Risky markets have had a torrid time lately. “Risk-free” government bond markets offer no safe haven in these storms, with steepening curves and considerable volatility in longer rates.
It seems clear that the U.S. Federal Reserve, charged with a dual mandate, is prioritizing fighting inflation over achieving maximum employment, which may imply risks to the outlook for economic growth. . Inflation expectations, while perhaps below their recent highs, are still not declining significantly.
The US economy remains strong, with a very healthy private sector and high corporate profit margins. But the tightness of the labor market is problematic, tightening wages on the rise. Markets rightly worry that the Fed may fail to negotiate a path to an economic soft landing in its fight for price stability, a failure that would be more in line with historical precedent.
Known unknowns and unknowns: Knight’s uncertainty
Donald Rumsfeld, US Secretary of Defense during and after the events of 9/11, was a controversial figure. At a press conference during the war in Iraq, he gave an answer that ended like this: “but there are also unknown unknowns – those that we don’t know that we don’t know”. This caused much mirth and considerable contempt to be poured upon him.
His apparent salad of words, however, brought to light a concept that economists and others have wrestled with for years – differentiating between risk and uncertainty, between something known to exist and something that can be valued and priced, and something whose existence/occurrence cannot be predicted.
In his 1921 book, Risk, Uncertainty and Profit, economist Frank Knight wrote about what he considered to be different types of probability, ranging from the roll of a dice, to events where it is possible to calculate some sort frequency, and finally what he called “estimates”, when there is no valid basis for any sort of statistical analysis, known as Knightian uncertainty.
Knight’s definitions may not be universally accepted, but they can be useful in analyzing human behavior in times of volatility.
In recent years, capital markets have been subject to a particularly wide variety of “unknowable” seismic events: entry into a pandemic; interlocks; vaccines; getting out of the pandemic; Russia’s invasion of Ukraine. All of this adds a particularly thick layer of (perhaps Knightian) uncertainty to decision-making.
Although good investors cannot predict the unpredictable, they remain aware of the possible existence of Knight’s uncertainties and never assume that an extreme risk that is nearly impossible at a distance can never occur.
With stock markets falling and credit spreads wider, it is clear that financial conditions are tightening. The technical picture may well be favourable. With many assets now entering oversold territory, extreme bearish sentiment could signal contrarian buy signals, with plenty of policy tightening already priced in. But it’s hard to paint a bullish picture for financial assets just yet, in these times of unrelenting uncertainty.
Although the damaging influence of COVID-19 on much of the western world’s economies has diminished significantly, China’s zero-tolerance COVID-19 policy is having a severe impact on economic activity, with a director’s index very weak purchase in April for the manufacturing sector indicating a possible contraction of the GDP. in Q2.
It was becoming apparent that global supply chains, severed as countries around the world went into lockdown, were until very recently on the mend. China’s importance to global growth in general, and in particular its role in the smooth functioning of these supply chains, means that real economic data such as imports and exports will be watched very closely to assess the real effects of falling sentiment.
Fears of slowing demand in China may lower the price of oil, which is potentially good news for inflation, but the conflict in Ukraine is putting strong pressure on food and oil prices. agriculture, which could continue if next year’s crops are also threatened.
Although the Federal Reserve hasn’t raised rates by 50 basis points in almost exactly two decades, the May move did not allay market fears that U.S. policymakers were still behind the curve, in particular by essentially ruling out any 75 basis point hikes in this cycle, thus effectively capping the speed, but not the amount, of policy tightening.
Fed Chairman Jerome Powell made it clear in his later comments that 50bps was the size of the hike of choice and that the Fed was focused on reducing inflation, and “will not hesitate” to bring rates to the levels needed to put the US economy back on the path to restoring price stability.
With the onset of quantitative tightening now confirmed by the Fed, another layer of uncertainty is added to the variety of supply and demand forces driving rates. According to Fed figures, the 10-year term premium is back in positive territory for the first time since late 2018. ownership of debt by investors, as opposed to the Fed.
Europe’s proximity to the conflict in Ukraine, as well as its heavy dependence on Russian oil and gas, creates a different set of risks to economic growth. Consumer confidence was hit hard in March with the outbreak of war, and uncertainties surrounding the prospects for a peaceful resolution could weigh on consumer and business spending plans.
With sluggish growth, and possibly serious disruptions in gas supply, as well as alarming inflation rates, the European Central Bank has its fair share of challenges. He certainly stepped up his hawkish rhetoric, on the dangers of second-round inflation effects pushing up wages, and pointing out that European real rates are still negative. Along with rising rates, peripheral spreads also increased, with debt-ridden Italian government bonds leading the way.
Its speed was alarming, but the depreciation of the Japanese yen in the first quarter did not shock investors, given the dramatic widening of interest rate differentials between the United States and Japan, as well as the weakness of almost all currencies of commodity importers.
A few weeks after the yen, the Chinese yuan also fell sharply, losing 4% against the dollar in April. It does not yet show signs of recovering that lost value, and Chinese policymakers will be eager to regain a sense of stability in the market.
The Chinese Communist Party’s zero-tolerance policy on COVID has weighed on the economy – as of early May, around 25% of China’s GDP was still affected in some way by the shutdowns. The policy is not expected to change until the fourth quarter, when a sufficient proportion of the elderly population should be vaccinated and in time for the important party congress, convened every five years, in November.
Chinese capital markets have seen huge inflows of portfolio investment, creating a new vulnerability in times of crisis: that of large outflows, whether from the outright sale of Chinese assets or the sale of currencies due to hedging activities.
Chinese officials don’t seem too upset with the currency’s weakness, not least because the trade-weighted currency, as measured by the RMB CFETS index, has been climbing for a few years and is now hitting multi-year highs.
However, while orderly currency depreciation can be tolerated, a much faster pace or signs of market disruption and dysfunction will likely mean authorities will intervene.