Jesse Imer
Fixed Income Investment Strategist
Macro & Markets
20 Aug, 2021

In Ernest Hemingway’s novel “The Sun Also Rises”, he wrote the brilliant two line:

“How did you go bankrupt?”

“Two ways. Gradually, then suddenly.”

And while the novel is not explicably about finance – it follows expats travelling from Paris to Pamplona to watch the running of the bulls – it’s remarkably good at portraying how change can quickly and unpredictably affect our lives.

As in the Hemingway quote, bankruptcy (or catastrophe) happens all at once, when we hit a critical state where a transformation occurs.

Piles of Sand

Some years ago I read a book called “Ubiquity: Why Catastrophes Happen” by Mark Buchanan which told of a scientific experiment conducted in 1987 by three physicists – Per Bak, Chao Tang and Kurt Wiesenfeld.

The proposal was that when we recreationally build sandcastles or other structures there’s a point where our creation will collapse – partially or wholly – where one grain will start an avalanche.

Sometimes it can be a small one, but sometimes it seems as if the whole structure tumbles down, all at once, “gradually, then suddenly.”

What the physicists did was play their own sandpile game at Brookhaven National Laboratory in New York, New York, where they created a computer program to continually pile one grain of sand on top of the others, repeatedly.

They didn’t really care about sandpiles, but it was a functional way to analyse what’s called “non-equilibrium systems”.

What they learned?

Some avalanches involved a single grain, others ten, others a thousand, others a million that brought the entire sandpile down.

The sandpile was chaotic in its unpredictability.

To find out why this unpredictability occurred, they analysed the sandpile (using the computer) from above, colour coding the pile based on its slope (steepness).

Where it was relatively flat and stable, coloured green.

Where steep and in avalanche terms ‘ready to go”, coloured it red.

What they found was that the pile started off completely green, but as they added more sand, the red spots grew into “a dense skeleton of instability…through the pile. Hence, then was a clue to its peculiar behaviour: a grain falling on a red spot can, by domino-like action, cause sliding at other nearby red spots.”

In summary, when the red network was sparse, the trouble spots were isolated and little chance of collapse. But when the red spots grew in numbers the consequences became less predictable – just like what we see in financial markets and asset price correlations.

Source: University of Chicago, re-creation of the original Bak, Tang, Wiesenfeld model]

Critical States

Going back to high school science class, we’d call this a “critical state”, where we’re taught that the point that which liquid changes to ice or steam is a critical state; just like the critical mass that induces a nuclear reaction.

Summarily, it’s the point that something triggers a change in the basic nature or character or structure of an object, group or being.

From Bak, Tang and Wiesenfeld’s work, we were able to better analyse the occurrence of earthquakes, climate change, but also in human-induced events such as stock market crashes.

Fingers of Instability

In his book, Buchanan calls the appearance of all the red dots (critical states) “fingers of instability”.

To quote (emphasis mine):

“After all, every avalanche large or small starts out the same way, when a single grain falls and makes the pile just slightly too steep at one point.

What makes one avalanche larger than another has nothing to do with its original cause, and nothing to do with some special situation in the pile, just before it starts.

Rather, it has to do with the perpetually unstable organisation of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.”

Instability Hypothesis

Doctor Hyman Minsky (a famous economist) showed us how stability leads to instability.

Basically, the more comfortable we get with a given condition or trend the longer it will persist, then the more dramatic the correction when the trend fails.

The proverbial “it doesn’t matter until it matters”.

You can see this all over the world, from the gradual trends that brought about Brexit or the election of Donald Trump, to the GFC in 2007/2008, to the fall of the Soviet Union or the annexation of Crimea, to potentially a future invasion of Taiwan.

Stable Disequilibrium

We end up in a critical state of what economist Paul McCulley calls a “stable disequilibrium”.

We have economic actors around the world participating in financial markets through equity, fixed income, derivative markets, international trade, globalisation, multi-national business and finance.

Each player works hard to maximise their potential profit or return and reduce their exposure to “fingers of instability”.

But the longer this game runs, according to Minsky, the more likely it is to end in a violent avalanche as more fingers of instability have time to build and cause the stable disequilibrium to go into a critical state.

As an example of this, economic John Maudlin references the Asia Crisis of 1997 where the debt explosion of that decade began to unravel, as Russia was defaulting on its government bonds.

At the time, the historically sound relationship between 20–30-year government bonds broke down, where country after country suddenly saw the relationship between their bonds begin to correlate, and a diversified pool of fixed income was no longer internally diversified.

These fingers of instability caused another crisis called “Long Term Capital Management”, where one of the world’s largest hedge funds run by Nobel laureates and renowned investors Myron Scholes, Robert Merton and John Meriwether brought the financial world to its knees.

Sandpiles of 2021

Over the past twenty years – but realistically since 1973 – there has been a gradual build-up of global debt.

We saw part of the consequential avalanche in 2007/2008 through the GFC, after red dots had been showing more frequently in 2004-2007, many of which are still present today.

At the time, the red dots of the US mortgage market caused avalanches around the globe, in property markets, in European banking solvency, in reinsurance company viability (think AIG and others); all at the same time.

Central banks learnt the way to handle such a crisis was to provide ample liquidity so that investors wouldn’t be forced to panic sell, liquidating assets at deep discounts to previous’ days price levels.

That liquidity was barely withdrawn over the last decade where we saw the Taper Tantrum of 2013 and the market sell-off in Q4 2019 when the Fed tried a second time around.

Fast forward to 2020 and 2021 and we’re at “QE to Infinity”, or as I like to call it, “Unlimited Kitchen Sinks”.

Which sandpile will cause the avalanche?

In the nature of the sandpile theory, we don’t know which finger of instability will causes the avalanche, we can only estimate what is the most likely.

However, there are any number out in the world right now:

  • COVID-19
  • China and USA tensions
  • China invading Taiwan
  • Possible terrorist attacks such as 9/11 or 7/7 bombings
  • Global debt crises
  • USA’s unfunded pension liabilities
  • Growing fiscal deficit spending and currency debasement
  • Higher global stock market valuations

No More Business Cycles

One framework we’ve employed over the past year has been that there are no longer economic cycles because of the distortions that government and central bank interventions are having on society.

We’ve written about these at length in:

Where we show that we don’t have BUSINESS cycles, but that we have CREDIT cycles where POLICY is more influential than FUNDAMENTALS.

This is where deficit spending or debt growth are utilised as the #1 policy measure to foster continuous economic expansion, where it seems slow or negative growth is a failure of our political institutions, rather than a fact of life.

Where our addiction to economic growth is the main finger of instability, which permeates our global sandpile.

Anti-Fragile

In Nassim Taleb’s book “Antifragile”, Taleb provides three lessons that show what it means to be anti-fragile.

1/ Fragile items break under stress, antifragile items get better from it

2/ In order for a system to be antifragile, most of its parts must be fragile

3/ Antifragile systems work because they build extra capacity when put under stress

I love this way of explaining the concept, as economic sandpiles that have many small avalanches never have large fingers of instability and massive avalanches because the small avalanches are allowed to happen and not build-up.

In effect, regulators, governments and central banks can prevent large losses by allowing small losses to occur, rather than allowing the fingers to grow and potentially bring down entire systems or cause global recessions.

Whereas the opposite is occurring, where efforts to prevent small losses are creating fingers of instability and unrelated events are becoming increasingly intertwined.

What we do?

We build portfolios that both participate and protect.

We don’t blindly buy passive index funds and assume markets will always bounce back.

We don’t get caught in buy-and-hold strategies of simply 60/40 stock/bond portfolios.

As John Maudlin says, “cautious optimism is always the long-term winner. Always. But a buy-and-hold portfolio in today’s world is neither cautious nor optimistic. Hope is not a strategy. And that’s precisely what a buy-and-hold portfolio is”.  

We stay nimble, and active.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.