Market Insights

The Zeitenwende Week That Will Be (27th February 2022)

The Prime Minister of Germany, Olaf Scholz, was not wrong when he stood before his parliament today and announced this was a Zeitenwende. Not just as some have translated it, a ‘turning point’, but more specifically ‘the end of an era’. And with that he tore up several decades of German policy towards Russia, announcing commitment to at least the 2% NATO goal along with 100bn EUR for a special defence fund. He threw in changes to energy policy including the acceleration of renewables and supplementary coal and gas reserves. Germany is very much embracing Going Left and Going Green.

But it’s not just for Germany that this weekend marks a new world. The announcement by the West that they would prevent Russia from using most of its FX reserves is a breath-taking acceleration into an economic war of which we are all now part. The West has decided that a G20 nation should no longer be part of its financial system. Previous freezes on FX reserves have happened to the likes of Iran and Venezuela. Russia has spent the last two decades insinuating itself into the western world; the plug has now been pulled overnight. The outbreak of Covid was a similar shock but one that would follow a clear path: a virus predictably evolves and people’s fear predictably waxes and wanes. We now have a non-linear actor playing a central role in events while the West has decided to escalate its response.

This will have far reaching ramifications politically but also delivers a short term shock to the markets:

  1. Nobody will know what the price of the rouble is, aside from it being far lower than it was on Friday. No western institution can therefore afford any exposure to Russia. The uncertainty is too great, both over the value of the asset and the creditworthiness of the counterparty.
    1. This is akin to the liquidators walking into Lehman Brothers on the morning of Monday 15th September and turning all the computers off. It wasn’t just that asset values had fallen, it was that it set off a chain reaction through the system whereby nobody knew who held the hot potato nor how little it was worth.
  2. There are now two financial systems: those for the Western world and those for the pariah states. It is up to the geopolitics to determine which becomes more powerful in the long term but in the short term the financial system is too interconnected to bifurcate overnight.
    1. Monetary authorities will only support the system in which their institutions operate.
  3. The disruption is deliberate and ultimately can be contained, for example by bailing out any systemically important institution if that should be required. But the disruption itself can and must continue.
    1. The US Treasury has operated a Department for Terrorism and Financial Intelligence for almost two decades. Their mantra is “Follow the Money”. They know who to hurt and how.

1 + 2 + 3 = western financial institutions will have to divest from anything that even hints of Russia.

But this chain reaction cannot be contained to Russia. Uncertainty levels have gone through the roof. The system has to deleverage.

  1. More collateral will be demanded as volatility will increase.
    1. This will force unwinds of positions, not least as some funds have to sell liquid assets in order to fund positions that have been rendered illiquid at the stroke of a pen. If you own an index whereby a portion sits in Russia, you will be forced to get out of it.
  2. What looked safe might now be far less safe.
    1. Gold isn’t particularly useful in a world where ease of payments becomes king. It’s expensive to store and can’t always be liquidated. Not to mention that Russia itself is likely to need to liquidate the Gold part of their FX reserves that they still have access to.
  3. Leverage had risen to high levels following almost two years of money printing.
    1. But the gamma/vanna position does not – yet – denote a crash risk. We are likely to see an orderly sell off in risky assets.

4 + 5 + 6 = cash is king. Everyone’s risk manager will tell them to take some risk off the table.  But what kind of cash?

  1. The demand for USDs will go up just as their supply goes down.
    1. Western institutions will simply have to own more US Dollars in exchange for ditching any less liquid currency. But where some emerging nations might have been selling dollars to stimulate their economies, that will no longer be possible. Throw in Fed Quantitative Tightening and supply of Dollars falls as demand goes up.
  2. Crypto currency is legitimised.
    1. A decentralised asset is valuable in a world where centralised powers can decide to seize assets at will.
    2. But its transparent and pseudonymous nature means good actors can burnish their credentials to ensure assets remain under their control, leaving the authorities to pursue the bad actors.

7 + 8 = USD, BTC, ETH = even Ukraine has tweeted it wants to receive the latter, raising $6m in the process. 

And then we come to Putin’s response. Nobody can with any authority predict what is in his mind. We knew in March 2022 that a virus would evolve to survive. Vladimir will attempt the same, although human logic is more non-linear than that of a pathogen. But we can all see the possible outcome of risks has now changed substantially. You probably didn’t start the year thinking you had to factor the capture of Chernobyl and the threat of nuclear war into your portfolio, but this is now a world where the impossible becomes possible uncomfortably quickly.

  1. The most immediate concern should be a cyberattack that disrupts western financial markets.
    1. The “Hound of Hounslow” apparently managed to spoof the most liquid stock market in the world from the bedroom in his parents’ house in 2010. We have seen countless more flash crashes since then as the system has become more automated. Even if hackers manage to cause a brief wobble in one market, the outbreak of hostilities will lead us to imagine that far more could be round the corner.
  2. Beyond that the hacks could hit health systems, national electricity, flights and so on.
    1. Facebook managed to take itself offline for six hours in October 2021 because their system was so interdependent. BA had to cancel all short haul flights this Saturday due to a technical issue.

9 + 10 = Be ready for what feels impossible. 

And then we have the long run impact:

  1. Opportunity and threat for China
    1. They can step in to help Russia where the West has frozen them out, but at a price that Russia may not be prepared to pay. Equally China is already reeling from the pandemic, both geopolitically and economically. They might like to think the renminbi can now challenge the USD for reserve currency status but they’ve just found out their 3 trillion dollars of FX reserves is worth less than it was yesterday. If they provoke the west now, they face the same bankruptcy threat as Russia.
      1. They might decide to distract from this by invading Taiwan – again we cannot know with any certainty but the likelihood has just increased.
  2. Global recession.
    1. We already anticipated long-run growth would struggle in the wake of the pandemic until we adjusted to the impaired velocity of people. Now we can throw in a monumental cost shock as the price of energy and food will rise further. This will weigh on Aggregate Demand.
      1. As if the world wasn’t already burnt out from two years of fear, this will panic consumers once again. Banks are unlikely to lend as much credit as confidence ebbs.
      2. Whereas Demand has outweighed constrained Supply, we now enter a period of depressed Demand – which will ultimately bring inflation back down.
  3. Monetary and Fiscal Response.
    1. This will be tougher to execute than in the pandemic.
      1. More spending will go towards Defence, which famously has a low multiplier in terms of its impact on growth.
      2. Debt and deficits are already creaking, although war provides a decent excuse to avoid bringing them back down.
      3. If central banks were already worried about a possible wage-price spiral with oil at $100, how will they feel if it gets to $200? They need to ensure they remain vigilant on the inflationary threat.
      4. Whatever It Takes was already dead. Now it’s a world of least worst options where either Russia withdraws its gas or Europe stops buying it, leaving everyone economically worse off.

The game has changed. This is no longer just about Ukraine. As Chris Pratt’s character in the remake of The Magnificent Seven puts it, “it was never about the cards”. The land war is just one front. We are now all in an economic war.

BM Talks: Sir Christopher Meyer speaks

We are joined in our latest edition of BM Talks by Sir Christopher Meyer, the former British Ambassador to the United States and Germany. He has written a number of books, most notably his account of his time in Washington, “DC Confidential“. He now tweets @SirSocks.

To listen, please click here or subscribe to our podcast which is now available on SpotifyGoogleApple and many more

 

We asked:

  • Who will win the US mid-term elections?
  • What is Joe Biden really like and will he lose to Trump in 2024?
  • What relationship should the West have with China?
  • Will we see a united Ireland?
  • Does he actually like using Twitter?
  • What was the greatest diplomatic challenge he faced?
  • Which world leader impressed him the most?

A full transcript of the 40 minute podcast can be found here

To listen, please click here and subscribe to our podcast which is now available on SpotifyGoogleApple etc

Feedback very welcome, and here is a list of all episodes to date

BM Talks: ASI’s Richard Dunbar speaks

We are joined in our latest edition of BM Talks by Richard Dunbar, Head of Multi-Asset Research at Aberdeen Standard Investments.

To listen, please click here or subscribe to our podcast which is now available on SpotifyGoogleApple and many more


We asked:

  • What does the future of asset management look like?
  • Where do ETFs fit in?
  • Can blockchain revolutionise the industry?
  • How has the virtual world worked during the pandemic?
  • In the search for yield, where do the opportunities lie?
  • What advice can you give someone starting out in the industry?
  • What are the prospects for the Union of the United Kingdom?

Here is a summary of the 40 minute podcast:

0.29 What does the future of Asset Management look like?

RD: At it’s core, it’s the same as 30 years ago, when I joined, i.e. help our clients. Just as investment trusts did in the 19th century. How we do it and the tools have changed. People are different, more quantitatively based. Wider skillset in general. Team based now. More solutions based, less demand for a single product. More scrutiny on how we behave as well, more stakeholders, e.g. ESG

4.12 ETFs have risen in popularity over the last decade, mainly passive but there are active ones, e.g. ARK. How do you look at it – is it the end or the future of fund management?

We have one of the biggest passive business in the UK and we are an active manager. ETFs are part of portfolios. They are a tool for active managers. They have focussed active managers on where they are adding value.

6.48 Blockchain, it could revolutionise AM. Have you looked at it?

Yes. It could do a lot of things, collaboration of counterparties, it could enforce data consistency. But so can existing technology too.

8.43 Elon Musk could use blockchain to build a really efficient asset manager, rather than sending a man to Mars!

Slightly less regulation in sending a rocket to Mars…

9.07 Regarding changes you’ve made in dealing with the pandemic, what about working from home?

Yes we have slightly fewer desks and more breakout collaborative areas in London, the Edinburgh office had that already as it is a newer office. We’re heading into a hybrid system. We need some creative type behaviours. We’ve had more engagement across the time zones. Working from home has worked because we know each other, new members could well become a problem. Also the young people need to sit beside us old people to see what really happens, there has been a formality to a lot of the meetings, having to organise a call, etc

14:06 How has the virtual world worked with settlements and trading?

This has all been done remotely and extremely well. We ensured the safety of the people and clients’ assets

16.05 The GARS fund has been a real trailblazer for managing risk and return, how will it evolve?

These funds will be a part of the solution in the future and there will be more bespoke use of all these tools

18.23 Turning to markets, given the desperate search for yield where are there opportunities?

US earnings were sky high and expectations have been exceeded, no one would have thought that. Aided by massive liquidity injections. The earnings growth expectation for the S&P was 25%, it has delivered 40%. A 15 pct pt beat has seen a 2% rise in equities, we sort of knew what was coming. The expectations for equity returns are modest. Our bond allocations are balanced, carry has some attraction. There is bias for higher yielding bonds. Real estate, slightly underweight, you need good quality.

27.37 Do you have tail risk hedges, or do you not look at it that way?

We do, not just traditional diversifying assets.

28.43 Do you have any views on the dollar?

We don’t have strong views at the moment and there are no strong views taken in the portfolio. Fair value in the dollar gives cover for EM

29.56 What advice would you give to someone starting out in asset management today?

Firstly, do start and then do keep going. It is a noble profession, sorry if that sounds too pompous. There is a requirement for advice in finance

31.18 Would you advise to take the CFA?

Yes I do! It is a good grounding. Also carry on with the organisation – don’t just do the qualification and then forget it

34.24 My final question, being from Northern Ireland and now living in Scotland, what are the prospects for the Union?

They are as precarious as they have ever been. Skill, sympathy, deftness of touch by unionist politicians is needed. The Union has brought great benefits and each part has brought their own benefits too.

37.42 Do we get a second Scottish independence referendum, do we get an Ireland border poll, which comes first?

The pandemic puts the referendum off for a while and polls have been volatile. A border poll is coming, with more trepidation South of the border.

To listen, please click here and subscribe to our podcast which is now available on SpotifyGoogleApple etc

Feedback very welcome, and here is a list of all episodes to date 

BM Talks: Rob O’Rahilly speaks on banking, fund management, balance sheets and beyond

We are joined in our latest edition of BM Talks by Rob O’Rahilly who was the international CIO for JP Morgan Chase and ran the asset management solutions business there. 

To listen, please click here or subscribe to our podcast which is now available on SpotifyGoogleApple and many more

We asked:

  • How has QE evolved since the financial crisis?
  • What are we to make of increased borrowing by governments?
  • What is the major source of systemic risk today?
  • What is causing wobbles in the bond market?
  • How far can we make a comparison between 2020 and 2008?
  • What will happen to the US Dollar?
  • What is the outlook for stocks, bonds and alternative assets?

To listen, please click here or subscribe to our podcast which is now available on SpotifyGoogleApple.

Feedback very welcome

BM Talks: Northern Ireland’s voices speak on the Ireland/Northern Ireland Protocol

We are joined in our latest edition of BM Talks by two of the longest running bloggers on Northern Irish politics, each raised on different sides of the debate: the unionist David Hoey and the nationalist Mick Fealty. The former runs The Dissenter blog, the latter Slugger O’Toole

To listen, please click here or subscribe to our podcast which is now available on SpotifyGoogleApple and many more

We asked:

  • What is the Ireland/Northern Ireland Protocol?
  • What happened over Article 16 and why?
  • What are the immediate implications for NI businesses?
  • How much friction is there between EU vs UK, UK vs ROI etc?
  • Will we see a United Ireland and Independent Scotland in 10 years?
  • Will we return to violence?

For a full breakdown of the 45 minute podcast, see below:

1:03 the NI Protocol: what exactly is this?

1:11 David: it is a device used to push the withdrawal agreement over the line, it is an addendum to the withdrawal agreement that leaves Northern Ireland in 3 different jurisdictions, it is in the customs union with GB and also the single market of the European Union

1:54 Article 16: what happened and why?

2:04 Mick: it’s meant to be an option of last resort, but when they invoked it they did not contact any governments whether Irish or UK. It’s meant to be when the protocol unexpectedly leads to serious economic, societal or environmental difficulties but it seemed to be invoked because of a punishment around vaccines. Then pro Brexiteers used it as a useful stick to beat the European Union, some of the controversy and instability around the Protocol is partly because of the precipitous action of the European Commission.

3:14 What are the immediate implications for NI business, is it more difficult to trade with their main market in Great Britain?

3:27 David: YES, but the degree with which it impacts you depends on the size of your business. So take a steel business, its £150 for a trailer load of steel. But if it were for a box of paper clips to the local stationers then that’s a lot of money. Small businesses are really struggling.

5:47 Mick: he’s right, trade goes two ways. There’s very little North-South trade. Most trade goes across the north channel (NI and Scotland) or the Irish Sea. The whole purpose of the protocol was to avoid the border on the north side, the irony of that is 90% of all consumer trade is across that sea border. Nationalists are more sanguine as they’re more comfortable with trade on the island of Ireland and supply chains will reroute through the island of Ireland. Northern Ireland will be able to sell into the GB market and the EU market without let or hindrance. When grace periods end we will be able to tell if this is sustainable or not.

8:36 Grace periods: there’s some confusion, the UK government said they could be unilaterally extended, but that appears to be against the spirit if not the letter of what has been agreed by the EU side. How sustainable are the grace periods?

9:12 David: it’s the respective interpretations of the protocol. The UK has a view that the Protocol has flexibilities, grace periods, etc. and not just the UK, the Republic has provided grace periods within its own tax system for people reporting into the Republic. The EU’s view is very draconian, it’s only what it thinks is right, is right, and the UK has to seek the approval of the EU who have threatened court That would be the ECJ as it will be for the Protocol, the same ECJ Boris Johnson said he got rid of. That’s a long process, it can take up to three years. Meantime, negotiations are going on. Grace periods were needed to stop the whole thing falling off a cliff in April, then with everything else going on, instability, etc, businesses not prepared, processes like tax are not prepared. The EU is then flexing and shouting

11:31 Why are businesses not prepared and whose fault is that?

11:41 Mick: two reasons, it went right to the wire and businesses didn’t know what they were to prepare for. The Brexit deal and Protocol are specific and they are being interpreted quite literally with little give from the EU. Businesses in NI never exported before. In GB the businesses that were affected were already exporting so had a bureaucratic facility within their businesses. This is hitting small dealers on the internet, Ebay, people reselling through Amazon, etc up to quite sizeable SMEs. Their GB suppliers are saying it’s too much hassle to send so we stick the price up; a case I heard of 11 keyboards for tablets being ordered and the cost was £800, luckily they had an office in GB who ordered it at a fraction of the price. So these companies have just never had to deal with this degree of regulation before. So the last minute nature of the deal and the lack of time to prepare markets on both sides of the Irish Sea

14:00 Moving onto the relationships between the different groups EU vs UK, UK vs ROI, NI vs ROI, how much tension or friction is there?

14:31 Mick: we used to argue over things like traditional marches or commemorations for retired terrorists, now we have a really chunky economic thing to bolster the old tribal discourse. There has been a lack of statesmanship all round. Right wing British newspapers have been read avidly in Dublin and the reaction has been almost psychotic. The polarisation of Dublin, never mind Belfast, politics has been striking. Sinn Féin is now one of the biggest parties in the Republic, since Brexit, it’s a profoundly anti-pluralist project as far as Unionists are concerned. It’s a populist party that Dublin doesn’t really recognise as such. So into this vacuum of statesmanship, the political landscape has been polarised. There is deep disquiet about this Protocol. Nationalists see the long-term benefits of this as it beds in but the short to medium term will be rocky. On the European Union side, especially now most of the major negotiations have been done, there has also been a statesman vacuum, just look at the premature invocation of Article 16, there’s no one home but commissioners and they’re not politicians. The leadership in Dublin that is still pluralist is leaking votes (Micheál Martin) and being undermined by his deputy. That leaves an anti-pluralist opposition. The long-term opportunity for NI is substantial but getting to that point is tricky.

18:08, On NI politics, polarisation has been happening for a while what is the political landscape like there now?

18:25 David: you can’t really divorce it from the anti-British rhetoric coming out of Dublin. This had been building before Brexit but has increased and is very much in the face of Unionism. We look at the South and see Sinn Féin, very much anti-pluralist, and is indeed taking a substantial part of the political space, but that’s also because of issues like Housing and Health. The two main parties are wrapping themselves in the green flag, which in itself helps Sinn Féin, they’re not dealing with the day-to-day issues that are really impacting. They now have to deal with the UK as a Third Country which they have never had to do before. Covid has suppressed some of the dynamic. Unionists have that feeling that devolved government is not working and I mean working at all not just for them

20.49 Mick you said Sinn Féin are a populist party but not being recognised as such, what do you mean by that?

20.56 Mick: they don’t see themselves in terms of Le Pen in France or Trump, Sinn Féin has wrapped itself around policies that David has talked about (Housing and Health). Their record on Ni says something else, they’re profoundly anti-system, no record of delivery or any signs they do anything once in government other than virtue signal. The anti-British thing is distracting people in Dublin from their woes. One reason I voted remain was I was concerned it would lead to this polarisation.

23.03 Is a United Ireland more likely and when will we see a border poll?

23.10 David: its not up to Sinn Féin to create a United Ireland, it’s the electorate. A United Ireland being closer is a difficult argument. Nationalists have said the Protocol is the best of both worlds, so if they are going to enter into an argument for a United Ireland how do we lose what’s best for both worlds and end up with something sub-optimal? Nationalists are very excited about what Brexit might do as regards a United Ireland, Unionists have sat back and said you talk about it, we want to deal with the day-to-day

26.03 Mick: Border Poll, two things that concern me, the demographics in NI do not suggest we are anywhere near a Catholic majority. There is a slowing down of growth in this respect. What’s increasing is those who declare themselves as “neither”, 14% to 17% and with this census could be 20%. Secondly, Sinn Féin who are at the forefront of this call for a border poll have effectively abandoned politics in NI and gone after real political power in Dublin. Now if they get into power in the Republic, they’ll have to deal with real issues.

29.28 Picking up on the parallels in Scotland, the SNP is in power but they’re running up against questions on their competence. If there is another referendum there, will we see an Irish Border poll within that period as well?

30.15 Mick: doubtful, the assumption is if Scotland goes NI will too but they hammered Unionists with a terrorist war thinking they’d give up. I will defer to David on that. If they get a Protocol that works and life is getting better, the material well-being of people in NI will come first

31.10 David: Unionists see entering a discussion on this as a rabbit hole and look to the day-to-day issues to solve. I don’t see Scotland or NI leaving within 10 years. 1912 is the foundation of Unionism, although people are looking at the Centenary of NI, back then we told everyone, we’ll do whatever it takes not to leave the Union

33.53 Will we return to violence?

34.11 David: Republican violence never really went away. The IRA have carried out murders. Sinn Féin is still linked to the IRA as recognised in a PSNI public report. Dissidents as they call them, unionists just see them as another shade of Republicans, have been killing recently, the journalist in Londonderry for example. As regards Loyalists, you’d have to be worried about a return to violence. The UVF was one of the most brutal groups in NI and was an effective killing machine in the early 70s.

37.09 Mick: violence has become a feature not a bug. A negotiation with men with guns has legitimised their standing. There is a democracy. I don’t think there is any space for a return to violence

38.44 Does any of this matter in a Covid world?

38.47 Mick: once trade flows return, we’ll see where the blockages are. For instance there is a grace period for medicines, so NI got the same vaccine benefits as the rest of the UK.

39.57 David: historical example, the Boyne is seen as an Irish Protestant and Roman Catholic thing, it was a battle of kings in Europe fought on Irish soil. The Protocol is the same.

41.10 Do you think President Biden will make a issue of NI/ROI

41.20 David: Nationalists will, the administration will be more sanguine.

42.01 Mick: doubt it weighs too heavily. The Good Friday Agreement, brought in Bill Clinton almost to act as MC, using his charisma and position. It won’t distract either Boris Johnson or Biden from doing whatever deal they need to do. The size of the UK economy does matter to the US. NI can trail off the back of that.

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Feedback very welcome