In 1950, the American mathematician Claude Shannon famously showed a calculation for the complexity of a chess board, resulting in some 10120 possible game progressions. Indeed, after each player has made just four initial moves there are some 288 billion potential positions that can arise. Similarly, the 2018 “investment chess match” is becoming increasingly complex, as the cyclical turning point described in our April blog post transpires in earnest. In fact, today’s changing investment regime has no precedent, and therefore cannot be adequately analyzed through an historical lens.
Global Liquidity Dynamics Vital to Understand
In the pre-crisis world, a “normal” cyclical progression centered on real-economy activity that policy makers responded to, and from which financial markets took their cues. Post-crisis, policy makers have targeted the financial economy via immense injections of quantitative easing (QE) with the goal of inducing a pro-cyclical reflexive real-economy response. Moreover, the ubiquitous simultaneous adoption of QE means that local policy initiatives have global impacts. Global liquidity is agnostic regarding its destination, so when liquidity is rising, regardless of its point of origin, a global “crowding-in” to risky investment expressions occurs and vice versa.
The most overt embodiment of this phenomenon occurred during the 2016-17 period, when near $4 trillion of developed market (DM) policy liquidity injections ultimately drove a first quarter 2018 investment narrative of “global synchronous growth.” Ironically, just as conventional wisdom adopted this narrative, the policy tide was turning, as the U.S. Federal Reserve accelerated initiatives to “normalize” monetary conditions and the U.S. Treasury stepped up debt issuance. Thus, in the U.S. the price of money is now rising sharply (short interest rates) at the same time that the quantity of money (the monetary base) is contracting. More recently, a concomitant follow-on of U.S. dollar strength is adding a third dimension to this tightening campaign.
Secular Trends, the QE Payoff, and Unintended Consequences
Another layer of complexity is added by growing global divergences in demographics and debt. While the major DM economies all face these secular headwinds, they are at varying stages of this precarious evolution. Japan is furthest along, followed by Europe, with the U.S. having really just begun the process of significant population aging. Accordingly, similar doses of QE-era policy have had divergent local impacts. QE has been most potent in the U.S. where every dollar of post-crisis base money creation has generated roughly $3 of nominal GDP growth. In contrast, ECB base money creation has a roughly 1:1 ratio to nominal growth, while Japan has suffered a negative return on its QE “investment.” As a result, excessive U.S. policy tightening risks undermining the policy goals of its DM central bank counterparts.
Through a traditional lens, ongoing U.S. tightening appears appropriate, as the rock-solid U.S. real economy flirts with full employment while cyclical inflation readings are set to move above the Fed’s 2% target. But the complexities of the modern QE era, like those of a well-played chess match, dictate that this tightening is having unintended consequences, and a series of rolling global financial shocks is unfolding with progressively significant complications. As a case in point, emerging markets (EM) and peripheral Europe are early 2018 victims of this phenomenon, as previously dormant fundamental vulnerabilities have become suddenly exposed to the potent U.S. policy tightening cocktail. In both these instances, acute local financial economy shocks have resulted in surging local real rates and bruised real-economy psyche. The net result may compromise global synchronous growth.
Another financial shock that may be less appreciated is the sharp contraction in U.S. equity multiples since the first quarter. This “correction” in U.S. equities represents a stealth tightening of financial conditions, as the higher implied cost of equity reflected in lower forward valuations is not accurately captured in mainstream measures of financial conditions, but can have a very real impact on corporate financial behavior.
Meanwhile, U.S. rates markets are correctly pricing in secular growth headwinds and the fleeting impulse of current U.S. fiscal stimulus, such that UST short rates have borne the brunt of tightening and caused the Treasury curve to flatten. As the Fed endeavors to discern an appropriate terminal funds rate, this so-called “bear flattener” can continue, leaving risky spread curves vulnerable to requisite steepening, an adjustment yet to occur.
All things considered, our 2018 investment chess strategy is a defensive one that centers on employing the pawns of short-duration, high-cash-flow assets, combined with a tactical deployment of more flexible and powerful investment chess pieces via convex upside expressions in equities and cautious investments in EM, where we must remain sensitive to political risk and currency evolution. In financial terms, this positioning represents an aggressive barbell that is heavily weighted to front-end secured carry, with some upside beta tools in case the Fed does slow its tightening pace in deference to rising systemic financial economy volatility, which would clear the path for a more favorable risk-on environment. The 2018 investment “chess game” is, so far, a tale of very few financial asset winners, and is replete with a high, and rising, strategic complexity. For now, we’re playing defense, but we are more than ready to redeploy assets to help secure a checkmate on behalf of our clients.