Is the Fed the world’s central bank or a domestic institution? As we see it, this is the key question for the Fed at its next meeting. The economic data since the last meeting, looked at in isolation, should lead them to continue hiking the Fed Funds rate – simply put, the unemployment rate now stands at 4.9%, and inflation has made further progress back to the target with core CPI at 2.2%. The charts below show the progress toward the dual mandate. On the employment side we look at the unemployment rate against the NAIRU measure. On the inflation side we use the sticky and flexible price series.
The MLM Index™ (see www.mtlucas.com for a description of the MLM Index™) does not include an allocation to equities. Many of our trend follower competitors do include them, and as a result we get asked all the time the reasons behind excluding them. As we have written about in previous posts (Portfolio Symmetry and Commodities are not Stocks), we believe that commercial markets like commodities, currency and interest rates are fundamentally different than equity markets, and need to be accessed in a different way, matching the economic rationale for the markets existence. Equity markets exist to fund the growth of capitalism and transfer capital from savers to businesses to be invested profitably. That’s a long only rationale in our mind, as the market participants are overwhelmingly one way. We think this is borne out by the tendency of equity earnings and prices to generally rise over time as economies grow. It also means that there isn’t a natural investment pool short the equity markets – no one has a business model that relies upon falling equity prices. One way you can see the differing utility functions is in the options market – implied volatility on puts trade at a premium to calls, as the demand for protection of a long investment book is much greater than the demand for call protection on a big real money short portfolio. Continue reading
Obviousness alert! – getting the asset class betas right is the most important first step in building a portfolio. Once those decisions are made, adding alpha is an important secondary objective. We invest along the same lines we see businesses operating in the real world – raising capital to fund growth through equity and credit markets, while managing the operational price risks that impact the running of the business as best they can. Both of these create risk premiums; markets exist to transfer them to investors. We try to balance them. To us, these two premiums are complementary, but need to be accessed in different ways. The investment risk premium funds economic activity by investing in equity and credit securities from the long side, directing capital to those who seek to expand and transfer capital risk. The price risk premium takes on exogenous input and output cost risk in commodity prices, currency movements and interest rates, facilitating hedging that allows business more certainty in operations, allowing them to focus on the core expertise. Crucially, it does this from both sides of the market, trend following long and short. Combining these is very attractive, as one side thrives on stability and generally rising growth, whilst the other thrives in times of instability. Put very simply, the investment risk premium looks for cash flows, the price risk premium looks for crash flows. We think of trend following as a beta in its own right, an important distinction between us and other more traditional long only approaches. It is a beta that most portfolios are wildly underexposed to, if they have any exposure at all. We believe in equalizing the risk between them, viewing both as having long term positive expected returns while being uncorrelated most of the time, and often negatively correlated in times of stress. When it comes to adding alpha to these balanced betas, we do all the things the academic literature leads you to – buy value, momentum persists, diversify, equally weight. Over time, we expect all of these alpha decisions to contribute strongly to the static beta approach above.
The diversification of balancing these premiums has played out a number of times over the years, and we are seeing it again as we start the new year. The stability the investment risk premium prefers is rattled by fears of global growth. This is getting offset by the price risk premium is capturing the fear as it manifests itself through flows in other asset classes – falling commodity prices, a flight to safety in bonds and flows into safe haven currencies. It has been a great example of a concept we have seen for many years, and highlights how more traditional long only approaches to investing in commodities don’t make sense. Structurally, over time, human ingenuity lowers the real price of commodities, while cyclically they move on supply and demand. They are not static long only investments, one needs to be able to take both sides of the market, taking on risk from producers and users. We think of interest rates in a somewhat similar way – a factor outside the control of a business that needs to be managed. Developed market bonds offer very low or negative real returns. Investors that leverage bonds in order to equalize volatility or returns with equity markets are running real risks – having the flexibility to take exposure on both the long side and the short side will be crucial in the coming years.