Blain: This Is A New Game, What Comes Next Isn’t Pretty…

Authored by Bill Blain via MorningPorridge.com,

“The church bell chimed ’til it rang twenty-nine times, for each man on the Edmund Fitzgerald”

Warning – Readers of a sensitive nature may wish to take a chill pill before reading this morning’s Porridge comment. Remember, the sun will come up tomorrow. The market might not.

Red Sky in the Morning – Sailor take warning. I woke to a vivid red sky this morning – by the time I rushed upstairs to snap a photograph it was already fading. In sailor lore Red Skies presage storms – it’s the rising sun reflecting off high levels of water vapour carried by approaching weather fronts that causes the bright red effect. Curiously, it’s been the quietest Caribbean Hurricane Season in decades, yet I suspect there is an almighty storm already upon global markets – we are so caught up in it we don’t realise its knocking on the windows – and about to knock them out!

The worst part of any storm is not the Eye (which is calm), or even the winds and storm surges as the gale approaches. The strongest winds are just outside the “eye-wall”, following the path of destruction. The really sustained high-winds and storm waves are in the following quarters. When it’s an Atlantic storm barrelling into Europe from across the Atlantic, is the bottom left-hand of the rotating storm where the winds are strongest and most destructive.

Which is all a long-winded way of saying.. this might get worse.. Much worse.

Despite many storm warnings – this market is ill prepared for the kind of instability about to hit, as recession, stagflation, geo-politics, domestic politics, energy, food, inflation and the rest combine in that most misused of metaphors; a Perfect Storm. There is no such thing – every storm is different – and it’s not the things you see coming that maims you, it’s the things you don’t!

Following Jackson Hole last week – where the Fed and other Central Banks confirmed the battle versus inflation means higher rates for longer – the market has staged a predictable sell-back. The numbers look bad – but hardly terminal. It still looks kind of normal for a typical September market reverse, a correction. The gains from the summer rally will probably be wiped out, but market participants will be expecting the next play to begin. In the next few days we will be back to talk of recovery.

Nothing much to panic about when the US 2 year bonds nearly hit 3.5%. Stocks in reverse. The VIX fear indicator of stock volatility is up to 27. None of these are chaotic – yet. Arrr…. The calm will not last…

The wind in the wires made a tattle-tale sound
And a wave broke over the railing
And every man knew, as the captain did too
T’was the witch of September come stealin’

The big issue is how prepared for a market blow are we? Anyone with a career record under 15-years has never experienced a real market gale – the last one being the Global Financial Crisis of 2008. I reckon that’s well over 50% of the financial workforce. Their careers have been forged in markets artificially supported by quantitative easing and Zero Interest rates. Now we are stepping into aggressive rate hikes and quantitative tightening – with the Fed confirming a steep pace of hikes to tame inflation, even if it causes a slowdown. And the financial conditions barometer is tumbling as consumers and business face impossible budget calls.

This is a new game.

Lots of young fund managers will be looking at their books and wondering how they are going to reverse the 10-15% losses they’ve sustained this year. The compliance and risk management mitigation mindset that dominates institutional investor groupthink will largely ensure they don’t bet the farm on big risky bets, but for most funds – which means the money folk are saving for retirement – it’s going to a very bad year.

Risk and groupthink mean there are going to be fewer folk out there looking for risky opportunities – potentially meaning the crisis last longer. Losses on losses, at a time when consumer discretionary spending and pension saving will have been hammered by inflation, will have profound consequences on the future market.  Forget the walls of money that’s fuelled funds, and speculative market rallies – we’re looking at significantly less money coming into markets.

Bankers will be smiling. They are focused on how the transfer of wealth from the poor to the rich was accelerated by QE and now means the top 1% of the global population own over 58% of societies wealth and assets. No wonder investment banks are hiring aggressively into private banking and wealth management services! Family offices don’t mind being smoozed.

Meanwhile… The Fed and the US economy can afford some economic misery. The US is largely detached from the global energy price shock, and will survive global recession in its largely self-contained domestic bubble. A recession will hurt – but won’t kill the economy.

This gathering storm is going to hit Europe hardest. Energy insecurity and the Ukraine war is responsible, but a large number of ECB board members are publicly calling for an unparalleled 75 bp hike to tame the inflation beast, and to reverse the sinking Euro (down 15% this year, and headed lower). Higher rates and a deepening economic crisis as Europe heads into recession and rising unemployment is scary, and doubly so as soaring energy costs look likely to trigger rising social tensions. As I’ve said before, when the going gets tough, the French will be revolting.

The dawn came late and the breakfast had to wait
When the gales of September came slashin’
When afternoon came it was freezin’ rain
In the face of a hurricane west wind

As for the UK. La-la land. New prime minister next week, promising tax cuts for the rich and regressive tax allowances to fight soaring energy bill – when the bottom 40% of the UK don’t pay tax. It won’t help the national mood to know our new Aircraft Carrier, the Prince of Wales, broke down a few miles from port yesterday on its way to a major deployment. Oops.. Sums up busted Britain.

What comes next isn’t pretty.

Since 1985 I’ve experienced a number of market crashes. They have been shocking, sharp and surprising. In every case they were caused by a blindingly obvious financial market imbalance – like consumer lending risks, over-exuberance, unsustainable expectations, etc. The coming crisis is very different – it’s been a series of exogenous shocks; Covid, and now Energy and Ukraine. It feels more fundamental that the simple market mispricings that triggered some form of market crash every 6-7 years. These were short, and we quickly recovered.

What is coming is something worse. This may be a once in a century storm…

When suppertime came, the old cook came on deck sayin’
“Fellas, it’s too rough to feed ya”
At seven PM, a main hatchway caved in, he said
“Fellas, it’s been good to know ya”

This is developing into something with a smattering of 1929 – unravelling massive financial mispricings – together with the exogenous effects of the wartime shocks in 1914 and from 1939. Forget inflation and growth, but consider issues like expertise, experience, groupthink, panic and fear, and the crushing of small investors trying to figure out where this might go next..

The captain wired in he had water comin’ in
And the good ship and crew was in peril
And later that night when his lights went outta sight
Came the wreck of the Global Economy

The one positive thing I can add.. following any storm.. the seas calm, the sun comes up, and we go out and do it all again..

Footnote – On August 11, 1979, 303 small yachts set out on the Fastnet Race from the Isle of Wight to the famous lighthouse off the South-Western tip of Ireland and back to Plymouth. There were strong winds forecast, but nothing unmanagable. It turned out much worse. The fleet was hit by a weather bomb as fronts combined to create a Force 11 Hurricane. 15 sailors died. Lessons have been learnt – mainly that: “there is nothing always about a storm at sea except its danger.”

Same thing in markets….