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What else can go wrong?

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Patrick Kelliher

Sorry I haven’t posted for so long. To be honest I found markets difficult to fathom these past two years. Notwithstanding repeated waves of Covid, lockdowns and economic disruption, many markets reached record highs, helped by unprecedented fiscal and monetary stimulus. Then, just when than we reached the point where we learn to live with the virus and revert to normal, Russia invaded Ukraine disrupting global supplies of food and energy.

The war in Ukraine has added to post-Covid supply chain problems to push up prices, with central banks tightening monetary policy as a result. This is turn has led to falls in markets with the S&P500 falling by nearly 20% since the start of the year to 20th May 2022, with the NASDAQ falling further by 27%. In the UK, the FTSE100 has barely dropped due to the preponderance of oil and gas shares in this index and the boost to dollar earnings from a fall in the pound, but the FTSE250 has fallen by over 15% in the same period. Meanwhile investment grade corporate bond spreads have increased from ca.100bps to ca.150bps since the start of the year [1], while the US$ has appreciated against the £ sterling and Euro in recent months, partly because of rises in US rates but also because its safe haven status as investors become more risk averse.

However, markets may have further to fall. The S&P500 is still 30% above its level in October 2019 when the IMF warned that US stockmarkets were over-valued [2], while the recent rises in investment grade corporate bond spreads just brings these back in line with historic averages. Markets face a wide range of risks which could drive them down further:

 

1. Monetary tightening 

Perhaps the key risk to markets relates to monetary policy. With inflation expected to continue rising over the rest of the year, markets expect further rises in base rates but there is risk that inflation and base rates rise further than expected pushing down equity markets and bond yields.

As well as base rate rises, the Bank of England along with the US Federal Reserve and other central banks are also adopting “Quantitative Tightening (QT)”, reversing the effects of “Quantitative Easing (QE)” thereby removing a key source of demand for bonds. This could de-stabilises markets, leading to a “taper tantrum” like in 2013 when the US Federal Reserve’s tapering of QE purchases leading to a spike in bond yields globally as well as equity market falls.

2. Recession

The evidence from the past is that sharp tightening of monetary policy to combat inflation usually leads to recessions. As it stands, the Bank of England forecasts UK GDP to contract by 0.25% in 2023 [3], and from below, there are substantial downside risks which could lead to a deeper contraction

3. Further waves of Covid 

With Covid circulating in unvaccinated populations in the developing world, it is more a question of when rather than if a new variant emerges. If such variants are more severe than Omicron and/or current vaccines do not afford protection, this could lead to fresh lockdowns and disruption to the global economy.

4. China slowdown

As it is, the spread of Omicron in China and the Chinese Communist Party’s zero Covid policy is leading to mass lockdowns which currently affect around 150m people. Coupled with a crisis in its property sector, including the potentially systematic defaults of Evergrande and other property developers [4], China could see a significant fall in growth, exacerbating the slowdown in global GDP.

5. Further oil price rises

Hard as it may be to imagine with current record high prices at the pump, crude oil prices are still far from their peaks. The current (23/5/2022) Brent crude price of c.US$113 / barrel is lower than the peak prices seen in 2011-2014, and if we adjust those for (US CPI) inflation, the peak back then was around US$160 / barrel in current dollar terms [5].

With Russia joining Iran and Venezuela as yet another major oil producer subject to US and EU sanctions, and Saudi Arabia not currently minded to increase production to offset the reduction in supply from these, oil prices could conceivably increase a lot further – unless a large recession dampens demand.

6. Crypto-currency meltdown

Rising base rates and falling equity markets have reduced investor risk appetite, and this is clearly seen in the precipitous drop in crypto-currency prices in recent months, with BitCoin falling 55% from a peak of nearly US$67,000 in early November 2021 to around US$30,000 as at 23/5/2022 [6] while some stablecoins like Terra, which were supposed to have a stable value of US$1 are now trading around 10 cents.

While it may be tempting to dismiss these losses as the result of a fad, these falls could have serious impacts. For one thing, the reduction in wealth is huge: the value of crypto currencies has fallen from c.£US$3 trillion in November to c.US$1.3 trillion [7]. Such a large loss in wealth could have a wider impact on consumer confidence.

A bigger concern for me is the potential for contagion, particularly if a stablecoin like Tether experienced a run of redemptions, forcing it to dispose of the assets backing this. Such forced sales could impact on mark to market valuations for other financial institutions, transmitting the crypto-currency crash across markets in the same way as losses on US sub-prime mortgages and forced sales of asset backed securities triggered the Global Financial Crisis of 2007/09.

7. Emerging market meltdown 

Rises in US interest rates clobber emerging markets as investors pull back from these to avail of the improved yield on US assets; while rises in the US$ make imports and loans priced in dollars more expensive. Further US rate rises and/or reduced investor appetite could lead to further capital flight and sharp currency depreciation. We have already seen Sri Lanka’s economy collapse, resulting in a sovereign default, while the Turkish Lira is in freefall. I believe it is likely we will see further crises in developing countries and large falls in the value of emerging market assets, which could further dent investor confidence and lead to wider market falls.

8. Brexit trade war 

The UK’s recent announcement that it may unilaterally alter the Northern Ireland protocol has not gone down well with the EU. While it is hoped a compromise can be reached, there is a risk that matters escalate with the EU retaliating by suspending other elements of its trade deal with the UK. This could add to the drop off in trade with the EU post Brexit, and exacerbate the forecast downturn in the UK economy, particularly if tougher border controls lead to further disruption to supply chains and boost inflation.

9. Geo-political risks

The war in Ukraine has highlighted the importance of geo-political risks, but what other geo-political risks could crystallise in the near future? I see four risks which are worth keeping an eye on:

(a) Quemoy and Matsu – with Russia’s invasion of Ukraine, many wonder if a Chinese invasion of Taiwan is next? Personally, I don’t see a Chinese invasion any time soon. An invasion of Taiwan would be a much bigger undertaking than say the US invasion of Okinawa in WWII, which was a bigger amphibious operation than D-Day. I am not sure the Chinese have the capability for such an operation, nor the appetite for the tens of thousands of casualties it may incur. Instead, I see China continuing to pressurise Taiwan with frequent air incursions (which have the effect of wearing out Taiwan’s aging jet fighter fleet) and possibly naval missile drills disrupting Taiwan’s shipping lanes, as it did in 1995/96.

However, if Xi Xinping did want to make a splash this year, when he is seeking a third spell as leader, he might make a start on forceful reunification by attacking the Republic of China’s islands of Quemoy and Matsu. These are in artillery range of the Chinese mainland, and came under bombardment twice in the 1950s. Given the significant advances in the PLA’s capabilities since then, this may be “low hanging fruit” for Xi Xinping to conquer and get the country behind him (maybe like Margaret Thatcher’s success in re-taking another inconsequential set of islands some 40 years ago).

An attack on Quemoy and Matsu could have profound implications for Taiwan, particularly if Joe Biden didn't support the defence of the islands. Whether Taiwan itself is next or not, the fear it could be would cause panic in a country which is a key supplier of semiconductors crucial to global manufacturing. It is also worth noting that Taiwan's life insurers hold over US$400bn in US$ bonds and are a key investor in US corporates and overseas US$ bonds [8], so Taiwanese jitters could potentially trigger much wider bond market falls and economic turmoil.

(b) Morocco and Algeria – another authoritarian government that may be thinking of a war to bolster its domestic image is Algeria, which has a fraught relationship with Morocco. These countries fought the brief Sand War of 1963 over a disputed border region, and relationships haven’t improved with Algeria supporting the Polisario Front in its struggle against Morocco’s annexation of Spanish Western Sahara.  

A recent Economist article [9] highlighted that Algeria has now suspended gas exports to Spain via Morocco, and has threatened to cut Spain off if it re-exports gas back to Morocco from the direct pipeline between Algeria and Spain. The article expressed the fear that Algeria’s leaders may seek a conflict with Morocco to deflect popular discontent with high unemployment and rising food prices, and that this could lead to a disruption to gas supplies to Europe at a time it is struggling to replace Russian gas, as well as lead to a large wave of refugees.

(c) Arab Spring II – rising food prices will hit many developing countries hard, particularly those in the Middle East like Egypt, which relies heavily on Ukrainian and Russian wheat to feed its people. There is a risk that high food prices combined with popular discontent over unemployment, corruption and the regime of General Sisi could boil over into civil unrest. A worst-case scenario would be for Egypt to become another Syria but with 5 times the population, leading to an unprecedented refugee crisis, and possibly disrupting the Suez Canal crucial to world trade.

(d) Iran v Israel – amidst all the turmoil in the Ukraine, little attention has been paid to the stand off between Iran and Israel over the former’s nuclear program. The Joint Comprehensive Plan of Action (JCPOA) agreed in 2015 promised Iran relief on sanctions for halting this, but the agreement was then abandoned by President Trump. Iran has since enriched uranium to the point that it is close to making an atom bomb, hoping to force the US to ease sanctions. While it was hoped a revised deal could be reached, talks have halted following the Russian invasion of Ukraine [10].

There is a risk that Israel could lose patience with diplomacy and seek to strike at Iran’s nuclear facilities, like their strike on Iraq’s Osirak nuclear plant in 1981. This would prompt retaliation from Iran: while their Hezbollah allies could bombard Israel itself, Iran could seek to close off the Straits of Hormuz, and/or attack Saudi Arabia’s refineries (as it – or its Houthi proxies – did recently using drones). The resulting disruption to oil supplies on top of embargos on Russian oil could lead to an oil shocks like those of the 1970s pushing inflation and interest rates well into double digits

10. Central bank independence

Finally, a longer term risk I am concerned about is the impact of the current inflation surge on the independence of central banks such as the Bank of England. At present politicians are having their cake and eating it, criticising central banks for not doing enough on inflation while also complaining about base rate rises. I think the criticism is unfair: the current spike is more due to external supply constraints than domestic demand, and there is a degree of 20/20 hindsight to criticism that monetary policy was too lax in relation to fiscal stimulus in 2020/21 when it was uncertain whether either policy would work to preserve economic demand amid lockdowns and business failures.

Still the reputation of central banks as guardians of sound money has been dented among conservatives, while many on the left may question why they tighten monetary policy when living standards are falling but print trillions of cash in QE to support asset prices and wealth when markets crash. I fear the consensus in support of central bank independence may erode over time. Note I don’t think independence will be abolished overnight. Instead, politicians may seek to interfere ever more with monetary policy and/or appointments until a time comes when the Bank of England is seen as no more independent than the Bank of Turkey. By that stage investor expectations of inflation will have hardened at a much higher level than now, and we will have reverted to the high inflation, high interest rate paradigm of the 1970s and 1980s.

 

This is a dismal litany of risks, and I acknowledge that my previous blogs predicting doom and gloom have been well wide of the mark. There is the potential for upsides. Maybe a deal can be made with Iran which would allow them to freely export oil again, driving down the price of crude and hence inflation, as may a Saudi decision to increase production. Maybe central banks can negotiate the difficult balancing act between getting inflation under control and avoiding recession. Maybe further waves of Covid won’t cause any disruption, and the current collapse in BitCoin turns out to be temporary blip. Maybe Vladimir Putin decides he is happy with most of the Donbas and Ukraine’s southern coast and decides to halts his invasion, allowing an uneasy peace to develop and some normality to return in Eastern Europe.

Nonetheless I continue to be very bearish about markets. I continue to hold most of my assets in cash (apart from a punt on oil and gas stocks). I think markets have lived a charmed life over the past few years, but I don’t think this luck will last forever….

 

[1] Based on US investment grade spreads sourced from ICE BofA US Corporate Index Option-Adjusted Spread [BAMLC0A0CM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLC0A0CM, May 20, 2022.

[2] See chapter 1, page 3 of “Global Financial Stability Report: Lower for Longer”, IMF, October 2019 available at: https://www.imf.org/en/Publications/GFSR/Issues/2019/10/01/global-financial-stability-report-october-2019

[3] See Table 1.(c) of the Bank of England’s Monetary Policy Report, Monetary Policy Committee, May 2022 available at: https://www.bankofengland.co.uk/-/media/boe/files/monetary-policy-report/2022/may/monetary-policy-report-may-2022.pdf

[4] Evergrande has c.US$300bn in liabilities and defaulted on some of its bonds in late 2021. A good overview of the systemic risks it poses can be found in: “What is the Evergrande debt crisis and why does it matter for the global economy?” by the World Economic Forum, September 2021 at https://www.weforum.org/agenda/2021/09/evergrande-debt-crisis-global-economy/.

[5] Oil prices sourced from U.S. Energy Information Administration, Crude Oil Prices: Brent - Europe [DCOILBRENTEU], retrieved from FRED, Federal Reserve Bank of St. Louis; available at: https://fred.stlouisfed.org/series/DCOILBRENTEU, May 22, 2022.  

US CPI sourced from OECD – see Prices - Inflation (CPI) - OECD Data.

Disclosure: I currently hold large long positions in oil and gas shares in my pension portfolios.

[6] Source: Coinbase, Coinbase Bitcoin [CBBTCUSD], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CBBTCUSD, May 23, 2022.

[7] “The cryptocurrency sell-off has exposed those swimming naked”, Economist, 18th May 2022 available at: https://www.economist.com/leaders/2022/05/18/the-cryptocurrency-sell-off-has-exposed-those-swimming-naked.  

[8] See chapter 3, page 46 of of “Global Financial Stability Report: Lower for Longer”, IMF, October 2019 above.

[9] “Gas fires in the Sahara”, Economist, 14th May 2022 available at: https://www.economist.com/middle-east-and-africa/2022/05/14/algerias-ailing-rulers-stir-tension-with-morocco

[10] A useful summary of the issue is “What Is the Iran Nuclear Deal?”, Council on Foreign Relations, 28th April 2022 available at https://www.cfr.org/backgrounder/what-iran-nuclear-deal

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