Everything (might) be fine

Is that a market downtrend snap I spot?

Source: TradingView

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The ASX 200 [XJO] has bounced aggressively in the past week of trading on the three-month chart.

What utter madness!

So, hear me out on this…

We (and the market) might be fine.

Somehow.

Now, for today’s exercise in careful but, hopefully, rational optimism about markets…

Let me draw your attention to the bizarrely wise musings of former US Defence Secretary Donald Rumsfeld.

(The irony of citing one of the architects of the most disastrous instances of Middle East military adventurism is not lost on me, promise)

Anyway, this is the famous “Rummy” quote:

“There are known knowns, known unknowns and unknown unknowns. Effective intelligence work must consider them all.”

Replace effective intelligence with effective investing…

And presto!

We have a bit of clever market philosophy (or for the nerds: epistemology).

Now, here’s what we know the risks are in markets right now:

• The war (duh)
• Private credit meltdown (clearly)
• Global recession (ouch)
• Receding global liquidity (complex, but yes, it’s happening)
• 1970s-style stagflation (hmm…)
• All five above items combining in a monolithic debt-unwinding event

Don’t mention the war

You might remember this scene from Fawlty Towers:

Source: X

So I’m not going to mention the war again today.

That’s because, for me, the dynamics of the Iran conflict are starting to obscure other risks in the market.

Here’s my proposed Donald Rumsfeld matrix of market risks:

Source: Lachlann Tierney

This is not exhaustive, of course, but it hopefully gives you an idea of what I’m talking about.

In green, we have the things that are definitely “known knowns” i.e. prominent aspects of current financial news media narratives.

In yellow, we have the space between knowledge and ignorance where the market determines asset prices.

Roughly speaking, these prices are determined relative to the expected risks attached to the scope of the bad outcomes found in the green square.

In red: Oh dear, we’ve all heard Murphy’s Law: “whatever can go wrong will go wrong.”

Perhaps there’s an unknown unknown out there that really stings us.

Maybe everything multiplies and gets worse until the worst of all happens.

Quantum computers plugged into a malevolent superintelligent AI that annihilates the entire human race. Nuclear warfare. Aliens. Bubonic plague on steroids emanating from a bioweapon manufacturing facility…

And so on and so forth.

That’s just a handful of scenarios that may be animating the strong market sentiment for gold over the last two years.

After all, Murphy’s Law has a corollary (O’Toole’s Law): “Murphy was an optimist.”

…but let’s talk about private
credit for a moment

This is the lurking risk, one rung below the war risk in terms of financial news media narratives.

Private credit is basically lending done by private funds rather than banks.

It now manages roughly US$1.5-2 trillion globally across about 1,000 funds.

That sounds scary.

And it is.

But context matters.

Harkening back to the GFC, two US government-backed mortgage giants, Fannie Mae and Freddie Mac, were on the hook for US$5.2 trillion of mortgage debt.

Inflation-adjusted to today, that’s US$7.5-8 trillion. Private credit is, at most, a quarter of that.

The bigger worry isn’t so much the size, it’s the archipelago of interconnected entities.

For example, the GFC had two choke points for Washington to patch.

A private credit blowup would span hundreds of funds, regional banks, insurers and pension funds.

Far messier to fix.

But then again, the scale of the backstop to a private credit meltdown should be smaller.

Things could get ugly, and I know my colleague Charlie Ormond is deep-diving into private credit regularly.

But maybe, just maybe… we could be fine.

Either way, it’s worth considering various scenarios as an investor and the outcomes that flow from them.

I’m positioning Australian Small Cap Investigator readers for a range of outcomes. Not just the doomsday one.

Have a great rest of the week.