For those of you television fans suffering from Game of Thrones withdrawal, we have just the answer for you: HBO's 5-part historical drama miniseries Chernobyl!
Yes, this is a TV show about the worst nuclear power plant incident in history (both in terms of cost and casualties), most of you probably know how it ends but hear us out. First and foremost, the filmmaking - created and written by Craig Mazin and directed by Johan Renck - is absolutely superb. The storytelling is creative and keeps you on edge throughout five unbelievable episodes. The top-notch casting is led by a one-two punch from Jared Harris as Valery Legasov and Stellan Skarsgard as Boris Shcherbina.
As investors, we seek lessons in all kinds of areas outside our limited narratives of the investment world. This story is chock-full of lessons, but perhaps the most impactful are the dire implications stemming from a "failure of imagination" or the inability to think through all the potential outcomes of less-than-ideal scenarios (see our blog on the topic: HERE). In the first episode of Chernobyl, a young engineer runs into the power plant's control room after the explosion. This is the exchange between he and Deputy Chief Engineer Anatoly Dyatlov, the deputy chief-engineer of the doomed plant:
ENGINEER: "There is no core. It exploded, the core exploded!"
DYATLOV: "He's in shock. Get him out of here."
ENGINEER: "The lid is off. The stack is burning. I saw it!"
DYATLOV: "You're confused. RBMK reactor cores don't explode."
After the exchange, Dyatlov continues to refer to anyone who reports that the core exploded as "delusional." Out of ignorance, he fails to consider the possibility that the core could explode and goes on to report to Communist Party committee members that the biggest nuclear disaster in the history world is "just a fire" and "the situation is under control." Chief Engineer Nikolai Fomin, Dyatlov's superior, also refuses to accept the horrifying possibility and insists an explosion from the fire is "the only logical explanation." The failure of imagination traveled up the chain of command, resulting in the Communist Party missing the chance to save countless lives in the days, weeks, and months that followed.
We strive to avoid a failure of imagination in our investment outlook; always attempting to think about what could go wrong. These days, we remain focused on what could put an end to this incredible business cycle expansion we have enjoyed since 2009 (BTW - as of July, this expansion is now officially the longest on record since 1900!). We know the Federal Reserve Bank - through its control of short-term interest rates from its interpretation of economic conditions - is the biggest threat to business cycle expansions. By the numbers, since the Fed has been in existence, every recession - save one - has been associated with the Fed, in an effort to stave off an overheated economy, raising interest rates too much, too fast, or both. A current source of concern is wondering if the Fed has already made a mistake by overtightening short-term monetary policy.
The signs are not encouraging.
Milton Friedman, the great Nobel prize-winning economist, taught more than five decades ago that "easy" or "tight" monetary policy is associated with short-term interest rates "below" or "above" some unobservable "equilibrium" interest rate. Equilibrium could be considered the “goldilocks” rate: not too low (to cause overheating), not too high (to cause a recession), but just right. This equilibrium rate balances economic growth at potential and inflation near a suggested target for the economy. It has nothing to do with the absolute level of interest rates, i.e. just because interest rates today are below levels from 10 and 20 years ago does not mean interest rates are low.
While we cannot identify the equilibrium rate in real time, it is fairly easy to tell if the Fed has been chronically above or below it: if GDP growth and inflation have been high, it is a sure fire sign that the Fed has been too easy; if GDP growth and inflation have been low, it is a sign the Fed has short-term interest rates above the equilibrium interest rate. When using this lens, it appears that GDP growth is slowing and inflation has never been sustainably above the Fed's 2% target during this business cycle expansion. Alas, perhaps the Fed's short-term monetary policy has been, and is, too tight.
Waiting for the Fed to correct this situation puts the soft-landing scenario (which is a very desirable outcome, slowing economic growth without recession) at the forefront of discussions this year at greater risk than would otherwise be the case and increases the chance of moving into a recession sooner rather than later. The implication for investors here, of course, is that recessions frequently coincide with bear markets.
It’s not possible to predict every potential outcome associated with the Fed's monetary policy stance or other investment phenomena. However, unlike Dyatlov and Fomin, we do have tools to help mitigate the fallout (no pun intended!) of our own failures of imagination. A sound financial plan incorporates strategies to moderate the effects of unforeseen events and outcomes. A prudent asset allocation helps to mitigate the damage when the investment ride gets rough. A long-term investment horizon puts equity market drawdowns into better perspective. We don’t fear the recession; as we have said, it is inevitable. Instead, we see opportunity in recession: what can all of us do in the cycle? What asset classes are more durable? What planning opportunities are available? To that end, we have created our ‘Recession Opportunity Kit,’ you can download our White Paper and find other helpful resources HERE. By the way, we don’t think the next recession will necessarily be a Chernobyl-scale catastrophe, but we do think it’s worth getting ready for.
For more information on this topic, contact Russell Moenich.