Evening Brief – 04.06.23

Three decades of low inflation have made a 180-degree turn into a period of sustained inflation, largely driven by excessive levels of debt, scarcities of essential goods and the rise in the cost of capital.

The tools administered to restore confidence in the financial system and the economy in 2008-09 have reached such extremes that now systemic risk of default and perhaps the least understood risk, diminishing liquidity as credit and buyers of risky assets become scarce, is rising.

These risks are difficult to hedge, and the linkage between the global economy and financial system, which is a tightly bound system, means risk in one sector quickly spreads to the rest of the system.

The rise in systemic risks raises costs and alters the risk-reward profile for all assets. The issue with assessing risk is that the full risks are never clear until they’re in the rearview mirror.

All assets are being repriced. This repricing is currently modest, but as risks further take hold, we can anticipate an acceleration of the current repricing.

In a system frailly maintained by greater extremes, investors’ confidence quickly erodes once the next extreme fails to make a dent. At that point, all bets are off as confidence in policymakers’ ability to restore it vanishes.

Once confidence disappears so does liquidity. Once markets are illiquid the problem isn’t limited to declining valuations. The real pain is finding a buyer who will enable you to convert the assets into cash.

It’s obvious the global risk premium has significantly increased and continues to do so. But most investors will look at US bond yields and think those returns do not look any better, and especially not if inflation is sticky. We live in a world of lower expected returns until asset classes have adjusted to lower valuations amid the acceptance of structurally higher inflation and increasing risk.