Macro

A Macro Classic?

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Classic_CokeMacro trades come in two flavors, modern and classic. Modern trades are short term, liquidity driven, mean reverting market dislocations. You stare at the screen, pounce, make or lose your money, and exit. Symmetric risk, big premium for risk management and timing. Classic trades are long term, cyclical shifts in the investment landscape. Classic trades take advantage of the myopic nature markets – extrapolating the present. Classic trades have the potential to make big money, because the risks are asymmetric and the herd is against you.

We think we see a macro classic – inflation. Take a look at this study from the St. Louis Fed… https://www.stlouisfed.org/on-the-economy/2016/february/future-oil-price-consistent-inflation-expectations. Current inflation expectations imply a future crude oil price of $0 under a semi-reasonable set of assumptions. Quibble with the model if you like, but you cannot escape the fact that current market pricing anticipate little future inflation. Am I able to predict what will drive future inflation….No. Like the card counter in blackjack, however, the deck sure looks rich.

Certain funds that Mount Lucas manages may or may not, from time to time, have positions which seek to realize an exposure to future inflation.  There is no guarantee that such positions, if established, will be established timely and exited profitably.

The Fed: Think Local Act Global?

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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.

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Better Than Advertised

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The BLS Quarterly Census of Employment and Wages, collected from unemployment claims data, provides the Labor Department with a comprehensive view of the jobs and earnings market for the U.S. economy.  The first quarter 2015 survey covered over 9 million establishments employing a total of over 135 million employees—around 98% of the total population of individuals on company payrolls. In contrast the non-farm payroll series surveys a small sample, 143,000, of the population of 9 million establishments.

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The False Precision Black Hole

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When I started at Commodities Corporation in 1979, we managed $100MM dollars. We had computers that sat on raised floors in climate controlled rooms. We were state of the art….and we still had 100 employees. Alas, fees were higher, but my point is that advancing data availability and data processing has been a boon to the investment industry.

But there has been an unmistakable downside to all this power and information, what my partner Roger has christened “false precision”. Everyone has lots of data and the power to manipulate it with ease. All questions can be answered with “hard numbers”. Risks can be fully calibrated (see previous post, A Note on Risk). Nowhere has this thinking reached more heroic levels of absurdity than at your Federal Reserve. From a Chairman Yellen speech, circa 2012:

Although simple rules provide a useful starting point in determining appropriate policy, they by no means deserve the “last word”–especially in current circumstances. An alternative approach, also illustrated in figure 10, is to compute an “optimal control” path for the federal funds rate using an economic model–FRB/US, in this case. Such a path is chosen to minimize the value of a specific “loss function” conditional on a baseline forecast of economic conditions. The loss function attempts to quantify the social costs resulting from deviations of inflation from the Committee’s longer-run goal and from deviations of unemployment from its longer-run normal rate. The solid green line with dots in figure 10 shows the “optimal control” path for the federal funds rate, again conditioned on the illustrative baseline outlook. This policy involves keeping the federal funds rate close to zero until late 2015, four quarters longer than the balanced-approach rule prescription and several years longer than the Taylor rule. Importantly, optimal control calls for a later lift-off date even though this benchmark–unlike the simple policy rules–implicitly takes full account of the additional stimulus to real activity and inflation being provided over time by the Federal Reserve’s other policy tool, the past and projected changes to the size and maturity of its securities holdings.

Lord have mercy! Can she really think this can work? Is there any Fed model that caught 2008, 1998, 1987, or any other market moving event? This is the event horizon of the false precision black hole. But don’t worry, just throw a bunch of junk mortgages in a bucket, stir, and voila – AAA. It’s all right here in this spreadsheet.

“Simple Enough To Be Good”

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picassoI just read a great book – The Simplicity Cycle by Dan Ward. It articulates wonderfully a philosophy that underpins everything we do here at Mount Lucas, something that we feel is incredibly important for investors to understand, and that investors in general are moving away from. The book isn’t finance based at all, a quick and easy read. The basic premise is summed up with the quote below:

“…humans gravitate towards complexity, in our technologies and religions, our laws and relationships, because simplicity is so often inadequate to our needs. We require a certain degree of complexity in our lives, just as we require a certain number of calories each day. Accordingly, we add layers, gizmos, features, functions, connections and rules to the things we create in an attempt to make them more exciting, more effective, or otherwise better. This preference, too, becomes a problem when it spirals out of control and produces industrial-strength concentrations of complexity that surpass our needs by multiple orders of magnitude….Simplicity is great and important, to be sure, but let me say it again: simplicity is not the point. What is the point? In a word, goodness…Simplicity matters because it affects goodness, but it turns out the relationship between simplicity and goodness does not follow a straight line. This means an increase in one does not always correspond with an increase in the other. Sometimes making things simpler is indeed an improvement. Sometimes not. Life is tricky that way”

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