The demand for credit - both public and private

 

Most investors are concerned about the size of government debt. They should be. Deficits are out of control, with interest pushing debt-to-GDP higher as the cost of past excesses. Primary debt remains high with no controls in sight, yet the problem is broader. 

There is a strong demand for private capital given the strong increases in global capex. The private sector is competing with public markets for savings, and the cost of capital is increasing. Technology is showing strong capex, but the commodity sector is also demanding capital. Beyond energy, there is a strong need for many metals, which is finally leading to more capex after the decline in the aftermath of the commodity supercycle in 2008.

The competition for capital is real, but it is not clear that public markets are a better credit. 

What is the fixed income market telling us?

 

Fed Chairman Warsh stated that he will not provide forward guidance. The fixed income markets should do their own signalling. The combined weights of bond market participants should tell others what they are thinking. The market is speaking, and it is telling us that rates are going higher. The spread between the 2-year Treasury market and the EFFR is widening, suggesting rates will rise for a longer period. The market is expecting the Fed to raise rates to fight inflation. There are no Fed rate cuts expected as desired by the President. 

Nevertheless, we have to place the current rate increases in context. It is a return to normal after the QE and ZIRP era. That does not mean the economy will not feel the pain. The cost of capital is ,rising, which means projects will be rejected because they will not be financially attractive. 

When the extraordinary continues for too long, it becomes normal, and a return to the true normal becomes abnormal.

The garbage can model and investment decisions

Investors within organizations often face the garbage can model of decision-making. Decisions are made in a chaotic environment where goals are unclear, and participation in the process is fluid. There is often organized anarchy. Problems arise and need attention. They could be random. Solutions may or may not exist when the problem appears. The participants that may help with the decision may shift, and the choices that need to be made, when and how much, are often unclear.

Within this model, resolution is needed quickly but is not always clear. Oversight is difficult because it is not always clear who is in charge of the decision. There is often an issue with flight. Decisions are delayed or abandoned as priorities shift. The garbage can model differs from rational decision-making, yet it more closely reflects reality. 

In a chaotic environment, decision-making is not optimal; anarchy is present. Hence, investors have to break the cycle of decision-making and focus on process. One simple approach is to use models that rationalize decisions, but sometimes choices are unique and require decisions outside a model. Organizations must become process-oriented to avoid these issues. 

So what is your process? Does the organization follow it? Is there clear responsibility for who has to decide? Are preferences clear? There should be a linear sequence of actions that lead to a decision, not all information and choices coming at the same time.  

Stories are important models yet flawed

“Partial knowledge is more often victorious than full knowledge: it conceives things that are simpler than they are and therefore makes its opinion easier to grasp and more persuasive."    - Nietzche 

"History will justify anything. It teaches precisely nothing, for it contains everything and furnishes examples of everything."

- Paul Valery 

Storytellers are model builders. There is a need to describe the causal basis of experiences. A stream of events needs some causal explanation or sense-making that is realistic and comprehensible. A story will use stylized facts to support an argument, but stories are not the same as models. It is a process of causal inference that is not always based on empirical testing from large samples of data. 

Stories are especially important when data are limited or uncertainty is high. In environments of radical uncertainty or complexity, a story or narrative is a useful tool for describing the environment and making sense of causal relationships. 

Organizations use stories to help explain their actions. The story will serve as a model for how an organization behaves. Nevertheless, these stories focus on certain mythical themes: rationality, hierarchy, individual leader significance, and historical efficiency.

The story can be flawed, so investors must question the underlying assumptions behind any story, no different from how model assumptions are reviewed and tested. Stories should be reviewed through a rigorous process to avoid flawed logic based on partial knowledge.