This week I seek inspiration from Donald Rumsfeld. The gentleman who was US Secretary of Defense through the Second Iraq War is remembered in this country with a quite unfair degree of ridicule for his 2002 comments concerning known knowns, known unknowns and unknown unknowns. The differentiation between the three types of risk is a requisite skill of the investment world. It was, one might even argue, the basis for the Nassim Nicholas Taleb’s seminal work “The Black Swan”.
Let us deal with the black swans first. The concept has developed an improper ubiquity in describing almost anything that is unlikely. Like Foinavon, or Leicester City. This is wrong. It was not impossible for Foinavon to win the Grand National; the odds of this happening were priced at 100/1. It may help if I explain a little of Nassim Taleb’s derivation of the term ‘black swan’. His argument is that there was a time in European history when a certain number of impermeable truths were known about swans. They were large, occasionally grumpy, good to eat and exclusively white. That was until someone sailed to Australia and found black ones. Until then, nobody would have considered that a swan could be black. Now this more or less fits the bill (purely unintended) of an unknown unknown.
Foinavon was a known unknown. And this is completely different. The point that both Rumsfeld and Nassim Taleb make is that it is very much easier to account for what you know you don’t know. My point of reference is the latest American bank to bite the dust: First Republic. Having been on the critical list for a number of weeks, First Republic has been forcibly consumed by the gluttonous JP Morgan.
This is probably very much for the best. The problem was that First Republic had, with hindsight, rather rashly provided very large mortgages with very low and fixed rates of interest. These were funded by deposits and other borrowings, which had become very much more expensive thanks to the rapid increases in the American fed funds rate. The bank had taken a massive bet on US rates staying low, and got it wrong. The estimable Jamie Dimon, chief executive of JP Morgan, insists that First Republic, and SVB before it, are isolated incidents and are not indicative of a wider, or systemic problem. He is probably quite well placed to know, but given that even First Republic’s regulator did not know the risks it had taken, we should not take Dimon’s word for it.
Nor will anyone else. We don’t know. However, the important part is that we know we don’t know. Or more accurately, the market knows that it doesn’t know. And that matters. The markets tend to be very efficient in pricing their known unknowns. The US (and global) regulators have an impossible task in micro analysing all the banks under their charge; as we argued in this column a couple of weeks ago, bad banks are an inevitability every once in a while. The regulators, though, have so far made a three-quarters decent effort in keeping everything under control. Two large American, and one European, banks have been successfully and relatively quietly absorbed into the wider banking systems. That is a job well done. For us, the greater risk is that, rather than seeing a series of failures and rescues, the banking system as a whole starts to be much more cautious and reins back on its lending. The US money supply (as measured by M2) is already shrinking; a tightening of credit as well would be much more of a challenge.
For banks currently feeling pain, this week is not going to help. The Federal Reserve is set to raise US rates by a quarter point tomorrow evening, with the ECB set to do the same on Thursday lunchtime. The markets are saying that, at least for the Fed, this will be their last upwards move. If the markets are right in this, and also in their expectation that tomorrow’s rise will be reversed before Auld Lang Syne is joyously sung, then rates are already too high. It will take time for the evidence to come though, and Friday’s update to the non-farm payrolls should show yet another month of strong hiring in the United States.
Finally, well done to all the Neil Sedaka experts who know last week’s line from Laughter in the Rain. Today, this should be a gimme: “That’s what my heart yearns for now”. Whose heart?
Jim Wood-Smith – Market Commentator and Head of Climate Transition
FPC1028
All charts and data sourced from FactSet
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