Things Fall Apart (Part 3)
October 24, 2018·23 comments·things fall apart
Investors obsess over three major risks that would crater markets by 20 percent. They prepare hedges and watch the headlines. But what if the real threat isn't one of these well-known shocks? What if it's the one thing almost no one is positioned for: a fundamental shift in how the world inflates?
• Everything your portfolio was designed to do assumes deflation wins. Long-term bonds, passive indexing, diversification into abstracted securities. All of it works brilliantly in a deflationary world. None of it works in an inflationary one.
• The Fed accidentally created the conditions for the opposite of what it intended. It flooded money to spur corporate investment and risk-taking. Instead, corporations just bought back stock. Now when rates rise, companies will finally have to take real risks. That creates inflation, not controls it.
• Nobody is talking about the mechanism that would actually allow inflation to take hold. Federal budget deficits are barely mentioned in financial media despite their size. Without narrative, there's no common knowledge shift. Without the shift, politicians never face pressure to actually fight it.
• Even as deflation risks loom, inflation expectations are rising anyway. The Fed, the White House, and Wall Street all want inflation. They're beating the drums for it in financial media. Something is shifting in the background while everyone watches the headlines.
• If inflation does arrive, your biggest portfolio anchor becomes your biggest vulnerability. Long-dated government bonds will stop protecting you. They'll just drain returns while everything else crumbles. The insurance policy becomes the wound.
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Comments
“A risk is something where we can assign some sort of reasonable probability to its occurrence…”
Three of the Horsemen are “risks”. Two of them, maybe all three, are non-recurring. How do you assign a probability to a non-repeatable event, or do you mean guesstimate as a process? You can assign probabilities to guesstimators. Do you use a coterie, either public or private, to assign the ‘reasonable probability’?
(I realize this is not about your main point.)
You just keep upping your game, Ben! When you say “there’s an argument for Bitcoin here” aren’t you really talking about Blockchain Technology broadly? Doesn’t this reaffirm what Neville Crawley wrote about on September 24 in his guest post re an Alternative Data Infrastructure System?
I filled out an online form today and one of the fields was country of residence. I had to scroll a lot to get to United States, and I realized that it’s usually at the top. I had a kind of frisson that this was what it was like living in a country that didn’t have the world’s reserve currency. I don’t know if it’s gold, SDRs, Bitcoin, or moonbeams, but if the world picks another reserve currency, American life changes fast.
I was asked once what really backs the US Dollar, and I said, “12 aircraft carriers.” You want an out of the blue, unimagined, unknown-unknown? Someone even gets close to putting a dent in one of those ships, and common knowledge that America rules the sea lanes will change quickly.
I agree, I always thought that Wall Street and economists underestimate (ignore? / don’t even think about?) the military component supporting the world’s reserve currency.
Since the last world war ended in '45 and the Cold one in ~'90 (and the Soviet economy and political structure was never going to support a reserve currency anyway), the military-might aspect has gone from being taken for granted to being almost forgotten about. It’s no coincidence that the British pound gave way to the US dollar as the reserve currency at the same time that the military fortunes of the two countries were moving in opposite directions.
Ben - thoughts on Gold? If, as you’ve noted, it’s insurance against CB failure, I have to assume you see it as part of the strategy when the Fourth Horseman arrives (carrying the 1970s economy in his saddle bag) and undermines CB credibility?
YES. And this will be at the heart of my what-to-do in politics note, the companion piece to this one.
It’s not my main point, but it’s an important question! You’re absolutely right that you can’t just “assign a probability” to, say, an Italy-driven Euro crisis, and this is exactly why it is a (very) poorly-specified risk. What you CAN do, however, is create a path set or event tree where some of the paths and tree branches ultimately end in a Euro crisis, and evaluate the nodes (sub-events) that take you along one of those paths or branches. The closer the node, the better you can estimate a probability, even if the far off nodes are not effectively estimatable AT ALL. This is exactly why I think it’s necessary to REACT to these poorly defined event risks if and only if they actually occur, as opposed to hedging in advance. If you hedge in advance, you’re really just hedging one of the sub-nodes, and you almost never get a fair price on that.
There are a couple of thoughtful guys out there who have been ringing a bell about this possibility. My sense is that it’s like a runaway federal budget deficit. Is it a serious and real unknown unknown that would change our fundamental investment fabric? ABSOLUTELY! Is there any sort of narrative being created that would change common knowledge (and thus behaviors) on this? No. And unless and until I see that narrative, I think we’ve got time before we have to DO anything to protect our portfolios from this uncertainty. That’s not to diminish its importance, but to explain how I think about its demands on my portfolio decisions TODAY.
Yes, I think the meaning of gold today is as an insurance policy against CB failure. And I think it’s a pretty cheap insurance policy! That said (and this definitely deserves its own note) I just can’t shake this nagging doubt that it will be as effective an insurance policy as it has been in the past. To be continued …
“God help us, but there’s an argument for Bitcoin here.”
Looking forward to more in-depth discussions on this!
We actually just published a 100-page long thesis on what’s really driving the cryptocurrency phenomenon (https://iterative.capital/thesis/). This traces back to the origin & cultural context of open-source software, cypherpunk movement, and how Bitcoin coordinates around human & machine consensus. We spent a lot of time on this. Promise this is not marketing/shill. I genuinely want to hear feedbacks from Epsilon Pack.
Interesting allegory of the four horsemen, especially where China and Inflation fall in order (War & Death).
Does it change the outlook if the three horseman arrive together or just lengthen the recovery timeline. At present all 3 narratives seem to be in play.I
Biblically speaking the four horsemen arrive together, with Hell following. Can we imagine a scenario where markets and participants encounter your four horsemen at the same time? Would certainly seem like Hell for asset managers.
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