Markets should be wary of normalizing threats

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Next month, Wilbur Ross, 86, the private equity luminary and former commerce secretary under Donald Trump, will publish a memoir, Risks and returns. Investors should be careful.

Because it is framed in the saga of Ross’s amazing business career – and conversion from left-wing to right-wing politics – there is a stunning episode involving Jay Powell, the chairman of the Federal Reserve.

In 2018, as Ross recounts, the president became so angry at Powell’s decision to raise interest rates that he told Ross to “please call this idiot and explain that I’m going to repudiate him.” job, unless Powell changes his tactics.

Ross refused, replying that “Mr. President… . . It’s not clear to me that it would be in your best interest to threaten to replace him (Powell).” And when Ross finally called, Powell insisted he had “no obligation to discuss” policy with the White House. Fed independence, in other words, prevailed.

Six years later, that might seem like ancient history. Or maybe not. First, it highlights the risks that will be faced if Trump prevails in November. But it also reveals another point: the degree to which markets are now haunted by a phenomenon known as the “normalization of deviance.”

In recent weeks, stock prices have surged, pushing the Dow Jones to record highs. This not only reversed the market decline seen in early August, but provided a better performance for the stock than almost all recent Augusts, as Zachary Karabell notes on the Edgy Optimist Substack.

That market performance reflects growing optimism about the prospect of a “soft landing” for the US economy after Powell signaled in Jackson Hole that a September rate cut was in the offing.

But the paradox is that this sunny mood has emerged even as the clouds – that is, the risks – continue to grow. A new wave of geopolitical risks threatens to (at best) disrupt supply chains and (at worst) produce more war in the coming months. Meanwhile, America’s November elections look very likely to produce (at best) deep political uncertainty and (at worst) internal strife.

The problem isn’t just what Trump might do with the Fed; His team also seems eager to weaken the dollar and implement tax cuts that would add more than $4 billion to the national debt, according to Penn Wharton.

This would be alarming under almost any circumstances. But it looks doubly risky now, given that America must maintain the confidence of global investors if it is to fund its exploding debt.

As Apollo’s Torsten Slok notes, the US debt-to-GDP ratio is heading well above 100%, debt service costs already account for 12% of total government spending and a third ($9 billion) of government bonds must be refinanced in the next year alone. Sip.

A Kamala Harris victory could provide more political continuity; he is unlikely to fire the Fed chair, for example. But her economic plans could raise the debt by $2 billion, Penn says, and feature unorthodox ideas such as price controls. The other huge risk is that if Harris wins by a narrow margin, he will almost certainly face protests, legal challenges and possible civil unrest from some Trumpites.

None of this bodes well for global confidence in America. But what is most remarkable is how few of these risks seem to be priced into asset markets (except for gold); instead, the feeling of “soft landing” optimism prevails.

Why? One reason is the amount of liquidity still floating around in the financial system after years of quantitative easing. Another is the belief — or hope — that Trump’s bark will prove worse than his bite, and that his more dangerous instincts will continue to be curbed by people like Ross.

However, the third problem is the so-called “normalization of deviance”. This concept was first developed by a sociologist named Diane Vaughan when NASA asked her to study the 1986 space shuttle Challenger disaster.

Before Vaughan’s study, it was assumed that the tragedy occurred because of a major safety lapse. However, she argued that the real cause was that before the disaster there had been numerous tiny “violations” of safety standards.

These were tolerated at the time because the system was resilient enough to absorb them. However, their cumulative impact has been to change the sense of “normal” in a slow and stealthy manner. After numerous such violations, deviance became normalized and was thus ignored until it produced disaster.

Markets are different from rockets. But in recent years, investors have faced such an amazing stream of domestic and international shocks that they have almost begun to normalize them as well. A decade ago, investors might have panicked if a US president threatened to remove the Fed chair or expand the budget deficit by trillions of dollars. Now I barely blink.

In some ways, this is a joy. It certainly shows how adaptable people can be. But it also creates a risk of complacency – and a presumption that the financial system will always be able to absorb new shocks.

So if stock markets continue to rise, investors should think hard about how to hedge against the “what if” scenarios looming this fall. Then they must ask themselves what deviant threats they have learned to normalize. Threats to Fed independence could be just the beginning.

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