The benefits of chaos

“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” (Anonymous though often attributed to Mark Twain)

Known knowns

Markets have ever been capable of starting a fight in a (mostly) empty room, as the last few weeks of turbulence again testify.¹ Our collective craving for so-called ‘known knowns’ in a world of unknowns (both known and unknown) is often the genesis of these spasms.

It is this that leads us to place ever greater trust in a trend the longer it continues. In this latest episode it was the faith in continuing Japanese stagnation and the associated monetary medicine that proved misplaced.

This macroeconomic staple of the last several decades provided the basis for many different trades. Whether it was Japanese investors scouring the world outside of Japan for juicier returns amidst a domestic dearth, or opportunists from the rest of the world borrowing in Japanese yen to supercharge their returns, the crowd was growing briskly in the first half of the year.

To that extent, a good deal of the hullabaloo of the last fortnight can be chalked up to increasingly good news on the Japanese outlook. As a result of this brighter path ahead, Japanese central bankers are (very) slowly peeling interest rates off the canvas.

However, when combined with brief hysteria over US growth following a mediocre employment report, the squeezed gap between US and Japanese interest rates forced many to liquidate all manner of associated trades.

Where next?

US consumers and businesses remain in good health in aggregate, even if the electorate still seems reluctant to credit it. One way of viewing this is the trend in private sector spending, excluding changes in inventories, net exports, government spending and depreciation (Figure 1). This cleaned number is both less volatile than the wider GDP series and likely more representative of the state of households and businesses.

Figure 1: US consumers and businesses remain in good health

Source: FactSet, Barclays

The pace of this demand growth may even be a little brisk for those worrying about the outlook for inflation. Nonetheless, this week’s inflation data should help permit the US Federal Reserve to begin easing (but not slashing) policy rates next month.

There are some areas of concern – there usually are. There has been a tick up in distressed debt within the US high yield/junk space. However, this is so far narrowly focused in media and seems more associated with creative destruction in the sector rather than just destruction.

The office real estate crisis is being kept in suspended animation, but there is surely an economic price to be paid by some for the changes to our working patterns following lockdowns.

Meanwhile, China remains precariously balanced with a much (much) bigger economic price to pay for its property woes. This, in turn, seems to be hobbling parts of the European economy given the entangling of the last several decades.

Investment conclusion

Putting it all together, the global economy looks plenty good enough in aggregate. Its keystone, the US private sector, remains in fine fettle and some long slumbering areas such as the UK and Japan appear to be blinking sleepily back to life.

The warning should be familiar,² as should the remedy. The longer a trend endures, the more those relying on it for investment returns assume its continuation. This is a story told so often in capital markets that it takes on an air of inevitability.

It doesn’t have to be. It takes discipline, adherence to process, a brutal awareness of one’s own behavioural faults (and those investors around you), and perhaps most importantly of all, healthy scepticism of the messages from past performance. For the latter part, the constant reimagining of alternate, counterfactual pasts can help to tease out the assumptions you are often blindly relying on.

Signs continue to gather that we are entering a different investment paradigm from the one that has dominated since the Great Financial Crisis of 2007-09. That world, characterised by low growth and inflation, permissive anti-trust, and a wide array of other inputs appears to be fracturing. The wise investors will be re-evaluating all their investments accordingly.

A little chaos can be helpful in this task, providing an opportunity to banish whatever rigidities we have allowed to creep into our investment thinking. The investment world ahead could look entirely different from the one in our rear-view mirror. This is part of the reason why the regulator is entirely right to insist that we treat the message from past performance with great care.