Welcome to Finance and Fury. Are we in for another black swan event in the coming months? I think that it is fairly obvious to everyone that we are currently in the midst of a bear market.

  1. In one major way, a bear market was expected at some point – but the timing of when this occurs is what is unknown
    1. This mostly surrounded the removal of the lifeline that markets were running off – with cheap money and excess liquidity – so when central banks commenced removing liquidity from markets and increasing the funding costs is what has created a situation – what also made he situation potentially worse if the forward guidance that they were providing – saying that easy money, low interest rates and QE policies would be in place until 2024 – so the removal of the lifeline was always going to create problems, but giving the forward guidance made it worse
  2. There is a lot of information about how the economy is bad, it is pretty common knowledge that markets are declining in response to tightening liquidity in conjunction with bad economic forecasts
  3. How low can it go? And how long does it last for – From fund managers I speak to, there is a general consensus that the bear market may drag on for another 3 to 6 months – this is based around current information –
    1. But this brings up major concerns about a black swan event – theory of a black swan event is a metaphor that describes an event that comes as a surprise that really shocks markets
    2. A lot of guess work – as the whole concept of a black swan is the surprise that surrounds it – and it is never just one event – it is a little oversimplistic to simply say a ‘black swan event’ as it is more a cascading set of events that eventually breaks investors confidence in a market, creating mass fear and panic, resulting in selling – it is essentially just the straw that breaks the camels back
  4. It’s not so much the surprise factor here as to being the major catalyst for a black swan event – markets never like surprises, but for a surprise to create a major selloff, markets already need to be in a vulnerable position – this is where there are many known knowns at the moment – so could this chain of event lead to a surprise that nobody sees coming?
    1. The first cab off the rank was the Fed with interest rate hikes, and the anticipation that most developed nations would follow suit – as they all soon did
    2. Then you had the Russia-Ukraine war causing chaos in Europe – further hurting supply chains for many goods
    3. China is also in the midst of fighting a bursting property bubble, slowing their economic growth
    4. You have an overvalued US dollar – putting a lot of pressure on emerging markets and developing countries economies, as well as pushing up their inflation levels for consumer goods
    5. The pound tumbling and then UK pension funds receiving margin calls and needing the BoE to purchase bonds to help meet their liquidity needs
    6. Then the Nord Stream pipelines being sabotaged – worsening an already bad energy pricing situation
    7. Property prices are starting to slump in many developed nations due to higher interest rates
    8. Major banks like Credit Suisse also struggling, with a 3% probability they default in the next 12 months
  5. Essentially, these inputs have been priced into markets due to the probabilities – not saying markets are fully priced in, like the EMH would say, but the probabilities of these events have been priced in, in anticipation of what could unfold from here
  6. Where things can get worse – is more surprise events that materialise along the way, until one finally breaks investors confidence to the point that it takes months, or years to recover
    1. One major ‘black swan’ could be the de-dollarisation of the financial system – Being that the US dollar is now overvalued along with its history of weaponization in trade disputes, along with the asset confiscations over the Ukraine war – this may prove the beginning of the end for the US dollar as the world’s reserve currency
      1. China along with a good chunk of the world’s biggest and fastest growing economies currently have an ambiguous relationship with the US – so it’s not hard to see these countries adopting alternative methods that serve them along with bypassing US sovereign risk
    2. Beyond this – the first quarter of next year may see a bunch of catalysts come together – to create a systemic collapse
      1. First – the US interest cycle will likely be reaching its peak – but also the depth of the US recession should also be clearer.
      2. Second – Europe will be coming through the worst of their energy problems, with winter nearing its tail end and with it, the higher demand on energy for heating – with Nord Stream, things are likely to get ugly in energy pricing, particularly in Germany, the largest EU economy
      3. Third – the BoJ’s Governor term will be ending, and with it, potentially their period of ultra-loose monetary policy
      4. Many moving pieces – if they all come through for a decline is yet to be seen
    3. Out of all of these, where cracks may really emerge could stem from the UK economy and financial markets – This is an example of a black swan event that could have played out –
      1. The Bank of England launched an intervention that they have never had to do to date to stabilize the U.K. Pension funds, and the confidence in their financial markets – this was though the BoE announcing a two-week purchase program for long-dated bonds and delaying its planned bond sales until the end of October
      2. The BoE made this move to save pension funds after a massive sell-off in U.K. government bonds following the new government’s fiscal policy announcements Friday
        1. Markets did not respond positively to governments fiscal policy announcements over the last few weeks
        2. Like many nations, the UK has seen a huge spike in energy prices – Liz Truss put in place an energy price guarantee – limiting prices that energy can charge at by the providers – average family will save around 1k pounds per year – this will be funded through gov deficit spending – which is estimated to be a cost of around 4% of GDP, costing at least 100bn pounds in the first year – but total costs could be 160bn pounds – being 6.5% of their GDP – this will likely lead to higher interest rates in the future, as confirmed by the BoE chief economist
  • In addition – unfunded tax cuts were announced that saw the pound fall to an all-time low against the dollar last week
  1. Comes from investors selling UK assets due to their doubts about the UK government plans – higher interest rates lead to declining bond values, and lower tax income reduces probability of UK meeting their debt liabilities, even though this is a small chance, the small chance has still been priced in, leading to a large drop in the long-dated bonds that are most sensitive to duration risks
  1. With the bond price collapsing, and the pound collapsing – UK pensions funds were in trouble
    1. So the BoE needed to step in to fund defined benefit pension – due to the panic among pension funds – due to some of the bonds held within them losing around half their value in a matter of days – the BoE had to step in
      1. The losses were so much that pension funds began receiving margin calls
      2. UK pension funds have been hit with variation margin calls of as much as £100 million
    2. The issue is that these long-dated bonds represent around two-thirds of Britain’s roughly £1.5 trillion in defined benefits – to fund these, bonds are used as collateral and then leveraged to fund the returns – the issue with the declining value of the UK bonds is that the defined benefits are already unfunded, and the gap will grow larger into insolvency as these plans are forced to sell more bonds to fund pension income payouts – which in turn drives down prices further – so the BoE is purchasing the bonds being sold off by pension funds to avoid the natural market price declines
      1. The BoE will commence buying up to £5 billion of long-dated gilts – those with a maturity of more than 20 years until Oct. 14th  
    3. Whilst the BoE is buying bonds – they have still retained their target of £80 billion in bonds sales per year – whether this materialises is anyone’s guess – but once the quantitative tightening restarts, more fears will re-emerge – as QT commences again

Where to from here?

  1. The UK economy is fragile – Following the bank’s bond market intervention by the BoE, economists expect short term stability, however the reliance on the CB to maintain this has increased
    1. In essence, this BoE intervention is plugging up a dam with a band aid – Markets would have been better served from government thinking through their policy decisions before announcing these, rather than a CB having to pick up the pieces, ironically from a problem that they created in the first place
    2. But with the BoE buying long-dated bonds is a sign that one of the largest CBs in the world is willing to restart QE as soon as markets become jittery to a real collapse, and not just a bear market correction, this does provide some comfort to investors that there is a back stop to black swan events
    3. What fell apart in 2008 in the GFC – banks were left to fail – Lehman Brothers and Bear Stearns – as there was no Central Bank policy intervention on the scale that we see today with programmes like QE – which only really kicked off in 2009, after these banks were left to fail on their own – in a way they could have been sacrificial cows to the market for being the only major banks to not fully participate in the bail out of LTCM just under a decade before the GFC – CBs could have just under estimated the market collapse from bank failures, then in a panic decided to bail out the rest once they say the level of market declines
  2. But in the UK, the raising of the interest rates while also engaging in quantitative easing in the short run is an extraordinary policy quagmire to navigate – remember that the point of QE is to lower the interbank cash rate, to increase the supply of money in conjunction with OMO – so this could point to a continuation of currency weakness and continued volatility in markets – if the pound continues to weaken against the USD and UK bonds continue to be sold off, then the BoE may have to continue QE to fund the DBs

How does all of this relate to Australia – If the US and UK have market fallout, our market will likely follow just due to a risk-off attitude of investors

  1. But beyond this concern – Rapidly rising interest rates domestically and international turmoil means that the outlook for Australia does remain murky – our GDP growth, whilst not good, isn’t as bad as other nations – and inflation isn’t as bad either
    1. So where we stand, a recession doesn’t look like a necessity in Australia- though we could certainly have one – the most probably cause is likely to come from a CB error – through a tightening cycle that is too hard too fast
    2. The RBA can afford to slow rate hikes to see how the economy is coping, but if they do this is the question –
      1. so far at least, consumer spending has held up, perhaps due to additional savings as interest rates have been low, in conjunction with travel expenses being cut, due to not being able to travel interstate or internationally for the best part of the past 2 years
    3. Our financial market situation is really beholden to two power – the US and China –
      1. The US doesn’t look like it is in great shape, nor does China
      2. Australia is in a good position relative to other nations, looking at earnings reports and PE’s, markets in Australia aren’t in an overvalued position – but they are likely to trend lower due to international problems
        1. Even the problems emerging in the UK are starting to show cracks in the issues with the monetary tightening that is occurring -I’m sure that it won’t be the last of the issues that is seen
      3. Investing everything now may be a bad idea – no way to tell – as the next few months will be a time of uncertainty –
        1. Clarity will likely emerge towards the first half of 2023 – there have not been three years of negative returns on the ASX in the past 122 years

Summary – Black swan events are never one single event – it is a cascade of related events that end up totally breaking the confidence of investors, creating a total market collapse and panic selling

  1. The bad news – there are many events in the works at the moment
    1. Interest rate hikes and monetary tightening – potentially leading to funding issue by many corporate and government debt issuers
      1. Such as the UK pension funding issues currently occurring
    2. Global energy price shocks are also occurring
  2. The good news – Australian markets are relatively sitting well – but we could always be dragged down by the US
    1. Bus absolute loss potentials are limited form index investing
  3. The irony is that underperforming markets in the EU, Japan and Australia could perform better than US markets over the next few years
  4. Not out of the woods yet – as an unknown event may play out – but at current course, the bear market is likely to last at least 3 up to 6 months before a recovery – this is based on a massive assumption that no new information materialises – hence it will be wrong and likely incorrect

But at the current point – is the best guess –  as a black swan may always be around the corner to break the markets back

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