"The flapping of the wings of a butterfly can be felt on the other side of the world."
Contagion Explained
Given the most recent COVID pandemic, many people are probably familiar with the phrase “contagion”. But if you’re not, contagion is, “the spread of disease from one person to another by close contact.”
But, contagion isn’t just a healthcare term, it’s also relevant in the financial industry. A “disease” in one part of the market or economy can often spread to infect other areas of the market or economy. Typically, when distress is serious enough in a segment of the market or economy, it can have rippling, nth order effects, that can negatively impact other market segments and the broader economy.
Here's how economic distress and potential contagion usually plays out in financial markets. Knowledgeable investors, sensing potential economic distress and contagion, begin selling assets to protect their portfolios. This initial selling pressure causes markets to decline and as the troubling news gets more broadly disseminated, more investors sell. At some point, depending on the severity and uncertainty surrounding the event, previously "this too shall past" investors switch say "uncle" and liquidate assets to rush to cash. A broad based rush to cash pushes correlations to 1. Overlayed throughout all of this is if prices fall enough, investors utilizing margin may receive margin calls, potentially forcing them to sell their positions, which further exacerbates the downward price spiral.
If the source of economic distress and contagion are serious enough, legislation is passed and monetary policies are enacted to restore confidence in markets and the economy. If the actions taken are sufficient to convince markets that everything is going to be okay, markets rebound and recover. If not, markets can continue to fall until further action is taken or the original source of distress works itself out.
Possible trouble in a segment of the economy is often easy to see but, what’s much more difficult to predict is potential contagion. The better one can predict the second, third, nth order effects, the better one can be sell early or create a playbook for navigating a market drawdown ahead of time.
Framework for Predicting Contagion/Nth Order Effects
If you can keep these economic principles in mind, often touted by Ray Dalio, then you can better predict nth order consequences and how contagion may spread:
One Person's Spending, Is Another Person's Income
One Person's Liability, Is Another Person's Assets
Where, assets represent future expected income, and liabilities represent future expected spending. So,
As incomes fall, so does spending (and vice versa).
Debt payments (principal on debt + interest) are a mandatory source of fixed or floating spending.
Credit risk increases as income and spending (ex-debt payments) falls or debt payments increase (from increasing debt levels are/or an increase in interest rates for floating rate borrowers).
Defaults cause the value of liabilities to fall, and therefore the value of debt held by debtholders to fall (an asset).
As the value of assets fall, so does the expected future discounted income, which causes asset prices to fall. When value/price of an asset deviates materially, inefficiencies exist.
Reduced future income expectations not only reduces future spending, it often leads to cuts in current spending as well (as previously expected future income is no longer available and additional saving is necessary)
A further reduction in spending/income leads to a further reduction in income/spending, both current and future, increasing credit risk and subsequent defaults.
The U.S. economy, by nature of it's banking system and it's currency, is highly levered and is dependent on future lending and spending.
And on and on we go, with the kicker of loans backed by collateral with price movements (i.e., stocks, bonds, and real estate), further exacerbates issues.
Some final notes on debt:
Debt taken out for non-income generating purposes is always "financially speaking" unproductive debt. An example would be carrying a credit card balance to fund consumption, like buying a bigger T.V. or a nicer laptop. I put "financially speaking" in quotes, because if you have to take out debt to say, make rent, buy groceries, and cover other truly non-discretionary spending, it's hard to argue that's unproductive in the broader context.
Debt taken out purely on the expectation of further price appreciation, and not on the underlying income the asset is expected to generate, leads to bubbles and eventual ruin, especially for those with no risk management or position sizing expertise. Examples would be using margin to buy non-profitable tech stocks in the early 2000s, the same in 2021 (along with other "meme stocks") and levering non-income generating properties in mid 2000s.
So with a framework in mind, let's get to what I'm seeing in the market today.
Current Trends and Concerns
So, the following are some of the troubling issues I see in today’s markets and economy that could lead to a shift in market sentiment or a recession. Of course, some could trigger a full-blown recession and panic by themselves while others more create drags on markets and the economy that make it more fragile. Of course, this isn't an exhaustive list (I'm sure I missed a few), so feel free to leave me your thoughts and ideas.
When looking over these a common theme will tie many of them together; the breakneck speed that the Federal Reserve raised short-term rates with long-term rates rising alongside them. There is no doubt in my mind that this must cause economic distress that markets are currently underestimating.
So let's get into why I'm currently whistling in the dark.
Fixed Income Market/Monetary Policy
The Fed Doesn’t Achieve “Soft Landing”, Trigging Recession
The Fed Unraveling Its Massive Balance Sheet
Longer-Term Interest Rates Adjust to Higher Inflation Expectations, Real Rates, or Both
Interest Rates Fall, Pent Up Demand Unleashes, and Inflation/Interest Rates Rise Again
Credit Spreads Rising, Increasing Debt Financing
Current Low Credit Spreads Suggest Complacency
Stock Markets
Stocks Near All-Time Highs with Elevated Valuation Levels
High Flying A.I. Stocks Disappointing on Growth Expectations
Higher Interest Rates (And Credit Spreads) Creep into Cost of Capital/Discount Rate Assumptions
Current Low VIX Levels Suggest Complacency
Private Markets
Everything About the Private Credit Boom (Opacity + Illiquidity + Little Oversight + Hot Asset Class + Financial Incentives = No Brainer for Trouble)
Private Equity/Commercial Real Estate “Extend and Pretend” Crowd
Private Equity/Commercial Real Estate Managers Who Bought High (2020-2021)
Interest Rate Caps Coming Due
Consumer Finances
Inflation, Inflation, Inflation
Slowing Job Market, Incomes, and Spending, with Unemployment Creeping Up
Housing Affordability and Homeowner’s “Golden Handcuffs” Begin Materially Impacting Home Values
Households with Floating Rate Debt (e.g., Outstanding Credit Cards Balances, Adjustable-Rate Mortgages, etc.)
Increasing Consumer Defaults (Credit Card and Auto-Loans Already Shooting Up)
The Government Gets Serious About Student Loan Default Collections
Business Finances
Layoffs, Closures, and Bankruptcies
Heavily Levered Businesses, Particularly Floating Rate Borrowers
Financial Services Businesses That Borrow Short and Lend Long
Current Lending is Slowing
Fiscal Policy
Continued Fiscal Irresponsibility Leads to Higher U.S. Credit Risk
An Increase in Individual and Corporate Tax Rates (TJCA Expiring in 2025)
An Increase in Protectionist Economic Policies, Particularly Against China
Underfunded Entitlement Programs
Current Account Deficit Starts Impacting U.S. Foreign Exchange Rates
Global Concerns
Increasing Political Divide and Wealth Gaps Lead to Extremist Behavior
Unknown Impact of A.I.
Underfunded Pensions
Commodity Spikes, Particularly Oil
Terrorist Attacks
Climate Change Impacts
Pandemics
The Big Bad
China Invades Taiwan
Game Over
The US Dollar Loses Credibility and its Status as The Primary Reverse Currency
Nuclear Warfare
A.I. Becomes Sentient (or so I'm led to believe)
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