wknd notes: Equilibrium is an Illusion


November 14, 2022
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November 06, 2022
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Each Sunday morning for over a decade, One River’s CIO, Eric Peters, has published “Wknd Notes.” It is an unorthodox take on markets, politics, and policy that’s widely read across our industry and within global policy/political circles. Eric has written for as long as he has traded and the discipline is part of his investment process. Drawing on wide-ranging, multi-disciplinary research, historical study, and discussions with interesting characters throughout the world, Eric collects those things he finds most thought-provoking each week and distills them into a concise letter. At times the ideas and views are consistent with his own, but just as often, they challenge his positions and it is this openness to opposing views that helps him maintain a flexible mind in the search for emerging opportunities and risks. His writing is a reflection of how he thinks, and as such it is as focused on identifying the right questions to ask as it is on seeking answers. The publication of this work is Eric’s way of exchanging ideas/information and developing dialogue with a network grown over his thirty-one-year career.

wknd note: wknd notes: Equilibrium is an Illusion

Marcel and I were discussing what an utterly extraordinary period in market history we find ourselves in today. That led to a broader discussion on equilibria, and more specifically, how the concept of balance in markets and perhaps in all things is illusory. It was a discussion he had years ago, in his previous life, as the chief strategist for one of the greatest investors of all time. Seemed like a good opportunity to step aside and have Marcel author this week’s complete edition of weekend notes (see below).

Happy Thanksgiving to you and your crew. E


Overall: “Buyer traffic is becoming increasingly scarce,” explained the Chairman of the National Homebuilder Association. “Even as home prices moderate, building costs have yet to follow.” When prospective homebuying is this weak, the Fed is typically cutting rates. Yet markets are prepared for another 100bps of rate hikes through next Spring. US existing home prices were down each of the past four months across all four regions. Price discounts aren’t enough – inventory ratios are higher as nobody wants to move unless they must. Bond markets are convinced that inflation is going to fall hard – higher real rates, a weaker economy, a stronger US dollar, and a massive deflationary impulse from global trade make it a safe bet. But there are oddities in the background. Labor is gaining strength. This doesn’t usually happen with a weaker economy and falling inflation. But it is happening. “Overtime and minimum wage violations are common violations found in food service industry investigations,” said the Department of Labor. Krispy Kreme quickly settled damages filed by 516 workers on Nov 7th. Starbucks workers staged their largest labor action on Red Cup Day, one of their busiest of the year. “If the company won’t bargain in good faith, why should we come to work,” the mood captured by a shift manager. US rail strikes are scheduled to start on Dec 5 – key chemicals shipments will stop days before. “Congress must quickly intervene to ensure a disruption does not occur,” the National Retail Federation warned. And it isn’t just the US – labor tensions are rising in the UK, Canada, Finland. Central bank balance sheets make unusual the new normal. The QT theme continues; the “T” for tightening bit has paused. Fed excess reserves rose again last week, having bottomed seven weeks ago. It’s a complication that policy has never experienced. Demand for US dollars has declined as investors fish for an equity bottom, pushing excess liquidity back onto the Fed’s balance sheet. Warren Buffet is one of those investors on the hunt for value. Berkshire’s 13F focused on cyclical infrastructure – semiconductors, energy companies, transportation over banks and technology stocks. What to make of this mix of marbles? There is a thirst to place current circumstances into a package that resembles the past, to give some comfort that the future isn’t as unknown as it seems. But it isn’t the 1920s or the 1970s, pre-war or post-war. There is no analog. Today’s starting points are like none we have seen. The biggest risk is extrapolating to the future from a past that feels comfortable, confirmed by recent data. Disequilibrium is the new equilibrium.


Marcel Kasumovich also wrote about the importance of listening to skepticism when assessing new digital technologies. To read it [click here].


Week-in-Review (expressed in YoY terms): Mon: China announces fresh 16 pt property rescue measures, Democrats maintain control of US Senate, Biden / Xi meet – agree to find ways to work together on urgent global issues, Fed’s Waller says still a ways to go, Fed’s Brainard says appropriate to move to slower pace of hikes soon, Russian officials “neither confirm or deny” rumors that US/Russian officials meeting in Turkey, BoJ’s Kuroda says will maintain monetary easing, UK house prices 7.2% (7.8%p), EU IP 4.9% (3%e), Brazil eco activity 4% (4.1%e), India CPI 6.77% (6.7%e), S&P -0.9%; Tue: reports of Russian missile striking Poland / killing 2 people, ECB’s Holzmann says will raise rates further but need to be cautious, SNB’s Jordan says ready to intervene in ccy market if necessary, Japan 3Q GDP -1.2% (1.2%e), China 1y medium term lending rate 2.75% as exp, China IP 5% (5.2%e) / ret sales -0.5% (0.7%e) / jobless rate 5.5% as exp, France unemp 7.3% as exp, UK unemp 3.6% (3.5%e), Germany ZEW exp -36.7 (-51e), EU ZEW exp -38.7 (-59.7p), EU trd bal -37.7b (-42b exp), EU 3Q GDP 2.1% as exp, US emp mfg 4.5 (-6e), US PPI 8% (8.3%e) / Core PPI 6.7% (7.2%e), Canada existing home sales 1.3% MoM (-0.4%e), S&P +0.9%; Wed: US says the missile that struck Poland unlikely fired from Russia, ECB’s Visco notes reasons for less aggressive ECB approach, Trump announces his campaign for 2024 Presidential race, Fed’s George says infl at risk of growing entrenched, Fed’s Daly says pausing is off the table right now, Fed’s Waller reiterates ways to go, Target warns US shoppers pulling back, Yellen meats with PBOC gov Yi Gang, UK’s Sunak did not discuss trade deal with Biden, Argentina CPI 88% (88.35%e), Japan core machine orders 2.9% (8%e), UK CPI 11.1% (10.6%e) / Core CPI 6.5% (6.4%e) / RPI 14.2% (13.6%e), UK house prices 9.5% (9.8%e), S. Africa ret sales -0.6% (1%e), Turkey house prices 189.19% (184.48%p), Canada CPI 6.9% as exp / Core CPI 4.8% as exp, US ret sales 0.7% MoM (0.3%e), US impt prices 4.2% (4.1%e), US IP -0.1% MoM (0.1%e), US NAHB housing mkt index 33 (36e), S&P -0.8%; Thu: UK announces two new fiscal rules – Debt/GDP must fall in fifth year and govt deficit must be less than 3% / GBP 55b of tax increases and spending cuts announced over next 5y, Republicans officially win control of US House, Indonesia CB hiked 50bp as exp, Philippine CB hike 75bp as exp, Lula presents transition bill with 175b BRL spending exemption – higher than exp / Lula unaffected by market reaction, Russia agreed to prolong the grain export deal that was set to expire, Winklevoss’ Gemini Earn halts redemptions in latest crypto upheaval, Fed’s Bullard sees rates at 5% at very minimum, Australia emp chg 32.2k (15k exp) / unemp 3.4% (3.5%e), EU final CPI 10.6% (10.7%e), US housing starts 1.425m (1.41m exp), US init claims 222k (228k exp), US KC Fed mfg activity -6 (-8e), S&P -0.3%; Fri: Kuroda says BOJ could raise rates but current easing stance remains appropriate in the face of higher CPI release (3.7% vs 3.6%e), rumors that Brazil’s congress will cut the spending excluded from the cap that Lula proposed yesterday, ECB’s Lagarde says rates may need to get to restrictive levels, N. Korea reportedly tested launch of an ICBM (S. Korea says ‘serious provocation’), Japan CPI 3.7% (3.6%e) / Core CPI 2.5% (2.4%e), UK cons conf -44 (-46e), UK ret sales -6.1% (-6.5%e) / Core ret sales -6.7% (-6.8%e), Canada home price index 6.6% (8.3%p), US existing home sales -5.9% MoM (-6.6%e), US leading index -0.8% (-0.4%e), S&P +0.5%; Sat: Army football beat UConn 34-17, Navy football beat UCF 17-14 (big upset).


Weekly Close: S&P 500 -0.7% and VIX +0.60 at +23.12. Nikkei -1.3%, Shanghai +0.3%, Euro Stoxx +0.2%, Bovespa -3.0%, MSCI World -0.6%, and MSCI Emerging +0.8%. USD rose +5.5% vs Chile, +4.0% vs Ethereum, +2.5% vs Sweden, +1.3% vs Indonesia, +1.1% vs Yen, +1.1% vs India, +1.1% vs Bitcoin, +0.9% vs Brazil, +0.7% vs Canada, +0.4% vs Australia, +0.3% vs China, +0.2% vs Turkey, +0.2% vs Euro, +0.2% vs Russia, and +0.1% vs South Africa. USD fell -0.5% vs Sterling, and -0.3% vs Mexico. Gold -0.8%, Silver -2.9%, Oil -10.0%, Copper -6.7%, Iron Ore +14.8%, Corn +1.1%. 5y5y inflation swaps (EU -8bps at 2.29%, US -11bps at 2.50%, JP flat at 0.90%, and UK -6bps at 3.59%). 2yr Notes +20bps at 4.54% and 10yr Notes +2bps at 3.83%.YTD Equity Indexes (high-to-low): Turkey +73.1% priced in US dollars (+143.7% priced in lira), UAE +23.3% priced in US dollars (+23.3% priced in dirham), Argentina +18.6% priced in US dollars (+88.3% priced in pesos), Chile +9.3% (+20.6%), Brazil +8.1% (+3.9%), Singapore +2.7% (+4.8%), Mexico +1.7% (-3.2%), Saudi Arabia -1.3% (-1.2%), Indonesia -2.1% (+7.6%), India -3.7% (+5.5%), Portugal -4.1% (+5.6%), Venezuela -7.3% (+88.2%), South Africa -8.8% (-1.2%), Thailand -9.2% (-2.4%), Greece -9.6% (-0.4%), Canada -11.2% (-5.9%), Australia -11.9% (-3.9%), UK -12.2% (+0%), Norway -12.6% (+1.2%), Spain -14.8% (-6.7%), Malaysia -15.6% (-7.5%), France -15.7% (-7.1%), Israel -16.5% (-6.9%), Denmark -16.6% (-8.6%), S&P 500 -16.8%, Germany -17% (-9.1%), Euro Stoxx 50 -17.1% (-8.7%), Italy -17.6% (-9.8%), Russell -17.6%, Switzerland -17.7% (-14.2%), MSCI World -18.2% priced in dollars, Czech Republic -18.8% (-12.8%), Netherlands -19% (-10.7%), Philippines -19.3% (-9.6%), Japan -20.4% (-3.1%), New Zealand -21.6% (-12.7%), Ireland -22.4% (-14.4%), Finland -22.6% (-15.3%), Belgium -23.1% (-15.3%), HK -23.4% (-23.1%), Austria -23.7% (-16.5%), China -24% (-14.9%), Colombia -25.8% (-9.1%), Sweden -26.5% (-13.7%), Korea -27% (-17.9%), Hungary -27.3% (-12.3%), Russia -28.1% (-41.7%), NASDAQ -28.8%, Taiwan -29.2% (-20.4%), Poland -29.4% (-20.8%).


The No Normal: “Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance,” reminded Powell this past summer, on Aug 26. The equity market had just jumped 15% from the lows on hopes of a gentler Fed. The Fed doesn’t tighten into weaker equity markets and a contracting economy. Ever. It’s a rule. Powell changed the rule, an opportunity to win back inflation credibility. And the market listened. The swap market anticipates inflation will collapse to an average of 2.28% next year from 7.02% this year.


The No Normal II: Hard landing. Soft landing. No landing. Investors are dusting off playbooks from the past. There is a little bit for everyone. Hard landing? Housing demand has fallen off a cliff. Prospective homebuyer traffic is down 49 points since the start of the year, the largest decline ever. Soft landing? Credit markets are showing almost no sign of strain, even in areas where activity is weak. No landing? There are too many job openings to talk about landings. Real wages have a lot of room to rise, and this could allow the global economy to fumble along.


The No Normal III: The Fed keeps hiking until policy rates are above inflation. It’s a bear market until credit cracks. The Fed pivots when something breaks, and nothing has broken yet. Equity valuations are bloated, and earnings-per-share are too high. EPS always declines sharply in recession. S&P 500 EPS is tracking growth of 6% in 2022 and consensus expected to rise another 4% next year. When the Fed is easing into recession, equity markets are usually in decline. Bear-market rallies are noise, not signal. This is the hard-landing playbook.


The No Normal IV: The soft-landing playbook sees 2022 markets anticipating a recession that never comes. Inflation was driven by temporary supply constraints. The US has withstood three quarters of housing contraction. Credit markets are fine because nominal GDP is running 7.3% annualized for the year, whereas real GDP is flat. The rapid rise in the US dollar is typically tied to foreign credit events. None have occurred. The fall in inflation will give a big boost to real incomes. Policy returns predictable path. All is forgiven – global risk climbs the wall of worry.


The No Normal V: These are normal debates in a world that is far from normal. There is no tidy fundamental equilibrium. Balance sheets add complexity, the blind spot of most investors and policymakers. Balance sheets mostly don’t matter. Those who care about them are often in the shadows of institutions, fretting over left tails being underwritten when buying credit. The Fed’s balance sheet is merely a window into deeper challenges. Reserve balances with Fed district banks are $3.176trln. It is the symbol of decades of policy preventing financial failure.


The No Normal VI: Capital was drawn to duration assets of all varieties in that world. This came at the expense of real investment. Emerging market countries were charged with filling that gap – an epic geopolitical miscalculation. And now, whatever the type of landing that lies ahead, decades of financial imbalances need to be reconciled. Markets need to incentivize a shift to tangible investment. People will hold on to their iPhones longer, keep that ThinkPad an extra year or two. You see, the landing isn’t the problem – it’s that we need to rebuild the runway.


Anecdote: Speculative trading is hard. Almost impossible as a career. My undergraduate thesis evaluated the non-linearities of stock market rumors of takeovers. Precise words were identified from the Heard on the Street column – on microfiche. I begged the Center for Research in Security Prices for data. No data, no paper, no degree. I devoured practical finance. And Jessie Livermore’s story sobered me. He made his first fortune inside bucket shops – gambling houses for stocks and commodities. They were illegal in the roaring 1920s; the gambling didn’t stop. Livermore lived boom-to-bust a few times over and died by his own shot, a self-declared failure. In the mid-2000s I was working beside a legend in one of the most challenging periods. I wanted to believe there was a fundamental, gravitational pull to markets. I spent a huge amount of time building models precisely for that purpose. I reasoned it to be a pendulum, with an unknown timing as to when the trend would pull back and overshoot its equilibrium. I figured that’s why I was there. Wrong. So horribly wrong. “But if there were an equilibrium, we would spend more time there, no?” Mr. Soros offered rhetorically. My life’s work shot down with a simple question. An observation that I could have made thousands of times. An army of PhDs in my orbit never asked it. There is no fundamental law of equilibrium in markets. There is data. There are prices. And there are brief periods in time where we think we know the connection between the two. The art of investing is recognizing when those prior connections become anchors more than a guiding light. Now is one of those times. What we thought we knew about economic cycles and markets doesn’t matter. The lessons we experienced do. This is a period of profound change.


Good luck out there,


Marcel Kasumovich

Deputy Chief Investment Officer

One River Digital Asset Management


Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, converse with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.