could continue on the destructive course of the past five years falls under that category. So far, lack of liquidity has cost the world a British Government and a banking crisis in the US. As conditions continue to tighten, the threshold as to what constitutes a ‘bad decisions’ is even lower.

Second, they must look beyond the S&P 500 headlines. The stock rally is very narrow, a gold rush on the back of Chat GPT’s success. There were more articles about ‘AI’ at the end of May, than there ever were about Bitcoin. However, we have no assurances that this technology will continue to develop at the exponential rate that present valuations imply. Meanwhile, ex-tech, stocks are negative, bonds are flat and haven’t mean-reverted after last year’s horrendous performance, and the yield curve is inverted.
Third, be wary of inflation. While year-on-year headline numbers in the US improve, in Europe wage growth is persistent. Services inflation is also proving sticky, and consumers are undeterred from spending. Rates simply aren’t high enough to cause the sort of economic downturn central banks want to see before ‘pivoting’ to an easier rate regime. And inflation could still flare up. Commodity prices have dropped significantly, so a rebound would mean supply-side inflation augmenting what is now demand-side inflation.

As we enter the summer, it makes sense to be mindful of risks. Yes, other stocks could simply catch up to the tech sector, but that won’t happen without some sort of catalyst. Positive catalysts are scarcer when liquidity is scarcer. And bond yields are hefty enough to improve returns on many portfolios, but if the Fed really means it when they imply that we are two years away from cuts, then patience is warranted.
Risks can still pay off. But it will be with a significantly lower probability than two years ago.

George Lagarias – Chief Economist