When all you have is a hammer, everything looks like a nail.
I recently started re-reading Thinking, Fast and Slow by Daniel Kahneman. I first read this many
years ago and was stumbling around for a good read on behavioural psychology. A very good friend
of mine suggested that I re-read it. I am very glad I took his advice.
For those that have not read Thinking, Fast and Slow, I strongly recommend it. I am very sure many
people reading this will at least be vaguely familiar with the book.
One of the initial topics covered is something called priming. An experiment was setup where
subjects spent time looking at images, videos and words associated with being elderly. They were
then asked to walk a set distance and path. The results were that people who had looked at the
material associated with being elderly walked the distance at a much slower speed than those who
had been subjected to material linked to youth. It seems however much we may not want to admit,
we are affected by what we see, hear and experience. Our subconscious absorbs material which
affects us without our even knowing. What is startling is that even if you are aware of this process,
you are not immune.
The other fascinating discovery which is probably more obvious is that where we can, we will try to
be cognitively lazy. When we start to see similar patterns to what we have experienced before, we
tend to use “Type 1” (reactionary, fast) as supposed to “Type 2” (slower, analytical) thinking. This
can often lead to biases and beliefs that are untrue as we reach conclusions too hastily.
There is no need to pour over the gory details of financial market performance over the past week.
What some may believe, as I do, is that the sell off in risk really started to accelerate when China
announced that they would be locking cities down to avoid the spread of COVID. Suddenly growth
expectations were talked much lower and recession started to enter the vernacular.
For quite some time, market participants were confused as to why the stock market was holding up
so well despite the move higher in rates markets globally. I guess the China lockdowns were the
straw that broke the market’s back. But I was surprised that people were surprised when we finally
did sell off. Perhaps what I did not estimate at all was the rapidity with which the market sold off.
Speed in sell offs always seems to be the factor that hurts before the magnitude. People are never
able to position for it ahead of time and then struggle to chase it lower out of fear of being caught
on an aggressive bounce.
Since 2007/2008, every time the world or market has experienced some sort of shock, the formula
has been the same; central banks cut rates and offer stimulus through QE to support asset markets.
We have been primed to believe that this is the response and behave accordingly. We also don’t
really question the narrative of cutting rates and the efficacy as we have perhaps become cognitively
lazy as it all seems a bit familiar. To find the right solution to a problem you first need to identify
what it is and be honest in your attempts to resolve it. The issue I have is that QE and loose
monetary policy cannot address the problems that we are currently facing.
When we first came out of Covid, inflation was meant to be driven by pent up demand and supply
chain bottlenecks. Both of which were meant to ease. However, inflation turned from being
transitory to structural. It also moved from demand driven inflation to supply side inflation where
we are just not able to obtain enough of the inputs that go into making stuff. Energy has been
proven to be a weakness for so many developed industrial nations. Oil companies have shed their
assets as globally we push towards a greener future. They have spent very little money on new
exploration given government stances. To exacerbate matters, we have a war going on between
Russia and the Ukraine which means access to energy becomes more strained. Probably scariest of
all is that access to food may become more strained. Wheat harvest expectations have fallen by a
third and I am not too sure what the next planting season looks like. Our answer to this set of
problems is to expect easier policy. Something seems very off with this line of thinking.
My understanding is that central banks are meant to tighten policy to reduce demand. Rates are
meant to be increased in such a way that unemployment does not spike. Meanwhile, costs of goods
increasing cause a cost-of-living crisis which also feeds into less demand. Somehow from this
combination, we are meant to have a “soft landing” and our inflation problems are meant to
disappear. This sounds exceptionally difficult to do in practice.
What concerns me is if easing is carried out before inflation is properly under control. The definition
of properly needs more explanation. For me, it is the point at which talks of easing does not cause a
sudden spike in demand that will see prices accelerate again. We may then find ourselves exactly
where we are now.
I think we have arrived at a place where central bankers really do not have control. The monetary
policy toolbox does nothing to address lack of oil or wheat coming out of the ground. It is akin to the
title of this post. I feel the investment community is hoping for a recession that would allow us to
slip back into carry trades. The game at the moment is to guess where the put strike on the Nasdaq
(substitute the index of choice) is to get policy makers involved to support the market. But with
unemployment at 3.6% and vacancy to applicant ratios near 2, we have a long way to go before
labour markets justify any central bank intervention in my view. Q2 GDP numbers may again be
negative which would mean technical recession. Will the FED turn dovish then? That isn’t obvious
to me if inflation remains sticky. There is a long time between now and this data being released and
a very high likelihood that things get worse before they get better. Remember, my view is that
China coming out of lockdown will be inflationary.
I think we need to apply a bit more “Type 2” thinking that we currently are.
Quay Partners Group is a service-as-a-platform investment management solutions for independent hedge fund managers and family offices.
Supun Ekanayake is a Partner at Quay Partners Investments (UK) LLP and has over 15 years’ experience trading across all asset classes.
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