Convex Tails

US yields have clearly shifted over the past 6 months or so. The move is justified – stronger global growth, a large fiscal package and a pickup in inflation. At this juncture, where do things stand? Interest rate futures are still pricing a hiking cycle a ways under the Fed projections. There’s about 100bps priced between here and December 2019. Not a high bar – we could reasonably have that this year, hiking once per quarter. To our eye, the measured and linear pace priced by markets is going to have to contend with economic activity that may be decidedly nonlinear. We just don’t know what happens when you slash corporate and personal taxes at very low levels of unemployment, pour on an infrastructure package at the same time, and see a pickup in global growth. Are retail sales linear when every paycheck in the country gets a big boost? Are capex plans linear when corporate taxes get markedly reduced and regulatory burdens reverse? Are wages linear at 4.1% unemployment? Is the impact of a reduced Fed balance sheet – particularly in mortgages – and an ECB that’s edging toward the door linear on term premium? How about corporate holdings of bonds under a new and drastically different tax regime? Or are these things convex? We may find out soon. It didn’t make sense that interest rate volatility was so low – it is all about the convex tails.

convextail

FOMC member interest rate projections and market pricing implied interest rate path.      SOURCE: Bloomberg

Markets Change and Shift…Issue 78

The chart below shows the 3 prices series – the US 5 year yield, the US Dollar-Japanese Yen exchange rate and the price of gold – inverted here. Each of these markets have their own fundamental drivers, but for periods of time they can share the same set of dominant factors that determine price action. A story gets built around them that sounds compelling, and correlations become self-fulfilling…for a while. In previous years, these markets have been a popular way to trade interest rate views, but the recent divergence is fascinating. It’s a good example on the importance of focusing on the areas closest to home when taking macro bets, rather than being lulled into related markets that may be correlated at the time. If those correlations change, you can be right on the view, but wrong in the implementation. That’s no fun for anyone.

The narrative around each is decently intuitive – if you thought yields would go up, positioning in the currency markets where interest rate differentials are often dominant drivers makes sense. Nowhere is this more true than in Yen, which has arguably the most extreme form of easing in yield curve control, pegging the 10 year JGB around zero. Further, Japan appears to be the furthest major economy from tightening. This made sense for a while – as you can see in the run up to the US election and the reactions afterwards, perfectly fine way to play it. The gold view was also fairly compelling – low rates would lead to inflation, which gold is a great hedge against (not that we agree, but that was the view). So higher rates, particularly real rates, would push gold down. Again, in the run up to, and coming out of the election, this was an OK way to position. Spreading risk between the three expressions was a defensible thing to do. The second chart drums it home a different way – it shows just USDJPY and the US 5 year yield, and the 30 day correlation. That’s likely too short a window, and correlations are odd things, but it gets the point across – they correlated at 0.8 during these periods.

The recent move higher though…not so much. Gold has not fallen, and the Japanese Yen has gone the opposite way. Only the rates view worked. That 0.8 correlation went to zero on a dime. New narratives are popping up to rationalize it away and sound smart ex post – but ex ante it wasn’t clear at all. No one knows if it will continue or will revert either. Markets change and stories shift – the more things change, the more they stay the same.

rgy1

Source: Bloomberg

rgy2

Source: Bloomberg

Spicy English

Two things have become clear, thanks to the slightly spicy English of Mario Draghi. To set the stage, it’s October 26th, 2017, and we wait for the latest announcement from the ECB. US 10s are near recent high yields, breaching the tough resistance of 2.40%. The Euro has come off the boil, and stocks everywhere are near the highs. Out comes the text, and Mario does not disappoint, hitting all his lines right on cue. Rates will remain low; however, the ECB will slow down asset purchases, in a measured way, starting next year. Then comes the press conference, and he confidently walks it back. Yes, the economy is doing well, but if we don’t see some inflation, we are fully prepared to hit the gas again. Boom. Bonds and Bunds rally, rates fall, Euro gets creamed, stocks take off. And the two things are….

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Why Financial Conditions Are Easing…

Two years ago, Dudley was spooked by tightening financial conditions.  Now, they can’t figure out why they are so loose.

I think there is a simple explanation.  Two years ago rates were so low that credit could not go any lower, as they would go below the default rate.  So it looked like financial conditions tightened.  Now, as the fed raises rates, credit has stayed at the same price, so it looks like financial conditions are getting looser.  Here is a chart of auto loans.  Rate has not changed.  Unless the central banks buys credit (as they have done in Europe, forcing HY below UST), the nominal rate cannot go any lower, but won’t go up right away either. If you are at the default bond in credit, do measures of financial conditions fail to make sense?

Despite three Fed hikes over the past year, the rates on new-vehicle loans remain near multi-decade lows.

source: https://fred.stlouisfed.org/series/RIFLPBCIANM60NM#0

The Doldrums

In the great series of historical novels about the British Navy in the Napoleonic era by Patrick O’Brian, and the associated movie Master and Commander, there is a poignant scene where the ship is stuck in the Pacific doldrums, sails limp at the mast for days. The crew looks for a scapegoat, a Jonas, to blame for their misery, and they find one in a hapless midshipman. For the good of the ship he grabs a cannonball and jumps over the side. A prayer is said, the wind returns, and off they go. Complacency is the buzzword of the day, but the winds will return as they always do, and the catalyst will be as much a surprise to the market as to the midshipman who found himself carrying a cannonball.

I am habitually early for meetings. The other day I had some time to sit outside the offices of a major investment bank at the start of the business day. It’s an evergreen notion for me … a scene repeated at all the banks and funds all around the world, hundreds of well educated, motivated, energetic young people all chasing the same pool of alpha. And I wonder, is there enough to feed all these hungry strivers? Risk premium is durable, varied and growing, alpha is zero sum and rare. At Mount Lucas, our approach is to own that risk premium in many flavors through our quantitative trading. Just this month we added a new flavor, a momentum based multi asset credit basket. It fits nicely with the other risks in our capital markets allocation. We continue to search for alpha in the realm of long term behavioral biases. I have to admit it’s tough going, particularly in the doldrums, but the opportunities are there, and we await a stiff breeze to see them realized.

 

Mount Lucas employs a number of different strategies each with their own investment objectives and risk profiles.  Any reference to a strategy or strategies mentioned above may or may not be indicative of all of Mount Lucas’ products.”

With Friends Like These…

There is a saying in our business,”the trend is your friend.” Given the recent downturn in trend following returns, I am reminded of another saying, “with friends like these, who needs enemies.” I was in a meeting recently with a consultant who asked a question we have heard many times over the years. How do you keep clients invested in managed futures in times like these? We know the history, the diversification benefits, the crisis protection, the long volatility profile…but, each time there is an extended period of challenging performance clients look to throw in the towel – because their equity investments are ripping up and managed futures is down. A good question, and the answer, I think, lies in the statement – it is a matter of faith.

Investors in the equity market have faith. They trust, and have been conditioned, that the market goes up over time, corrections are temporary. Participating in the capital formation of companies provides a risk premium to the investor and is an investment in the economic growth of a country.

Managed futures on the other hand is viewed as a trading strategy, it goes long and short, it is typically quantitative based. The perception is…I can’t have faith in a model, it can break. But this perception is misplaced, trend following measures a real economic risk premium in the market, just like equities (see older posts diving deeper on this topic, Portfolio Symmetry, Commodities are not Stocks, Benchmarking Alternative Beta). Investors in this market are rewarded by taking the price risk companies seek to shed. Faith should be in the durability of this premium, just like there is in the equity risk premium. Faith is gained by understanding this risk premium, when it works (periods of volatility and instability), and when it doesn’t (periods of low volatility and stability). Similar to equities, faith should be garnered from the underlying economics of the markets.

The Speed of Change – Buying Puts and Calls

Value investing can be counter-intuitive at times.  Acting against our own intuitions is not an easy thing to do; it’s uncomfortable.  We form our thoughts and reasons based on what we see and experience in the present, and extrapolating our present situation into what the future holds is something we all do.  Predicting the trajectory of long-term trends that have already begun is not rocket science, but investing requires you to be right about the trend, as well as the timing of that trend.

Bill Gates wrote the following a while ago

‘we always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten. Don’t let yourself be lulled into inaction.’

It comes to mind as I think about some of the stocks we hold, some of the stocks that are doing really well and the difference between a great company and a great investment. There is a lesson in the drivers of value investing and how it interacts with momentum, and more broadly on real visceral fears that are out there, manifesting themselves in the politics of both the left and the right. One way to think of value vs growth investing is as extrapolations of the current set of worries out to the future. Everyone remembers the Blockbuster video example, killed off by Netflix, and see that story writ large across big chunks of the rest of the economy and stock market. Disrupted businesses are everywhere – just this week Hertz announced a bad set of numbers, sequential declines in revenues and a bigger than expected loss. The stock got hit hard. On the other side? The new ride sharing services, Uber and Lyft, raising money at high valuations as people extrapolate to a future of self-driving on demand cars, and no place for old school Hertz. Amazon making it tough for big box retail is another example. Tech, robots and AI are coming for jobs and business as we know it.

Many instances of these seem perfectly valid, and it’s easy to paint the picture. The likes of Amazon, Netflix and Tesla are amazing businesses that have changed the world and achieved incredible things. The issue we have is that they seem priced for ever greater levels of growth into perpetuity, and don’t seem to take into account what we think is one of the key reasons value investing works – the people running the businesses are scared as well, and where they can, they fight back. Some will be unable to. But not all. Take General Motors and Tesla. General Motors trades around a 5 PE and pays a dividend north of 4%, and the last couple of years has about $9bn in income. The numbers are a bit different for Ford, but the picture about the same. That income is an enormous amount of firepower. The people running these businesses are not stupid, and I’ll bet are more worried about electric vehicles and driverless cars than you or I. The market focuses on Tesla and the incredible way it’s broken into the car market, its Gigafactory, and its solar roof product. They are extrapolating a future whereby Tesla hits the big time with its $35k Model 3 and kills off Ford and GM – at these prices that’s what is implied. Relating it to option buying, by buying Tesla investors are effectively buying calls on this amazing future – things need to get to this new world quicker, and it needs to be more amazing than it seems now. They may be right, but boy are those calls expensive here. With GM and Ford, we see value investing as akin to buying puts on the speed and scale of this societal change, and think that the extrapolation has gone too far – and doesn’t take into account the firepower of the businesses. If the transformation doesn’t happen, takes longer, or investors decide to pull financing from the Tesla project (and they sure will need a lot of funding to build out the scale the stock price is banking on) maybe things looks different and old Detroit transforms itself. That $9bn pays for a huge amount of R&D to fight back – indeed when you look at it, the first few firms to get an electric vehicle to market at a mass market price point have already done so. They Chevy Volt, the electric Ford Focus, the Nissan Leaf. GM is hiring 1000 engineers in Silicon Valley to expand Cruise Automation, the self-driving car unit it spent some $600m on last year. Ford is doing similar, investing $1bn in a self-driving car firm in Pittsburgh.  GM is into the battery game as well, opening battery factory in Shanghai. One can make the same case with Walmart and Amazon – Walmart has some $20bn in operating income, and an e-commerce business growing at 30% a year. At its root, Walmart isn’t too far from being an Amazon warehouse with a door and a checkout – it has a brand name, incredible logistics and supply chains – and won’t go down without a fight.

All of this isn’t to say that Tesla and Amazon aren’t incredible companies pushing the world forward – they certainly are. What they also do though, is to bring others up with them, galvanizing competitors into action. Capitalism in all its glory. We think the markets are extrapolating the future too far in both directions – the new kings Tesla and Amazon and their ilk to the high side and older world names to the low side. Back to the Bill Gates quote, investors are focused on the first part, over estimating the next two years at the expense of how things will look in ten years. The people in Detroit and Bentonville are focused on the second part, and not being lulled into inaction. Buying old Detroit at valuations like this is hard, it goes against the story of change. What you are doing by buying is really selling a put on the speed and scale of the change. We’ve seen a movie like this before at the turn of the century. New world growth expectations were out of hand and the growth premium over that five year period was enormous. The following five years were reversed, as value investing outperformed strongly. The chart below has some details on it. That’s how value investing works, in cycles, and it works because it’s uncomfortable.