Heisenberg Report

For The First Time In Modern History, A Better Future Is Not The Base Case

Who remembers “the spiral”?

Early last month, we brought you excerpts from what, at the time, was the latest weekly missive from the incomparable Aleksandar Kocic, the Deutsche Bank derivatives strategist who regular readers will recall has been playing in a league of his own for years. In that piece, we documented the evolution of Kocic’s vol-leverage ellipse which, with each successive crisis, spirals outward. Each burst bubble must effectively be subsumed by an even larger bubble as the policy responses become more dramatic over time commensurate with increasingly severe busts.

As sellside strategists go, Kocic is peerless. We’ve long argued that a holistic, cross-disciplinary approach is the best way to go about making sense of markets. That’s what research should be about. Attempting to understand markets through an innovative lens, building on an existing body of work to push the discussion forward, and fleshing out the concepts proposed in that previous work as part of an ongoing effort to explain phenomenon by reference to frameworks that seem to have some explanatory power.

Needless to say, that’s a tall order and it’s not something that most people are capable of even in the context of freewheeling blog posts, let alone under the time constraints and compliance overhang that come with penning weekly analysis for a bank. But Kocic manages what should by all accounts be an impossible task with ease: he seems to be developing his own theory about what’s driving volatility in real-time, with each weekly note building on the one before.

Along the way, he’s built up a veritable lexicon of terms and an expanding list of market metaphors that draw on other fields of study. One of those concepts is the “permanent state of exception,” which comprises the current base case for where we go from the lower-left quadrant of the vol-leverage plane (if you’re new to this, you may want to skim the linked post above for the background). Here is the original visual:

And here it is in spiral form:

Ok, so as we detailed previously, there are four possible outcomes going forward. Here’s the base case illustrated with the red arrow in the second chart (black dashed arrow in the first chart):

Permanent state of exception: We continue to operate in a regulated environment. Leverage is limited, but care is taken not to overconfine the system so we avoid the Japanese scenario. While this appears as a prudent approach to reality, it implies giving up all the ideas of unlimited growth, something that made US economy look better than the rest of the world. Compared to what we have seen before, this means settling for much less than this country is used to aspiring. Although a reasonable proposition, it is emotionally a difficult choice that is and will remain subject to substantial political manipulation. It is unlikely that populist narrative will not continue to challenge this choice.

See the problem with that given the prevailing political environment? Consider what we said about that last month:

That is a decidedly unpalatable proposition – especially in the Trump era. “Settling for less” is not at all consistent with Trump’s amorphous #MAGA promise. In fact, inherent in #MAGA is a certain deliberate ambiguity that implies an infinitely high bar – as Trump himself put it on the campaign trail, “you’re going to say Mr. President stop! It’s too much winning. And I’m going to say ‘no, we have to win more!’”

Well on Wednesday, Kocic is out with his year-ahead preview and in it is a section called “problems with the base case.” Those problems mirror our assessment as excerpted above and the implications for America’s politics are profound.

Implicit in an acceptance of the permanent state of exception is the idea that, for the first time in history, we are being asked to acquiesce to a future that is actually worse than the past. Here’s Kocic from his note out Tuesday:

As much as the base case trajectory appears as “reasonable” and a worry-free choice, its biggest problem is its legitimation. Easy money provided by central banks to restore growth was easy for capital, but not for labor.

Policy response to crisis added further to inequality by blowing up the financial sector and inviting speculative rather than productive investment. The Keynesian bond which ties profits of the rich to the wages of the poor seems to have been severed, cutting the fate of the elites loose from that of the masses and the well-being of the economy. With subaverage growth and highly skewed wealth distribution, the economy is converging towards what for a growing majority increasingly resembles a zero sum game. To the vast majority, that is saying that the best days are behind us.

This is the most difficult aspect of the base case scenario: There has been no political system in modern history — inclusive, exclusive, democratic or oppressive, all the same – that has promised anything but better future to its constituents. For any ideology the gradient between the present and the future has always had to be positive. It is difficult, if not impossible, to conceptualize any political narrative capable of making the reverse acceptable. And in a context where economic growth is a universal metric of progress, problems with the base case become even more acute.

The implication there would seem to be that the current system is on its last legs. For the masses, accepting this base case involves resigning to a fate of ever growing inequality. For all intents and purposes, it means giving up and conceding that for most of us, the future will not in fact be better than the past.

This is a particularly worrisome scenario in the current environment because as Kocic goes on to note, “the legitimation of the base case will continue to define the populist narrative as a voice of change [and] politics will be shaped along the lines of looking to disrupt the status quo with quick short-term fixes, which could emerge as outright triggers of stagflationary trajectory.”

In other words, the myopia associated with policies ostensibly aimed at “making things great again” could end up catapulting us from the lower left-hand quadrant in the charts above to the upper-right quadrant. That, for Kocic, is “the most acute risk” for markets as it would entail a number of dangerous outcomes, not the least of which would be the disorderly unwind of the bond trade and all the volatility that would invariably accompany it.

Implicit in all of this (and as illustrated by the four arrows in the charts) is the notion that there are no truly “good” choices – only difficult ones.

And that goes both for markets and for society as a whole.