Risk Trends: The Neurotic’s Checklist
Event risk in 2023 gives room to handcraft long-tailed risk factors that can maim the markets. Such odds are very low.
I put together a Neurotic’s Checklist for major risk buckets for those who want to assume the worst can play out.
The list has a lucky 13 items, so pick your poison for those you think are relevant.
They are all quite real but harmful if consumed in excess.
In prior lives, I would write commentaries on industries using the title “Bulls, Bears, and Betweeners” as starting points for debate on valuation. The idea was to offer my view of what those different opinion groups might be using to frame where risks were headed and how that stacked up against valuation. In such cases, it is also important to not play any “straw man” games to stack the deck and bias the rationales. Instead, the goal is to try to frame rational and well-reasoned views since investors take views for a reason. Those are for separate commentaries. The attached version of the list is more extreme.
The differences in conclusions across Bulls and Bears would usually be stark. I will do the Bear, Bull, and Betweener checklist for the current markets in separate notes, but I thought I would first lead with a new one – the Neurotic’s Checklist. The others will be shorter since Neurotics worry about more things. Neurotics run the gamut from those worrying about risky long positions to those wholly in cash and storing canned food in the basement with the extra ammo.
Bring on the Neurotics Checklist…
Given how wide the range of potential outcomes can be viewed for certain risk variables (inflation, Fed actions, geopolitics, trade risks, etc.), I thought it might be useful to break the main topics out (see list below). The list could certainly be longer, but it is a start. Some of these risk categories are very hard to quantify these days, but an extreme view on any one variable can tip the scale in overall risk aversion or “sector avoidance.” It is also a fair statement that any one major variable can spill over into others. The most sweeping broad category that is the biggest challenge to quantify is geopolitics. Oil cartel behavior and trade clashes at least have a history. Taiwan and Ukraine are in a category of their own.
Please note I do not list the risk topics in order of relative importance. After all, a true neurotic can craft a worst-case scenario where any single category can set off a spiraling multiplier effect. To be clear, this list is not my view on the markets. It is just an exercise in framing what can scare investors, lenders or employers in times of great uncertainty.
Geopolitics (global trade, national security) and dysfunctional politics (i.e., Washington) are the most amorphous and unpredictable since logic often does not apply in the search for power. In the halls of Congress, the spinal tap often comes up bone dry and I would guess many investors do not expect that to change. The appetites of dictators (or wannabe autocrats) or smaller scale power junkies runs the gamut from Manifest Destiny to the March of Folly to the Three Stooges. Name calling is a recreation, but the reality is that decisions must be made, votes taken, and policy and budgets implemented.
Among more threatening items, the debt ceiling will see a lot of coverage this week, but that looms as a bigger issue for next year when items like Medicare and Social Security show up in the debate. This list is just food for thought on how fixating on what can go wrong can trigger risk aversion if some of these items move to the front burner in 2023 and the heat gets turned up.
THE NEUROTIC'S CHECKLIST
Below we break out the 13 categories in underscored bold fonts. Feel free to scan for any of interest. The nasty political one comes last.
Inflation Drivers Will Feed Wage Price Spiral
The true neurotic just needs to look back at the failure to successfully address inflation in 1973-1975. That failure eventually devolved into the brutal double-dip recession of 1980-1982 after Volcker showed up in Aug 1979 and declared war on inflation. The view now might be “been here, seen this one” (or looked it up in the Fed histories). A failure by the Fed to get it done in early 2023 could generate much more aggressive moves. The 1970s history is that “partial” measures fail.
Volcker is still seen as the Zeus of tightening bolts, and the current challenge may call for a new Zeus-style move soon if the core CPI numbers get stubborn and wages stay in the 5% area YoY. Volcker kept the tightening pressure on with fed funds at average levels well above inflation. Under Volcker, the fed funds floated and the primary vehicle was growth in monetary aggregates, but the fed funds line was generally well ahead of CPI and PCE inflation (see Fed Funds – CPI: Reversion Time? ).
Without that sense of mission on beating inflation, workers will keep demanding higher wages and companies will keep using pricing power. That is what a worker will do and what a company will do. It is their duty to their shareholders or to a household’s financial wellbeing. For now, employment measures are not showing signs that wages will suddenly stall or that labor is losing pricing power (see Jobs Conundrum: Good is Bad, Bad is Good, Jobs and the Fed: JOLTS Gets Heavy Powell Focus).
The consumer sector has shown a willingness to draw down personal savings (low saving rate trends) while also being happy to “buy now, pay later” as they delay big ticket purchases like homes with mortgages so high. They have other places to spend some of that money they had been saving. The strong consumption numbers show demand profiles that will cause workers to keep looking for higher wages so they can keep pace with their own spending (or close the dissaving gap).
With job openings at such lofty levels, there is only one cure to the wage trend – make the openings go away. The market also has seen low layoffs and high quit rates. That means the Fed will look for more layoffs (just not with their outside voice). Wages are harder for the Fed to derail. Even overt government wage-price controls in the 1970s just delayed the inevitable. The 1980-1982 double dip cured it. That is what the Fed now will be looking to avoid.
Oil and Gas Volatility
Oil and gas markets still face a brutal price spike ahead in 2023: The neurotic view is that the Russian situation is doomed to get worse for oil, and the impact of the price caps will backfire with Russia willing to take aggressive action to punish the West as winter weather rolls in and peak demand for gas approaches. The Neurotics can get plenty of pushback from the idea of recession effects on oil demand (lower), but the counter is that China is easing lockdowns (higher demand) and the US economy could avoid recession (steady demand). Bulls and Bears on oil always can counter the magic word “Cartel” (OPEC supply management) to justify their positive or negative views. The Saudis have surprised the market before and always could again. If demand weakens, supply will tighten. Roll your own subjective supply-demand outcome.
The Neurotic says the US is still lagging in E&P investment on growing production back to record levels even though oil production just hit the highest since March 2020 this fall (source EIA). Record natural gas production in the US and the fact that the US is still holding down the position as the #1 oil producer certainly offers room to push back on price gouging accusations. The Neurotic points out that the policy design is unfriendly to expanded production and antagonistic to the industry (hard to argue with that). The fear is that the oil companies will punish the administration for that strategy. Those discussions tend to be about politics and not economics, opinions more than facts. Winter will be the season of energy reckoning for Europe, however, and winter is officially here in days.
The Neurotic also sees Iran as a ticking bomb (perhaps with a major underground explosion at the end of it). Nerves are not helped by the increasing role of Iran with Russia in its Ukraine war. Nukes deployment by Iran could (would?) lead to bombing of facilities, and then we see fresh rounds of retaliation. More tension out of Iran will give some investors a fresh case of “Strait of Hormuz syndrome” that drives fears of a massive disruption of oil supply and LNG.
The senses have been dulled since the early 1990s on Mideast conflict (in the old days, harsh language would send oil higher), but Iran is one of those tail risk events that stands apart from the usual Middle East tension. The Iran threat to oil/LNG transport may come to a head in 2023 with US-Saudi relationship eroding and the Iranian nuclear evolution getting too close to the real thing. Iran and the Saudis are enemies, but many suspect one of those parties (the Saudis) would not mind more inflation being caused in the US ahead of the 2024 elections. Iran would rather the US Congress fight over China.
Geopolitics - China
The Taiwan issue is arguably a bigger geopolitical threat than Russia to the US since Russia is not going to war with the US over supplying Ukraine. Of course, Putin is always trying to capture the title as biggest threat for ego purposes. Apart from the most extreme scenarios of Putin completely losing his mind, China is the main event.
China sees Taiwan interference quite differently than the current US political leadership (White House and Congress) given a history we don’t have the space to detail here. You don’t have to rush for an old copy of Red Star over China, but the history is a deep and troubled one that assures hostility and enmity at worst and permanent distrust at best. The history is at the very least convoluted. Most now know that FDRs maternal grandfather on the Delano side made his fortune in China dealing opium, and he did it more than once after losing fortunes along the way in US market panics. The history gets stranger from there.
The history of the China Lobby and Henry Luce is a major chapter in the US-China history as is Nixon, who shifted from his redbaiting and dalliance with McCarthy to being the man who could open China relations after warming it up with the famous Ping Pong Diplomacy (as depicted in Forrest Gump). The fact that Carter later embraced recognizing China on the UN Security Council was controversial in 1979, but most major powers in Europe had already viewed the People’s Republic as the one China, first recognizing the PRC and later establishing diplomatic ties (and not recognizing Taiwan). Even if the contortions of the One China Policy made for ambiguity, recognizing one of the most populated countries and a major nuclear power was not exactly fighting the tape. The trick is navigating the ambiguities without threats and escalation.
The Korean War (1950-1953) offers a different kind of reminder (my father served there in the Marines) that China is not inclined to back down from a fight. The Korean War is memorable for a ruthless North Korea surprise attack on the South but also for Douglas MacArthur knowing there was no way that China would get involved in Korea (not a good market call from his palace in Tokyo). China now has quite a Navy to execute on blockades (contrasts with the “million-man swim” derision of earlier decades on this topic). They also have too many pilots that think they are filming Top Gun China Style. That creates risk. The national security and geopolitical rags I look at have a field day with analysis of such risks in today’s world. Meanwhile, both US political parties have entered a “I talk tougher than you” game on the topic of China. That will spill over into trade policy (tariff and trade wars), which gets its own listing on the Neurotic’s list.
The bottom-line reality is that China would go to war over Taiwan and could use supplier chain sanctions as a tool as well. The Russia-Ukraine war just made that an established tool of sanction policy. Supply shocks from critical China-based supplier operations would be very effective and a blockade of Taiwan would not necessarily require firing a shot. It would also be brutal on the China economy (now map that onto commodity prices). This is usually the time when the words “unintended consequences” come into play and Allison’s Essence of Decision gets the dust blown off the cover.
China Trade
China is now the second largest supplier to the US (EU #1). China gets focus on supplier chain risk scenarios since so much of the import share is supplier chains in the classic sense in contrast to the EU (heavy on Pharma/Medicines, Automotive, Aerospace, Equipment). The EU also has major investments in the US (Autos, Trucks, Steel, Chemicals, etc.) that it supplies (notably components), so that US-EU trade deficit has some asterisk supporting US job creation. China used to be the #1 importer, but it fell to second after the 2018-2019 tariff battles dropped it to second behind the EU, who now ranks #1 in both imports and exports in 2022. The twist on China trade is the direct relevance to inflation as a low-cost supplier of such a wide range of products from the higher end (computers and electronics) to the low end. Slap tariffs on China and it is either inflationary when passed on or dilutive to earnings when costs rise.
Even in the absence of Taiwan escalation, trade relations with China are in the tank. The ongoing battles within the WTO framework show constant China-US trade spats. Those are usually behind-the-scenes technocratic “fine print” spats, but bureaucratic battles could get triggered into a broader clash that destroys the WTO. Some recommendations from Congress and special outside advisors paint a bleak picture ahead. One commission established by Congress back in 2000 recommended Congress consider revoking Permanent Normal Trade Relations status. That would most assuredly lead to more clashes and supplier chain issues. That would lead to inflation (supply shortages or price pass-throughs) or cause weaker margins in the absence of pricing power.
The strategy of trying to hammer China with tariffs was always going to be a lot less successful than hoped and would inspire retaliation that would need to be offset in part by government relief payments (specifically to the ag sector). The costs were often downplayed with misleading statements from US leadership including, “We are collecting billions from China in tariffs.” That was explicitly and factually false since the buyer pays. It still gets repeated by a dwindling few. They were collecting zero in tariffs from China. Buyer pays.
The tariff structure means expense pressure for companies or a need to exercise pricing power in whole or in part. Such tariff measures are intrinsically inflationary. The exercise of trying to make buyers change their sourcing practices (onshoring, reshoring, and the newer “friendshoring”) will necessarily take years for many product groups. A tariff “shock and awe” approach would not cause much awe on the China side and bring retaliation along with some justifiable cases to bring to the WTO (even if the appellate process at the WTO has been crippled in recent years with minimal resolution). That tariff strategy has now been tested. It made a statement but the 2% handle GDP growth did not show a massive trend of reshoring (there was some).
Trade strategy will get mired in politics, but tariffs and protectionism are here to stay. The Chamber of Commerce and many trade groups are against tariffs. Pro-union protectionists (e.g., Bernie Sander et. al) hate free trade deals and race to the bottom on wages. America First is about tariffs as we have already seen. That is a rough backdrop in inflation fighting. Retaliation will be inevitable and even immediate with the ag sector at the top of the list, but the targets for US exports from the China side could do damage. Boeing would surely feel even more pain relative to Airbus, but for now China needs the planes for their own growth domestically and internationally. Analyzing the export mix of exposures in China across markets is much smaller than the import depth and breadth. Major categories of trade include aircraft, cell phones, automotive, capital goods, and food/agriculture.
The bottom line for neurotic fear is an escalation could bring a shutting down of supplier chains that would make the COVID supplier chain stress look like an economic paper cut. Shutting down supplier chains and blocking purchasing practices has already been tested and utilized by the US and EU with Russia. Sanctions are the new arms race and could spread to the China supplier chains with selective shutdowns or broad-based sanction attacks and removing logistics alternatives. From autos to pharma, that would be a shock too far.
Geopolitics - Russia
The Russian situations seems so much more straightforward than China to a run-of-the-mill neurotic. While a monomaniacal dictator who may (or may not) have health problems who invokes nuke imagery is never a good thing in the equation, the fact is that there is no end in sight in Ukraine. The invasion of Ukraine is failing badly and only assures it will keep going on unless someone gets Putin an offramp or Russian elements take action to change leadership (hard to do in a dictatorship).
The largest land war in Europe since 1945 will see energy prices remain painful for the EU with their natural gas dependence even if oil can find a Plan B in time. LNG operations take years to get to the full capacity to meet the needs of Europe. The US is not helping the case with the anti-pipeline mantra. The OPEC cartel gets to enjoy the flexibility in managing oil prices since someone else is to blame for high prices. The worst of worries for the Neurotic is that the Russia situation pulls in Belarus, and then there is escalation all around. The Turkey and Hungary problem with their pace on NATO on Finland/Sweden membership creates some alarming scenarios for the EU since all objective parties agree that Sweden and Finland would be useful, additive, and reliable partners. The EU is always noisy. Now it is also much more precarious since economic stress ahead is assured.
The longer the war goes on, the more pressure there will be on the tenuous EU unity. The split-control Washington could lead to battles on Ukraine funding given more than a few Putin-friendly folks in Congress and on the political media circuit. Under the Constitution, the GOP is now in charge of the purse strings with control of the House since that is where budgets start before it goes to the Senate and White House. Ukraine may turn into a budget battle that would turn ugly quickly. Reconciling legislation between the Senate and House will not be easy in 2023.
In the meantime, oil prices will remain dislocated and subject to material swings with OPEC+ married to Russia. The volatility of oil does not contrast with the commodity markets seen across most of my career since the early 1980s. Oil seems to do exactly the same thing but for different reasons. From the Iran crisis of 1979 to the recent turmoil, oil volatility is not a new risk. The early 1980s saw OPEC supply aggression set against massive new sources of supply that drove a crash in 1986. The Iran-Iraq war resolution drove a fresh crash only a few years later.
Big swings in oil are hardly new. What is new is that the US is the #1 oil producer just ahead of Russia and the Saudis in 2022. The US being by far the #1 liquids producer (Oil + NGLs) is also new. Another new twist is that the US is likely to remain among the Top 3 LNG exporters in the world with Australia and Qatar. That is an advantage that runs into a lot of political crosscurrents in the climate debate. This debate will heat up with a new House lineup.
US-EU Trade Policy Tension
US-EU trade policy gets dirtied up on clean energy: The EU is the #1 trade partner of the US and ranks #1 in both goods exports and goods imports. There is no comprehensive free trade agreement between the US and the EU, the Eurozone, or any major auto producing nations in Europe, so the recent US actions on EV tax credits is a problem between the EU and US and even could be a WTO violation (sure looks like one). The EU will only negotiate as a trading block, and that reality derailed the Trump team “bilateral only” strategy. The EU-US trade chasm that may be unfolding in the auto sector is bringing some policy difference into stark clarity.
The application of the Inflation Reduction Act around EV guidelines for tax credits is a problem with Japan and Korea at this point, who are also caught up in the dynamics of the US-China geopolitical rivalry. The EV wave is the biggest change in the auto industry since Karl Benz got the wheels turning (apologies to Henry Ford…but he improved the assembly line practices). Subsidies will be a touchy subject generally, but China is trying to position itself as an EV supplier chain hub. Add in an America First angle in the 2024 election year and there is much at stake. Then add in the next piece of the puzzle of where many of the German, Japanese, and Korean transplants are located (primarily Red States in the US) and there will be a lot of politics. If those nations want a level playing field, they will need to make EVs and batteries (and increasingly supply them) in the US. That is based on the IRA and Biden driven legislation.
The scramble to capture the EV supplier chain has the US well behind China right now, but a combination of investment and industrial policy and now legislation is looking to change that position to the US being at the top. The fact that it is good politics cinched the priority of that approach as also underscored by the very slow moves to pull back tariffs put in place by Trump. The Inflation Reduction Act is at its core protectionist based on the various assembly plant locations and local content requirements. The protectionism extends to non-EV investments also.
At some point, the market will simply realize protectionism is here to stay in the US to drive regional jobs growth and contest China. The problem is that provisions such as those in the IRA will alienate and infuriate our #1 trade partner in the EU as Macron made clear on 60 Minutes a week ago. The topic is now being bandied about in the trade bodies. Escalation could lead to more trade battles, more tariffs and protectionist retaliation from the EU. More immediately, it could lead to some setbacks in EU unity in the costs of funding the Ukrainian war effort. We saw more setbacks on WTO policy decisions to end last week on the “legality” of US tariffs under such provisions as Section 232 on the basis of national security. I will cover that recent WTO action separately.
While it is a topic for another day, tariff battles in theory drove investment retrenchment in 2019 that flowed into weaker GDP numbers. Weaker capex in the US was setting the stage for cyclical weakness (and the 2019 UST curve inversion). With so much investment already in place by Germany, Japan, and Korea in the US and USMCA/NAFTA countries, the gamble is on who would “rather fight than switch” in terms of battery capacity and US-based content. The Neurotic says the EU will fight while the realist might say “they will switch and play the long game.” The US appears determined as a matter of trade policy to be an EV hub, and that protectionist approach might be a template even if the IRA was a partisan vote.
EU, Eurozone, and NATO Unity
EU and Eurozone cohesion breaks down: The market saw intra-EU breakdowns before back in 2010, peaking in late 2011, and petering out by July 2012 on the phrase “Whatever it takes?” The Brexit drama was a separate and less threatening action for the EU. The theories around the Eurozone system breaking up set off material volatility and bouts of risk off in 2010 and later 2011. A true Neurotic might see the next time being the one where dropout threats from the most leveraged and troubled sovereigns in the Eurozone actually come to pass since the state of the sovereign economies in 2023 could be much more challenging than in 2011.
Europe will face enormous stress and rising rates this winter, and the health of the banks will get gut-checked in counterparty risk and loan quality. The US economy cannot operate in isolation from those macro effects nor can the credit or equity markets. That means EU stress will cross the ocean and hit the US as well. Whether the North vs. South battle of Europe gets revisited is a worry. A few nations could break ranks on Russia and then face payback from other nations on fiscal policy requirements or political standards (e.g., Hungary). These risks need to be watched on multiple fronts including fights over NATO membership.
EM Sovereign Debt Stress
The global inflation, strong dollar, fear of global recession, and recurring famine panics have seen more commentators talking about waves of sovereign defaults. Bank regulators and regional Fed economists are writing up such risks as food for thought. The recurring histories of mismatches of local revenue and expenses vs. USD liabilities is not a new challenge. We had those in the Asia crisis in 1997-1998 and during the ensuing EM contagion panic in 1998 that saw Russia default and Central and Eastern Europe come under a cloud. Some of us were ringside for the near meltdown of Mexico in early 1995.
Contagion has become a word that has been devalued in recent years (sort of like the term “Lehman event”), and that is a bigger threat when the banks get infected. Those with considerable expertise in Emerging Market debt have been vocal on the topic this year. “Anything China” will be the main worry if the situation deteriorates.
Crypto Contagion, Crypto Counterparty Risk
There is a scramble by investors, industry players, regulators, and risk managers to get their arms around contagion risk and risk aversion in the crypto markets. The SEC last week proposed some disclosure requirements that require declarative sentences on the nature of any exposure whether in terms of direct exposure through the asset side (owned or loans against collateral, etc.). That SEC move might get the ball rolling ahead of year end reporting but there is no regulatory stick in it so far. Disclosure might get held up against the “materiality” requirement that most companies can drive a truck through, but at least the crypto crisis has caused the SEC to make some requests.
Crypto has fanatical supporters whether they be investors, entrepreneurs, or those in office who got their campaigns or political interests greased directly or indirectly. The world of crypto has always been easy to embrace for some and impossible for others. For those who see the evolution of that market as dependent on increased demand needing to run ahead of the pace of innovation and supply, then these are tough times for asset prices. Underdeveloped markets with a lack of actuarial history are always vulnerable, and that is not new. As of now, the regulators and industry cannot agree on whether crypto can be linked to a security in the legal sense. That does not bode well for the SEC approach.
Demand is backpedaling and “transparency demanded” is not “transparency delivered.” Weak disclosure, negligible reporting requirements, and a limited history can make for very good stories on the upside early in the game but can also lead to very bad results if too much goes wrong and too many parties get surprised. Risk aversion is usually the result. The TMT bubble, Subprime RMBS, and the structured credit fiascos (CPDOs, credit synthetics, etc.) are there to look back at. Most of those were in regulated industries with established reporting requirements. The crypto crisis brings another dimension.
The use of leverage and questions around who is on the other side of any OTC monetizing trades will get fleshed out in coming weeks, and the need to stabilize confidence in markets might pick up the energy of effort. More statements of “no exposure” from more major banks will help. No “material exposure” is a phrase that can lack substance since “material” is the world’s most abused term in financial services, especially when they frame it vs. total assets. The numbers on gross exposure on crypto collateral and related advances would be a nice wish list for disclosure (not happening).
After the losses on old fashioned total returns swaps on public equities in the Archegos meltdown, it is hard to have blind faith in controls when very rich individuals/funds are looking for ways to bolster their liquidity with leverage on their assets. Those assets are worth a lot less now. Those business lines in the mega wealth parts of global banks can get mysterious in risk controls. In closely held operations, the monetizing trades might just be about cash for the rich and beautiful. In other cases, the exposure might be about turbocharging a leveraged bet on crypto assets. The latter (leveraged on risk assets) tends to get more attention. The former (loans against assets for personal liquidity) can be quite large and never be transparent. We are operating in braille right now on crypto counterparty risk and the entities exposed.
Housing Bubble and a New Housing Sector Crisis
A housing sector crash will inflict widespread harm in 2023: The Neurotic wants to return to the housing bubble scenarios of the credit crisis era after such a period of high housing inflation. Sharp erosion of market clearing prices at higher mortgage rates have been driving recent vintage home sales into negative equity positions for many buyers. More of those trends along with recession fear could depress consumer sector confidence. The wealth effect will trump the reality of how much more valuable the home is relative to even just a few years. That is one theory.
For the Neurotic, the recent sequential trends in rates and theoretical home equity erosion will dictate consumer sentiment. While that ignores the fact so many homeowners refinanced at record low mortgage rates, no one likes to see their home have lower market values so quickly. The Bulls of course push back on that view of housing for a range of reasons, but the Neurotic is having none of it. The general effects of seeing home equity erode will drive a mood swing. The effects from a macro standpoint will be a shocking decline in homebuilding in the next peak period of 2023, and those declines will have multiplier effects on regional economies. That’s the more extreme theory on the cyclical downturn in housing. I don’t see it that way, but this is the Neurotic’s checklist after all.
Commercial Real Estate Risk
Commercial real estate will face its third crisis in 40 years: The Commercial Real Estate neuroses are coming back in a big way in 2022 for the first time since the credit crisis and accompanying CMBS implosion. Commercial real estate stress scenarios have been creeping into the picture starting with a harsh view on the pandemic era effects on the Office Property category. Big NYC REIT names such as SL Green and Vornado are down over 50% YTD, and the trade press is running ugly headlines on the broader commercial real estate space nationally.
Commercial real estate lending as a % GDP had broken from the trend line in the early 1970s, late 1980s and then again in the credit bubble boom for structured credit (2005-2007). This time around, the headlines are more concentrated in a few property categories, but the anxiety is spreading. Some headlines from trade rags (e.g., TheRealDeal and others) add more empirical evidence from the industry to the case of nerves (one eye grabber: “Analysis Predicts $500B value destruction”).
The idea in some major categories such as Offices is that the combination of COVID effects, the secondary and tertiary effects of higher rates, and recession risk will set off the spiral on a combination of demand for the asset class and tenant stress or lease restructurings. Some of the worry is cyclical with chatter about overbuilt Industrial properties and the usual worries about sustained pressure on Retail real estate. The theory that rising interest rates shortens the real estate cycle is fair enough, but the headlines around “Zombie Properties” and suspension of redemptions by Blackstone in its property fund gets the Neurotics extrapolating. Blackstone made a lot of money on some recent divestitures, but the focus is on the exits and worrying about valuation pressure and asset quality strains ahead.
Tech firms and new tech-centric growth startups that overbooked real estate needs are part of a feared wave of space reassessments that will keep bringing major retrenchment. Meta space cutbacks were in the news while financial sector cutbacks is showing up in some forecasts. Others argue B and C properties are the real source of vulnerabilities, but A properties are not immune. The main thrust is that credit will get pulled back and some market discovery in transactions will get investors worried on new valuation data points. The market will see more lender reserving headlines on real estate as risk managers ask the revenue side to slow down (i.e., credit contraction).
More news flow about how inflation is going to hurt some segments of real estate will keep piling up. The biggest risk might be that economic trends might hammer too many tenants at a time when properties also will have fewer buyers. Commercial real estate is a broad and well-staffed discipline, but Neurotics will be watching the headlines.
Manufacturing Cycle Downturn
Manufacturing will get hammered in 2023: Manufacturing has held up remarkably well so far and industrial production and capacity utilization statistics are not sending negative signals yet (see Capacity Utilization: Durables Still Steaming Along). Earnings have not given much room to get too panicky, but a recession outcome is a very different story with rates rising, capex budgets under review, and major trading partners (EU at #1) feeling pain now and likely to feel even more in the coming months. The current activity levels are going to start to fall prey to recession fears, but that has not been in the running numbers so far. With the 2023 outlook season upon us, prediction of weakness on balance is not a risky call. Some forecasts are already much gloomier than that.
Prediction on the direction of ISM data and PMIs have generated some very bearish commentaries lately. The ISM dipped into contraction mode below 50 for the first time since spring 2020, so the theory is that rebuilding of inventories easing supply chain headaches and rising working capital costs with higher rates all set the stage for a slowdown in manufacturing activity as 2023 rolls in. The potential for supply chain risks from US-China stress is a part of the correlation effects of other neuroses into one big bag of recession angst. The idea is that volume declines will take high fixed cost manufacturing operations into the red as they cross below break-evens.
From a risk standpoint, weaker manufacturing growth has some natural cash flow stabilizers in working capital liquidation, trimming capex, and lower operating costs for materials and components if supplier chains stay functional. Manufacturing has been strong in 2022 and hanging in, but this is the time when the risk symmetry points down.
Secular strengths in such markets as energy (clean or old-fashioned dirty E&P), auto EV transition investments, expansions linked to the Chips Act, infrastructure spending follow-through from supportive legislation, and the other parts of the Inflation Reduction Act that impact manufacturing are among variables to debate. The Neurotic says those will not be enough to offset the demand destruction from higher interest rates and an inevitable recession in the US and the coming months of pain in Europe. If the (unstated) cornerstone of Fed policy is reeling in demand and rolling back the consumer via fewer jobs to curb inflation, then manufacturing will need to be a victim. The questions as always revolve around unintended consequences.
A strong dollar is usually not a great thing for domestic manufacturers for obvious reasons in the export market. Diversifying the supplier chain offshore was a major strategy heavily embraced since the 1990s that was supposed to mitigate the risks on the currency side by making dollar costs of offshore supply chains somewhat of a natural currency hedge. The lower labor cost arb of moving offshore was not spoken of as freely given US labor sensitivity, but labor was clearly a major factor. The potential for more protectionism in the US ahead could unwind some of these long-term sourcing strategies. The same applies to deteriorating relations unsettling supply chains in the future.
Washington Dysfunction, Debt Ceiling Brinkmanship
Washington dysfunction is a fat tail threat on debt ceiling risk: Politics is always a touchy topic, and people get annoyed when you say the obvious sometimes. I grew up in a house the featured supporters of Nixon and Wallace and even McCarthy (1968 and 1972 primaries), so political weirdness is nostalgic for me. If you have a partisan view, you can usually find half the people in the debate will agree with you and the other half will be offended. That is, unless you torch everyone by the same standard. Then you offend everyone. Let’s go with the second option.
The adage that “as I get older my parents get smarter” is one that most people know. It is a derivative of a Mark Twain quote: "When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much he had learned in seven years." The Congress corollary is “As I get older, Congress gets dumber.” There is no qualifier. I could add “meaner, more dishonest, and more allergic to reading” but that isn’t punchy enough.
Pointing at a less than studious member of Congress also smacks of elitism by implying reading and research is critical to knowledge (that smacks of bicoastal elitism). My question: were Thomas Jefferson, Alexander Hamilton, the Adams family, or other Founding Father types elitist by daring to crack open a few books? Or Abe Lincoln reading by candlelight in his cabin? We are moving into a period of very complex economic challenges. At the very least, studying topics might help someone in elected office at least know what to ask the lobbyist and PAC check writer before caving. These problems apply both to the way-out left and the extremist right. The evidence indicates that policy is a partisan power play and not about the efficacy of well-researched, recommended actions. That is not an aphrodisiac for optimism.
The big worry around the views of the “risk oblivious” lies dead ahead, however, with the debt ceiling taking on more importance in the age of polarization in a tight Congress that shifts more weight to those who want to disrupt as a goal unto itself. The apparent need in Washington to avoid any inconvenient conceptual frameworks or proper applications of facts could soon leave the US in its next game of debt default brinkmanship.
The threat of default created buying opportunities back in 3Q11, but at least no one pulled the default trigger. Avoiding default may not be so clear next time. Government shutdowns are old hat (and usually boomeranged on those that caused it like Newt in the mid-1990s). The real systemic worry ahead is an actual UST default and not just a temporary shutdown. Congressional members being dumb on the scale of the risks make default a legitimate worry. If one party seeks to undermine Social Security and Medicare on the threat of default, the other side might say “default it is.”
As a rule, these days one can expect partisanship and too often a cowardly betrayal of core principles. Those get sacrificed as a path to power, and there is no reason to expect this to change. If sacking the capital is something people can get past, why not a UST sovereign default in the interests of their version of partisan purity and blind party loyalty? This affects the game theory in “fill or kill” legislation in a split government.
Generally, a split Washington is a relief since no one party can do too much damage (see Elections and Markets: I’m Not Dead Yet). The debt ceiling can be the exception to that rule if the small group of hard liners takes over the process. You have one current Senator whose father in Congress recommended default in 2011. Hopefully it is not a family tradition. If people can oppose election outcomes, why not have your own theory on UST defaults? They can color themselves heroic in their minds.