Alpine Macro has an interesting article on risk. They provide two extremes, melt up and melt down.
Melt Up or Melt Down?
Please consider some snips from Fat Tails.
Everyone on Wall Street is freaking out over the 2/10-year yield curve inversion, with recession being the most feared outcome. I am fully aware of the fact that the expression of “consensus view” is often biased and very influenced by a subjective assessment of the outlook. But it seems clear that the risk perception of the investment world has migrated to the darker side.
With more investors believing that a recession could be just around the corner, there could be only two extreme cases — things turn out to be either a lot better than feared or much worse than what is currently discounted. Which is it?
I had a conversation recently with a very shrewd and smart investor whom I have known for nearly 30 years. Let’s call him Joe. Joe is seriously concerned that things could turn out to be much worse than most anticipate. His bearish case starts with Trump being highly unpredictable, and no one seems to know his game plan for his trade war with China. This is very bad for the economy in general and harmful for business investment in particular.
Besides, Joe is worried that the trade war could easily degenerate into a full-scale Sino-U.S. confrontation that leads to military skirmishes in the South China Sea, an invasion of Taiwan by the PLA and China cracking down on Hong Kong demonstrations, all of which could lead to economic sanctions, trade embargos or financial blockage. These aredepression shocks that can inflict huge financial losses.
Besides, even if Trump is defeated by any of the leading Democrat candidates today, Joe thinks that the U.S. stock market would get destroyed, along with the dollar. In his view, all Democrat presidential hopefuls are racing to the left and their policy agendas are best described as extremist. As a result, Joe has completely shunned risk assets, but he does not like bonds either. To him, European bonds are rip-offs and long-dated U.S. Treasurys are too expensive, offering no investment value.
“Where do you put your money?” I asked. “Gold. Period.” replied Joe.
The Other Tail
I understand Joe’s concerns and don’t think he is irrational. China-U.S. relations are obviously front and center of the stock market fluctuations, and policy in both Beijing and Washington has been hijacked by hawks. Nevertheless, I think Joe is too pessimistic and that we should not ignore the other side of the tail risk: that things could turn out much better than what is feared.
Both Trump and Xi are not only rational, but highly calculating. With U.S. elections fast approaching, Trump’s pain threshold has been lowered. He will do whatever it takes to get re-elected, and this means that he will have to tread very carefully not to push the stock market over the edge.
Xi is dealing with a slowing economy and, of course, he hopes to stabilize trade relations with the U.S. China’s decision to not go for tit-for-tat retaliation on Trump’s latest set of tariffs is a smart move, allowing Trump to “save face” and could pave the way for some sort of a deal. In other words, Trump’s outburst over China’s retaliation two weeks ago might have been the peak of the trade tensions leading to the U.S. presidential elections.
Besides, neither Xi nor Trump want to have a “hot war”, as both know the impact of any shooting war between the two countries would be devastating for the world. Besides, it is extremely unlikely that Beijing will send troops into Hong Kong to squash the protests.
Why Any Fat Tail?
I think that was an excellent discussion but why does there have to be any fat tail?
Yes, consumers are still holding up and yes there is a heck of a lot of recession talk, me included. But that does not imply an extreme move.
I side with those who do not expect a crash. By crash I mean a 25% decline in a calendar year or short stretch in adjoining years.
But I also side with those who find investing at these lofty heights a bad idea.
Most Frustrating Move
The most frustrating and damaging move would be a very long, very slow decline coupled with fake breakdowns and fake breakouts. Why not -15%, +5%, -10%, +3%, -15%, +8%, -18% etc etc and at the end of it all stocks are down 50%or more over 7-10 years.
The bulls and bears would get chewed up.
I do not think a “crash” is likely simply because credit conditions are not the same as in 2008 and 2009.
On the other hand, valuations are stretched as much as 2007, 2000, and 1929.
Admittedly, this is the scenario I felt likely for several years and it has not played out that way, yet. Perhaps it never does.
My point now is think about something besides an either this or that setup.
I still favor a brutal neither but I do side with “Joe” on gold.