Assessing the Known Unknowns
“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know.”
This quote from former U.S. Secretary of Defense Donald Rumsfeld might be a good starting point to help frame the current investing environment. Markets do not like uncertainty and the known unknowns state is where that tends to reside. We take comfort in knowing what we know and can’t control things we don’t know that we don’t know. As investors, we seem to fret most about the things we know we don’t know.
While the list of worries is long, we will focus on three key uncertainties that, if known, should give us more clarity about the direction of markets. As some of these unknowns are coming into view, each of them creates unknowns of their own.
- Central bank intervention has been critical, but it’s hard to know how they will withdraw.
- In turn, this creates uncertainty around long-term debt sustainability, which creates questions about profit margins.
- To complete the circle, this creates questions about how long central banks need to maintain their interventionist policies.
Central Banks: Global central banks have transitioned from their traditional role as lender of last resort to buyer of last resort. While most investors believe the free-market system is the best allocator of resources, that belief gets challenged by moral hazard considerations. The massive monetary and fiscal interventions during the pandemic were aimed at easing the financial burdens of a government-mandated shutdown, yet there are still consequences to these actions. As price setting and determining winners and losers moves out of the domain of private markets and into the purview of central banks, investors need to take this into their calculus. The infamous Fed put is on full display having reached further into private markets than ever before. Ultimately, the value of a currency depends on the trust and confidence of the central bank. Clearly delineating and adhering to rules of engagement when it comes to intervening in markets would help investors clarify the role of the central bank and better assess the impact on asset class prices. For investors, it may be wise to supplement rigorous fundamental financial analysis with a dose of “I’ll have what the Fed is buying” during these uncertain times.
Debt Levels: We’ve had a surge in overall global debt levels following years of low interest rates, weak economic growth, slow inflation and massive monetary interventions. The argument that low interest rates and subdued inflation created a good environment to take on additional debt during the pandemic is valid. However, the accumulation of debt does have consequences. If it is being put to productive use (i.e. higher growth purposes) we can rationalize the increase, yet if it is for nonproductive uses (i.e. low/no growth purposes) it pushes us closer to the liquidity trap. Very low interest rates are failing to translate into a meaningful bump in growth, and any pull back in monetary accommodation results in economic growth challenges. As risk begins to outweigh return, we encounter a battle with deflationary pressures. In an environment where countries emphasize exports over imports, we risk supply exceeding demand, resulting in a larger savings glut and rising deflationary pressures. Deflation/default is one way out of debt and inflation is another, as the purchasing power of the money being repaid declines over time. While inflation is a primary concern for bondholders, it would indicate consumers and businesses are spending again and wages are rising. A third way to manage excessive debt levels is to grow faster than the debt accumulates. However, in a debt-driven economy any inflationary pressures are likely to result in higher interest rates which have proved difficult for the economy to absorb. For investors, the focus needs to be on how the debt levels are managed going forward (taxes/issuance/monetization) which should give us a clue as to whether deflationary or inflationary forces will dominate.
Profit Margins: Exogenous shocks have a way of exposing the vulnerability of certain buffers and tend to elicit behavioral changes. The model may need to change for companies that benefitted from globalization and the move toward lower cost production and more efficient, just-in-time inventory management of global supply chains. The pandemic has revealed how some businesses were too reliant on single supply sources and how little production control they actually had when one or more links in the chain are broken. To this end, we may see companies desire to hold higher cash levels and diversify supply chains and production capabilities. However, this is likely to come at a cost. Companies that operated efficiently under the old model will need to figure out how to optimize profits in the new environment. Obviously, paradigm shifts create winners and losers and creative destruction is the means by which we move out with the old and in with the new. To that end, some companies will adapt and prosper, some companies will benefit from an acceleration of trends that are already in place and others will struggle. It seems unlikely that company profit margins will immediately bounce back to pre-crisis levels. It is more likely that profit margins will be challenged for an extended period depending upon the pace of the economic recovery and any subsequent behavioral modifications. For investors, the key will be determining which companies can protect and improve their profit margins during this time of change and uncertainty.