New Year: New Unknowns

Hey everyone,

It feels like we're tiptoeing on the brink of chaos as we kick off this new year. Just when we thought we'd bid farewell to COVID-19, the war in Ukraine swooped in, demanding the spotlight.

The list of things that could go wrong is longer than a CVS receipt, but don't let that dampen your spirits! Instead, let's use this exercise to sharpen our risk assessment skills and, if fortune favours us, save our portfolios from potential disaster.

So today, we’ll break down the severe structural headwinds facing markets and then do the impossible task of brainstorming potential black swan events that could redefine how we approach investing in 2023.

Brace yourselves; it's gonna be a bumpy ride.

Market Headwinds

Record Inflation 

The main question hanging over markets is about what comes next for inflation. As we know from the Fed's reporting, it's been easing over the past few months, but there's a nagging concern that high wage growth could prevent it from returning to the Fed's cosy 2% target.

Even though inflation has dropped significantly from the June 2022 highs, it's still at a 40-year high.

So don't be caught off guard when inflation remains sticky in 2023, like that pesky gum on the sidewalk.

The Fed

The relationship between inflation and interest rates will likely be the dominant factor influencing the market this year, like a clingy ex who just won't let go.

In Howard Marks' memo "Sea Change", he outlined an intriguing outlook on the Fed Fund rates. In his view, the buyers who've driven the S&P 500's recent 10% rally from the October low have been motivated by their beliefs that:

• Inflation is easing.

• The Fed will pivot to a stimulative policy.

• Recession worries will blow over.

But here's the reality check: the labour market is tight, with wages rising and the economy growing strongly.

Before declaring victory on inflation, the Fed must be convinced that inflation has settled near the 2% target and that inflationary psychology in the market has been extinguished.

So, while the Fed may slow the pace of its interest rate increases, don't expect them to start throwing money around like candy anytime soon. I believe we'll see a Fed Fund's Rate range of 2-4% rather than a fast decline to 0-2%.

Black Swans

Now that we've explored the implications of sticky inflation and interest rate uncertainties, it's time to get into even murkier waters – potential black swan events on our horizon.

By definition, black swan events are rare, unpredictable occurrences with significant consequences. Their very nature makes it impossible to foresee them with certainty. However, preparing ourselves for all possible scenarios makes us better investors.

So, even if we can't truly predict these events, let's look at possible setups that might lead to the unexpected this year.

Consumer Debt Crisis

With growing inflation, consumer debt (the amount individuals owe lenders like credit card companies and banks) has surged in the US like a tidal wave.

In November 2022 alone, US consumers increased borrowings by $28 billion.

Outstanding consumer credit grew 7.1% in 2022, according to a Federal Reserve Bank of New York report, while revolving credit, which mainly includes credit cards, grew by 16.9%. This was the most significant jump seen in three months and the fifth-largest monthly increase in nearly 55 years.

So what the hell does this all mean?

First, the average consumer (the engine of spending in the economy) is about to get slammed. Initially, the assumption was that rising interest rates and skyrocketing inflation would kill consumer spending. But guess what? It didn't. 

Consumers have continued to spend as if we're still in a zero-rate environment where sunshine, rainbows, and money are plentiful.

Because of their aggressive spending in an increasingly tight monetary environment, there's a massive risk that many consumers may default on their debt obligations.

This year, consumer defaults could be a significant catalyst for declining growth and a potential institutional credit crunch.

The Ex-Dollar Oil Trade

The dollar's status as the global reserve currency is being threatened by China's Yuan, like a jealous sibling looking to steal the spotlight.

One of the most recent signals that overthrowing the dollar is already underway is the potential oil deal between Saudi Arabia and China. Essentially, China is working to buy oil and gas with the trade denominated in their native currency, which supports their goal of establishing the Yuan internationally and weakening the dollar's grip on world trade.

Similar deals have already been struck between Russia and China.

The shift to the Yuan fundamentally threatens the assumption that the dollar is the de-facto global reserve asset. While this deal going through may not have a significant short-term impact on dollar supremacy, it could cause a massive loss of market share over the next decade. It also adds to the already-heightened tensions between the Western World and China.

This point is best suited as a "Black Swan" since the likelihood of a sudden, dollar-destabilizing event this year is pretty low. Although, it'll still be worth paying attention to US dominance on the global stage as time passes.

Putin Going Nuclear

The last Black Swan event is reasonably straightforward.

Since Russia invaded Ukraine last year, constant fears of escalation have existed. The biggest being nuclear warfare.

While the "nuclear taboo" put in place in the West has outlawed the possibility of nuclear war today, I believe there are powerful narratives at play that give more substance to this risk.

The reality is that, on the ground, the Russian military is struggling. Moreover, Ukraine's unlikely resurgence has backed Russian forces into a corner. Putin may feel the same way.

Just in December, Putin himself announced that the threat of nuclear war is growing. He said, "Whether or not Russia may be the first to use nuclear weapons, whatever the circumstances may be, we cannot be the second", - saying that if nuclear weapons were used on Russia, their capability to retaliate would be non-existent.

This sounds like a man backed into a corner with few available options.

Then there's the “legacy” narrative. This is the most significant factor that no one talks about.

Think about this; if you were the Dictator of Russia - a global superpower and challenger state to the West who controls more than half of the nuclear weapons globally - and were losing a potential generation-defining war against the West, with your legacy as Russian leader hanging in the balance, what would you do?

We cannot underestimate the probability that Putin presses that big red button to save his legacy as the modern-day Russian Dictator.

If this happened, it's safe to say that the Western World wouldn't be the only thing getting nuked.

Prepping for Uncertainty

While I may sound like a doom-and-gloomer, let's face it, it's essential to think through these scenarios. After all, that's what being prepared is all about. The world has a funny way of surprising us when we least expect it.

Going through thought exercises like these sharpens our ability to assess the potential risks and, in turn, makes us more resilient investors. Remember, markets are unpredictable, and uncertainty is the only certainty.

To wrap things up, I'll leave you with a powerful quote from Winston Churchill:

Reflecting on the past can provide valuable insights into how quickly the world can spiral into chaos if we're not vigilant.

As we begin the new year, let's take the time to ponder what's happening, monitor developments, and, most importantly, stay prepared.

That’s all for today. If you found this post insightful, share it with a friend or anyone who might appreciate it.

Thanks for sticking with me to the end.

— Luca