HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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March 20, 2022

Revision of Beliefs, Mixed Messages & Long Term Problem Solving

Consider a turkey that is fed every day. Every feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say. On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief. Nassim Taleb.The Black Swan – The Impact of the Highly Improbable

Revision of Beliefs

It is becoming increasingly accepted that we will have to revise many beliefs we have held about our world. I selected the above quotation earlier this week from Nassim Taleb’s book The Black Swan – The Impact of the Highly Improbable, only to find that two other commentators (Marc Rubenstein and Matthew Syed) are using the exact quote in recent days. With a nod to their evident brilliance, I have decided to plough on regardless and continue my direction of thought.

Western Turkeys

 

Wandel durch Handel (change through trade) has been Germany’s official economic policy and consequence of its geopolitical stance of Ostopolitik. This noble idea is that trade and engagement engenders mutual respect and understanding among nations and ultimately makes them more like us. It was an argument used by the US and Europe in the 1990s in the debate about whether China should be accepted to the West’s economic high table, the World Trade Organisation (it was in 2001). An important argument favouring this concession to China was that allowing China to develop more quickly will inevitably make them more like us. It would draw our interests closer together and offer the best chance for China to become a liberal democracy, including improved human rights. (It has actually made us more like them). The main driver for the success of the German economy has been its unquestioned manufacturing capability based on plentiful Russian gas and enormous Chinese markets for machine tools and automobiles. The German economy has become the most fattened turkey on the farm, but we are all guilty of swallowing the same delusion.

Contract Law 

 

Trust in contract law has been a base layer belief of the West for the last few hundred years. It is a pillar upon which capitalism’s unparalleled wealth and emergent sophistication rest. Nowhere has this been more evident than in the operation of financial markets. Last week one of the oldest operating financial hubs, the London Metals Exchange (LME) halted the trading in nickel after a 250% rise in the price and cancelled all trades. The LME rewound the market to the closing price of $48,078 per metric ton from the previous day. Erasing all gains and losses for this extraordinary day. The chief executive officer of the LME explained that it was necessary to protect market stability, saying the prices were “becoming disconnected” from “physical reality.” There has been a developing conspiracy narrative that the Chinese owners of the LME, the Hong Kong Stock Exchange, moved to protect nickel’s largest short seller, Chinese owned metals producer Tsingshan Holding Group.

Single Point Failure

 

However, the LME was doing what the New York Stock Exchange (NYSE) did in halting the retail trading platforms from buying GameStop in 2020. It was an act of supreme self-preservation. The surface layers of the LME and the NYSE consist of prices and trading volumes with many buyers and sellers. But beneath both is a centralised and highly complex system of clearing and settlement, which are ultimately mutually guaranteed by their members. These systems of centralised market plumbing, largely incomprehensible to most participants, can quickly emerge as vulnerable single points of failure at times of crisis.

Mutual Guarantee

 

I can remember being contacted by my employer, a London Accepting House Association member, one Saturday in 1995. It was remarkable because I received an email on the weekend (itself unprecedented), which told me to go to the office the following day at the request of the Bank of England. A fellow Accepting House Association member firm, Baring Brothers, as it turned out, was in a spot of difficulty, and we were obliged to help. Barings had lost several hundred million dollars in a rogue trading event in its East Asian operations. It subsequently turned out that Nick Leeson’s unauthorised positions cost the industry about $1bn, a record held until 2008. The estimated unrealised losses on the contracts traded but invalidated by the LME last week are calculated at eight times the Barings losses, most likely still a low ball figure.

Reserve Currency

 

The elephant in the room of beliefs subject to revision revolves around foreign currency reserves, sovereign credit, and the idea of money. No sooner had Putin moved his army into Ukraine than the West imposed a sanctions policy of financial “shock and awe”. The Central Bank and Treasury of a significant global economy were excluded from the global dollar payment system, an unprecedented move. This act represented the confiscation of Russia’s extensive foreign exchange reserves held in US Treasuries and US$ deposits. Without getting into the ethics of this, it has implications. As Lyn Alden said: In a world where official reserves can be frozen, some degree of reserve diversification would be rational for most countries to consider, and as investors, we should probably expect this to occur over time. This is especially true for countries that are not strongly aligned with the United States and western Europe. Already Saudi Arabia has reportedly agreed to sell its oil to China in Yuan, and imports of Russian oil into India have taken a quantum leap, almost certainly not paid for in dollars. All of which undermines the belief in the accepted global reserve status of the US$.

Russian Default? 

 

One notable twist to the Western war narrative occurred last week. The rating agencies widely predicted and attracted big headlines in the media that Russia was almost certainly going to default last week. However, Russia paid the $170m of interest due to its trustee bank in New York on the required date, of which little mention was made. This action is not illustrative of a complete Russian collapse. Indeed foreign-owned Russian bonds vindicated the causal link between risk and return and traded up from c.20cents to c.50 cents on the dollar. Why did Russia choose to do this? The fog of war means it is impossible to know, but they certainly don’t currently have many other uses for US dollars. Indeed it may be the point that they wanted to see if the US authorities would let them make such a payment, inevitably utilising the SWIFT mechanism by some means.

Confiscate or Inflate

 

It remains clear that any country fearing a future falling out with the US authorities will, after the events of the past few weeks be less likely to own US Treasuries and dollar deposits in its reserve assets than it did previously. As Lyn Alden also points out this is not just due to fear of confiscation: Not only can fiat reserves (bonds and deposits) be frozen by foreign countries that issue those liabilities, they also keep getting devalued with interest rates that are far below the prevailing inflation rate because debt levels are too high to raise rates above the inflation level. Official sovereign reserves represent decades of accumulated trade surpluses for a nation; the last thing they should want to do is hold the entirety of those reserves in melting ice cubes that diminish the purchasing power of their national savings. The world collectively has about $15 trillion USD-equivalents worth of official sovereign reserves. More than $12.5 trillion is held as fiat reserves (dollars, euros, yen, franks, etc). Most of the balance of $2.5 trillion is held as gold. Fiat reserves consist of government bonds and bank deposits and can be easily frozen by the countries that issue them. 

Financial Repression

 

In 1912, John Pierpoint Morgan testified before Congress and said that: Gold is money. Everything else is credit. More recently, economist Paul Krugman said: fiat money if you like, is backed by men with guns, making the point that a strong government can force the use of its currency over all other types of monies (more proof of force than proof of work), at least for a medium of exchange, albeit not necessarily a store of value. For decades, it has been the case that if someone thinks money shouldn’t be fiat currency, they’re considered a tinfoil hatted eccentric, or worse. However, the reality is the accepted fiat/petrodollar money standard is only forty years old, only twice as old as the first internet browser. Gold, on the other hand, the original proof-of-work store of value, has been used as a form of money for thousands of years. It is not a coincidence that private investors were prevented by law from owning gold from the early 1930s until the mid-1970s. This period coincided with a time when the US level of interest rates seriously lagged the appreciation of the general price level, destroying the value of accumulated fiat-based savings.

What is Money? 

 

Crypto billionaire Arthur Hayes and Credit Suisse strategist Zoltan Pozsar have recently popularised the inside and outside money concepts. Inside money is that which is another person’s liability. This form of money includes fiat currency, bonds, and other financial obligations that run on centralised ownership and payment rails and are vulnerable to confiscation or single-point failure. Outside money is any form of value storage or payment method with an intrinsic self-contained, permissionless worth such as gold bullion, Bitcoin or rare stamps. Pozsar and Hayes both advocate a higher allocation to outside money as a wealth preservation strategy, although they differ on the prospects for Bitcoin to serve this purpose. For the past forty years, mainstream finance and media have held a strong, almost unshakable belief in inside money. As I have mentioned previously, this is like fish having no understanding of the water in which they swim. This belief is again subject to revision.

Mixed Messages

Last week saw a counterintuitive but not uncommon feature of financial markets. As the US Federal Reserve raised interest rates for the first time in nearly six years, US and European equities recovered strongly. In many cases, equity markets are back or almost back to those seen before the Russian invasion. Notably, the West’s equities were rising on the belief that the rate of tightening was not as harsh as some feared. Meanwhile, Chinese equities were in even sharper recovery as their authorities signalled outright loosening and stepping back from last year’s regulatory crackdown. The standard interpretation was that this policy change was due to new Chinese covid shutdowns, but it was also because, unlike the Fed, they could.

However, bond market signals were less optimistic. While not quite in recession territory, further flattening of the yield curve is a concern. The other hair-trigger measure of recession, the oil price was volatile but recovered nearly 10% from the low towards the end of the week, an increase of historic proportions, but inconsequential compared with the previous week, it was barely mentioned. Yet this move is probably equity market supportive in the short term.

Long Term Problem Solving - Microlise

My next Maverick podcast guest is the CEO of AIM-listed Microlise, Nadeem Raza. Microlise dominates the niche UK market for supplying large transport fleet operators with systems for controlling and improving asset efficiency. Nadeem joined the company he now runs over 30 years ago as a software engineer doing nearly every job in the company in his long tenure. He relates how he can remember when the company first adopted email, as he installed the first email server and domain name. It was a fascinating discussion regarding technology development and harnessing its various facets to solve complex problems for large corporate customers. He also explains how going through an MBO in 2008 focused the mind on reshaping the business to a more resilient SaaS model. His claim that what doesn’t kill you makes you stronger reminded me of my favourite Taleb quote: Not everything that happens happens for a reason, but everything that survives, survives for a reason. Nadeem was Microlise’s largest shareholder before IPO last year. What marks him as different and maverick is that he chose not to sell any of his shares and subsequently bought more a few months later. Learning of his long-term approach and passion for solving his customers’ problems was a welcome relief from the non-stop onslaught of doom-laden macro news. It is uplifting to know that despite all the top-down problems clouding our view, the future is being built bottom-up by free-thinking people making incremental gains in so many niche activities that improve our condition.

Jeremy

Ealing

20/03/2022

The above should in no way be construed as investment advice. I am not your financial advisor. DYOR 

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