2022-11-28 What Is Lars Thinking ("WILT")

Submitted by Lars.Toomre on Mon, 11/28/2022 - 10:00

Presently in Palm Beach county Florida, it is very cloudy with considerable fog. The weather well matches my current mood and outlook. I am very unsettled and am fearful that the American economy and capital markets are on the precipice of considerable change.

The biggest risk is the COVID virus in China. Will that country continue with its zero covid policies (including economic lockdowns and keeping citizens welded into their living spaces) that effectively will also shut down much of its export-focused economy? Or will it respond to the very unusual protests coming from its citizenry, particularly its youth? A very large portion of global trade involves China and its likely lockdown will impact goods availability and prices in Asia, Europe, and North America.

Another very significant risk is tied to the time of the year. Broker/dealer annual accounts generally close at the end of a calendar year. As a result, financial institution balance sheets are cleaned up for presentation to regulators and third parties via the annual audited financial processes. Hence, what already has been abysmal liquidity will get even worse as the month of December progresses. What this means is possible sharp moves to either the upside or downside will overshoot on relatively low volume.

A third significant issue is that both the fixed-income and equity markets have experienced record negative returns on a year-to-date basis. Active portfolio managers, hedge funds, and various others have strong incentives to improve their performance relative to benchmarks by 2022 year-end. As a result, often during periods of low liquidity, there can be excessive reactions, much like was experienced in the minutes after the November CPI report was released.

Another issue is more subtle but likely to have a continued impact over the next few years. The Covid-19 experience and Trump-era sanctions on China taught multi-national organizations that perhaps it is not so wise to over-engineer supply chains for economic efficiency. The strong need for resiliency has led to the "on-shoring" goods manufacturing trend and increased inventories on the balance sheets of goods-producing organizations. There is no way under such circumstances that productivity can remain at past levels, and just to remain at past economic outcomes, costs must rise. This fact alone puts into the question of whether the Federal Reserve can indeed get inflation back down to the 2% target from about a 3-4% level.

Finally, there are the issues of American politics, the revisions of economic statistics, and the FTX cryptocurrency debacle that are sure to throw "proverbial curve balls" in the next few weeks. There is supposed to be an American Federal budget passed by mid-December. Will the debt ceiling limit be pushed through in the "lame duck" session? What "surprises" will be sprung with the Republicans scheduled to assume control of the U.S. House of Representatives? What will consumer spending be like this holiday season? How will consumer confidence hold up with so many of the young technical types suffering losses in the crypto asset sell-off and likely fraud(s) committed by Sam Bankman-Fried and his associates? So many reasonable questions and all of the above does not include Europe, the winter energy crisis or the Ukrainian war.

In short, there is much to be concerned about. From my experience at Lehman Brothers running the mortgage derivative and securitization trading desk in the 1980s, my advice is to remain nimble and raise one's own personal liquidity. These are the times when the pros truly dance. Also, particularly during times of such uncertainty, make sure to use your journal and write things down. Clarity of thought in times of foggy outlook is truly invaluable!