“I had an epiphany recently: Everything, without exception, requires additional energy and order to maintain itself…. Existence, it seems, is chiefly maintenance.”
-Kevin Kelly, The Inevitable
The narratives are hungry. The beast needs to be fed, and right now there is a dearth of fresh material. Pre-election growth momentum gave way to Trump the Builder, which became Soft Data is leading Hard Data, which led to the Synchronized Global Upturn, which then morphed into Durable Business Optimism, and most recently, Earnings Growth is Solid. Any one of these can still be the reason why stocks continue to rally, credit spreads continue to tighten, and interest rates trend higher. The challenge is that these narratives have so far persisted against a backdrop of negativity: North Korean sabre rattling, optically weak 1st quarter US growth, intensifying criticism of income inequality, the scourge of automation, the relentless appearance of political dysfunction in Washington, and most importantly: commodity prices which don’t necessarily jibe with intensifying growth. Counteracting that negativity takes energy, action, and results.
In a sense, the decay of a stagnant narrative is a force of nature. The Second Law of Thermodynamics says that the entropy (amount of disorder or chaos) of a system in isolation always increases. So, to avoid more disorder, we need to feed the beast. It can’t sit in isolation. And though the chaos doesn’t feel normal, it is, on some level, natural.*
I suffered through thermodynamics years ago in a physics classroom, and coincidentally my father holds a US patent which applies the entropy concept to business strategy planning. However, only recently did I recognize the broad applicability to both investing and everyday life. It was, as Kevin Kelly describes in The Inevitable, an epiphany. Why is it that a perfectly good laptop or smartphone seems to degrade and perform so poorly a year after you bought it? Why are well-preserved classic cars so unusual? Why is it that the inside of my house with two young children always looks like a disaster area? Why is it that replacing Obamacare is so hard? Without an input of energy, the chaos of a closed system always increases. Such a system even requires some energy just to keep the chaos from getting worse – to run in place. The more complex the system is, the more energy is required to counteract the progression toward disorder. Whether the system is a physical machine, a household, a socialized healthcare arrangement, or an entire economy, counteracting the increasing chaos requires work: energy, thinking, analysis, effort, and results. In essence, if it feels like much of our human energy expended day to day is carrying out some kind of “maintenance,” the Second Law of Thermodynamics confirms that we’re stuck with that burden.
Narratives need maintenance like everything else. So, to that end, we’re getting to the point where investors need some satisfaction from a subset of: tangible progress on the pro-growth aspects of the Trump agenda of regulatory reform, tax cuts, and/or infrastructure spending; material rebound in US growth from the dismal Q1; or continued progress on global growth, in particular from Europe. The circumstances surrounding the departure of FBI Director Comey hold a dual significance in this metaphorical discussion. First, those events look chaotic to me, and though it looks and feels uncomfortable, we can use the Second Law as our security blanket and call it completely natural. Secondly, because the events were disorderly it will require energy to counteract the spike in entropy, energy which could have (and should have!) been spent developing the inclusive pro-growth policy priorities. And so the organic strength of the US and global economies are left to pick up the slack. Confirmation of anticipated economic momentum over the near term is likely necessary to sustain the narrative, in effect to avoid the decay.
*A Wikipedia binge on entropy is a fascinating odyssey through (not quite) perpetual motion machines and macroscopic systems (like orbiting planets) which appear stable but in fact are slowly decaying. Fellow fans of the movie Interstellar will appreciate that radiation through gravitational waves is one such way in which the entropy of an orbital system increases.
About two weeks ago, I started brainstorming the topic of this blog post. In my first draft, I started the piece by stating, “no one cares about financial conditions anymore.” This is because when conditions are easy, you don’t hear much about them. But clearly, my post was “leaked” because this week financial conditions indices (FCIs) are the topic du-jour! The headline risks emanating daily from Washington, D.C., have quickly brought this topic back into the spotlight.
But first, let’s put the recent experience of this year into perspective. In the first few months of 2016, US equity prices fell over 10%, 10-year Treasury yields rallied 60bps and 10-year inflation breakevens declined to post-crisis lows. Last year, the market narrative was fear of a recession in the United States, a hard landing in China, and a global growth meltdown. At that time, market strategists were quoting measures of financial stress and their paralyzing effect on markets and central banks. In the first quarter of 2017, market strategists didn’t seem interested in FCIs.
I want to explain why we should be monitoring financial conditions both when they are in vogue (which typically is the case when conditions tighten sharply) as well as when they are not. Here are three reasons:
The Fed has promised two more rate hikes this year and three more next year while the market is pricing in less than 1.5 hikes in 2017 and less than 1.5 hikes in 2018. Given the state of FCIs over the first few months of this year, markets should be pricing in more action from the Fed. The risk, of course, is that financial conditions tighten suddenly and sharply. Risk-markets are vulnerable to shocks which could be triggered by a number of factors including those currently emanating from Washington, D.C. Ultimately, as the Fed approaches its mandate objectives, the path of the Federal Funds rate will not be derailed by one bad payrolls or inflation report but instead by the magnitude and the pace at which financial conditions tighten or loosen.