Currently the markets are deeply focused on inflation. More specifically…the lack of it as wages have risen, growth has picked up and the labor market has tightened. Core PCE has dropped to 1.55% recently. Is this a sign of underlying weakness in the economy that the Fed should respond to?
In our view, no. This San Francisco Fed Economic Letter from a couple of years ago should be the guidepost.
They split inflation into procyclical and acyclical components. Procyclical components generally have moved in tandem with the economic cycles, prices rising as the economy booms and falling when it weakens. The acyclical components dance to their own tune. They concluded that procyclical inflation had returned to its pre-recession level, while acyclical inflation had remained low, driven by idiosyncratic factors. The data are updated through March 2019 in the chart below. The white line is procyclical, orange line is acyclical.
Procyclical inflation is running at 2.5%, up a little over the past 6 months. Acyclical inflation is where the drops are. It has fallen from 1.8% to 0.9% over the past 6 months. As the San Fran Fed says, it is still being driven by drops in health care costs. There is no economic signal for the Fed to worry about here, and easing policy to remedy makes little sense. More broadly, commentators hoping for health care inflation to go back to the levels of a decade ago in order for the Fed to hit a policy goal are out to lunch. The Fed has the granularity of data to see more clearly what is going on, it seems a shame this doesn’t get more air time. Mary Daly, the San Francisco Fed Chair, presented the case in New York recently – it would be good to see the issue at the forefront.
Major asset markets are generally too large to be overly influenced or pushed around by any one participant, and so are characterized as reflecting the wisdom of the crowd. This is thought of as a positive, as individual participants value different things, have different utility functions and approach and weigh the same incoming information in different ways. The net result, through different individual buys, sells and portfolio shifts gives the ‘best’ value at any one point.
We read an interesting exchange from polymath Sam Harris on the wisdom of crowds the other day that got us thinking about how this works in reality over fairly short, but significant, periods in markets. While the wisdom of crowds notion is true over the medium term, over shorter periods, some participants do cause flows that overwhelm. The events of early 2018 are a good example. The exchange is below; Harris had spoken at an event the previous night in New York with psychologist and economist Daniel Kahneman.
Frank Villavicencio: Sam. I attended & enjoyed it but didn’t get to ask my question: your take on collective decision making. Given the many identified flaws in our individual cognitive abilities, should we consider humans as more optimized for collective, swarm-like decisioning?
Sam Harris: The crowd is only wise when individual errors are uncorrelated. When correlated—as is the case when specific biases are widely shared—there’s no safety in numbers.
Hits the nail on the head. When the errors are correlated, you don’t have a crowd, you have a mob.
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As the trade impasse with China continues, it is worth trying to think about some paths for what comes next. The US administration has a raft of complaints around issues of the bilateral trade deficit, export penetration, tighter intellectual property protections for US innovation and state support for business.
First thing to note, for all the partisan rancor in the US, and the Trump hating in Europe, it feels like this is one issue that has rapidly become consensus – China finds few friends on these issues in DC, Europe, Wall St or the corridors of power in American business. By way of example, in late March 2018 the US, through the WTO, filed a Request for Consultations with China concerning tech IP rights. In early April, the EU and Japan amongst others formally requested to join the Consultations. By June, the EU had filed an expanded Request. Continue reading →
It is likely the depth and severity of the 2008/09 crisis are contributing, through something akin to PTSD, to the deafening drumbeat of recession calls. The interviews out of the WEF in Davos are almost unanimous that a recession is coming in the next 18 months or so. David Solomon, the new Chairman and CEO of Goldman Sachs put the odds at 50% for 2020. It is by now certainly the consensus view, and judging by the interest rates curve, it is in market prices. We think this has gone a ways too far. Sure, there are paths that lead to that outcome, it is perfectly possible. But 50%? Or a base case from here? We think that’s a stretch.
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Frustrating. A sharp break in the market for stocks, diversifying assets (hedge funds, risk premia, risk parity, trend following, equity l/s) all down. What gives? In a word- Vol. In the hedge fund space, or more specifically the quant hedge fund space (which is responsible for bulk of trading flow today), trading in the short run is being dominated by reactions to changing vol. Whether you are risk parity, risk premia, trend following, equity l/s, momentum, value, carry, etc., the common theme is sizing positions based on vol. When vol is low, take bigger positions, when vol is high take smaller positions. So, what happens when equity markets break and vol spikes? Hedge funds “de-risk”, “de-lever”, “gross-down”, “vol-adjust”, “risk manage”- lots of names, all mean the same thing.
Think about it. You invested in all those factors, methods, markets, using all manner of sophisticated quantitative methods, but they all get unwound at the same time. Irony is, it is the manager’s risk management that is creating systemic risk in your balanced portfolio. Continue reading →
Roger Alcaly wrote the following review of The Man Who Knew: The Life and Times of Alan Greenspan for the February 23, 2017 issue of The New York Review of Books.
Alan Greenspan served as chairman of the Board of Governors of the Federal Reserve System, the most powerful financial position in the world, for eighteen and a half years, from early August 1987 through the end of January 2006. The second longest-serving Fed chairman, his tenure largely coincided with a period sometimes called the “great moderation,” when economic growth was relatively steady, inflation low, recessions short and mild, and serious crises defused without debilitating downturns.
Under Greenspan’s leadership the Fed had an important and well-publicized part in containing threats to the financial system and economy such as the stock market crash of 1987, the junk bond collapse a few years later, the Asian crisis of 1997 with the deep fall in the value of Asian currencies, Russia’s default in 1998, and the bursting of the tech stock bubble at the beginning of the new millennium. Although it may have received more credit than it was due, the Fed’s successes earned Greenspan widespread adulation, including the Financial Times anointing him “guardian angel of the financial markets” and Time saying he was chairman of “the Committee to Save the World.”
But despite—or because of—his achievements, Greenspan and the economy were eventually brought down by his continued failure to contain financial bubbles, sharp rises in market prices that were not reflected in underlying values. That a sustained period of stability and success in imiting potential dangers would engender complacency and hubris among both policymakers and investors is hardly surprising. Even so, Greenspan’s overconfidence is deeply troubling, for he, like the economist Hyman Minsky, was well aware of the dangers posed by financial bubbles that develop during periods of great stability. Sebastian Mallaby’s new biography, The Man Who Knew, ultimately aims to assess how seriously this one great failure undermines Greenspan’s legacy. Continue reading →
Everyone knows that bonds are rich. Right thinking people and smart beta types have looked for ways to get fixed income type results without buying bonds. At this point, it feels like bond markets are driving asset prices the world over. Negative interest rates have perversely led to bonds being used for capital gains while equity markets are being used for income. I’m pretty sure that wasn’t in the textbooks. Versions of these flows can be seen everywhere. Where bonds go, utility stocks, consumer staples, quality factors follow. Financials are the opposite of this flow, driven by net interest margins and return on equity. As bonds fall these stocks rally.
Here is a little thought experiment. Let’s compare the results of buying a basket of momentum stocks (single factor concentrated basket, price momentum) with the results of a basket tempered by volatility (2 factors, momentum (high is good), and volatility (low is good)). The difference between the two models shown below in blue, compared with the 10yr yield in red.
Source: Bloomberg; Momentum results derived from back test using Mount Lucas proprietary models
Hmmmmm… people love low volatility momentum stocks because they look like bonds. But as Minsky made clear, over time the things people buy for stability can become a source of instability. The seeds of the demise are being sown, the price moves have brought forward a lot of future income.
2nd quarter PCE is going to be 4.5% annual rate. Things are looking up. What if rates do go up. The exit door will not be wide enough.
St Louis Fed President James Bullard has released a paper detailing a revised approach to economic forecasting. It’s a very smart way of looking at the world – read it here. Briefly, he is saying that the current way of viewing the world as converging to a single state is no longer useful and instead should be thought of as a set of possible regimes the economy could visit, with the regimes being generally persistent, requiring different monetary policy responses, and switches between regimes as not being forecastable. In his submission to the FOMCs quarterly economic projections, he declines to provide a forecast for the ‘Long Run’, as it is outside his model projection range. His low projection of the Fed Funds rate over the coming years reflects his view that the present regime has a low neutral real interest rate, a switch to a higher regime is unforecastable. If it were to happen, it would cause a change to many variables – policy would not reflect a gradual shift to a single state, but would have switched regimes.
This approach to forecasting was pioneered by James Hamilton. The math is pretty complex (lots of markov processes, etc.), but here is a simple way to look at it. Suppose we have two possible states in the world, the bull state and the bear state. The variable that determines the state is unobservable, and since you can’t see it, you can’t forecast it. Suppose in the bear state that the daily returns to an asset, like the stock market, are selected from a normal return distribution with a negative mean. Conversely, in the bull state, the mean is positive. If the state variable is pointing at bear, the trend will be down, if bull, the trend will be up. The trendiness of a market is determined by how likely we are to remain in the current state. For example, if the probability of jumping from one state to another is 5%, trends are more likely to persist than if the probability were 20%. What causes the state variable to jump is unknown, as Bullard describes.
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Can trend following make money in a low rate environment, and is it all bonds?
We often get asked whether trend following strategies can make money in a low interest rate environment, or in a similar vein, if trend following is just a levered long bond position that’s now run its course. In short, we think that higher rates can help some aspects of trend following strategies, but certainly should not be a driver of a long term allocation decision. The portfolio benefit of an allocation to trend following to an investor or plan with more traditional equity and credit market exposures is not solely – or even largely – driven by the fixed income exposure. Using a simple trend following model in commercial markets (commodity, fixed income and currency – we explain here why we think that’s the right approach) below we break down the sources of returns in times of crisis, and suggest an economic rationale as to why it isn’t just about bonds.
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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.
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