With price inflation rising out of control and interest rates rising strongly, the trading environment for commercial banks has fundamentally changed. With bad debts looming and bond prices in entrenched downtrends, procrastination is now the enemy of bankers.
We are at the beginning of The Great Unwind, and this article elaborates on my first article for Goldmoney on the subject published here.
The imperative for bankers to respond to these conditions overrides all other matters if their businesses are to survive these changed conditions. We are entering a cyclical downdraft of the bank credit cycle which promises to be cataclysmic. And the monetary policy planners at the central banks can do nothing to stop it.
After outlining the scale of the problems faced by each global systemically important bank, this article looks at the future for the $600 trillion derivatives mountain.
It was born out of the long-term decline in interest rates from the mid-eighties, which ended last year. It is almost entirely distributed through banks and shadow banks.
The question to address is, what is the future for the derivative mountain, now that the long-term trend for falling interest rates is over? And what are the economic consequences?
If it’s you in the hot seat…
Imagine, for a moment, that you are the CEO of a commercial bank involved in lending to businesses and with profit centres acting in a range of financial activities. As CEO, you are answerable to the board of directors for the bank’s performance, and ultimately the bank’s shareholders for maintaining and advancing the value of their shares.
Furthermore, let us set this imaginary exercise in the present. These are the issues that should keep you awake at night:
In common with your competitors, the ratio of your balance sheet assets to total equity is almost the highest in the history of the bank, in many cases for other banks over twenty times leaveraged.
Official inflation, measured by the CPI is about ten per cent, and producer prices are rising somewhat faster. Your central bank expects a return to the 2% target in two- or three-years’ time. But your contacts at the central bank have privately admitted to you that they cannot imagine the circumstances where this would be true without a deep recession.
Bond yields are rising, and losses are beginning to impact on the bank’s investments. The bank has relatively little direct exposure to corporate bonds and equities, but they are commonly held as collateral against customer loans.
How are higher interest rates impacting the quality of the bank’s loan book? The bank supported its business customers through the covid pandemic, which increased the indebtedness of them all. This exposes the bank to excessive default risk if rates rise further.
The mortgage loan book has been a profitable business for decades. But the bank is beginning to see a material rise in delinquencies. If loan guarantees are not forthcoming from government agencies, the bank may have to shut this activity down.
What impact will higher interest rates have on the bank’s derivative exposure? What are the counterparty risks in derivative chains? Derivatives that involve inadequately capitalised counterparties should perhaps be sold on, or where the bank has the option to do so, closed down.
The underlying problem is that the conditions that led to the bank becoming increasingly involved in diversified activities, such as investment banking, trading, and investment management have now changed. Since financial deregulation in the 1980s, the bank has expanded into these profitable areas. The whole industry moved from dealing in credit into generating fee income. The growth in fee income can be directly related to the long-term trend of falling interest rates, which apart from interruptions such as the dot-com excesses and the Lehman crisis, stimulated growth in corporate finance, underwriting, investment management, and trading in financial securities. The expansion of these activities in turn led to a massive expansion of derivative markets, with new instruments being devised, such as credit default and interest rate swaps.
If, and this is really what should worry you, the long-term trend of falling global interest rates has ended and is now set to be reversed, not just temporarily but for the rest of the decade and perhaps beyond, then the reasons justifying the bank’s expansion away from its core lending business have come to an end. As CEO, how do you unwind the deep-rooted departmental interests, and keep the shareholders onside?
It is time for the whole executive to be urgently involved in a wide-ranging debate about how serious these threats might be and where you should take actions to protect the bank’s shareholders’ interests. Given the high level of balance sheet leverage, the bank’s survival is at stake if you act indecisively or too slowly. You are facing head-on the unpleasant prospect of The Great Unwind.
Balance sheet ratios
There are two ratios that concern bankers. The first is the relationship between liquid and illiquid assets with respect to sources of balance sheet funding. These are set by regulators through Basel regulations, now in their third iteration. Banks are required to submit details of their balance sheets periodically to bank regulators in accordance with the net stable funding requirement formula as set out in Basel III.
The second ratio is of less importance to regulators, which is the relationship between Tier 1 capital and the total balance sheet, which Basel regulations simply states that the maximum leverage ratio is for Tier 1 capital to not be less than 3% of the bank’s balance sheet assets. Put another way, subject to certain conditions, a bank can theoretically leverage its assets to equity as much as thirty-three times. But it should be noted that within that leverage ratio, a bank is permitted to net off certain classifications of credit, reducing its apparent balance sheet size. The following are examples of hidden forms of balance sheet assets and liabilities:
Security financing transactions, which include repos and other derivatives, can be netted off where they are between the same counterparty and maturity. For a true accounting picture, a bank balance sheet should reflect credit and debt obligations on both sides of its balance sheet until they are extinguished.
Long and short credit derivatives can be netted so long as there is no maturity mismatch. Again, the full obligations should be reflected on both sides of the balance sheet. And valuation methods give banks enormous wriggle room, an issue which regulators are unable to properly address.
Off-balance sheet items are only partially recognised through standardised credit conversion factors. Where a bank has off-balance sheet activities, they should be properly reflected in its accounts.
Therefore, true bank balance sheet leverage can be considerably greater than a bank complying with Basel regulations will declare in its audited accounts. But while conforming with Basel regulations, the board of a bank has a primary duty, often forgotten even by some directors, to their shareholders.
It is changes in the ratio between a bank’s assets and its shareholders’ equity which drive the cycle of bank credit expansion and contraction, which in turn drives the business cycle.
While they have a specific expertise in assessing lending risk, bankers are human. When they perceive lending risk to decline, they increase the quantity of credit offered, recorded as assets on their bank balance sheets, without increasing shareholders’ equity. Their confidence is synchronised through individual banks’ market intelligence and commonly available information concerning lending conditions. What few bankers realise is that it is expansion of their cohort lending which creates the very confidence in the lending conditions being observed.
The benefit to the bank is enhanced by expanding the ratio of total balance sheet assets to shareholders’ equity. A gross lending margin of two per cent becomes 20% for the shareholders on a balance sheet ten-times leveraged. However, this depends on margins being maintained, which, when banks compete with each other for lending business, is unlikely. Furthermore, the trend for declining rates over the decades due to the policies of the monetary authorities has led to a general increase in shareholder leverage as banking cohorts try to maintain profitability on slimming margins.
We all know that this recently reached an extreme position, with unnaturally negative interest rates imposed by central banks principally in Japan, the Eurozone, and Switzerland. In response to heavily compressed rate margins, the large commercial banks in the Eurozone were leveraging up through repos to gear up the slimmest of lending margins. The European repo market has been rolling over in excess of €9 trillion in all currencies with euros the largest component by far.
For these reasons, the most highly leveraged G-SIBs (global systemically important banks) are in the Eurozone and Japan. Table 1 below shows their balance sheet leverage from highest to lowest (the third column), and the price to book rating upon which the market values this leverage risk. Share prices were as of last weekend.
With the Eurozone’s and Japan’s G-SIBs heading the list of most highly leveraged banks, the question before us is now that interest rates are rising, how will these banks adjust their balance sheet ratios to more normal levels, which are probably in the region of eight to ten times or even less? True balance sheet gearing in all cases is likely to be far, far higher principally because of the accounting treatment of derivative obligations. These are the banks leading involvement in repos, have significant derivative positions, have netted out foreign exchange, commodity, and credit derivatives, and have only partially reflected off-balance sheet obligations through standardised credit conversion factors.
In general terms, in the new interest rate environment banks are almost certain to restrict counterparty risk by reducing their exposure to other banks for two reasons. Firstly, contracting balance sheets throughout the banking industry enhance systemic risk significantly, and a significant number of the banks in Table 1 are highly likely to fail. And secondly, as a cohort bankers are motivated to act the same way for the same reasons at the same time, even for banks without derivative exposure. The contraction and consequences of interbank obligations should not be ignored.
The problems of rising inflation, interest rates, and bond yields
After decades of minimal price inflation, central banks were caught unawares when consumer prices started to rise and continued to do so. Initially, they said it was transient. When they were laughed at, they then merely pushed back their forecasts of consumer price inflation returning to the 2% target back a year. The chart below, of the current UK’s Office for Budget Responsibility forecast is typical. It is due to be updated on 17 November, but it is a racing certainty that the OBS will still expect it to return to 2%, a little further delayed. To admit otherwise is to acknowledge a complete failure of monetary policy.
The US Congressional Budget Office is similarly unrealistically optimistic about the outlook for consumer price inflation. The illustration below is lifted from the CBO’s website.
But with consumer prices already rising in the US, UK, and Europe at a 10% clip and likely to go higher in the coming months, the interest rate disconnection is substantial and can only be bridged with interest rates doubling or even tripling from current levels. Even if they only double, business plans for all manufacturers and service providers will go out of the window. And with that catastrophe, bad debts for the banks will simply soar.
The effect on financial securities will be no less devastating. While banks generally limit their bond exposure to shorter maturities — typically bills and bonds maturing in less than a year — it is likely that banks in the Eurozone and Japan will have some exposure to longer maturities. They might have some exposure to corporate bonds and collateralised debt obligations as well, which will be at risk from rising interest rates. This is not to be ignored, and the evidence of a downturn in credit availability for corporates is already evident in loan officer surveys. Our next chart, of US banking sentiment towards corporate borrowers confirms that credit contraction for non-financial borrowers is already underway.
Clearly, bank credit is set to contract mightily, and together with higher interest rates it is likely to lead to escalating non-performing loans, insolvencies, and rising unemployment. These conditions are likely to develop before interest rates can properly reflect the debasement of the major currencies, reflected in the rise in consumer prices.
Economists commonly assume that the developing recession will restrict consumer demand, leading to an amelioration of the consumer price inflation problem. Furthermore, some supply chains are beginning to flow again, particularly with respect to computer chips. But before we can consider how a fall in demand affects prices, we should remember that the initial market effect of contracting bank credit is always to drive interest rates higher, due to accelerating credit demand arising from lost sales and accumulating inventories while banks are trying to reduce their credit obligations.
Since almost all recorded transactions that make up GDP are settled with bank credit, its contraction will reduce GDP as well. The extent to which this is the case cannot be mechanically predicted. However, since bank balance sheets are very highly leveraged and rising interest rates will force a severe credit contraction, the effect will not be trivial. If a banker is to retain control over non-performing write-offs, he must not delay in reducing his exposure.
It is for this reason that the cycle of bank credit is like a saw-tooth series of gradual increases followed by sharp declines. And the more exaggerated the increase, the more catastrophic the decline.
Mortgage loan books
It turns out that the sub-prime mortgage crisis of 2007-2009 was little more than a blip in the growth of bank lending for residential property ownership. But America with Fanny Mae and Freddy Mac is different from other jurisdictions, where banks have become highly active originators in the mortgage business.
With old memories of ruinous interest rates, borrowers have consistently gone for fixed rate mortgages in preference to floating rates. Some 80% of residential mortgages in the UK are fixed rate for between two and five years before they are reset. Until recently, to opt for fixed rates was the wrong decision. Banks have profited mightily, not by simply lending long and borrowing short, but by covering fixed rate offers with interest rate swaps allowing a healthy turn for the bank, with early termination expenses covered by penalties for the borrower.
For a bank, the beauty of this business lies in the transaction size and minimal administration. And with house prices continually rising, the collateral has been secure. But this has now changed dramatically, with mortgage rates soaring and house prices turning lower. The previous lucky minority who opted for floating rates find they face an enhanced risk of repossession of their homes. And interest rates have probably only started to increase.
From a banker’s point of view, this is turning into a very bad business. Payment defaults are certain to increase rapidly; not just for those on floating rates, but with the majority of borrowers on two- and three- fixed rate deals which are maturing at a rapid rate. A two-year fixed rate of less than two per cent faces renewal at over three times that. And no banker wants the bad publicity of foreclosing on homeowners and their families in droves, “who through no fault of their own” face eviction.
In any event, when homeowners in large numbers face eviction, the lenders have the problem more than the homeowners. It is both politically and practicably impossible for lenders to evict families in large numbers and put their homes up for sale. Apart from anything else, residential property values would collapse under the combined weight of higher borrowing costs (if mortgages are still available) and an increasing supply of liquidated housing stocks. Look no further than what happened to property prices in cities like Atlanta in 2007-2010, as the liar-loans were unwound. All that happens from the bank’s point of view is that even solvent borrowers would be pushed deeply into negative equity.
The difficulties in managing these politically toxic issues will not be the only problem facing bankers. Existing fixed-rate mortgages have been covered through credit default swaps, which are only as good as a bank’s counterparties. If, say, a British bank has a highly leveraged Eurozone bank as its counterparty, it will soon be thinking about counterparty risk in a more focused way. Where it can, it should seek to novate these obligations with more secure counterparties. But that comes with costs.
In a rising interest rate environment, this easy-come business will not be easy-go.
Wider derivative considerations
According to the Bank for International Settlements, OTC derivative market interests in the global banking system amounted to $600 trillion equivalent of notional amounts outstanding last December.[i] Being based on only seventy dealers in twelve countries reporting to their respective central banks, the statistics are not the whole picture, capturing an estimated 94% on average of their wider triannual survey covering an additional thirty nations.
To this can be added a further $40 trillion in regulated futures and options markets, in which banks play a major counterparty role. To give an idea of the sheer scale of these activities, global GDP is estimated at roughly $100 trillion.
The credit nature of OTC derivatives is poorly understood, and therefore widely ignored by commentators. Nevertheless, these are credit obligations which are only extinguished after the terms of the individual derivative contracts have been satisfied. But being purely financial, they differ from a contract which has on one side the delivery of goods or a service, and on the other a settlement invariably in bank credit. A financial transaction, be it a forward settlement, a swap, or an option exercise, involves both debt and credit obligations. And since debt is synonymous with credit because one always balances the other in both parties’ books, until a financial obligation is settled there is twice the notional credit involved.
The simplest example to take is deferred settlements, such as foreign exchange forwards. In these cases, there are two parts to the contract: there is the initial agreement, under whose terms there may or may not be a partial margin payment due immediately, and the second part is satisfaction of the entire contract by its completion.
At a notional $104 trillion — the BIS’s figure for mid-2021— foreign exchange contracts are the second largest segment of the $600 trillion OTC total. Ten per cent of that $104 trillion are options. According to the BIS’s triannual survey, only 84% of foreign exchange contracts are captured in the semi-annual statistics, so a truer figure is $124 trillion.
By maturity, they split 80% up to a year, 15% one to five years, and the rest over five years. Therefore, these are not a simple case of next day settlement, but credit obligations of material duration.
The status of options is different from forward settlements, being initial settlements for a transaction that might not eventually take place. The buyer of the option has no further credit obligation other than the initial payment of a premium to the seller of the option. But the latter party does have a continuing credit obligation which is not in his power to extinguish before it finally matures. Because all foreign exchange contracts on the BIS’s statistics represent only one side of foreign exchange contracts, the whole amount of $124 trillion are definitely credit, the majority of which, only excluding options, is duplicated by matching credit obligations for the other counterparties. Therefore, total foreign exchange derivative credit in trillions is double notional amounts outstanding less one side of notional options. This amounts to $236 trillion.
According to the BIS, the gross market value of this credit is $2.548 trillion. The BIS defines gross market value as “the sum of the absolute values of all outstanding derivatives contracts with either positive or negative replacement values evaluated at market prices prevailing on the settlement date”. In other words, to the extent to which the banking system is counterparty to these OTC derivatives, in total their balance sheets will reflect this figure, and not actual credit obligations, which are almost a hundred times greater.
It is in this context that counterparty risk must be considered. Counterparty risk is a wager that delivery of a credit obligation might not occur, and the relevant figure with respect to foreign exchange commitments alone for assessing it is $236 trillion. As an indication of the scale of these credit obligations, the BIS reports that the total of global bank credit to the non-financial sector amounted to $226.3 trillion at the date of its latest derivative statistics, similar to the scale of foreign exchange derivative credit on its own.[ii]
In round figure terms, all other OTC derivatives in the BIS statistics total about five times the recorded foreign exchange total. They include in the BIS’s notional amounts:
Interest rate contracts — $475.2 trillion
Equity-linked contracts —$7.28 trillion
Commodity contract — $2.22 trillion
Credit derivatives — $9.06 trillion
Credit default swaps — $8.80 trillion
Not otherwise classified — $337 billion.
Interest rate derivatives in rising rates
Interest rate derivatives make up the vast bulk of all OTC derivatives, with the notional contract amount of interest rate swaps totalling $397.11 trillion, and forward rate agreements adding a further $39.44 trillion. A swap is a financial derivative in which two parties agree to exchange payment streams based on a specified notional amount for a specified period. And a forward rate agreement is a contract in which the rate to be paid or received on a specific obligation is for a set period of time, beginning at some time in the future.
What concerns us here are the consequences of a rising trend of interest rates for the values of these contracts. FRAs might continue thrive if interest rate relationships along yield curves permit. But an environment of rising counterparty risk might be a hurdle too high for participating banks to overcome. A far more important consideration is the future for interest rate swaps.
Unlike the foreign exchange contracts described above, interest rate swap notional amounts are not bank credit obligations. The credit commitments of both parties are only for the income streams on a notional amount. An originator, usually a bank, funds a fixed interest stream from a floating rate, rather than the other way round.
A clue to the relationship between the gross market value of these contracts and interest rates is illustrated below, which is of interest rate swaps only originated in US dollars.
The chart confirms what we would expect: that major falls in the Fed funds rate stimulate the gross market value of interest rate swaps; and increases in the funds rate correspondingly leads to falls in their gross value. From this, we confirm that declining interest rates lead to profits for banks taking floating rates and offering fixed rates. This is the protection that customers from the gamut of pension funds to homeowners seek from higher rates. While over the long-term interest rates were declining, interest rate swaps were a profitable form of insurance product for the banks to offer. And we can now see that with sharply rising interest rates, not only will these profits vanish, but the banks are bound to exit this market entirely.
This is the heart of The Great Unwind. It will be a surprise to observers to see the BIS’s OTC derivative statistics collapse as interest rates rise further. Existing contracts with time to run can be closed down by buying out counterparties, entering offsetting swaps, selling the swap to another party, or entering an option on offsetting swaps. But these solutions to a bank withdrawing from interest rate swap obligations will be very costly, if available at all, as the entire banking cohort attempts to depart from this market.
Undoubtedly, large losses will result, threatening the entire global banking network through enhanced systemic risk.
Derivatives and the Bretton Woods III meme
That we are entering an entirely new banking and financial environment was originally put forward by a Credit Suisse analyst, Zoltan Pozsar, earlier this year. Pozsar argued that since the ending of Bretton Woods, a new financial era had dominated financial markets, which he described as Bretton Woods II. He contended that the trend for lower interest rates has now ended, that global supply chains will be repatriated, and that the era of the petrodollar is over. Instead, Bretton Woods III will be the era of commodity-based currencies.
Driving his argument was the imposition of currency sanctions against Russia. In his 3 March article, he posed the question: is the OTC commodity derivatives market the gorilla in the room?[iii] His concern was over margin calls faced by producers and others in the physical commodity business hedging physical product by carrying short positions in the futures markets. As if on cue, Trafigura, the big commodities trader, had to be refinanced within weeks of Pozsar’s note having received massive margin calls on its OTC positions.[iv]
Since Pozsar’s note, Saudi Arabia has signalled the death of the petrodollar by aligning itself with the Russia-China axis, and is scheduled to join the BRICS organisation next year. Members of the Eurasian Economic Union are planning a new trade settlement currency, said to be linked at least partly to commodities. And Moscow is setting up a new gold exchange to handle Russian and other nations’ refined gold, which will almost certainly adopt China’s 99.99% gold kilo standard.
Undoubtedly, the movement towards commodity-linked currencies, the decline of the dollar’s hegemony, and of western financial markets will have a major impact on commercial banking. One wonders how many of the banks weaned on financial activities can make the transition back to traditional lending. And if global supply chains are a thing of the past, will they be prepared to provide the credit for investment in replacement component production in the advanced economies?
As a subset of commodity derivatives, the London Bullion Markets’ forward contracts were estimated to be $781bn on 31 December 2021, of which gold forwards and swaps represented $528bn. At that date, this was the equivalent of 8,975 tonnes compared with 1,595 tonnes in the main gold contract on Comex — a ratio of 5.6 to one
The other side of the LBMA banks’ derivative positions is unallocated customer accounts, originally devised and expanded as a means of diverting demand for gold that would have otherwise driven up the price of bullion. The trend towards increasing quantities of paper bullion relative to the physical is likely to be reversed, because suppression of the gold price is now leading to accelerating demand for physical bullion.
While Keynesian hedge fund managers claim that higher interest rates are bad for the gold price, rising interest rates are bound to render derivative trading unprofitable for banks which find themselves both short of derivatives, and technically short to their unallocated bullion account holders. As quickly as the London bullion market developed in the 1980s, it is likely to diminish as interest rates increase.
Economic consequences of contracting bank credit
Today, the priority for commercial banks is to reduce their balance sheets to more normal conservative levels in their shareholders’ interests. Without considering secondary factors, the likely consequences of a severe credit contraction for the nominal GDP statistic could be to reduce it by a third or more in major jurisdictions. Realistically, central banks will have no option but to finance the losses of tax revenue and the increased welfare burdens falling on their government’s shoulders. The expansion of central bank currency and credit will replace the contraction of commercial bank credit.
Empirical evidence suggests that a population is more alert to the inflationary implications of central bank credit expanding than that of commercial bank credit. Essentially, if the public deems the currency to be stable, it will respond to higher prices when it is the result of bank credit expansion by moderating their spending. But if the public sees the currency as being unstable, they will vary their spending, and therefore their liquidity reserves accordingly.
Clearly, the political imperative will be to replace lost commercial bank credit with central bank credit. Nor can we rule out “helicopter drops” in an attempt to stimulate recovery. But having tried these measures during the covid pandemic, the public reaction to central bank debasement in a deep recession is almost certain to be less tolerant.
Central banks, which are already ceding control of interest rates to market forces will find they continue to rise as currencies’ purchasing powers continue to quicken their collapse.
As dealers in credit, banks face the most difficult times in living memory. Austrian economists have long understood that the business cycle is driven by a cycle of bank credit. The root of the credit cycle has been ignored by statist economists and policymakers who respond by suppressing the evidence. This has been going on with increasing intensity since the 1980s, when the Fed under Paul Volcker broke with interest rate suppression to slay the 1970s inflation dragon.
Since then, the era of pre-Bretton Woods price stability has been replaced by the fiat dollar as the reserve currency, with demand for it engineered by Triffin’s dilemma: balancing the export of dollars through budget and trade deficits with global demand for it. The expansion of derivative markets served to conceal the inflationary effects by shifting the supply of dollar credit into financial markets, away from non-financial activities. This lessened the consequences of currency expansion on the prices of goods and services, allowing the monetary authorities to suppress interest rates without apparent ill effects.
That period has now ended, and The Great Unwind of all the distortions accumulated over the last four decades has begun. No one in government and central banking circles saw it coming, and they are still in denial.
Commercial bankers are becoming acutely aware of the dangers to their business models. At the moment, they have only a growing fear of the consequences of interest rates seemingly out of control. Having been protected from free markets by central banks and their regulators, this loss of statist control is immensely worrying for them.
It is now dawning on commercial bankers that they have been left high and dry, with over-leveraged balance sheets, loan business rapidly souring, loan collateral falling in value, and a derivative merry-go-round about to implode. They must stop pandering to regulators and public opinion, and now protect their shareholders from The Great Unwind by dumping credit obligations as rapidly as possible ahead of the wider banking crowd.
From banking deregulation in the mid-eighties, it took nearly four decades to get to this point. The Great Unwind might take only as many months.
Columnist Peggy Noonan wrote that Santos was “a stone cold liar who effectively committed election fraud.”
And now Santos has taken the dramatic step of removing himself temporarily from the committees he’s been assigned to: the House Small Business Committee and the Science, Space and Technology Committee. The Washington Post reports Santos told his GOP colleagues that he would be a “distraction” until cleared in several probes of his lies.
Santos’ lies may have gotten him into hot water with the voters who put him in the House, and a few of his colleagues, including the New York GOP, want him to resign. CBS News reported that federal investigators are looking at Santos’ finances and financial disclosures.
But the bulk of Santos’ misrepresentations may be protected by the First Amendment. The U.S. Supreme Court has concluded that lies enjoy First Amendment protection – not because of their value, but because the government cannot be trusted with the power to regulate lies.
In other words, lies are protected by the First Amendment to safeguard democracy.
So how can unwitting voters be protected from sending a fraud to Congress?
Any attempt to craft a law aimed at the lies in politics will run into practical enforcement problems. And attempts to regulate such lies could collide with a 2012 Supreme Court case United States v. Alvarez.
The Supreme Court rejected the government’s argument that lies should not be protected by the First Amendment. The court concluded that lies are protected by the First Amendment unless there is a legally recognized harm, such as defamation or fraud, associated with the lie. So the Stolen Valor Act was struck down as an unconstitutional restriction on speech. The court pointed out that some false statements are “inevitable if there is to be open and vigorous expression of views in public and private conversation.”
Crucially, the court feared that the power to criminalize lies could damage American democracy. The court reasoned that unless the First Amendment limits the power of the government to criminalize lies, the government could establish an “endless list of subjects about which false statements are punishable.”
In Alvarez, the Supreme Court expressed concern about laws criminalizing lies in politics. It warned that the Stolen Valor Act applied to “political contexts, where although such lies are more likely to cause harm,” the risk that prosecutors would bring charges for ideological reasons was also high.
The court believed that the marketplace of ideas was a more effective and less dangerous mechanism for policing lies, particularly in politics. Politicians and journalists have the incentives and the resources to examine the records of candidates such as Santos to uncover and expose falsehoods.
The story of George Santos, though, is a cautionary tale for those who hold an idealized view of how the marketplace of ideas operates in contemporary American politics.
Democracy has not had a long run when measured against the course of human history. From the founding of the American republic in the late 18th century until the advent of the modern era, there was a rough division of labor. Citizens selected leaders, and experts played a critical gatekeeping role, mediating the flow of information.
The election of George Santos illustrates the challenges facing American democracy. The First Amendment was written in an era when government censorship was the principal danger to self-government. Today, politicians and ordinary citizens can harness new information technologies to spread misinformation and deepen polarization. A weakened news media will fail to police those assertions, or a partisan news media will amplify them.
Justice Stephen Breyer’s concurring opinion argued that a different test should be used. Courts, Breyer said, should assess any speech-related harm that might flow from the law as well as the importance of the government objective and whether the law furthers that objective. This is known as intermediate scrutiny or proportionality analysis. It is a form of analysis that is widely used by constitutional courts in other democracies.
Intermediate scrutiny or proportionality analysis does not treat all government regulations of speech as presumptively unconstitutional. It forces courts to balance the value of the speech against the justifications for the law in question. That is the right test, Justice Breyer concluded, when assessing laws that penalize “false statements about easily verifiable facts.”
The two approaches will lead to different results when governments seek to regulate lies. Even proposed, narrowly written laws aimed at factual misrepresentations by politicians about their records or about who won an election might not survive the high degree of protection afforded lies in the United States.
Intermediate scrutiny or proportionality analysis, on the other hand, will likely enable some government regulation of lies – including those of the next George Santos – to survive legal challenge.
Democracies have a better long-term survival track record than dictatorships because they can and do evolve to deal with new dangers. The success of America’s experiment in self-government may well hinge, I believe, on whether the country’s democracy can evolve to deal with new information technologies that help spread falsehoods that undermine democracy.
Miguel Schor does not work for, consult, own shares in or receive funding from any company or organization that would benefit from this article, and has disclosed no relevant affiliations beyond their academic appointment.
Having not long finished the festive season and commenced a new year, many of us take the moments shortly after to reflect on the year that was, and also consider what we would like to see in the year ahead.
With that in mind I thought I would take a look back at 2022. Last year will likely be remembered for three key events, firstly it generally saw the world exit the pandemic cloud of COVID-19. Secondly, we saw the commencement of the war between Ukraine and Russia. Thirdly, we saw inflation return with a vengeance being quickly followed by one of the fastest tightening cycles in history by Central Banks. The official cash rate in Australia increased from 0.1 per cent in April 2022 to 3.10 per cent by the December meeting of the RBA.
This mix of events led to one of the strongest risk-off years we have seen since the Global Financial Crisis, there are few places for investors to find sanctuary with losses occurring across both growth and defensive assets alike.
Investor sentiment was broadly very negative during 2022, it is always a challenge for any growth (or risk) asset to perform well when the market doesn’t have an appetite for risk of any kind.
If we look specifically at the Australian small ordinaries index, its return for the calendar year of 2022 was negative 20.7 per cent. To give this context the ASX 100 declined by 3.9 per cent and the ASX 300 return was negative 6.1 per cent. It is fair to say that the risk on trade in Small Companies over the last few years moved into reverse in 2022. This was a consequence of the above macro factors, coupled with a more bearish investor and market.
What to consider for 2023?
In moving to our outlook for 2023 we need to initially consider the 3 points above and ask where we see them today and where they may evolve to over the next 12 months. With the final question being what impact this will have on equity market performance?
As a starting point it is fair to say that the impact of COVID-19 continues to pass and become more of a memory than a current issue. Even China who were the final strong hold have now moved to accept an existence with COVID-19 and they cope with re-opening and reintegrating with the rest of the world. As it stands today, we would expect the impact of COVID-19 to continue to diminish from here. One datapoint that has been interesting to follow over the pandemic has been a UBS Composite Supply Chain Indicator which is now in a strong downward trend and moving closer to pre-pandemic levels.
A second example where we can see this is in spot indexes for international container freight costs which are now off roughly 80 per cent from their peak 18 months ago. This is interesting as it was one of the early contributors to the increase in inflation. As a leading cause it is positive to see this returning to more normal levels.
Next, we move to the war in Ukraine, which continues to grind along, and will no doubt continue to influence energy prices and broader speculation. Having said that, although the outcome is unknown, this is what at times in markets is called a known unknown. We are all aware of what is happening, many governments and countries are working around it. This is best seen in Europe where they continue to diversify their sources and supply of Energy, along with continued fast tracking of non-Russian dependent infrastructure. Short of a shock surprise, this event we can largely say has been priced into markets.
Finally, inflation and interest rates have been a biproduct of the above two events. These two arguably caused the most disruption to equity markets in 2022. At the time of writing the most recent inflation data for Australia was released last week and came out higher than consensus expectations with trimmed inflation (removing the most volatile items) coming in at 6.5 per cent against an expectation of 6.1 per cent.
At this point most major market commentators have the belief that we are likely to see two further interest rate increases in the first quarter of this year. Post this timeframe the speculation begins to grow; a portion believe inflation is going to be more stubborn and require further effort from Central Banks. Other market commentators believe that the remaining two expected rate increases will be sufficient to manage inflation, particularly given the delayed transmission mechanism we have here due to the nature of Fixed Rates and their term to reset.
Some also believe we may see interest rates start to fall in late 2023, which would become a tailwind for equities, in particular some of the growth names which had the toughest performance over 2022.
What can we expect from small caps?
Looking through all of this noise and to our outlook for Australian Small Companies for 2023 we think as always the starting point is important. At a market level we started 20 per cent cheaper than the same point in the prior year. Further to this we have seen some earnings downgrades in some parts of the market, where others have proven to be far more resilient than expected. Sectors like the Resource sector managed to grow their earnings over 2022. So in some pockets, we find valuations from a fundamental perspective to be very attractive.
While there is a belief that interest rates have further to go, we still see some significant risks in the more speculative parts of the market. This is mainly around companies that will have little control over their earnings power in the next 12 months, or are less mature and as a result less capable to weather the economic conditions ahead. Increasing interest rates are also not favourable for building stocks, or some consumer stocks (although some of the high-quality names will be resilient and based on valuation look interesting).
Any companies that missed the market’s expectations on earnings were punished, if the company had to go as far as an earnings downgrade the market showed little mercy. We think this trend will likely continue into the February 2023 reporting season. These are risks we are aiming to avoid by assessing the quality of our investments and their earnings streams.
Looking further out, there is an argument that Australian Small Companies offer a significant investment opportunity for investors over 2023 if they wish to add some risk to their portfolios. They were the most sold down part of the market in 2022 so the valuation of this sleeve of the market looks attractive.
History tells us that once the economy has reached peak inflation, the peak of interest rates is usually not too much further into the future. If we do in fact only see two further rate rises from the RBA and inflation is contained then we will start to have a foundation that would be more solid and look to underpin a backdrop that would be conducive to a rally in equity markets.
As always we are not out of the woods and do expect some earnings challenges to come to the fore in February’s interim reporting season. Stock selection and active management will be critical to navigate this.
Should we see an improved outlook and also a reduction in interest rates later in the year we may start to see an improvement in investor and market sentiment. This is likely the final ingredient needed to see capital flows return more strongly to equities and in particular Small Companies.
Overall we continue to have a meaningful exposure to the Resource sector as we think that with China reopening and supply shortages still an issue for Europe in the medium term, coupled with the continued drive of decarbonisation that 2023 should be another supportive year for the sector.
We have quality exposures to structural growth companies that over a medium term investment horizon represent excellent value and are growing quality businesses. We believe we are closer to the end than the beginning of the inflation and interest rate story which over the course of 2023 we think will provide a favourable foundation for the market and the Montgomery Small Companies Fund.
LAWRENCE — As humanity tries to find its footing after the COVID-19 pandemic, the University of Kansas is taking steps to help ready the United States and the rest of the world for future global health crises.
Credit: A. Townsend Peterson
LAWRENCE — As humanity tries to find its footing after the COVID-19 pandemic, the University of Kansas is taking steps to help ready the United States and the rest of the world for future global health crises.
A. Townsend Peterson, a University Distinguished Professor of Ecology & Evolutionary Biology and curator of ornithology at the KU Biodiversity Institute and Natural History Museum, is part of a team of researchers that earned funding from the National Science Foundation to establish the International Center for Avian Influenza Pandemic Prediction and Prevention, dubbed “ICAIP3.”
The mission of the new multi-institutional center is to tackle grand challenges in global health with a focus on avian-influenza pandemic prediction and prevention. Most famously, the 1918 flu pandemic showed influenza viruses that start off in birds can kill millions of humans. But avian influenza, or “bird flu,” has triggered outbreaks around the world in recent years that killed billions of poultry and wild birds, as well as hundreds of people.
“The COVID-19 pandemic has been a wake-up call for the world, highlighting the importance of investing in public health and the basic science underpinnings of public health,” Peterson said. “It has had a scale of economic and public health impact that is unparalleled in our lifetime. This center would have ongoing viral monitoring around the world, but particularly in regions that tend to give rise to pandemic flu strains. We would have a predictive understanding of which types of new bird flu strains have pandemic potential. You can imagine the value of monitoring wild bird populations and seeing all the standing variation in flu viruses, and being able to say, ‘Hey, this one virus — this is what we need to watch.’”
The ICAIP3 center will be supported by the Predictive Intelligence for Pandemic Preparedness (PIPP) initiative, part of the NSF’s efforts to understand the science behind pandemics and build the ability to prevent and respond to future outbreaks.
“We need to be thinking big-picture when it comes to pandemics,” Peterson said. “COVID-19 is just one example of many diverse pandemics that have occurred throughout history. The Spanish flu, the plague pandemics, typhoid fever and avian influenza are all examples of diseases that have had a significant impact on human health and the economy. We need to be proactive in our approach to understanding and preventing these types of outbreaks, rather than waiting for them to happen and scrambling to respond.”
The total award for the PIPP project is roughly $1 million. Aside from KU, the ICAIP3 project has partners at the University of Oklahoma, where the work is headquartered, as well as the U.S. Geological Survey, the University of California-Berkeley and the World Health Organization Collaborating Centre for Studies on the Ecology of Influenza in Animals and Birds with St. Jude Children’s Research Hospital.
Peterson said the collaborators aim to apply for additional funding once ICAIP3 has succeeded as a proof-of-concept during its initial 18-month phase, structured to align with the PIPP aim to explore ideas for later competition for center-level funding.
The team will work to establish ongoing viral monitoring around the world, focusing most on regions that historically give rise to pandemic flu strains. The goal is to build understanding of the types of new strains holding pandemic potential and help predict and prevent outbreaks in coming decades.
Peterson and his collaborators will test available computer models that track “spillover,” where a disease can spread between animal species (“reservoir-poultry spillover” happens when wild birds give a disease to chickens, for example). Next, the team will work to improve these modelling approaches and run spillover simulations.
“If we do this well, what will come out is a model of the geographic, operational and individual-scale behavior of a pandemic-potential virus,” Peterson said. “Part of that potential is — does it stay just in one place? Or does it spread? If it does spread, does it take years, or does it spread in days?”
In essence, the KU researcher likened the work to devising an early-warning system to benefit researchers and public health officials as they decide where to devote resources for maximum effect.
With avian influenzas, part of this work must incorporate data about birds’ migratory patterns.
“You get some early warning of an outbreak going on and you say, ‘Okay, we’re pretty sure it’s a specific hypothetical virus — now, what are its most likely patterns of behavior?’” Peterson said. “How quickly will it leak from wild birds into domestic birds? If it’s coming from Asia, where would we expect it to appear in the U.S.? If you had this thing spread in the summer and get up to Siberia, then the jump may be way down into the U.S. because some of those birds think eastern Siberia is western Alaska and migrate south into the Americas in the fall. We would have a model that’s far better than what we have right now.”
Along with integrating huge amounts of disparate data into improved computer models, the collaboration will aim to build a community of researchers around a “One-Health (Human-Animal-Environment Systems) approach” they said is needed take on “the complexity, dynamics and the tele-coupling of HAES across multiple spatial and temporal scales and organization levels.” Peterson said he hoped the work also would strengthen the nation’s ability to track disease in birds and other species, as well as safeguard public health and prevent societal disruption.
“What in our lifetime has had the scale of economic and public health impact compared to COVID-19?” Peterson said. “Maybe 9/11, if you could count the war efforts after that. We’re too young to have lived through the World Wars, which probably were on the same scale here in America. But what, since then — can you think of anything? If you want a stronger America, you make an America that has a strong public health system that can respond to socially driven health threats like vaccine hesitancy. Measles was gone, polio was gone, but now they’re popping up in communities that are less well-vaccinated. And we’ll see more mosquito-borne diseases — like West Nile virus, Zika, chikungunya and dengue — all of which have recently emerged in the U.S. and each in a very different way.”