Does the flap of a butterfly’s wings in Brazil set off a tornado in Texas?”Was the question Edward Lorenz posed as he dove into his exploration of Chaos Theory.
It was his way of stating that a tiny, inobservable change in input can lead to a massive, very observable change in output. This occurs in nonlinear (aka chaotic) systems where intricate interdependencies between components of the system take little wing-flaps and amplify them exponentially through a series of feedback loops.
The same thing happens in financial markets, where changes in one part of the world can lead to very drastic effects across global capital markets, Covid-19 being the case in point. These effects in turn force policy makers into responding, which creates new sets of consequences, etc. We are therefore living with a set of consequences which stretch back and forward through time, a reality which is simply too complex for the human mind to comprehend.
Our natural response is to reduce this complexity into smaller, more understandable parts, but doing so makes us blind to just how far reaching the consequences of our actions are. Ironically, by ignoring complexity, we become stuck inside a complex feedback loop of our own making, where each new action we take keeps us locked into situations with no good options.
We hope that as readers make their way through this Collection, they can get a sense of the nonlinear nature of markets, and an appreciation of the importance of thinking through the lens of complexity rather than simplicity.
The global chip shortage has been rolling on for months now, with no end in sight. While a lot of it can, and has, been attributed to Covid disrupting global supply chains, there is more to it. Using the butterfly effect as a metaphor, Covid is merely the butterfly flapping its wings.
Of course, this makes the chip shortage the tornado, or at least, the most visible tornado right now. “Now”, because the chip shortage is brewing different kinds of trouble. Firstly, it has, and still is, causing massive production headaches in the auto sector. Carmakers simply have no visibility on how much they can produce, and when production can return to pre-shortage levels.
This in turn is leading to plant closures and layoffs, which is obviously bad news. The last thing any economy needs as the world tries to emerge from Covid’s economic shadow is even more layoffs.
There is also the spectre of higher inflation looming over the economy because of the chip shortage. This will happen when manufacturers who use these chips in their products get to the point where they can no longer tolerate the higher prices and start to pass it on to consumers. It would be yet another supply squeeze (oil, shipping, copper) jacking up prices for already beleaguered consumers.
But how did things cascade to such an extent?
Using the Iceberg model, we know that Covid is the event. It is after all the most visible cause of all of this, and hence our metaphorical butterfly. As for patterns of behavior in the system, the trend has been towards Just In Time (JIT) manufacturing for automakers (and lots of other industries).
As such, the system has restructured itself over the years to become as efficient as possible. In normal times, it can churn out new vehicles to meet demand with minimal waste, reducing the need for manufacturers to hold cars as inventory awaiting sale. Needless to say, this saves the automakers a lot of money, and the overall efficiency of it tells us what the system’s paradigm is – greater profitability.
Unfortunately, JIT comes at the cost of making the entire production process extremely fragile, as delays in any part of the process can lead to massive disruption. Our Covid butterfly illustrates this point perfectly.
As workers all over the world got locked down, chip makers suddenly found themselves having to meet a wave of demand for all the technological hardware that the new working from home reality required. This includes computers, laptops, monitors, TVs, etc, that consumers were buying in response to being stuck at home.
This in turn reduced the amount of chips that foundries could sell to automakers, creating our shortage. At this point, the entire system is destabilized and very susceptible to negative feedback loops. For instance, if consumer demand for autos holds up at current levels, or spikes even higher as more countries get closer to fully reopening, then automakers will have to order even more chips.
Foundries are obviously not in a position to meet this demand anytime soon, which creates the potential for a real spike in prices as everyone scrambles for chips. Inflation (not the good kind), will result, and as we are already observing, auto-worker layoffs.
As you can see, while Covid was the spark, it was lit in an environment completely unprepared for, and hence extremely vulnerable to the slightest disruption. Who knows how many more negative consequences will cascade from this, or even when this tornado of a global chip shortage will end?
Do low rates lead to higher stock prices?
Or is this a case of correlation ≠ causation?
A common argument used to explain the link between low rates and roaring equities is that low interest rates mean higher present values, and therefore higher equity values.
What does this mean, and more importantly, is it valid?
What proponents of this argument are referring to is the Discounted Cash Flow (DCF) method.
DCF is a method of creating a model of a company’s financial standing by first forecasting its financial performance and cash flows up to some point in the future.
For example, an analyst could forecast up to 10 years worth of future cash flows to get some idea of how the company’s financial statements could look like in a decade’s time based on what is forecast.
This is the “CF” part.
After this is done, a terminal value needs to be determined.
Terminal value being a suitably dramatic name for the business’s cash flows beyond the previously forecasted time period (10 years in the above example). It assumes that a business will continue to generate cash flows at a fixed growth rate in perpetuity.
It is important to note that the terminal value makes up the bulk of the forecasted cash flows’ present value, simply because it stretches into perpetuity. This in turn makes the final equity value very sensitive to changes in interest rates.
Which is when the “D” part comes in.
In order to get an estimate of the company’s equity value today, the sum of future projected cashflows has to be discounted to the present.
As such, interest rates* matter in DCF models because of the “D” part. The lower interest rates are, the less future cash flows and the terminal value will be discounted by.
This necessarily means a higher present value, and hence a higher forecasted total equity value and share price. Which is what folks are referring to when they say that lower interest rates lead to higher equity prices.
It is important to note that this argument is based on a very broad assumption: that a lot of market participants, at least enough to heavily influence prices, are making the decision to buy stocks based on DCF models.
However, this just isn’t true, not least because of the limitations inherent in DCF modeling.
Firstly, based on our brief overview of how DCF models are constructed, it should be clear just how subjective the whole process is.
Every analyst will have different forecasts for future cash flows, growth rates, and terminal values. Hence, each DCF model will project different equity values for the same company.
Moreover, the DCF makes some big assumptions, not least of which are those used in the terminal value calculation.
How realistic is it to assume that a business’s cash flows will grow at a fixed growth rate forever?
Because of these factors, the final equity price that DCF models forecast really is good only for “reference”.
Given how quickly financial conditions, narratives, and the global economic environment can change, most market participants do not have the luxury of relying too heavily on DCF model forecasts.
That is, however, not to say that DCF models are useless. Their true value lies in the thought process that analysts have to go through while working out their forecasts.
This rigor helps them really understand the company’s business model from a micro level, but not a macro, systems wide view of interdependent variables that together affect the company’s stock price.
Ultimately, the people who buy into the low rates = high equities narrative fall into the trap of reductive thinking, attributing outcomes to a simple, single cause.
As a result, they neglect to consider the overall complexity of markets, as well as the power of human emotion and herd behavior.
*If you are interested in learning more on how interest rates affect the discounting process in DCF models, look up “Weighted Average Cost of Capital (WACC)”
The head of the IMF has publicly raised concerns about higher interest rates causing financial conditions to tighten, raising the probability of an emerging market debt crisis.
Her thinking here is decidedly mainstream: high interest rates stifle economic growth by increasing borrowing costs, pulling capital away from emerging markets (EM).
It really isn’t so simple.
Firstly, we must figure out what high interest rates are relative to.
If high interest rates are relative to rapid economic growth, in that an economy is firing on all cylinders, with rising levels of aggregate demand and the good kind of inflation, then there really isn’t that much to worry about.
High interest rates in this scenario are only “high” because they are viewed relative to what they were at some point in the past. This is simply the human anchoring bias at work, and low rates in the past offer little insight into what high rates in the future might or might not mean.
As stated above, the level of current economic growth (and related confidence) is what matters to current levels of interest rates.
Also, high interest rates are not destructive in a growing economy because they are a sign of business confidence. A natural consequence of this is that interest rates are high when growth is high, and low when growth is low.
Obviously, the mainstream perceives interest rates differently because their paradigm is central bank-centric. This causes them to view low rates as evidence of a higher money supply, and thus higher future economic growth, because of central bank action.
Unfortunately, this way of thinking of low interest rates is a fallacy, as observed by Milton Friedman.
A simple way to see why this is so is to consider it from a borrower’s perspective . A business will borrow if they believe that they can earn returns in excess of the interest rate they are paying. Hence, high rates illustrate that borrowers are somewhat confident of higher future returns.
As such, high rates on their own are not indicative of borrowers’ being less able to service their debts.
Also, higher rates are not necessarily indicative of tighter financial conditions. If confidence is high enough to spark more borrowing, this will lead banks to charge more for loans, i.e. raise the interest rates that they charge.
In turn, this means that the banking system is making more loans, and more loans means an increasing money supply!
If access to credit is somewhat equal, then financial conditions really are not tight at all. If access to credit is not equal, then financial conditions will be tight for some, but not others. In this scenario, the lucky ones with access to capital will survive, while the unlucky ones will struggle to meet their interest payments.
The real problem comes when high interest rates are relative to stagnant or low economic growth. This is because economic conditions simply do not allow debtors to make enough money to service their debts at these higher rates.
How would such a situation arise?
Since growth is low or nonexistent, we know that rates are not high because of business confidence and expectations of higher future returns. Instead, there must be some other reason, for instance, a collapse in confidence in the country’s government and/or economic prospects.
As the word “collapse” implies, such a scenario is one where everyone runs for the exit at the same time.
Which begs the question, how would such a collapse come about?
To be continued…
How would an emerging market collapse come about?
Again using the mainstream narrative/paradigm as a starting point, such a collapse comes about from capital outflows. This is just a fancy way of saying that money will move out of one country and into another.
Common reasons for such outflows include political upheaval in a country, more often that not combined with its creditworthiness going out the window – hence higher rates.
Sometimes political upheaval causes plummeting creditworthiness, and sometimes plummeting creditworthiness causes political upheaval. More often than not it is hard to tell which came first, but regardless of how it starts, it always ends with the general population suffering immense hardship.
Good historical examples of these include the Asian Financial Crisis in 1997, as well as the European debt crisis that began sometime in 2009.
Of course, capital outflows can and do occur without such chaos. This happens regularly as investors re-allocate capital across different international markets in order to get the best possible returns on their capital.
For instance, an investor who owns US Treasuries which yield 2% might sell those and buy emerging market bonds, which yield, say 4%.
It is very important to note that because US rates are perceived as the global risk free rate, it is difficult (but not impossible) to find fixed income instruments that yield less than the equivalent maturity UST.
Consequently, capital outflows for the purpose of earning higher returns almost always happens in one direction – out of USTs.
However, capital can still flow into the United States to invest in other kinds of assets. These include, but are definitely not limited to, traditional financial assets like bonds and equities, as well as more niche financial products like venture capital.
Such inflows tend to occur when the US economy is growing at rates that are relatively higher than other economies, causing investors with an international reach to reallocate their cash in favor of these opportunities.
This is the concern that the head of the IMF is raising, that a relatively stronger US economy would pull capital away from emerging markets. This could cause a spike in emerging market rates due to concerns over their creditworthiness, as economic growth remains stagnant, negatively affecting businesses’ and the government’s ability to service their debts.
Of course, this sequence of events is built upon the assumption-masquerading-as-belief that the Great Reflation of 2021 is real.
Real in this case meaning the furious rally in yields is indicative of an economic recovery that is broad based and robust. Which is what is needed to create rising levels of aggregate demand and, from there, the “good kind” of inflation.
This is, in turn, predicated on the unwavering belief in the efficacy of monetary and fiscal policy.
The Fed’s trillions in QE and support to the financial system, together with Biden’s trillions in stimulus to households, businesses, and potentially infrastructure, is supposed to turbocharge the US economy to new economic (and inflationary) heights.
But, what if none of these beliefs are as absolute as the mainstream narrative makes them out to be?
To be continued…
We already know that supply issues have played a large role in current upward price pressures, as opposed to only demand going gangbusters.
We also know that QE does not work as advertised, and that any inflation that results from Fed intervention is more likely than not to be the “bad kind”.
Fiscal stimulus can provide some reprieve and even a bit of a spark, but without growth in money supply (through actual money creation), it is unlikely to lead to any kind of robust and sustained recovery.
Does this mean that the head of the IMF’s concerns will not come to pass, and that there will be no capital outflows from emerging markets to the US, leading to an EM debt crisis?
Ironically, no. If policies continue down their current trajectory, that is “More QE!”, and “More and larger fiscal stimulus!”, capital will still flow to the US, and EM’s will still face a debt crisis.
How is this possible?
It is possible because EMs, and the rest of the world, are dependent on USD liquidity. Unfortunately for all of them, the only central bank that can issue USDs is the Fed.
While the Fed has past form with stepping directly to alleviate global USD shortages in 2008 and March 2020 (USD Swaps with foreign central banks), they tend to do so only in times of acute stress. That is, when the crisis is already upon everybody else.
The Fed won’t step in directly to provide USD liquidity in international markets before a crisis flares up (or at least, they have not done so before) for a handful of reasons.
Firstly, crises are almost impossible for them to predict firsthand, even when others can (‘08 and ‘20 are both examples of this).
Secondly, it isn’t in their mandate to provide USDs to anyone other than the US banking system.
Thirdly, the Fed either does not realize the importance of USDs globally, and/or completely fails to understand how the international USD market works.
As you can see, the third reason actually feeds directly into the first and second ones. The Fed simply does not see that it needs to pay attention to the global Eurodollar market, not just banks in America. Although, thankfully, this is beginning to change with their introduction of the standing FIMA facility.
Consequently, when USDs are hard to come by in the Eurodollar market due to collateral constraints and/or banks’ reduced appetite for risk, EMs do everything they can to secure the USDs they need.
This occurs in two phases; in the first, they scramble to sell as many of their current Treasury holdings as they can in order to meet their immediate USD liquidity needs.
Which is why at the beginning of most crises, UST yields tend to spike higher for a short period of time, baffling the media and mainstream commentators, before proceeding to do what everyone expects and tumble lower.
Tumbling yields mark the start of the second phase, where EM governments and institutions hoard whatever USTs they have left*.
This hoarding occurs as international Dollar funding/repo markets seize up, and financial institutions all over the world rush to get their hands on scarce USTs. All of which results in surging demand, lower yields, and even more collateral scarcity.
Both phases often occur concurrently with large spikes in USD exchange rates all over the world.
That is, the USD very rapidly strengthens in value relative to EM currencies, as banks and businesses scramble to obtain the Dollars they need from a global financial system that is no longer willing to provide them. The very definition of capital outflow.
Naturally, while the global financial system is scrambling for USDs, EM interest rates will have also skyrocketed as investors in EM fixed income sell their holdings to avoid further losses.
These higher rates will hinder their ability to service their debts, but the damage this causes will be far outweighed by that of the now much stronger USD.
*Remember that EMs need USDs at this point in time, and generally won’t be buying USTs because they are using their available Dollars to meet their financial system’s USD based liabilities
To be concluded…