Choose Your Own Misadventure: Bronfman E.L. Rothschild 2016 Q4 Review

Choose Your Own Misadventure

Happy New Year everyone! Part of our early January ritual is to read a number of market and economic projections for the upcoming year. And although they are interesting and (generally) thoughtful, to be frank, the articles are basically all the same. For 2017, the common themes are inflation and higher interest rates, lower taxes in the US, global growth (albeit minimal), a renewed interest in fiscal as compared to monetary policy, and political (or of late, tweet) risk.

The predictions above seem reasonable, but questions remain - how accurate will they be? And even if some turn out to be correct, what should we do about it? Regular readers of our musings know that we often discuss poor calls made by market pundits (e.g. Fed calling no contagion in 2007, the Greek Crisis, Brexit, and the recent US Election). Let’s just call it our guilty pleasure of denouncing the linear thinking used to generate opinions about dynamic and interconnected markets. But even when one follows only the most pragmatic analysts, forecasts often fall flat.

We do not write this to be the consummate contrarians or skeptics (roles quite revered in our business). It actually comes down to simple exponential mathematics and the innate human need for narrative. The Choose Your Own Adventure children’s books, popular in the late 1970s and 1980s, come to mind. These books put the reader in the role of the protagonist. Every couple of pages they face two or three options (e.g. if one way, flip to page 21, if another go to page 70), each of which leads to more options, ultimately generating one of many endings. Some of these books carried readers through 400+ distinct adventures. The narrative flexibility of these books generated enough enthusiasm to become best sellers. Kids were enthralled, demanding re-reads where only a slight deviation from the prior path created a completely different ending. This is where the parallel lies. The reason pundits are destined to get calls wrong is not because they are not well thought out, but because they present a linear story that has to get so many things right.

The path predicted through the Choose Your Own Adventure book of the economy and the markets has to be the path. They have to correctly: 1) identify an event, 2) call the timing, 3) call the result, 4) call the market reaction, 5) call the magnitude of the reaction, and finally, 6) call how long it takes to develop. Although not impossible, probably less likely than 50/50. We could elaborate with the miscalls of the most recent Presidential election or Brexit Vote where #1 and #2 were predetermined, but #3, #4, and #5 were missed by many, and #6 is still to be seen. For a better view, however, we step back to an event that played out five years ago where we can see all six: the downgrade of US government debt.

  1. Standard & Poor’s (S&P) downgraded US government debt from AAA to AA rating during a period of “fiscal cliff” brinksmanship that had many on edge.
  2. The ultimate news came down in August of 2011, although earlier in April of that year the S&P had put the US on credit watch negative.
  3. Markets were mixed regarding whether there would or would not be a downgrade.
  4. This is where the Choose Your Own Adventure story really took off, generating countless counterfactuals. Forecasts were broadly mixed. Many assuming a downgrade expected US Treasuries to sell off and the US dollar to weaken. The rationale was quite reasonable as the general rule of thumb is that bonds sell-off if downgraded. There were also concerns that money managers holding AAA paper by rule/covenant would be forced sellers of US Treasuries. Expectations were for risk assets to also sell off (equities, commodities, etc.) with the only safe havens being gold and the Japanese yen.
  5. The magnitudes of the calls varied so greatly that it is hard to pin down a consensus. Some called for an almost immediate recession, while others thought the markets would be marginally impacted.
  6. Calls on how long it would play out correlated highly with depth of reaction. Those calling for rising US interest rates and subsequently higher borrowing costs for the US Government saw reduced spending and potential for another recession. Others saw it as a blip, akin to Japan’s downgrade in 2002.