October: Waiting for “Lehman”
Global financial markets were remarkably volatile the first half of October, driven by news-flow (and speculations thereof), be it about CPI data or the fluid UK pension fund situation. The Gilts got into a doom-loop (pension funds selling their devalued Gilts trying to meet margin calls, in turn driving Gilts even lower). Other sovereign bond markets reacted “in sympathy” across the globe. Liquidity tightened and volatility rose in the US Treasuries market and accordingly, the MOVE index rose to its highest level since 2009. In typical “credit anticipates, equities confirm” fashion, the equity market became erratic by making frequent about-face turns, not only from one day to the next, but intraday. The sharp but short-lived upswings were thought to be “gamma squeezes”: Market makers forced to buy stocks to hedge spiking volumes of naked out-of-money calls (read: “lottery tickets”) they sold to speculative Robin Hood YOLO (You Only Live Once) traders. Invariably, these upswings promptly turned tail. All in all, it was “Whiplash City”.
If the UK pension funds were the new Bear Sterns (the foreshock), then waiting for the new Lehman (the quake) was the cause of jitter and disorder. A disorderly market is a sign that policy makers have lost control of that market to traders (in the case of the bond market, — “bond vigilantes”). Put another way, in exploiting arbitrage opportunities, traders are exposing and punishing past policy mistakes, — like Soros did with the BOE back in the 1990s. The adage “Most current problems are the result of past ‘solutions’ by policy makers (because policy makers always harvest current gains and defer future pains)” was apparent in October.
The reckless at best QE and ZIRP ‘solution’ implemented by central banks since the 1980s (but especially since 2008) had created permanent distortion, now recognized by even the “fooled mass”. Fed insider Pedro da Costar posits the days of central banks running the world are numbered. By now, they have so utterly revealed themselves to be the creators of current wealth-divide and global inflation that they can no longer surreptitiously engineer boom/bust cycles of asset bubbles without scrutiny. That’s good news for those who want stability; bad news for the “fast money” Wall Street crowd. Regardless, correcting permanent distortion is necessarily a long and painful process. This time around, it won’t be one big impulsive “crash and done” for equities (followed by a V-shape recovery made possible by central bank intervention) as in 2000 and 2008. There are too many cross currents this time around for a swift “whoosh”. Instead, we have the current zigzagged mini-crashes and vicious counter-trend rallies which may turn into a spectacular implosion IF “Lehman” appears (and triggers a domino of insolvencies). If “Lehman” does not appear, then “death by 1,000 cuts” is likely to persist. In either case, financial markets are likely to languish for years amidst a long and deep recession. Much hardship will befall the plebeians (see following chart). The patricians who fail to rotate out of old Big Tech and either opportunistically ride the Commodities Supercycle or shrewdly exploit “new tech” of the exponential digital age (i.e. Web3, Dao, et al) will risk losing money.
The Fed (and other central banks) are purportedly out to tame inflation by cooling down the physical economy. But the way they're doing it is by constricting bank credit (by raising rates and stopping further injection of liquidity into the banking system via QE). This is like the crack dealer abruptly cutting off supply to crack addicts (all modern economies are deeply addicted to cheap and ample credit supply by the central banks since the 1980s, but especially after 2008). Dead bodies are bound to float to the surface sooner or later (note: interest rate is the “cost of crack” but QE is the availability of crack; the latter is far more important to the addict). Since the Fed gave commercial banks plenty of (interest-earning) “excess reserves” via QE since 2008, this time the new Leman will likely be an over-leveraged (remember, QE + ZIRP invited leverage) non-bank with a portfolio of risky assets (taken on in desperation when yield-starved by the Fed’s past ZIRP policy). Pension plans and insurance companies come readily to mind. Non-financial “zombies” (hanging on by their fingernails, getting increasingly zombie-like due to ever-higher cost of capital) are close behind. The number of dead bodies and the speed of their surfacing will depend on the degree of contagion. That is, marginal holders of “dead body” securities will be impelled to sell other assets into an increasingly illiquid stock market just to stay alive, creating a doom-loop of cross-asset selling that feeds upon itself.
Jitter and disorder begged the question: “Just how overvalued are current equity prices, still?”, which in turn invited special scrutiny of this October’s Q3 earnings release. The following chart shows the typical recession trajectory, and signs of earnings recession from Q3 earnings will validate the red circle marking “where we are”. (Unemployment will no doubt rise along this trajectory, giving the Fed one more thing to think about besides “something breaking”.)
AMD and FedEx were the first out the gate, and “canaries in the coal mine”. Of the two, FedEx — the company with the front row seat to the global economy — is the more important bellwether to watch:
Leading up to the last week of October (when the Big Techs — FAAMG — reported earnings), the Robin Hood YOLO speculators staged another options driven rally ,— begetting a fierce short-squeeze just like the first half of October. As the Big Techs revealed dismal earnings, their stocks cratered (META, already down 59% for the year prior to earnings release, tacked on another 23% loss in just one day; AMZN, already down 35% for the year prior to earnings release, plunged 20% in afterhours post-release), but instead of exiting the market, invested capital rotated into “value” Dow stocks, the energy sector (up big for the year), and Small Caps (bottom fishing the worst-beaten). Then, sideline cash came in to front-run November reopening of corporate buybacks, making the last week of October a spectacular up month. The Dow and Small Caps both roared almost 6% higher, and the S&P500 was up 3.8%. Nasdaq was the worst performer because of Big Techs. Does this face-ripping counter-trend rally have leg? Per the 2008 analogue (see following chart), maybe one more up month is in the cards, — which is consistent with the reopening of corporate buyback in November. But then who knows what “forward guidance” Jay-Jay will give at FOMC on November 2nd? The Fed has two dragons to fight. Does it want the equity market to go up, or down at this stage of the fight?
In any case, FAAMG looks poised for its second down leg (see following chart). The ad revenue business model does not work in a recession that is getting deeper and longer (induced by rapid and sharp rise in interest rates). Neither does selling discretionary products not being able to pass on rising costs. Bear markets don’t end until the last “general” has fallen, and these “generals” have a lot more to fall. As well, can there be any doubt of imminent layoffs at Twitter and Airbnb? The rotation into Dow in October, however, may be a hint of investors’ continued attraction to “value” over “growth” per DCF at higher interest rates. Continued rotation may well cushion the overall equity market’s fall even as Big Techs take another leg down.
Finally, Japan’s FX intervention on September 21st — to halt the Yen from precipitous fall — was the harbinger of more FX interventions to come. Currency reserves around the world have already suffered a record drawdown in order to defend pegs to the relentlessly rising US dollar. When pegs eventually break (as Switzerland’s abruptly did in 2015), businesses and households can implode. Worse, in cases of pegs for the purpose of stabilizing exports prices (which apply to virtually all emerging economies and oil producers), abrupt de-pegging (particularly in a period of global economic slowdown) can lead to currency crisis (read: Asian Contagion 2.0). The bedrock of global finance — the U.S. Treasury market — is already an “unstable pile of tinder” (highly volatile due to rapid and sharp rise in interest rates, as discussed earlier). A currency crisis would be “lighting a match to it”. Not only will the final nail be driven into the PetroDollar coffin but all other foreign buyers of U.S. Treasuries — Japan being the most important — can disappear overnight (there is no exit strategy to Japan’s Yield Curve Control and any FX intervention to ameliorate the Yen’s consequential fall is destined to have only short-lived efficacy). All eyes are now on signs of destabilization of the global currency market. Until then, capital flight into the US as a result of the “Dollar Wrecking Ball” will continue to seek a home in — thus cushioning an otherwise sharper decline of — US equities simply because the Treasury market (along with other sovereign bond markets) had been a more treacherous place (ironic, since sovereign bonds are supposed to be much less risky than equities):
To say this picture is alarming is a gross understatement. When equity markets crash, rich people get less rich. But when bond markets crash, global commerce can seize up. We were on the brink of that in 2008 when containers were held up in various ports because letters of credit weren’t honored due to inter-banking mistrust. This time, it wouldn't be mistrust but a total lack of demand for Treasuries when the supply keeps coming, — driving rates ever higher and liquidity ever lower. Virtually every pension fund will be driven to insolvency — just like the UK pension funds — by their collapsing sovereign bond holdings. This is why October was the start of “Waiting for ‘Lehman’”
On the flip side, with one year T-bills at 4 1/2%, we may be closer to peak rate than we think. If capital leaves the equity market in favor of risk-free 4 1/2% or thereabouts, yields will be capped to avert the previously described ‘credit events”’. In other words, TINA (There Is No Alternative) leaving the room may prevent “Lehman” from ever entering the room. In that (less likely) scenario, the next down leg of equities will happen sooner than the “wait for Lehman” case, but bonds will rise. The resumed inverse relationship will make for a more normal financial market.
For the history book, October 2022 was also the month of The Sick Joke, and the Liz Truss versus a head of lettuce meme. While the financially naïve may not appreciate how sick the joke really is, the head of lettuce had already won over Liz Truss before the month was even out. There was no mistaking our living in “interesting” times.