The World is Short Convexity
TUE 22 FEB 2022
As my astute Italian friend noted overnight, a key reason why there is always such a strong resistance to consider extreme outcomes like monetary policy reversals, inflation persistence, acknowledgement of higher neutral rates, depletion of inventories and wars is that most investors are short convexity. Stated differently, the real world is not linear and systemic risk can increase at an accelerating rate as correlation moves towards one in a major episode.
That said, we would reinforce our observation last week that it is important to acknowledge what “we don’t know” with regard to the current episode in Eastern Europe. All we can do is manage risk and identify where there might have been an emotional overreaction due to forced selling or de-leveraging. The most plausible strategic reason for the threat of aggression is to extract concessions from the West, protect Russia’s gas market or for the domestic audience.
However, what we do know from previous episodes is that they are typically idiosyncratic and tend not to have a lasting impact on global risk assets more broadly. As we noted last week, European high yield spreads have widened in-line with US high yield spreads (chart 1). Put another way, there has been a relatively limited contagion impact so far. Although clearly, there has been some selling in equity futures.
Of course, where the current episode has potential to for greater contagion is in the energy and materials sectors where Russia is a major supplier. The challenge in this sector had already been developing ahead of the recent events. In trend terms, world resources have been depleting fast as the easier and cheaper to extract have already been extracted. At the same time, the global population is still growing and therefore so is energy consumption. As a result, increased capital constraints on fossil fuel producers is inconvenient in the short run. It also means that the shortfall in production will need to be filled by national oil companies in less friendly countries. In the near term, these factors also exacerbate the pressure on global supply chains and inflation pressure.
Over the past few years, US producers tended to respond to high energy prices by expanding production fairly swiftly. However, greater capital constraints and the pivot by the current administration away from fossil fuels has seen the US rig count materially lag the spot price in the recent recovery (chart 2). To be fair, this might also be a function of greater capital discipline and focus on shareholder returns. On the positive side, higher energy prices might also improve the competitiveness of innovation and pivot to alternatives.
From a broader macro perspective while our sense would be to fade the emotional increase in risk perceptions from the episode in Europe, we remain concerned about the near term impact of Fed rate hikes and liquidity withdrawal on equities and credit. That risk is much better appreciated and priced than it was at the end of last year. However, our sense is that investors might still be underestimating, inflation persistence and where policy rates end up in this cycle.
From our perch, investors are probably too pessimistic on growth and profits risks later this year. But it is possible that there has been a shift to a more challenging growth/inflation trade-off. On the positive side, risk compensation is considerably more attractive in Asia Pacific (chart 3) and macro cycles typically don’t end until policy rates rise above neutral levels (we are still a long way from that).