A Minsky moment resembles a snake attack: a sudden and violent destructive move, much like a stock market crash. It originates in a slow psychological process according to economist Hyman Minsky, namely a gradual weakening of the financial system through mounting debts in periods of irrational euphoria.
Can we verify this hypothesis? And is the Minsky moment actually unpredictable?
Like in Sergio Leone’s film, the story of the S&P 500 is played out with three characters:
In March 2021, we warned the Speculator of the likely end of the Price-Earnings ratio expansion cycle. In June, we warned the Moderate investor that the game was no longer worth the candle. Today, we address the Rentier: The S&P 500 earnings yield is now offset by inflation.
For 50 years, when the Rentier expressed dissatisfaction, it was a message for his two fellow investors to take shelter.
Ahhh, the simple scientific world of René Descartes! Single cause, single effect. In the economic world however, this unfortunately is not the case. One cause can even bring about two opposite effects.
A devaluation, for example, usually produces a deterioration in the external accounts first and then an improvement second. Economists call this phenomenon the “J-curve.”
However for more than 20 years, the financial policies of developed economies have turned the page upside down. The “J” has become an “η.” Immediate relief and pain for tomorrow.
The tapering in view of the US Federal Reserve now raises the question: Would “tomorrow” be the end of the summer?
From 1985 to 2007, the economic world went through a period of “Great Moderation,” highlighted by the amortization of fluctuations in business cycles. However, economic evolution, like the history of our universe, follows a process of micro-macro alternation – periods of “Ricardian” stability – which is exhausted over time, and bifurcations.
Are we at the dawn of a great bifurcation?
Does China today play the role of the leaking seal at the origin of the 1986 Challenger Shuttle explosion? Chinese authorities are stiffening up against their own capitalism deemed too “Western,” be they in the tech, food-delivery, real-estate, or tutoring industries.
Here, we focus on the risk of propagation, from Chinese equity markets to world equity markets.
Managing portfolio risks has nothing to do with massaging the average volatility; it is all about not being caught in violent market bifurcations. There are ways not to time bifurcations, but time the risk of bifurcations. Why? Because like nature, financial markets exhibit measurable fractal forms for the better, and for the worse.
This letter introduces fractality for two reasons:
Two weeks ago, a friend of mine lost his tennis racket on the highway. The racket fell right out of his bag attached to the back of his motorcycle. He quickly took the first exit, returned to the spot, pulled his motorbike into the emergency lane, and spotted his racket lying there on the highway. Did he end up crossing the road to retrieve it?
Managing risk does not mean forecasting.
Will the financial market crash?
This is anyone’s guess; the future is unpredictable. But what about the risk?
Given the inflationary shock on oil developing month after month, the odds of a 50% drawdown on the S&P 500 have been multiplied by a factor of 100.
For seven months in a row, Gavekal-IS macro, monetary, and behavioral models remained very equity-friendly, serene as a Tibetan monk. In the meantime, Gavekal-IS publications displayed a series of macroeconomic warning signals building up for a potential climax around August or September. See for instance February’s “Inflation: The Equity Nightmare,” and “US PE Expansion: Game Over!” publications, and May’s “Economic Boom and Financial Bust.”
Today, Gavekal-IS models crossed the Rubicon: criticality is ahead, risk-off!
In a series of three publications in February 2021, we explained how accelerating inflation – not simply high inflation – had been awfully bad news for equities for 140 years. Some of our readers argued that rather than inflation, interest rate was the key driver of equity behavior. If central banks continued using their purchasing power to cap government bond rates at low levels, equity markets should be fine.
Here, we refocus our analysis on interest rates, and our conclusion remains the same: last round for equities!
Benjamin Franklin believed in free trade. “No nation was ever ruined by trade,” he said, adding, “even seemingly the most disadvantageous.”
Now fast forward to equity markets today; world trade in volume is one of the seven macro rules embedded in the artificial brain of TrackMacro, Gavekal-IS’ software providing real-time investment portfolios.
Last month, TrackMacro issued a “strong” signal on trade. World trade is anticipated to boom.
Does this mean equities should rally?
Some forty years ago, Charles Gave introduced the “Four Quadrants” concept, used by generations of investors to drive asset allocation in global investment portfolios. The concept crosses inflation and growth to cluster four macroeconomic situations: inflationary boom, inflationary bust, disinflationary boom, and disinflationary bust.
Here we revisit the concept with a scientific eye, applied to ecosystems. We focus on the second derivative of economic production or asset prices, i.e. the acceleration or deceleration of growth and inflation, intentionally ignoring the levels of inflation and growth. A new “Four Quadrants” is born, bridging macroeconomy and simple mathematics. It massively amplifies Charles’ discovery decades ago.
What is it telling us? That the US game on equity price-earnings’ expansion is over.