Lobnek Newsletter, December 2022

It was the 90’s, I was in a car with a friend and we were driving through Death Valley, that long stretch of desertic land between California and Nevada^[1]. We were on a road trip to Las Vegas, the city of bright lights and countless slot machines with their distinct chorus of loud beeps and chimes. The long drive through the barren wasteland of the desert and a horizon of nothingness was striking enough to leave me with a lasting impression. It was getting dark and as we got closer to our destination, a surreal dome-shaped glow of light suddenly popped out of nowhere. What a spectacle it was, the stark contrast between nature and the man-made, I had frankly never seen anything like it.
 
We came across a bunch of signposts and a couple of billboards through our ride, but there was one in particular that drew my attention. It was a signpost informing us that the fine for littering would be a crazy $1000. I remember thinking how odd it was to impose such a steep fine in the middle of nowhere, it didn’t take me long to realize that in fact it made perfect sense. The fine had to be disproportionally high for it to work, if only because the risk of getting caught in such a sparse environment was infinitesimally small. It reminded me of the financial “black swans”, those improbable and highly impactful events the markets occasionally get stuck by^[2].
 
The barren landscape had made it impossible to enforce the ban by traditional means, so they resorted to using psychology to do the trick: raise the penalty high enough and there will come a point where you won’t need any policing, people will just think very carefully before dumping their trash outside. Certain potential “threats”, like the signpost example, are better managed through the use of psychology, others require some form of tangible action and many use a combination of both psychology and action in varying degrees. Nuclear weapons are a prime example of the time-tested deterrent effect of Mutually Assured Destruction or MAD^[3]. You don’t acquire nuclear weapons to use them, you use them as a way to keep your enemies at bay.
 
Have you ever wondered why the war in the Ukraine is dragging on for so long, or why the first and last time nuclear weapons were used was in World War II? The psychology of fear can go a long way to influencing behavior. When we hop on a plane, the risk of an accident doesn’t cross our minds anymore unless, of course, we are part of that minority of people that suffer from such phobias. We happen to be living in the golden age of flight safety, its track record has become impeccable over the years. Remarkable advances in all kinds of technologies over the last two decades especially mean that planes are now designed with so many layers of redundant systems and processes that a risk of experiencing a catastrophic event has been brought down to almost nil.
 
There was a time when bank runs happened quite frequently, causing instability to the financial markets and the economies at large, dragging them into deep and lasting recessions. Of course, that was before central banks came with sufficient force, like nuclear weapons, to alter conditions radically enough for people to take notice. Suddenly, those highly contagious, recession-causing bank runs occurred much less frequently before vanishing almost altogether. At some point it became clear that the central banks no longer needed to intervene, their past bailing out interventions and their potential “firepower” were enough to reassure the public that their lifetime savings would not be wiped out when a major crisis hit.  
 
The advent and actions of central banks were a game changer for the markets in the way they radically altered the investor’s perception of risk. By centralizing the management of this particular threat, a major source of uncertainty had been vanquished. Economies not only became more stable, but they were also able to expand faster and suffered fewer and shorter lasting recessions. Now fast forward to the present where markets have been rocked by the blowup of FTX^[4] which, to be honest, was nothing more than a Ponzi Scheme of sorts. FTX was the fifth largest cryptocurrency exchange, minting its own token literally out of thin air to carry out all kinds of sometimes dubious transactions that eventually left it heavily exposed. It was a matter of time before its questionable practices would come out into the open and the consequences were not only dire but swift.
 
The meteoric rise of cryptocurrencies has always been about blockchain’s decentralized architecture. Individuals, corporations and even governments could see the value in digital currencies that could be traded in a peer-to-peer manner, without a central authority tracking its use and taking a cut. It seems nobody had stress tested the foundations carefully enough to realize that its decentralized architecture would prove to be its Achilles heel in times of crisis. FTX was certainly big enough to be considered “too big to fail” if only because of the high risk for contagion it carried. But what happens when you operate outside the boundaries and there is no entity out there that has the will, let alone the capacity to bail out? I guess we just realized, and the big question now perhaps is what happens next!
 

Where Do We Go From Here?

The sudden collapse of FTX is raising fears of contagion, but exposure in the financial markets appears limited and therefore relatively contained. The same cannot be said for FTX’s peers and other exchanges in this space which are now having to fend off a growing sense of apprehension and panic amongst investors and the attention of regulators. There are also the negative wealth effects from this year’s sharp corrections in Bitcoin and other digital currencies, which have wiped out hundreds of billions of dollars’ worth of value. The prices fetched in this year’s high end collectable watch auctions, for example, are nowhere near the all-time records of 2021^[5], suggesting that spending from stimulus and the crypto wealth have all but dried up.
 
The “crypto winter” is causing additional headwinds for the economy that is already reeling from the combined effects of chronic inflation, de-globalization setbacks, persistent logistical and supply chain challenges and a pandemic that is not going away anytime soon. Europe in particular is finding itself in an increasingly vulnerable position, squeezed by the acute energy shortages from its over-dependance on Russian supplies and a growing threat to its industries, as U.S. economic nationalism to counter China’s hegemony is drawing investments in its direction. With the arrival of cooler winter weather, sustained high fuel prices will be feeding the inflationary spiral, creating a growing dilemma for the ECB which needs to balance between ensuring that prices don’t get out of control on the one hand and ensuring that the tightening doesn’t cause the more vulnerable economies of Italy and others to tank.
 
The deglobalization process that has been underway since Trump became president is likely to endure for some time, as manufacturing is recalibrated to prioritize political rather than economic needs and as both sides reposition themselves in light of the new world order. In the short run this means further disruptions and higher prices for goods and certain services, which could drag on for years before efficiencies bring things back to where we were before the pandemic. The war itself will also linger on, Russia’s recent setbacks and the cold of winter give Putin a strong incentive to maintain an offensive position.
 
The recent market rallies on the back of better than expected CPI figures in the U.S. suggest that sentiment has shifted from anticipating further aggressive Fed tightening, which would risk triggering a deeper recession, to a more controlled approach, increasing the chances of a smoother recovery later on. This could just be a blip, of course, which would mean that the recent market gains are nothing more than froth for the next correction. The results of the mid-term elections were the other surprise for the markets, with Democrats keeping control of the house and ceding congress to Republicans, casting a somewhat dark cloud on Trump’s 2024 election prospects.
 
With growing hostilities between the new cold war belligerents, military conflict on the steps of Europe, inflationary pressures that linger on mean that the trend towards diminishing global inequalities is now reversing course. That will likely further fuel populism which, in turn, could reinforce a negative feedback loop, the long-term effects of which can only be dire for markets and the economy. The conclusions of the recent COP27 climate change conference which amounted to not much more than further promises, pledges and deferrals to do more to curb the damages we are causing for the environment is a case in point.

 
Altug Ulkumen, CFA                                                          
Independent Contributor                                  
aulkumen@gmail.com

[1] https://en.wikipedia.org/wiki/Death_Valley

[2] https://en.wikipedia.org/wiki/Black_swan_theory

[3] https://en.wikipedia.org/wiki/Mutually_assured_destruction

[4] https://nymag.com/intelligencer/article/sam-bankman-fried-ftx-bankruptcy-what-happened.html

[5] https://fortune.com/crypto/2022/07/29/crypto-downturn-luxury-watches-price-declines/