As We See It: Value

Here’s a fun chart one of our colleagues spotted. On August 30, 2020, Salesforce replaced Exxon in the Dow. The following chart shows the total return of each since the change:

Source: Bloomberg

We realize the keepers of the Dow want to stay up with the times, but it’s not like Exxon was going out of business.

We can find no better argument for an allocation to value stocks. Valuation is often driven by fashion. I seem to recall that, at the height of the pandemic, Zoom had the same market cap as Exxon. Fashion. Style. The key thing to remember about stocks is that no one needs to own them, demand is completely elastic. Unlike, say, commodities, the price of a stock is not part of any practical business decision beyond capitalization. In simple terms, that means they can trade anywhere and anytime. It also means that value managers must buy things that are often wildly out of fashion, not our natural human tendency.

So, break out the leisure suits, the big lapels, and the super wide ties, and buy some value.

As We See It: Yen Intervention

The big story in the past week was the massive currency intervention by the Bank of Japan (BOJ). Hard to know exactly how much went through, but reports were in the range of $70bn on Friday alone. FX interventions by major central banks are less frequent than they were years ago. This was the first BOJ buy side intervention since 1998. There is a pretty simple reason we don’t see intervention much anymore – it does not work. Let’s have a quick look at what’s going on.

Against the trend of most other central banks, BOJ policy has been to maintain low interest rates and keep long term yields under 25bps (a policy called yield curve control, YCC), despite rising inflation and a global backdrop of major economy yields rising substantially. They have been the principal buyer of Japanese Bonds, leading to a crash in liquidity. In recent weeks we have seen multi day streaks when the benchmark ten-year bond (the JGB as it’s known) has not traded. Forcing long-term interest rates to below market levels (the 10y swap market has rates around 70bps) has created massive pressure on the currency, and the BOJ has tried to stem the tide.

Intervention is like trying to hold 100 ping pong balls underwater at the same time – sooner or later one will pop up. As long as the BOJ keeps interest rates artificially low and continues yield curve control, the currency will eventually, intervention or not, get blasted. When the Fed is guiding market yields close to 5% and even the Europeans are raising 75bps a meeting, the policy gaps are untenable. Something has to give. As we write this, the BOJ is intervening again – they moved the currency about 1 percent, and then it immediately sold off again.

So why is the BOJ doing this. Japan is by far the most indebted major economy. That was fine as long as rates were low. What changes that calculus is – you guessed it – inflation. Unwinding these policies is like landing a jumbo jet on a football field. As the now ex UK PM Truss found out, the room to maneuver can shrink pretty quick.

Source: Bloomberg

As We See It: The UK Bond Debacle

Same tune, different words. Every. Single. Time.

Some big pool of money (BPM) would like something for nothing. Large financial institutions (LFI) are happy to help. Heck, they even compete to help the most. As long as X never happens – and of course it never does – we can give you exactly what you want. In the 1980s, pension funds wanted to be long stocks but not the downside tail. Buying puts was too expensive. No problem says LFI! We will give you something called portfolio insurance. Instead of paying implied volatility, you can own an option-like structure at realized volatility. As long as the market does not gap down a lot – which of course it never does – there is plenty of liquidity to execute the hedge. October 1987 put an end to that little fantasy. Then there were those good old sub-prime loans. Some BPM would like some higher yielding debt. No problem says LFI! Each mortgage may be risky, but they are much better behaved when we look at a big basket of them and we’ll spread them out all over the country. As long as house prices never go down, which of course they don’t, and certainly not all over the country, these bonds are golden. We’ve even paid someone to give them a AAA rating! That ended…not well.

The current situation. UK pension funds (BPM in this case) have a problem. On paper, falling interest rates lower the discount rate on the future liabilities of the fund. Makes the fund look bad. Can’t have that, say LFI. We will buy a leveraged position of long duration bonds. As rates fall, the increase in liabilities will be offset by gains in the long bond portfolio. If rates begin the rise, the losses on bonds will be offset by paper gains in the reduced liabilities. Sounds good, or as Dire Straits crooned…Money for Nothin. This will work fine, as long as we don’t get a real fast inflationary spike in rates, which of course we won’t because we know inflation is dead. Whoops…

Source: Bloomberg

Rates spike, liabilities do fall on paper, but the margin call on the bond long requires real money…right now. A classic liquidity mismatch. All of a sudden, pension funds have a margin call. On this latest yield spike, the central bank has to intervene in the name of financial stability. Liquidations spread to other markets as the funds scramble for cash. Normally history doesn’t repeat exactly, but rhymes. In this instance though, it’s closer to a straight rerun. This happened in Orange County, CA in 1994 when rates rose, and it’s literally used as a finance case study on risk management and what not to do. And yet here we are, just far enough along for a new generation to make the same mistake.

Rule 1 in finance…keep it simple.

Postscript – October 11, 2022

The FT has published a fabulous piece on the episode at this link (paywall). It fills in the BPM and LFI cast of characters and has some great quotes – turns out our read was pretty accurate all told…

As they made their pitch to overhaul the pension scheme of one of Britain’s biggest retailers, Next chief executive Lord Simon Wolfson remembers the consultants were “very sure of themselves”.

“Liability-driven investing”, the consultants promised, was a stress-free way to protect the fund from swings in interest rates by using derivatives.

There is one particular phrase that still sticks in Wolfson’s mind from the 2017 meeting: “You put it in a drawer, lock the drawer and forget about it.”

“The speed and the scale of the move in the gilts market was unprecedented,”

“The crunch event was not in anyone’s models,”

But even he acknowledges that its complexity is an issue, with tricky collateral management and an orchestra of instruments from gilt total return swaps to gilt repo and inflation swaps. “Undoubtedly the problem is that people don’t really understand it,” he said. “It’s like trying to explain some aspects of quantum physics to people who aren’t really physicists.”

…pension schemes in aggregate will have to come up with as much as £280bn to fully recapitalise their interest rate and inflation hedges with new lower levels of leverage. This is in addition to the £200bn that schemes have already had to deliver to meet LDI collateral calls…

As We See It: Everything Selloff, But…

When you woke up yesterday morning, this was the headline of the lead story on Bloomberg News:


The past week had been really tough, with bonds and stocks both crushed, regardless of locale. There were panic moves everywhere, but particularly in sterling. Third world type emergency action being considered to control the slide. If the Fed’s mission was to break something, well, mission accomplished. Negative skew everywhere. There was, almost, no place to hide.

Almost because there was one place to hide, a well known asset class that advertises success in periods of adversity and volatility. An asset class that exhibits positive skew, or as my partner likes to say, it crashes up. An asset class that is up this year, and up this month, yet is not particularly dependent on manager skill. Simple Alternative Beta indexes capture the returns nicely. Its liquid and easy to access in a variety of formats.

What is it, you say? Its Managed Futures, of course. Now let me warn you. There will come a point when the markets will settle down, Darth Powell will take his foot off the brake, and traditional assets will recover. Managed futures will likely give back some recent gains, perhaps with a vengeance. But if you had it in your portfolio, the profits you gained could have been rebalanced into those cheap equities and credits, primed for the next move higher. It’s a beautiful thing, but you need to be in the game to win.

As We See It: Commodities Peak? – A Lotta Bit of Yes And A Lotta Bit of No

Here’s a question in everybody’s mind – Have we seen the top in commodity prices? We can see both sides of the argument.

Yes. The Fed is going to move far enough to break things, that will push us into a recession or worse, and commodity prices fall in recessions. It’s global too, with Europe and Japan falling out of bed. China won’t come to the rescue this time either, with the Ponzi bubble that is China real estate deflating and Covid lockdown mania. With the USD on a tear recently, for those overseas buying things priced in USD it’s even worse. Oil in Europe and the UK is through 2008 spike highs already, demand destruction ensued then and will now. Forget it, the commodity trade is over.

No. Virtually every commodity, from grain to oil to electricity to butter of all things is tight.

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One great example, beef. Beef is one of the few commodities that has risen very little over the last year. Why is that, you ask. Because US ranchers have been liquidating the herds and putting that beef on the market, as costs have risen.  That has kept near term prices lower, but if the economy recovers, the herd will not be rebuilt fast enough and prices will rise rapidly. A classic whipsaw, and it’s happening everywhere. Prices have risen because of supply issues, and raising rates will not help supply as it raises the cost of production. Should the Fed take its foot off the brake, supply will not be replenished fast enough to satisfy instantaneous new demand. Result – higher prices, a bit down the road.

Last week we said – watch rents.  Look at this chart. If we have seen peak hawkishness, get bullish commodities.

As We See It: CPI

The reaction to last week’s CPI print was pretty dramatic. We see a couple of related factors:

  • Given the fall in gas prices, the S&P had bumped off the bottom in anticipation of a soft print. Positioning went from negative to perhaps modestly positive. CPI caught the market on the wrong foot.
  • Gas prices as reported in the CPI did fall as expected, but just about everything else went up (see graph below). Everyone knows gas fell because of releases from the Strategic Petroleum reserve. That policy is the definition of “transitory” (they will need to buy it back, no less). With everything else going up, inflation fears pulled a Lazarus.

Watch rents. Lagging but steady inflation indicator, closely tied to wages.

Source: Bloomberg

The Inflation Supertanker

I recently had a conversation with a colleague about the idea that portfolios over the last 40 years have been conditioned for falling interest rates. If that supertanker makes a turn, a lot of money will be on a collision course. He said in 1984 there was an equal and opposite issue … buying bonds for the prior 20 years had been a fool’s errand. The cycle climaxed in June 1984 with a hot GDP, a low inflation print and a collapse in bonds. Even though inflation was low, no one wanted to own them.

I was intrigued and pressed the conversation with our resident bond historian and partner, Paul DeRosa. His response below:

It was the bond buying opportunity of the 20th century. The long period of inflation and the large deficits run by the Reagan administration conditioned people to believe inflation was only temporarily low and that it would return, as it had in 1980. I bought 250 million of the 13 ¾ of May 2014 and was down 10 million on the trade before I wrote the buy ticket. With the funds rate at something like 11.5%, the yield curve actually got steeper rather than flatter. The current situation is something like the inverse of that period. We’ve had a long period of low inflation, and a lot of people still think it is temporary. So, I would expect rates to rise grudgingly and the yield curve to stay flat. The good thing about finance is that illusion eventually has to face reality. By late summer of 1984, the high interest rates had the economy on its proverbial tail. Payroll employment started to sag. I remember buying a boatload of the Treasury 4-yr Note in September, but it still was very hard to get people to accept lower yields. To keep from worrying about it I played squash at the New York AC, but checked the market between games.

Just to finish this up, 1985 was a pretty good year for the bond market, but the big break came in Spring of 1986, when the crude oil price collapsed. It took a big external event to change expectations about inflation. I completely missed that move because I misread the situation. The stock market also rallied, and I couldn’t figure out how bonds could rally with the stock market so strong. Well, the answer, of course, was the stock market was rallying because it saw rates falling.

Pricing Escape Velocity – The Rubber Hits Abbey Road

The chart below is fascinating to us, particularly in light of the fairly modest in magnitude, but quite speedy rise in UK yields. The chart shows the difference between futures prices for sterling 3 month LIBOR expiring in September 2022 and 3 years later, in September 2025. They price at 100 minus the interest rate, so a price of 99.5 equates to a 0.5% prevailing rate at expiry. Roughly speaking, individually the contracts can be interpreted as the markets best pricing for interest rates at those points in time, the spread between them gives a look at how the path is priced to get there.

A year ago, rates were priced to be at about zero in September 2022, and not much higher – maybe 1 hike – by September 2025. At a starting point of functionally zero rates – that’s a pretty poor prognosis for 5 years time. Earlier this year, the spread between contracts increased as the nearer maturity contract dropped a little in price – implying higher yields – while the longer maturity contract fell more in price. The spread widened to a high of 78bps in early summer. That’s the market roughly saying things are a bit better economically – over the next few years we will see about a hike per year.

The interesting part is not even the most recent drop in the September 2022 contract, as the market is pulling forward all those hikes into the next 1 year. Higher inflation and a better economy allowing the Bank of England to hike. So far so good, a bit aggressive maybe, but sure, probably some natural gas inflation in there. The interesting part to our eye is that the spread has collapsed. It is as if the market is saying ‘Sure you can hike now – but you’ll get to 1% and have to stop as the economy can’t withstand it, that’ll be it, maybe you’ll end up cutting again’. Now there are other things at play here in terms of pricing along the curves and longer rates being driven by other things – but as a fairly clean barometer its reasonable. The rubber is hitting the road on markets determining escape velocity. Will we get a self-sustaining recovery and a more normal economy that can sustain these yield levels and maybe higher as things take off? Or not? Its fascinating to watch play out…

Source: Bloomberg

You Can Eat Or You Can Sleep

“You can eat or you can sleep”. The biggest change I have witnessed over the course of the past 3+ decades is the change in investor preference, particularly hedge fund investors, away from positive skew to negative skew… from sleeping to eating. I sleep well. The quote came from a discussion my partner had with another manager who runs a fund that is often aggressively short volatility. He, like all of Wall Street and beyond, have monetized this preference for negative skew – regular returns most of the time, with the occasional blowup. They are eating well.

The preference for negative skew flies in the face of conventional finance theory and behavioral economics. After all, why would people buy lottery tickets? Smarter people than me have worked these ideas over, and it’s a bit of a mess. Let’s just think about 3 possible drivers (I am not bashful about stealing others good ideas). Some of these thoughts are motivated by a great blog post that can be found here:

  1. Falling Yields. Investors will give up positive skew in return for higher yields. In a low rate environment, one can get a higher yield by selling options. The last 25 years have seen persistently lower yields, and a wildly expanding options playground. Man wants a green suit, turn on the green light. Build product that yields well but has negative skew.
  2. Moral Hazard – that thing officials used to worry about. No more. The central banks of the world, and, increasingly, the folks at the controls of fiscal policy, all but guarantee the financial downside. A hedge fund / family office that exploded earlier this year drew only fleeting notice from officialdom. Why? Because it was a garden variety bad trade, housed at one particular fund. There was nothing systemic about it … because it was a positive skew position. It was a classic one-off. Importantly, at the end of the day, they knew what he could lose. Systemic option selling has unlimited downside, and the players will not let that happen. Investors have grown to rely on this protection and have piled in – moral hazard.
  3. Principal/Agent. No one likes to be told they have lost money. Agents know this. They also know that if they have company, it goes down easier with the principal. Join the crowd and count on number 2 above. Early in my career, we were trying to interest a large consultant in our fund. He listened politely, but at the end of the day he said that he was investing in a mortgage fund that made money every month. The meeting ended (as I recall we took him to dinner and a ballgame… I still regret it). That fund blew up a few months later in the first of the many mortgage meltdowns. He survived… in fact sold the consulting firm to a private equity shop. Eating well.

Contrary to these changes in preference, we have no intention of changing our stripes. We understand that our style is a more difficult hold than a steady earning, negative skew manager – that’s why there are very few of us left. But in a portfolio context, there is real value in a strategy that pushes against the prevailing wisdom. And we have demonstrated, over 3+ decades, that we can sleep well.

Stresses In The Bond and Funding Markets: Post Mortem

We wrote a few times during the depths of March and April on stresses we were seeing in bond, credit and funding markets. It was clear things were not functioning correctly. It was equally clear that both monetary and fiscal policymakers were trying as hard as they could to counteract. Now that some time has passed much more detailed examinations are coming out that are well worth reading to get a better idea of how the plumbing works, and sometimes gets blocked.

The first is from the NY Fed Liberty Street Economics blog and details the Feds Large-Scale Repo program.

The second is in the Financial Times (paywall) and details the moves we witnessed in the US Treasury markets:

The third is from Josh Younger of J.P. Morgan writing for the Council on Foreign Relations:

All succinct and detailed pieces that will explain a lot of what went on.