wknd notes: Complex Challenges, Beautiful Performances

“I wonder how long before the market internalizes this?” asked the CIO, as much to himself as to me. We were discussing Modern Monetary Theory (MMT) which has captured the popular political imagination, as they race to address inequality with a range of new programs, just as the enormity of our government’s mountain of unfunded liabilities comes into view. “It will attenuate the bond-equity correlation on the next sell off in stocks,” he mused. The era of Fed dominance and monetary manipulations is ending, replaced by the reassertion of politics and fiscal preeminence. “What do you think the probability of an infrastructure accord is in the next 6mths?” he asked. “Rising.”

Overall: “This is a really exciting motor skill that we would like robots to learn,” said the proud scientist, motioning to his magnificent creation. The robot was constructed entirely from 3D printed parts, brought to life by code, backed-up in the cloud, and was somehow teaching itself to move across the ice using artificial intelligence. “Not because skating is particularly useful, but because it combines so many complex challenges into one beautiful performance.” And in the rhythm of its limbs, blade marks on the ice, were faint traces of every scientific achievement in all human history - an extraordinary journey of endless discovery, each generation feeling its way into the unknown, every advance uncertain. “The winds of change have crossed the Alps,” tweeted Italy’s Deputy Prime Minister Di Maio, taunting France’s Macron, his Yellow Vest protests now spreading across the continent, leading Europe to who knows where. What had spontaneously appeared 13 weeks ago has taken on a life of its own, growing, evolving, searching for meaning, expression. All revolutions proceed thus. A Tunisian fruit merchant, on fire. Women dressed in white, storming Congress. Why exactly they start, where they lead, how they end, no single person knows. Nor does a think tank, a corporation, a government, a religious institution - yet the interplay between each forms a collective intelligence that mysteriously guides us on. “The Russian president has set the task for the defense ministry to take tit-for-tat mirrored measures,” said Putin’s defense minister in response to the US withdrawal from the INF Treaty, sparking a new scientific race to defend ourselves from ourselves. And a passionate group of young American politicians outlined a New Green Deal to combat our rapidly changing climate. As every human advance creates new hurdles, obstacles, challenges - some natural, others of our own making, but each drawing us forward, unmistakably, as if by chaotic design. Into one beautiful performance.

Week-in-Review (expressed in YoY terms): Mon: Mankind slowly recovers from most boring Superbowl in history, EU investor sentiment 4yr low, UK construction spending 10mth low, Sanders/Schumer plan to introduce a bill limiting stock buybacks, S&P +0.7%; Tue: Japan PMI services +0.6 to 51.6, US envoy in NK ahead of talks, RBA rates unch at +1.5%, Russia calls for talks to end Venezuela crisis, Italian service sector slips into recession, DOJ/DHS find no material foreign interference in US 2018 mid-term election infrastructure and candidate operations, US ISM services -1.3 to 56.7, Google 2018 investment spending nearly doubles to $25bln, S&P +0.5%; Wed: RBA opens up possibility that next move is rate cut, Tusk “special place in hell for Brexiteers without an exit plan,” France/Germany advance with next-generation fighter jet plan, Germany factory orders -7.0%, Italy’s 30yr auction at 3.85% attracts record bids, Brazil rates unch at +6.5% for 7th meeting, US mthly trade deficit shrinks to 6mth low, Boeing shares hit record, Trump State of the Union, S&P -0.2%; Thur: India cuts rates 25bps to +6.25% (CPI +2.2%), Libya to boost oil production, Ukraine Parliament vote paves way for EU/Nato membership, European Commission cuts 2019 Italy GDP forecast by 1.0 to +0.2% (blames populism and rising rates), UK rejects calls to ease fracking restrictions, BOE lowers 2019 GDP forecast to +1.2%, Mexico rates unch at +8.25% (CPI +4.37%), Kudlow “US/China still have sizeable way to go in trade talks,” Trump rules out a Xi Jinping meeting ahead of March 1st trade deadline, S&P -1.0%; Fri: OECD “2019 gross gov’t borrowing to hit record $11trln and net borrowing to hit $2trln – between 2007-2018 OECD gov’t debt/GDP rose from 49.5% to 72.6%,” Russia upgraded by Moody’s to investment grade, Russia rates unch at +7.75% (CPI softens to +4.3%), Italy industrial production -5.5%, German finance minister rejects concerns over serious economic downturn, Nigel Farage launches “The Brexit Party,” iron ore surges to 4yr high (up 25% since Vale mine disaster in Brazil), Canada employment +67k (prev +9k), Fed’s Daly “tightening financial conditions in recent months is doing some of the central bank’s work,” Daly considers using QE as a regular policy tool (not just went rates hit zero), dollar-index posts biggest weekly gain in 6mths, Bezos accuses National Enquirer of politically-motivated extortion, S&P +0.1%; Sat/Sun: US lawmakers closing in on border-funding deal ($1.3bln-$2.0bln range).

Manufacturing PMI (high-to-low): Norway 58.3 in Jan (55.9 in Dec), US56.6/54.3, Netherlands 55.1/57.2, Switzerland 54.3/57.5, Hungary 54/54.3, India 53.9/53.2, Greece 53.7/53.8, Canada 53/53.6, UK 52.8/54.2, Austria 52.7/53.9, Brazil 52.7/52.6, Spain 52.4/51.1, Vietnam 51.9/53.8, Sweden 51.5/51.8, France 51.2/49.7, Mexico 50.9/49.7, Russia 50.9/51.7, Singapore 50.7/51.1, Japan 50.3/52.6, Indonesia 49.9/51.2, Germany 49.7/51.5, South Africa 49.6/49, Czech Republic 49/49.7, China 48.3/49.7, South Korea 48.3/49.8, Poland 48.2/47.6, Hong Kong 48.2/48, Italy 47.8/49.2, Taiwan 47.5/47.7, Turkey 44.2/44.2. Services PMI: Russia 54.9/54.4, Spain 54.7/54, US 54.2/54.4, Ireland 54.2/56.3, Sweden 54.1/55.8, China 53.6/53.9, Germany 53/51.8, India 52.2/53.2, Brazil 52/51.9, Japan 51.6/51, UK 50.1/51.2, Italy 49.7/50.5, France 47.8/49, Australia 44.3/52.1.

Weekly Close: S&P 500 +0.1% and VIX -0.42 at +15.72. Nikkei -2.2%, Shanghai +0.0%, Euro Stoxx -0.5%, Bovespa -2.6%, MSCI World -0.4%, and MSCI Emerging -1.3%. USD rose +2.5% vs Sweden, +2.3% vs Australia, +2.2% vs South Africa, +2.0% vs Brazil, +1.3% vs Canada, +1.2% vs Euro, +1.0% vs Sterling, +1.0% vs Chile, +0.7% vs Turkey, +0.2% vs Yen, +0.1% vs India, +0.1% vs Indonesia, and flat vs China. USD fell -9.5% vs Ethereum, -4.1% vs Bitcoin, -0.1% vs Mexico, and -0.1% vs Russia. Gold -0.3%, Silver -0.5%, Oil -4.8%, Copper +1.5%, Iron Ore flat, Corn -1.1%. 5y5y inflation swaps (EU -7bps at 1.44%, US -10bps at 2.18%, JP +1bp at 0.12%, and UK -4bps at 3.51%). 2yr Notes -4bps at 2.47% and 10yr Notes -5bps at 2.64%.

2019 YTD Equity Index Returns: Argentina +20.5% priced in US dollars (+21% in pesos), Turkey +13.1% in dollars (+12.3% in lira), Brazil +12.6% (+8.5%), Canada +12.1% (+9.1%), Russia +11.7% (+5.6%), Russell 2000 +11.7%, Colombia +11.4% (+6.7%), Chile +11% (+5.4%), Saudi Arabia +10.1% (+10%), NASDAQ +10%, Thailand +9% (+5.6%), Finland +9% (+10.1%), Philippines +9% (+8.1%), Indonesia +8.9% (+5.3%), Australia +8.3% (+7.5%), Israel +8.3% (+5.1%), S&P 500 +8%, HK +7.9% (+8.1%), Netherlands +7.1% (+8.2%), China +7.1% (+5%), Mexico +7% (+3.7%), Austria +6.9% (+7.9%), UK +6.6% (+5.1%), South Africa +6.2% (+0.6%), Belgium +6% (+7.1%), Korea +5.8% (+6.7%), Portugal +5.4% (+6.6%), Ireland +5.3% (+6.4%), Norway +5.3% (+4.1%), Denmark +5.2% (+6.2%), Switzerland +5.2% (+6.8%), Sweden +4.9% (+8.4%), Singapore +4.9% (+4.3%), Greece +4.8% (+6%), New Zealand +4.8% (+4.1%), Czech Republic +4.7% (+6.1%), Italy +4.6% (+5.6%), UAE +4% (+4%), France +3.8% (+4.9%), Euro Stoxx 50 +3.4% (+4.5%), Poland +3.2% (+4.5%), Spain +2.6% (+3.7%), Germany +2.3% (+3.3%), Japan +2.2% (+1.6%), Malaysia +1.3% (-0.2%), Taiwan +1.3% (+2.1%), Hungary +1.1% (+1.4%), and India -1.4% (+0.7%).

Powell’s Pivot: “Trying to gauge whether the Fed recoil is enough to give us another roll of reflation,” said the CIO from London. “Will we get a weaker dollar, a China/EM rebound, an EU reprieve too if we duck or fudge Brexit?” he asked. “Or is the backdrop of 2.5% US rates plus ongoing QT already too tight?” The dollar’s reaction to Powell’s pivot is critical. “If the dollar enters a downtrend - particularly versus EM currencies - then we have 6-9mths of reflating; but if the dollar chops sideways then Q2 will be bad for liquidity and so it’ll get tricky again.”

Powell’s Pivot II: “The market’s mindset seems to be: We found the Fed put and it’s struck at a 20% decline,” continued the same CIO from London. The market has a wonderful way of finding pressure points - no sooner had it found Powell’s then he pivoted. But how will markets react to an economic rebound? China trade deal? $1trln infrastructure program? “So, next time the Fed seems to be operating against the market’s will - eg when data is supportive of more rate hikes, but markets are feeling liquidity constrained - the journey to -20% will be much faster.”

History is Forecast: “We’re thinking through our systematic exposures,” said the CIO, a consultant to America’s allocators. “Which means we’re carefully considering correlations and regime shifts.” Systematic strategies are designed to profit from environments in which the future resembles the past. “But in practice, this all tends to be lost when working with most of the large allocators,” he said. “They look at correlations over the past 10yrs and deploy capital assuming they’ll persist. Embedding the past into the asset allocations. History is forecast.”

History is Forecast II: “You’ve not been paid to diversify for a decade,” continued the CIO, a consultant. “This late in the cycle, allocators love the idea of diversifying strategies.” Systematic trend, real assets, global macro, long vol. “But diversifiers can underperform for 5yrs at a time, and that’s about the limit of what allocators can endure.” Being out of sync for 5yrs on average means in some cycles it may be 3yrs, in others 7yrs. “So in the end, most allocators don’t invest in diversifiers, believing they’ll probably redeem just before they inevitably outperform.”

Then: No sooner had we rejected the Paris Climate Accord then we framed a Green New Deal. No sooner had we eviscerated Obamacare then we considered Medicare for All. No sooner had we adopted a historic tax cut then we debated 70%-90% tax rates and abolishing billionaires. No sooner had student debt equaled the size of our $1.5trln tax cut then we considered free college tuition. No sooner had the Tea Party dissolved into $1trln deficits then we started talking about MMT. No sooner had America publicly confronted the assault and harassment women have forever faced then a record wave of women swept the mid-term elections. And no sooner had these things became evident then we entered a historic era of volatility and change.

Anecdote: “Surely you remember Bill Simon?” asked the CIO. And I shrugged. “You’ve seen so little,” he said, sighing, frustrated by my youth. “Well, Bill Simon was a Wall Street bond king who became Treasury Secretary under Nixon, when markets were rioting. Treasury feared they’d have a failed bond auction in 1976.” The inflationary process began in the mid-1960s -- fueled by a massive tax cut (1964), anemic productivity growth, tight labor markets, and public policy that encouraged strong wage gains to battle inequality between rural poor and middle-class urban workers. In 1966, rate hikes sparked a non-recessionary 20% equity decline that frightened the Fed into reversing policy. Stocks rallied to new highs in 1968. And that was it. Two decades of post-war prosperity and stability gave way to the tumultuous 1970s. The Fed fell hopelessly behind the curve until Volcker took over in 1979. In early 1980, on an inflation-adjusted basis, the S&P 500 was down 50% from its 1968 peak, and on that basis reclaimed the 1968 high in 1993. “So, in 1976 people legitimately feared the government would fail to fund itself. But Bill Simon had a plan. He’d issue bonds 50bps higher than prevailing market yields.” Odd-lot buyers could purchase up to $300k for their personal accounts. “I stood in line with hordes of others to pick up free money,” recalled the CIO. “They were called the 8s of ’86.” The 8% coupon bonds maturing in 1986 rallied briefly but by 1981, prices had fallen 25%. “Traders today have no sense for how quickly markets can revolt when inflation and budget deficits start rising, even modestly,” he said. The US budget deficit grew from 1.0% in 1973 to 3.9% in 1976 (it will be 5.0% in 2019). “But when I look at how markets started to behave in Q4 of 2018, perhaps they got a little glimpse.”

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.