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Nov 1, 2022

Time To Get Real

by John DeGoey

The word “Pollyannaish” means unrealistically optimistic. If someone acts that way, they tend to show optimism that is naive. The word is based on Pollyanna, a fictional character who is excessively optimistic. Those who are Pollyannaish tend to remember pleasant items better than unpleasant ones, and their minds tend to focus on optimistic perspectives.

That tendency is what drives the thinking of some financial pundits today. Rather than being unduly optimistic or pessimistic, people should strive to be realistic. However, since everyone is prone to behavioural biases, many of which are unconscious, people think they are being consciously realistic when, in fact, they are being unconsciously optimistic. Or Pollyannaish.

People described as Pollyannaish tend to be dreamers and idealists. I consider myself to be those things, but in a particular way. I dislike Bullshift, a term I coined that captures how some people have become unduly bullish. My vision of a better tomorrow involves a world where people solve problems by meeting them head-on—honestly.

In other words, the current context matters. Cassandra was a character in Greek mythology, a Trojan priestess dedicated to the god Apollo who had her utter true prophecies. The problem was no one believed her. Michael Burry of Scion Capital uses Cassandra as his Twitter handle.

Like Burry, I think a major financial and economic crisis looms, and I lament that few people listen when I try to warn them. I could be wrong, of course, but unlike Cassandra, I offer no claims of prophecy.

My upcoming book, Bullshift – How Optimism Bias Threatens Your Finances, explores this problem along with other behavioural biases. I started writing it when COVID-19 hit. At the time, I thought markets would drop significantly, and I was right for about five weeks in February and March of 2020, but I miscalculated the impact of easy money on markets and economies. Like Cassandra, I was mocked.

Today, we find ourselves in the opposite situation. The dire consequence of runaway inflation means that, for the first time in modern history, central banks will be aggressively tightening as economic forecasts worsen. I was one of the few who seemed to underestimate the power of central bankers when they cut rates. In contrast, most people in the industry now seem to be underestimating the power of central bankers when they raise rates. It cuts both ways.

When I was wrong, I was pretty much alone in my “reading of the room.” But now, I think many others will be proven to be wrong in their reading. Central bankers have already admitted that they erred by being too slow to respond to inflation. I believe they feel obligated to rectify that error despite the consequences. Put another way; I think we are headed for a severe recession.

As of 9 August 2022, the Canadian two-year ten-year yield curve inversion gained steam, growing to 57 basis points. In September, both the Bank of Canada and the U.S. Federal Reserve hiked rates by an additional 75 basis points. Valuations remained high, and debt levels (both public and private) remained near all-time highs, too. 

The challenges of war in central Europe and lingering supply-chain disruptions seem to be more intractable than anyone expected. And, of course, inflation is now three times higher than what central banks say is the high end of the acceptable range. To me, this looks like a confluence of circumstances that will lead to a major recession and will not surprise me if the economic events of 2022 and beyond are one day called a depression.

Here’s the thing. I don’t want to be a pessimist, but I am trying to be realistic. The reality is that by the summer of 2022, interest rates were back to where they were pre-COVID and in line with what many observers would call a neutral stance. Basically, inflation is at a multi-generational high, and we have barely begun to use monetary policy as a meaningful antidote to what ails us. At least, not yet. A strong reduction in inflation is desperately needed, but the only way to get there is to raise rates much higher than the so-called neutral rate. If a two per cent interest rate is considered neutral when inflation is at two per cent, how can a rate below four per cent be considered neutral when inflation is over eight per cent or even nine per cent? Central bankers don’t want to hike beyond the four per cent range, but they may have to.

Despite this conundrum, the consensus is that the coming recession will be shallow and short-lived. The expectation was that central bankers would “pivot” and become dovish to avoid severe economic hardships. The problem, of course, was that if they did not raise rates significantly—to the point where inflation takes a significant downward turn—inflation would be seen as less of a threat than it is. There is little doubt in my mind that central bankers don’t want to raise rates too much, and there is even less doubt that they will hike, anyway.

So, the consensus seems to be that everything will be fine soon enough. However, the outcome may wind up somewhere between what we want to happen and what we think will happen. All I know is that people desperately want to believe what they want to believe. It’s Confirmation Bias. Given the positive experience around monetary policy interventions in early 2020, it is also an example of Recency Bias. Finally, given that no economists or financial advisors today were in business back in the 1930s, we can assume that none of the pundits today is drawing from personal experience regarding depressions.

Optimism is usually a good thing. Famed social psychologist Daniel Kahneman even said that if there was one attribute that he could endow a newborn child with, it would be optimism. When we experience garden-variety pullbacks, optimism helps people stay the course and take a long-term perspective which often helps calm nerves and dispel anxieties. In my view and in my experience, optimism serves as a force for good 19 times out of 20. But it’s also my view that what’s coming is the 1-in-20 outlier that could make us question everything we know—or think we know.

For the record, Kahneman’s Prospect Theory shows that people feel the pain of a loss about twice as acutely as they feel the joy of a gain.

The challenge with optimism is when things get uncommonly bad. How will you react to something you have never experienced before? We don’t know. Over the past three or so generations since the end of World War II, citizens in the West seem to have developed a sense of entitlement to a level that is impossible to sustain. We’ve made massive advances in our standard of living and life expectancy and great advances in health care, public education, and technology. Is it any wonder that we think the world owes us a better life than what our parents had? And that our children will have better lives than us?

Meanwhile, here is the reality. The “peace dividend” that’s been around for 30 years is no longer being paid, and the world is becoming far riskier in every way. Climate change is causing massive damage in terms of lost farmland, more refugees, weather catastrophes, and more. Populism is on the rise everywhere and is aided and abetted by income inequality and the social unrest that gives it oxygen. Also, misinformation is rampant to the point where seemingly intelligent people on opposite sides of an issue cannot even agree on the underlying facts of a problem, much less come to an honourable solution.

None of these realities is particularly new but denying their existence does not make them go away. As it pertains to the economy and capital markets, I prefer to remove the rose-coloured glasses. Call me Cassandra if you want, but all I’m doing is making a plea for realism. When I take off those glasses, I can look my critics in the eye and call them Pollyanna.


John DeGoey is a Senior Investment Advisor and Portfolio Manager at Wellington-Altus Private Wealth Inc. (WAPW). His views are his own and not necessarily those of WAPW and do not constitute a recommendation.