“There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, ‘I don’t see the use of this; let us clear it away.’ To which the more intelligent type of reformer will do well to answer: ‘If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.’”1
- G.K. Chesterton, The Thing
Chesterton’s Fence is a mental model inspired by the above quote from his 1929 book, The Thing. It’s a lesson in second-order thinking, the practice of not just considering the consequences of an event, but the ripples of additional consequences caused by the consequences of such an event.
A powerful heuristic used for decision making in investing, second-order thinking allows us to consider future possibilities and probabilities we might not see thinking only with recent muscle memory; or more precisely, business cycle muscle memory.
The Funding Crisis
The bank funding crisis that resulted in several bank runs and closures in March reignited the market’s deflationary signals across the multi-asset landscape:
- The two-year yield repriced nearly 61 basis points on March 13, a one day move markets haven’t seen in over 40 years.
- The front month contract on WTI Crude Oil fell over 20% peak-to-trough in March, over 10 trading days.
- Federal Funds Futures went from pricing in nearly four hikes for the remainder of 2023 to pricing in over three rate cuts, over the course of a weekend.
The Fed allowed the banks’ equity and debt to be destroyed and depositors saved. They also expanded their balance sheet temporarily to help banks shore up their own balance sheets for the next year to attenuate the funding problem and rebuild confidence across the small bank system. It’s a tough environment for small banks right now, so the Fed had to move with depositors on the run.
Trained on bank failures from the Great Financial Crisis, trading algorithms engaged the deflationary playbook: sell commodities, sell cyclicals, buy technology, anticipate the imminent credit crisis and the Fed to once again rescue, cut rates and bail us out. We understand the positioning. It makes sense. But this is first-order thinking. Do we need a different playbook for a higher inflation regime?
Adam Grant touches on this exercise in his book Think Again:
“Intelligence is traditionally viewed as the ability to think and learn. Yet in a turbulent world, there’s another set of cognitive skills that might matter more: the ability to rethink and unlearn.”2
Inflation or Deflation?
Last September we discussed the factors driving the trend component of inflation. The emergent decline in global labor supply, a decade of commodity disinvestment and increasingly pro-labor political agendas have given us reason to pause and contemplate.
We find the political driver particularly potent right now. The last forty years saw policies that primarily benefited the few at the expense of the many, widening inequality in wealth and income. There are several recent examples of political flashpoints interfering with markets in ways that are reversing this trend. To name just a handful of these observations:
- Targeted capital destruction of property developers and common prosperity efforts in China
- Targeted capital destruction of mismanaged banks in the US and Europe
- Shared appreciation loans for first-time home buyers in California
- Billions of dollars in food rebates sent to low-income citizens in Canada
- Street politics in France opposing pension reforms
- German unions striking, seeking a 10%+ pay raise for ~2.5 million workers
While only a 13% weight in the Consumer Price index, the Food component carries quite a bit more weight from a political standpoint. The Washington Post released a fantastic piece of data-driven journalism3 last week citing just how difficult food inflation has been for Americans at the median income and below. When people struggle to feed themselves, the chances of political turbulence is greatest.
The genie is out of the bottle. It’s very likely what wins votes in coming elections will be nothing close to austerity. The Federal Reserve has less control of inflation when fiscal forces are working against its goal.
Implications for Portfolios
While we’re currently experiencing a cyclical dis-inflationary impulse as we lap the peak in year-on-year consumer price index (CPI) comps over the next few months, the trend component of inflation has drivers with momentum. A regime of global policies moving to benefit the many over the few has consequences for this trend component, particularly at a time when the mother of all demand-supply shock sequences just took inflation to levels we haven’t seen in forty years.
Assuming an eventual credit crunch, recession and Federal Reserve (Fed) response on failing regional banks is intuitive, but the second-order thinking is that any effort by the Fed to stimulate the economy may very well provoke a new leg to the multi-year bull market in commodities as they price in the recovery in growth. Regardless, commodity prices may stand to benefit from heightened geopolitical tension, renewable energy investment and ripples of a historic global fiscal expenditure on the demand side, in addition to tightening financial conditions and continued fossil fuel disinvestment constraining supply. This all works directly against the Fed’s stated primary goal of fighting inflation.
The Fed is likely further out from bringing back accommodative monetary policy, misleading market participants once again with another dose of Quantitative Teasing.
Important Disclosures & Definitions
1 Chesterton, G. K., The Thing / G.K. Chesterton Sheed & Ward London, 1929
2 Grant, Adam. Think Again: The Power of Knowing What You Don't Know, Viking, an imprint of Penguin Random House LLC, 2021.
3 Why Americans Are So Pessimistic About Their Finances, Washington Post, March 27, 2023.
Performance data quoted represents past performance. Past performance is no guarantee of future results; current performance may be higher or lower than performance quoted.
Consumer Price Index (CPI): a measure of the average change over time in the prices paid by urban consumers for a representative basket of consumer goods and services.
One may not invest directly in an index.
AAI000246 06/30/2024
