Over the last three weeks, we’ve variously suggested that despite the readily apparent YTD “rally bias” (if you will) for risk assets of all stripes, market participants have been mired in a narrative tug of war.
Nobody wants to risk fading a Fed that’s clearly predisposed to being a bit more accommodative now that financial conditions have tightened up a bit (i.e., now that some steam has been let off and the risk of asset bubbles inflating further has been ostensibly reduced), but then again, nobody is particularly comfortable going “all in” at a time when the political situation inside the Beltway is hopelessly fraught and the odds of a comprehensive trade deal (i.e., a truce that resolves the structural issues at the heart of the Sino-US conflict) being struck by the March deadline are basically zero.
If you ask me (and you implicitly have or you wouldn’t be here), any hints at tweaks to the pace of balance sheet rundown next week should be viewed in the context of a Fed that’s staring down the very real possibility of the following factors colliding in March:
- the government being shut down again (after the three week CR signed on Friday expires);
- a national emergency being declared (by Trump, in the service of building his wall without Congressional approval);
- debt ceiling jitters starting to surface (in light of and underscored by the fractious political backdrop);
- the March deadline on the trade truce expiring with no comprehensive agreement, causing the tariff rate on $200 billion in Chinese goods to more than double to 25%
Next week could be pivotal with respect to all of those factors and the jam-packed docket likely helps explain why stocks closed Friday with their most muted weekly move in months (folks are torn in two directions with no clarity on which narrative will prevail).
Underlying all of this confusion is “recession obsession” – especially in the US. We’ve spilled gallons of digital ink on this over the past two months. Here are a couple of excerpts from something we posted last weekend documenting the causes of historical downturns:
When the recession obsession started to set in in earnest last month, analysts were quick to note that the narrative was starkly at odds with the economic data. Of course markets are forward-looking, but the disconnect between how equities and credit (for instance) were acting and the data was so glaring that even pessimistic strategists found it difficult to reconcile.
The problem is that when everyone loses track of their own role in the narrative, the potential exists for things to become self-fulfilling, as sour sentiment begins to manifest itself in real economic outcomes which in turn feed back into sentiment in a pernicious loop.
That brings us to the latest from Deutsche Bank’s incomparable Aleksandar Kocic, who on Friday evening was out with the latest “chapter” in what we’re fond of describing as a “book” which serves as a comprehensive framework for understanding the interplay between markets and policy. That’s how we generally describe his weekly notes, the latest of which is called “Cognitive Instability”.
This week, Aleks picks up on a familiar theme – namely that market participants are drawing spurious conclusions about the state of the economy for a number of reasons, not the least of which is that people don’t have a good grasp of what it is the Fed is trying to accomplish re: re-emancipating markets. We are, Kocic says, “troubled with the opinions we have of things and not by the things themselves.” Here is how he describes the current state of affairs:
At the core of current market developments lies cognitive instability — a cumulative erosion of traditional frames of reference, changes in interpretive frameworks and proliferation of intersecting narratives. There is too much new information, and not enough understanding. This “agitates” community and spontaneously creates the urgency for stabilization. There is an open contest for a narrative — not necessarily the most accurate, but one capable of providing the best fit — that would restore stability. The challenge is to construct from amorphous mass of unintelligible information, tendencies and speculations an acceptable narrative that restores the cognitive equilibrium.
One thing that stands out here is Kocic’s penchant for assessing the situation not so much from the perspective of someone who is himself wrapped up in the “problem” (and thereby inherently incapable of extricating himself enough to deliver a dispassionate take), but rather from the perspective of a keenly interested observer whose assessment doesn’t seem to be skewed by a desire to see things play out in a particular way. As regular readers know, Kocic’s analysis comes across as noticeably devoid of bias – he seems far more interested in the dynamics themselves, the interplay of the various actors and the cross-disciplinary parallels than he does about foisting something upon the reader. That’s not to say he doesn’t deliver trade recos. He does. We don’t typically cover those here (they’re not generally applicable to the broad investing public) but what I would note about those recos is that they never come across as forced, but rather seem to kind of materialize in the natural course of things as a logical extension of the analysis.
Ok, so Kocic goes on to say that when things get dicey, the discursive mode displays the following three symptoms:
- Refusal to engage with the complexity of the situation,
- Emergence of conviction that there must be an “agent” (external or a disruptive force from within) responsible for the mess, and
- Refusal to know (ignoring or mistrusting the evidence)
As an aside, that could very easily apply to the current political environment, especially as it relates to populism – voters enamored with the populist narrative generally refuse to engage with the complexity of globalization, have convinced themselves that there are external or internal agents at work and betray an aversion to facts.
When it comes to recession obsession, Kocic frames things in terms of mistaking correlation for causation. “To be clear about the distinction between correlations and causality, we keep in mind a simple example as a framework: Bad weather is correlated with wearing warm clothes, but wearing warm clothes does not cause bad weather”, he reminds you.
This gets to point number 1 above. For Kocic, market participants are refusing to engage with the complexity of the situation as it relates to the curve in favor of knee-jerk allusions to cycles past.
What you should note here is that Aleks doesn’t frame this the same way the ubiquitous “yield curve apologists” frame it. That is, Kocic’s “this time is different” isn’t couched in half-hearted allusions to the term premium or some kind of hopelessly transparent effort to defend current Fed policy. Rather, he does what he always does: he walks through what happened previously and whatever comes out of it, comes out of it.
“Every time the yield curve inverted in the past, both the reason behind the inversion as well as the underlying economic backdrop were different”, he writes, adding that “in addition, post-2008 presents a paradigm shift, an altogether different economic and social environment with entirely different rules and problems where most of historical lessons either fail or are at best misleading.” Here is Kocic explaining what happened in 2000 and just prior to the crisis:
In the past two tightening cycles we had a qualitatively different situation than now. 2000 was the internet bubble burst – it had nothing to do with Fed hikes, it just ran its course and died of “natural“ causes. During that time, productivity growth was above 3% and investment was booming. When the bubble burst, all these trends reversed and the recession followed. Although 2004-2007 was also a bubble, it had a different course and it differed in almost every other respect. Regulatory environment and a booming securitization industry prevented transmission of rate hikes to the consumer. Productivity growth was again above 3%. Fed hiked 400bp (they had to because inflation was rising) but consumers were borrowing low through mortgage ARMS. All these factors forced Fed’s hand: the Fed had to overshoot and the curve inverted. While in the hindsight, this might not have been the best decision, ex ante, this was the only thing policy makers could do if they followed their original mandate. Rate hikes by themselves did not cause the recession. The downturn was triggered when ARMS started resetting and subprime borrowers felt all 400bp at once, which started the chain reaction of defaults following with rapid disinvestment, loss of jobs, counterparty risk, liquidity crisis and recession.
So there’s that. What’s different now? Well, a lot, actually. The regulatory environment is obviously completely different, productivity growth is low and inflation remains well-anchored or benign at “best” and moribund at “worst” (and the scare quotes there are to indicate that how one characterizes inflation depends on one’s predisposition with regard to what counts as “success” when it comes to making monetary policy – that’s another debate).
Additionally, the post-crisis world has been defined by the suspension of normal market rules (the “state of exception” in Kocic’s vernacular) and the inevitable consequences of that purportedly temporary state of affairs in which, paradoxically, the rules must be suspended in order to restore normal market functioning.
“During the QE days, we saw for the first time a mode of unconditional and cooperation across different asset classes with persistent rally in stocks (risk assets), bonds and currency”, Kocic writes, noting that “normally such episodes are rare and transient – three assets cannot rally at the same time, one always has to subsidize the other two.”
The onus of re-emancipating markets falls to policy makers, but unwinding the stimulus (lifting the state of exception) is a precarious endeavor and is fraught with risk. Kocic brings back in the idea of the Fed transitioning from convexity supplier to convexity manager. To wit:
As the recent market turbulence is showing, Fed continues to run considerable addiction liability in that respect. A decade of stimulus and convexity supply has acted as a powerful “drug” whose withdrawal requires extraordinarily fine tuning, in the same way an abrupt withdrawal of substance can be damaging or even lethal for the addicted subject, while a slow withdrawal might be ineffective.
Almost invariably, someone will misconstrue that quote or otherwise take it out of context, so please do bear in mind that Aleks believes this is necessary in order to restore stability to markets in the long run.
So, that covers point 1 (i.e., “Refusal to engage with the complexity of the situation”).
On points 2 and 3 (i.e., “Emergence of conviction that there must be an ‘agent'” and “refusal to know, ignoring or mistrusting the evidence”), Kocic flags the chart in the left pane below as “defining the central point of the current market’s anxiety and the underlying debate regarding its interpretation.”
On the left is the history of (properly normalized) S&P, overlaid with the (scaled) PMI. Obviously, the two are coordinated (with some periodic divergences). Kocic zooms in on the recent obsession with the balance sheet unwind (and with communications around the unwind of accommodation more generally), noting that market behavior in Q4 “shows that the Fed is still running a considerable ‘addiction liability.'” To wit:
Monetary accommodation and central bank liquidity continue to be perceived as the main mechanism of economic growth and source of market stability. Financial markets staged a dramatic sell-off, and only when the Fed softened its rates path (in response to tighter financial conditions) did stability return. It would be difficult to construct a more convincing example of addiction than this.
Now, look at the visual in the right pane above. The blue line represents the residual of stocks adjusted for the economic environment. As the chart header suggests, downward spikes are thus dislocations between stocks and the economic regime. If you’ve followed Kocic’s previous work, you could write the rest of the note yourself. Previously, as shown in the chart on the right, residual outliers pop up when the Fed is already easing. Of course that doesn’t mean rate cuts “cause” recessions. Rather, it means the Fed is easing to prep for the possibility of a downturn. As Kocic puts it, “if you expect cold weather along the way, you will bring warm cloths.”
Given that we’re now witnessing outsized residuals while the Fed is still hiking, the market interprets that as the Fed being the “agent” (from point 2 above). For Kocic, though, the Fed is engaged in an ongoing effort to normalize markets. This is the restriking of the Fed put and the dynamics associated with that effort (which Kocic predicted would see the S&P fall to between 2300 and 2400 before being “in the money”).
Far from being a “policy mistake”, then, this is actually the opposite. It’s deliberate and wholly inline with what the Fed is trying to do. Do note that, as Kocic mentioned last week, there is a point beyond which tightening will render policymakers unable to avoid a “hard landing.” When that point of no return appears to be approaching, the Fed should be expected to respond, and indeed they have.
All of the that said, Aleks is acutely aware of the potential for a self-fulfilling prophecy to take hold and on that note, we’ll leave you with one final quote from his Friday missive:
While we disagree with the recessionary interpretation of the current market configuration and perception of the Fed’s role in it, we do share concerns about the risks such interpretation can create, in the sense of it becoming a self-fulfilling prophecy (along the same lines as abrupt withdrawal of addictive substance can have fatal consequences for the patient).