Just made it back from the Middle Teton with Jackson and his buddies. No better way to spend time with people than to share adventures. Marcel Kasumovich, our Head of Research, is writing wknd notes for the rest of July. Marcel is a truly special human being, one of the top five minds I’ve encountered in all my travels, filled with wonderful market stories, life lessons, and sporting a few scars like all of us who dare reach. A wise soul. A talented communicator. And the former Chief Strategist for Soros, who helped George position for and successfully navigate the Global Financial Crisis. Mara is his editor-in-chief, as she has always been for me. It’s fun to see what they create together. Below is Marcel’s third edition:

Overall: “Now let's talk about inflation. The report on the consumer price index (CPI) for June was a major league disappointment,” offered straight-shooting Fed Governor Waller. “It is a very unusual move to increase by 100 basis points…and that really reflects the very unusual circumstances,” Bank of Canada Governor Macklem, emphasizing this will avoid larger hikes later. Central banks getting ahead of inflation brings recession into focus, caution dominates business attention. “High inflation, waning consumer confidence…the never-before-seen quantitative tightening and their effects on global liquidity…are very likely to have negative consequences,” said Jamie Dimon. JPM increased loan loss provisions and halted equity buybacks. “We'll be slowing the pace of hiring for the rest of the year,” Alphabet CEO Pichai offered to employees. Blackrock CFO Gary Schedlin explained “we are mindful of the current environment and are proactively managing the pace of…our discretionary investments” in describing slower hiring plans. Political decisions are challenged in periods of economic uncertainty. Ukrainian President Zelensky expressed shock in the decision to return turbines to Russia, as Russia demanded to satisfy Europe’s gas needs: “If a terrorist state can squeeze out such an exception to sanctions, what exceptions will it want tomorrow or the day after tomorrow?” Meantime, the IMF sought to support those hit hardest by higher inflation and rates. “We hope for a resolution of the current situation that would allow for our resumption of a dialogue on an IMF supported program [for Sri Lanka],” said the IMF Director of Communications. And it is not just debtor countries. The China Securities Regulatory Commission asked banks to disclose the degree of their mortgage exposure. “Our downgrade is a reflection of the current very tough operating environment for China property developers combined with a tight funding environment for all of them,” Moody’s said, justifying their 91 property developer downgrades in the last nine months compared to a total of 56 from 2011-2020…all in the face of a mortgage payment boycott on unfinished homes.

DeFi and DAOs showed resiliency and fragility in strained digital markets. Our research team looks at the lessons from MakerDAO – a fascinating case study in risk management. We will integrate those lessons into our ONE Bridge protoype. [click here].

Eric Peters did a podcast on Blockworks this week, discussing macro markets, why this cycle in digital is over, how to think about what comes next, and advice for his younger self. For Spotify [click here] and for YouTube [click here].

Week-in-Review (expressed in YoY terms): Mon: Chinese lockdown fears rise as Shanghai sees fresh Covid surge, Canada says it will return NS1 turbine to Russia, Japan upper house election shows strong support for PM Kishida, Kuroda says monetary easing will continue, Moody’s downgrades Mexico, Sri Lankan protestors overtake presidential palace, Fitch cut Turkey’s credit rating to junk, Japan M2 3.3% (3.1%e), Japan machine orders 7.4% (5.6%e), Chinese new loans 2.81t (2.4t exp) / China M2 11.4% (11%e), S&P -1.2%; Tue: EURUSD touches parity for first time since 2002, Yellen meets with Japan Fin Min Suzuki – will continue to consult closely on exchange markets and cooperate as appropriate on currency issues, Shanghai covid cases exceed 50 for 4th straight day triggering mass testing effort, Twitter sues Musk, Rishi Sunak emerges as front runner for upcoming Conservative leadership race in UK, Croatia to adopt the EUR on 1/1/2023, China to repay most victims of a bank scam after hundreds protested over the weekend, Japan PPI 9.2% (8.9%e), German ZEW -40.5 (-53.8e), EU ZEW -51.1 (-28p), India IP 19.6% (20.8%e), India CPI 7.01% (7.1%e), US NFIB 89.5 (92.5e), S&P -0.9%; Wed: US CPI 9.1% (8.8%e) / Core CPI 5.9% (5.7%e), BOC surprised with 100bp hike (75bp exp), BNZ hikes 50bp as exp, BOK hikes 50bp as exp, China trade with Russia +27% from same period in 2021, Fed’s Bostic says “everything is in play” leading the market to price in 70% chance of 100bp hike in July, Chile CB hike 75bp (50bp exp), Google to slow hiring for the rest of the year, Texas power grid pushed to the limit as heat wave rolls on, New Zealand home sales -38.1% (-28.4%p), China expts 17.9% (12.5%e) / impts 1% (4%e) / Trade balance $97.94b ($76.8n exp), Turkey unemp 10.9% (11.2%e), EU IP 1.6% (0.3%e), S&P -0.5%; Thu: Italy’s Five Star refuses to back Draghi’s gov’t / Draghi says he will resign / President Mattarella rejects his resignation, Japan PM Kishida says should be willing to use fiscal policy to ease the burden of inflation / asks for 9 nuclear reactors to help ease energy constraints over winter, Singapore CB unexpectedly tightens policy by re-centering the midpoint of the SGD NEER band, Philippines CB hiked 75bp in an unscheduled move, Fed’s Waller says 75bp is his base case for July, Fed’s Bullard advocates to hike 75bp again, Fed’s Daly says 100bp is in range of possibilities, JPM temporarily suspends share buybacks, crypto lender Celsius files for Chapter 11 bankruptcy, China holds emergency meeting with banks as rapidly growing number of homebuyers refuse to pay mortgages for unfinished projects, German wholesale prices 21.2% (22.9%p), Sweden CPIF 8.5% (8.1%e) / Core CPIF 6.1% (5.8%e), India wholesale prices 15.18% (15.63%e), Turkey IP 9.1% (8%e) / ret trade 20.8% (15%p), S. Africa mining production -7.8% (-10.9%e), US PPI 11.3% (10.7%e) / Core PPI 8.2% as exp, US init claims 244k (235k exp), S&P -0.3%; Fri: Japan Fin Min Suzuki says watching FX developments with great urgency and will act appropriately on currency if needed, Chile CB announces $25bln intervention to stem ccy weakness, ECB’s Rehn says likely to hike 25bp in July and 50bp in Sept, Manchin says he won’t support economic package that contains spending on climate measures or tax hikes, Sri Lanka President resigns after fleeing protestors over the weekend, Yellen blasts Russia at the G-20 Fin Min meeting, China reports highest daily virus tally in 7w, China 1y MLF unch at 2.85% as exp / China 2Q GDP 0.4% (1.2%e) / IP 3.9% (4%e) / ret sales 3.1% (0.3%e) / surveyed unemp 5.5% (5.7%e), Indonesia expts 40.68% (30.26%e) / impts 21.98% (20.10%e), EU trade balance -26b (-35b exp), Israel CPI 4.4% (4.5%e), US empire mfg 11.1 (-2e), US ret sales control 0.8% MoM (0.3%e), US impt prices 10.7% (11.4%e) / expt prices 18.2% (19.9%e), US IP -0.2% MoM ( 0.1%e), US UofM sentiment 51.1 (50e) / 1y infl exp 5.2% (5.3%e) / 5-10y infl exp 2.8% (3%e), S&P +1.9%.

Weekly Close: S&P 500 -0.9% and VIX -0.41 at +24.23. Nikkei +1.0%, Shanghai -3.8%, Euro Stoxx -0.8%, Bovespa -3.7%, MSCI World -1.3%, and MSCI Emerging -3.8%. USD rose +3.4% vs Bitcoin, +2.9% vs Brazil, +1.8% vs Yen, +1.5% vs Sterling, +1.2% vs South Africa, +1.0% vs Euro, +0.9% vs Australia, +0.9% vs China, +0.8% vs India, +0.7% vs Canada, +0.6% vs Chile, +0.4% vs Mexico, and +0.1% vs Indonesia. USD fell -10.6% vs Russia, -1.0% vs Ethereum, -0.7% vs Turkey, and -0.2% vs Sweden. Gold -2.0%, Silver -3.0%, Oil -6.9%, Copper -7.8%, Iron Ore -16.8%, Corn -3.3%. 5y5y inflation swaps (EU +6bps at 2.07%, US flat at 2.47%, JP +7bps at 0.94%, and UK -10bps at 3.63%). 2yr Notes +2bps at 3.13% and 10yr Notes -16bps at 2.92%.

YTD Equity Indexes (high-to-low): UAE +9% priced in US dollars (+9% priced in dirham), Chile +4.9% priced in US dollars (+18.2% in pesos), Argentina flat in dollars (+24.8% in pesos), Saudi Arabia -1% (-1.1%), Turkey -2.8% (+28.3%), Venezuela -3.4% (+18.2%), Portugal -3.8% (+8.7%), Indonesia -3.8% (+1.1%), Singapore -4.5% (-0.8%), Brazil -5.2% (-7.9%), Mexico -12% (-11.6%), India -13.6% (-7.5%), HK -13.8% (-13.2%), Norway -14.2% (-0.9%), UK -15.1% (-3.1%), Malaysia -15.6% (-9.5%), Colombia -15.8% (-9.7%), Thailand -15.8% (-7.5%), Canada -15.9% (-13.3%), China -16.6% (-11.3%), Australia -17.2% (-11.3%), Denmark -17.7% (-7.6%), Israel -17.9% (-7.7%), South Africa -18.1% (-12.2%), Spain -18.8% (-8.8%), S&P 500 -18.9%, Switzerland -20.2% (-14.7%), MSCI World in dollars -20.5%, Philippines -21.1% (-13%), Greece -21.2% (-11.1%), Russell -22.3%, Czech Republic -22.4% (-14.2%), Japan -22.7% (-7%), New Zealand -23.3% (-14.7%), Belgium -23.9% (-14.1%), France -25.3% (-15.6%), Netherlands -25.4% (-15.8%), Taiwan -26.2% (-20.1%), NASDAQ -26.8%, Germany -27.8% (-19%), Russia -28.2% (-44.3%), Euro Stoxx 50 -28.4% (-19.1%), Finland -28.6% (-19.8%), Korea -29.4% (-21.7%), Italy -31.8% (-23.5%), Sweden -32.1% (-21.3%), Austria -33.9% (-25.9%), Ireland -34% (-25.4%), Hungary -36% (-21.8%), and Poland -36.3% (-25.5%).

Weakest Link: Weak links lie within sectors and economies experiencing uninterrupted growth. Expectations are extrapolated from recent realities. Underwriting standards relax as growth hides risks. New Century Financial grew mortgage originations from $357mm in 1996 to $60bln in 2006. $1.2bln of capital. $17.4bln in credit lines. “CloseMore University” was the internal nickname. Originate. Sell. 60% dividend yield to discourage short-sellers. The sudden-stop in mortgage buying was the end of the line – the largest non-bank mortgage originator filed for bankruptcy April 2, 2007.

Weakest Link II: Weak links exist without systemic financial risks. Take Freeport-McMoRan (FCX). Emerging markets, China, and commodities recovered swiftly from the 2008 crisis. Strong free cashflow encouraged FCX to diversify into shale oil and gas just as China was tightening credit, sparking a global recession. The market put high odds on FCX default – long-term debt fell to 40 cents on the dollar. The company deleveraged. Terrible for shareholders. Today’s supply constraints are born from the underinvestment in those weak-link moments.

Weakest Link III: Commodities cratered in the 2015 downturn, expectations for terminal policy rates collapsed, and bond curves flattened. Long duration assets – broadly, like intellectual property – were the preferred investment. Buyouts surged: leverage companies with high free-cash-flow yields and use ‘cost synergies’ to deleverage. Even with rates low, those deals can be challenging. The Kraft-Heinz marriage in 2015 was funded by ballooning debt. But deleveraging was too slow. Shareholder value was destroyed. Another weak-link case study.

Weakest Link IV: The clues for the next crisis are usually found in the solutions to the previous one. The post-GFC macro megatrend was to issue more debt and less equity. Less equity is less principal risk. Less principal risk lends itself to weaker underwriting. That trade was funded through capital markets after the GFC, not by banks who were in a regulatory penalty box. Dealers now have less than one-tenth the credit inventory than 2007. Fragilities are now in capital markets and liquidity channels. March 2020 was a preview. Policy either accommodates or intervenes.

Weakest Link V: The leverage lending market – high yield bonds and leveraged loans – exploded to $3trln in 2021, double a decade earlier. Underwriting standards eroded. Covenants to protect creditors vanished. Opportunistic refinancing surge. But the tide is turning. JP Morgan took a $257mm write-down in Q2, stuck with loans they couldn’t move. Flexible pricing to discount unwanted loans is the new normal. Companies need to adjust – end buybacks, retain earnings. More principal risk. Fast or slow – excesses in leverage lending will be resolved.

Weakest Link VI: Debtor countries are driving inflation. Creditor countries are not immune. Inflation flips the narrative – US dollar reserves are a captive tax against creditors, savers. China gross national savings is 45% of GDP versus 18% for the United States. Chinese households flocked to what they could – physical assets are an extreme 69.3% of their wealth. Real estate dominates. Underwriting is weak. Highly indebted builders are funded by presale deposits. Credit downgrades are now rampant. Demographics are a severe headwind. Regional economies are unbalanced, fueled by coal. Political, financial, and environment threats are acute.

Weakest Link VII: The digital ecosystem is living its version of the GFC. Losses – some expected, many unforeseen – are being crystalized. It is small enough today with few direct linkages to the ‘real’ economy that digital is a spectator sport. But the areas of resiliency are the ones that can make the broader financial system stronger. Decentralized Autonomous Organizations brought risk-management changes to protocols at an unprecedented pace. It is for the public to see and learn from – its integration into the mainstream is part of the solution.

Anecdote: “Marcel,” his voice so distinctive, a charming, gentle accent. “It’s the beginning…please…let’s find…as they say…the next weakest link. Okay, bye-bye.” It’s Feb 2007, subprime just tanked. At that point in my career, I had mostly solved solvable problems –it’s a safe way of thinking. He was asking me to think through something with no verifiable solution but a verifiable outcome: The weakest link. New Century Financial was my best guess. If that survives, there’s no crisis. “This ‘subprime’ is the beginning…the beginning, of course…” he encouraged. “Do people not understand reflexivity?” A statement disguised as a question. I hunted. The subprime cracks were contained…initially. The sound from China demand was still piercing. Oil prices were back on the rise. “Be patient,” he would say to me – a gracious gentleman in all times, yet ruthlessly efficient with ideas and risk. New Century Financial was bankrupt by early April 2007. Cracks began to splinter funding markets. Naivety was my superpower. No priors. No banker friends. Boulder on my shoulder. “May I have an update please?” he would ask on the other line. I would take a breath, ready to launch. “Start at the beginning” was his playful ask for the bottom line. Avoid excessive detail. Detail was for my conviction, not his. Weakness would be exposed, harshly. August 2007. Funding markets froze. Trust between intermediaries lost. Not normal. After novel intervention and a couple of rate cuts, the equity market was almost back to the highs on Nov 1, 2007. We navigated. “People declaring victory?!” he’d push. “Enthusiasm is deeply…well…misguided.” A banking crisis simmered beneath the surface. And so, more than a year after initial study, sweat, resignation, and navigation, he was ready. “Now’s the time”…to be bearish. Philosophic. Risk as a philosophy. A mindset. A way of life. And a kid from the peach capital of Canada on the ride, learning lessons I could only appreciate by leaving. “Some clever notes on Malaysia…please…you know. Okay. Bye-Bye.”

Good luck out there,

Marcel Kasumovich

Head of Research

One River Asset Management

Toronto, Canada

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.