Issues 2023
Doug Nolan
Bubble: A self-reinforcing, but inevitably unsustainable inflation.
Bubbles are a monetary phenomenon, fueled by some underlying source of Credit expansion.
If accommodated by loose monetary policy, Bubbles have a proclivity to surprise to the upside – with an escalation to “crazy” excesses during the “Terminal Phase” of “blow-off” excess.
Bubbles eventually burst.
The bigger and more prolonged the Bubble, the greater the systemic monetary disorder and associated price distortions, along with deepening financial and economic structural maladjustment.
Accordingly, the more ingrained Bubble excess becomes, the more central bankers will be compelled to forestall collapse.
Such efforts will only extend “Terminal Phase” excesses, with systemic risk rising exponentially.
Importantly, and as understood generations ago by “Austrian” economic thinkers, the pain and dislocation unleashed during the bust is proportional to the excesses of the preceding boom.
Last year marked an inflection point for myriad historic global Bubbles.
Some were pierced, and a few of those suffered painful collapses (i.e. crypto). Others were pierced, but persisted.
In general, the riskiest of the speculative Bubbles suffered the greatest deflation. Importantly, however, key Credit Bubbles continued to inflate.
Despite Fed tightening measures and surging market yields, extraordinary Credit growth was ongoing in the U.S.
A historic lending boom (bank and non-bank), along with notable GSE expansions and deficit spending, fueled system Credit growth likely second only to 2020’s pandemic Credit melee.
In China, continued massive bank lending and fiscal stimulus secured yet another year of double-digit system Credit expansion.
The gap between Credit growth and GDP widened alarmingly.
There are reasons to expect moderation this year from both major global Credit engines.
Issue 2023: It’s a post-Bubble environment, with Bubble deflation proceeding in earnest, though ongoing strong Credit growth would create the appearance of relative stability.
In the event of a meaningful Credit slowdown, an increasingly disorderly unwind of financial and economic excess would be expected.
The mortgage finance Bubble collapse quickly reverberated throughout the markets and economy.
It’s worth recalling that the year-2000 bursting of the “tech” Bubble had more creeping economic and Credit impacts. GDP didn’t turn negative until Q1 2001 (-1.3%).
More systemic Credit crisis dynamics didn’t erupt until 2002.
It is entirely possible that systemic Credit crisis can be held at bay until 2024.
But deteriorating Credit performance is a key Issue 2023 – for both corporate and household sectors.
The year begins with decent economic momentum – including a 3.5% unemployment rate and almost 10.5 million job vacancies.
But this could prove the high-water mark for years to come.
The historic “tech” Bubble is deflating.
Layoffs are accelerating, with Amazon’s 18,000 job cuts emblematic of the newfound cost-cutting focus sweeping through what is these days a major sector of U.S. and global economies.
While strong Credit growth continued throughout 2022, the year marked an abrupt end to an historic period of free “money” – along with a corresponding reversal of speculative flows.
Whether it was crypto or the NDX (Nasdaq100), we witnessed a dramatic reversal of speculative finance with major ramifications.
The booming venture capital industry, having luxuriated for years in the loosest monetary conditions imaginable, suddenly saw the money spigot turned down a couple notches.
Issue 2023: This could be the year of the dying startup.
After years of manically financing negative cash-flow and uneconomic enterprises, the reversal of speculative finance has created a major predicament for both companies and their financiers.
Scores of startups will hit the wall, unable to obtain the financial resources necessary for survival.
And while the likes of Microsoft, Google/Alphabet, Amazon and NVIDIA have ample cash reserves, so many of their customers do not.
It’s been a most protracted and far-reaching “arms race.”
“TMT” – technology, media and telecoms – the cloud, crypto, 5G, blockchain, smart devices/Internet of things…
Professional sports franchises, along with incredible media contracts and college athletics spending booms.
More recent investment Bubbles include EV and autonomous vehicles, renewable energy, biotech, robotics, artificial intelligence/machine learning, genomics, virtual/augmented reality, healthcare technologies…
And let’s not forget the so-called “FinTech revolution,” with scores of enterprising financial services companies that have yet to experience market, economic and Credit downturns.
No matter the amount of technology and sophistication, subprime is subprime, and speculation is speculation.
I expect 2023 fallout from “private Credit,” “private assets,” and private equity – important segments of contemporary finance that made it through most of 2022 largely unscathed.
Enormous amounts of finance flowed freely into these structures during the pandemic stimulus years through the end of 2022.
Outflows won’t be accommodated as easily in 2023.
The downside of “phony happiness.”
January 2 – Financial Times (Daniel Rasmussen):
“After about a decade of significant outperformance culminating in a Covid boom, technology investors faced a sharp reversal this year.
By the end of June, Nasdaq was down 29.5% and the Goldman Sachs Unprofitable Tech index was down 52%.
Yet one corner of the tech market was strangely unaffected.
The US Venture Capital index compiled by Cambridge Associates was down only 12.5% through the end of June (the last available data)…
This gap between private markets and public markets is the largest since the bursting of the dotcom bubble more than two decades ago.
Few would argue that these venture capital marks are accurate in aggregate in any meaningful way…
Institutions have fallen in love with private markets, lured by promises of higher returns and lower volatility.
Allocations to VC have soared along with allocations to private equity, private real estate and private credit.
But perhaps these investors have been lulled into complacency, paying an illiquidity premium for the ‘phony happiness’ of private marks.
By doing so — instead of receiving a premium as economic theory suggests — there is bound to be a drag on returns.”
My analytical framework points to extraordinary down-cycle pain and dislocation.
“It happened gradually and then suddenly.”
Ongoing strong Credit growth and significant (pandemic QE-related) financial reserves can continue to somewhat postpone the day of reckoning.
But these same forces should also be expected to sustain powerful inflationary biases throughout the economy.
Issue 2023: Little relief for the Fed.
While inflation will surely track lower than June’s 9.1% (y-o-y), strong wage growth seems to preclude a return to the Fed’s 2% inflation goal anytime soon.
Our central bank will weigh conflicting evidence of recession, economic resilience, disinflation and increasingly entrenched inflationary pressures.
Attempts to gauge the status of market financial conditions will be obscured by ongoing market instability.
Issue 2023: Market Structure remains a huge issue.
Over the years, I've focused on the systemic risks associated with derivatives, risk shifting, and “dynamic hedging.”
The market can’t hedge itself.
If a significant segment of the marketplace moves to hedge risk, there’s no one with the wherewithal to absorb potential losses.
“Portfolio insurance” was instrumental during the 1987 stock market crash.
The scope of market risk hedging has grown exponentially over the years.
The sellers of derivative protection have operated under the assumption of liquid and continuous markets.
They sell protection, and then hedge exposures as necessary, by selling underlying instruments into declining markets (i.e. stocks, bonds, currencies…) – so-called “dynamic hedging.”
And the presumption of liquidity - and the entire derivatives hedging market structure – has been possible only because of the evolving central bank liquidity backstop (i.e. Fed put).
The necessary ingredients for a historic market crash are out there for all to see.
The central bank liquidity backstop was reconfirmed for global markets last September (by the Bank of England).
So, the perilous game of offloading massive market risk onto derivative hedging markets presses on.
Rather than fearing meltdown risk, deeply complacent markets have been conditioned to view market stress and big hedging episodes as opportunities for short squeezes and the forced unwind of hedges.
As witnessed in 2022, this market structure (major market directional derivatives hedging and attendant “dynamic hedging”) promotes instability and market volatility.
Short squeezes were commonplace throughout markets, with notable squeezes in U.S. stocks in late March, July/August and October/November.
One of these days, markets will stumble to the edge of the precipice – and not recoil.
Issue 2023: Market structure will make the Fed’s job only more challenging.
In particular, the backdrop remains conducive to recurrent short squeezes, with this year’s squeezes and the associated loosening of market financial conditions only more problematic.
Weaker economic data and encouraging inflation news would likely spur disproportionate market rallies and squeezes.
By loosening market financial conditions and underpinning inflationary dynamics, squeezes would pressure the Fed to pursue even higher policy rates.
This is a thesis already with supporting evidence.
January 6 – Bloomberg (Edward Bolingbroke):
“Treasuries aggressively bull-steepened Friday after December jobs report showed slowing wage growth, sparking sharp declines for front-end yields.
Curve trend gained momentum from a series of block trades in Treasury futures consistent with new steepener positions and flattener unwinds across a range of tenors. Futures volumes were almost double average…”
Two-year Treasury yields sank 19 bps Friday, with 10-year yields down 16 bps.
Benchmark MBS yields collapsed 28 bps to 4.99% (down 40bps for the week).
Corporate Credit spreads narrowed to near multi-month lows.
The iShares Investment-grade Corporate Bond Fund ended the first four trading sessions of 2023 with a 3.0% gain, with the iShares High-Yield Bond Fund up 2.6%.
The (bond volatility) Move Index dropped six points in Friday trading to a near multi-month low 114.
The S&P500 surged 2.3% during Friday’s session, with the Semiconductors up 4.7%, the Dow Transports 3.4%, the Nasdaq100 2.8%, the Bloomberg REIT Index 2.7%, and the KBW Bank Index 2.5%.
The Fed is aware of its dilemma.
January 4 – Bloomberg (Craig Torres):
“Federal Reserve officials last month affirmed their resolve to bring down inflation and, in an unusually blunt warning to investors, cautioned against underestimating their will to keep interest rates high for some time.
Going into the meeting, markets were pricing in rate cuts in the second half of 2023.
The tone of the minutes of the Federal Open Market Committee’s Dec. 13-14 gathering suggested frustration that this was undermining the central bank’s efforts to bring price pressures under control.
Fed officials noted that ‘an unwarranted easing in financial conditions, especially if driven by a misperception by the public of the committee’s reaction function, would complicate the committee’s effort to restore price stability,’ according to the minutes…”
“Unwarranted” or otherwise, market structure ensures exaggerated market reaction and looser conditions in response to favorable inflation data points.
Fed officials will be compelled to push back with hawkish commentary. Cat and mouse.
Markets are pricing in a 4.95% peak Fed funds rate at the June 14th FOMC meeting, with rates then declining to 4.48% by the final meeting of the year on December 13th.
Expect stern push back against market expectations for a 2023 Fed pivot.
There is strong consensus on the committee that tight conditions will be necessary, at least through the end of the year.
Markets seem to have an equally strong consensus view that the Fed will be forced to jettison its hawkish resolve and pivot dovish.
Issue 2023: Dysfunctional market structure, while promoting volatility and looser financial conditions along the way, ensures instability, fragility and strong odds of a market accident.
Issue 2023: High probability of global market accidents.
Let’s start with Japan.
Haruhiko Kuroda’s term as Bank of Japan (BOJ) governor concludes at the end of March.
I expect the “Abenomics” experiment with unbridled monetary inflation (negative rates and massive QE) and market intervention (yield curve control) to be wound down soon after his departure.
Disorderly adjustment in the Japanese bond market and with the yen is a distinct possibility.
We’ll never know the role played by Japanese-based liquidity throughout 2022, as the BOJ clung to aggressive monetary stimulus in the face of surging global inflation and bond yields.
It certainly provided a powerful pillar of cheap finance for global “carry trades” and leveraged speculation more generally.
Indeed, with the Fed shifting more hawkish early in 2022, it was a relative slam dunk trade (easy in hindsight) that the BOJ and ECB would significantly lag the Fed’s pivot.
As such, the weak yen and euro (strong dollar) provided a degree of currency market predictability in a general backdrop of heightened market instability.
Issue 2023: Acute currency market uncertainty and instability.
Last year’s hawkish Fed, strong dollar regime has given way to a much more ambiguous and unsettled backdrop.
Both the BOJ and ECB are “behind the curve” and will play catch-up.
The Dollar Index dropped 1% on Friday’s “risk on” market rally.
How big are yen and euro short positions?
And if dollar weakness materializes in 2023, this would provide an inflationary boost through rising energy, commodities and import prices.
Issue 2023: The year of precious metals?
Precious metals were generally out of the blocks quickly to begin the new year.
Metals performed relatively well last year in the face of dollar strength and rising rates.
A year of currency market uncertainty, persistent inflation, and ongoing expansion of non-productive Credit would seem to support the precious metals.
After a 2022 inflection point, I would expect 2023 to provide more New Cycle momentum.
There will be ebbs and flows, but the cycle of hard asset outperformance versus financial assets is in its infancy.
FT: “ECB Rate Rises Expose Fears for Italy as Eurozone’s Weakest Link.”
Italian 10-year yields sank 47 bps this week (4.23%), more than reversing the 40 bps surge during 2022’s final two weeks.
Italian and European periphery bonds remain acutely vulnerable to tighter ECB policy and global “risk off” dynamics.
A warm start to winter has crushed European energy prices, significantly improving near-term inflation prospects.
Yet energy prices and inflation remain subject to extraordinary uncertainty.
Issue 2023: A European periphery debt crisis is likely in the event of another serious global de-risking/deleveraging episode.
When it comes to acute uncertainty, China is at the top of the list for 2023.
Can China sustain another year of double-digit Credit growth?
Can Chinese bank assets continue to balloon at a double-digit pace, stuffed with late-cycle suspect loans and state-directed financial support (i.e. developer bonds, local government financing vehicles, government bonds and such).
Issue 2023: Will confidence in China’s financial structure be sustained?
A desperate Beijing is currently in crisis management mode.
There will be ongoing massive fiscal and monetary support.
Chinese banks will be directed to lend aggressively.
I even expect Chinese officials to play a little nicer in the sandbox, recognizing that they must try to stem the exodus of business and investment out of China.
Faced with economic meltdown risk, it’s in Beijing’s self-interest to deescalate trade tensions with the U.S., Australia and others.
China is in trouble.
When the Covid waves subside, there will be pent up demand.
There’s huge stimulus in the pipeline.
Massive Credit growth can hold economic depression at bay – for now.
But there will surely be greater fallout from the 2022 bursting of the great Chinese apartment Bubble.
Beijing measures will help, but I don’t expect manic enthusiasm for speculating in over-priced and poorly constructed apartment units to reemerge.
I believe consumer and business confidence has taken such a decisive hit that it will take years to recover.
China has commenced a multiyear down-cycle.
Epic structural maladjustment will be revealed as Credit growth slows.
How rotten is that system?
For now, the more pressing question is how long can China’s currency hold up in the face of ongoing massive Credit expansion, with too much being of the non-productive ilk.
There are already indications that Beijing is resorting to tactics to mask the support provided for the vulnerable renminbi.
January 5 – Financial Times (Hudson Lockett and Cheng Leng):
“China is changing its tactics on the renminbi…, with a shift away from direct intervention and towards lower-profile, indirect tools to steer the market.
The currency dropped almost 8% last year against the soaring dollar.
But Beijing smoothed out that decline using tools such as so-called ‘invisible reserves’ held by state banks, rather than its more typical heavy-handed intervention by the People’s Bank of China. Beijing’s new approach… poses a challenge to traders seeking to anticipate the renminbi’s next move…
‘China’s overall foreign exchange management framework has changed,’ said Becky Liu, head of China macro strategy at Standard Chartered.
‘When you directly intervene, people calculate how much [reserves] you have to burn on a monthly basis and how many more months you have left.
In that situation people will short the renminbi at all costs,’ Liu said.
‘This time around, they’re putting a lot of other measures in place so the amount of foreign exchange interventions needed is lower.’”
Sign of weakness.
It's difficult to believe that there is not massive amounts of finance seeking to exit China.
I also suspect there is vulnerability to an unwind of a huge “carry trade” leverage in higher-yielding Chinese instruments.
Beijing understands that a major drawdown of its international reserve position risks igniting a run out of the renminbi.
So, it will resort to all kinds of games, including derivatives, and calling upon its banking system for currency-bolstering operations.
Issue 2023: Can Beijing thwart a crisis of confidence - in Chinese policymaking, in China’s banking system and with its currency?
The September UK bond market crisis illuminated how closely correlated global markets have become, and how “risk off,” illiquidity, and a crisis of confidence in one market can be quickly transmitted across markets.
Late-September was a reminder of the risk of a synchronized “seizing up” of global markets.
Issue 2023: Can the world avoid a crisis of confidence in global markets?
There are so-called “white swans,” “gray swans,” and “black swans.”
I expect to see all varieties this year.
It’s hard to believe we’re now in the fourth year of the pandemic.
There is every reason to expect only more extreme weather events.
Not to be overly pessimistic, but bursting Bubbles tend to unleash all kinds of troubling developments – market, financial, economic, social and geopolitical.
There will be more FTXs and SBFs.
If this week is any indication, expect only greater Washington dysfunction – a troubling prospect for a year when policymakers could be called upon for crisis management.
And I hope we can get through the year without a major geopolitical crisis.
Hopefully, we are surprised by fruitful negotiation, rather than escalation in Ukraine.
Can Putin contain his rage against the U.S. and the West?
How would the West respond to major war escalation?
Does China ratchet up support for Russia?
We should assume China continues its intimidation campaign and preparations for conflict with Taiwan.
And one of these days there’s going to be an accident between U.S. and Chinese aircraft (or ships) over the South China Sea or Taiwan Strait.
The Korean Peninsula is an accident waiting to happen.
Meanwhile, the backdrop is ripe for bouts of destabilizing social unrest around the globe.
There are festering EM crises lined up like dominoes.
In the unfolding post-Bubble environment, I fear crisis of confidence contagion – monetary and fiscal policymaking, markets, currencies, financial systems and economic structures.
In the near-term, market rallies would spur a bout of “the worst is behind us” optimism.
Already, there’s lots of talk of Goldilocks, soft-landings, and even “immaculate disinflation”.
I hope the bullish analysts are proven correct.
But as an analyst of a series of historic Bubbles for going on three decades, I can’t shake the fear that things are likely worse than even I believe.
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