wknd notes: Ghosts of Investments Future (Part III)

Wishing you and your family a happy, healthy, prosperous new year. As you know, I take late-Dec off from writing. Lindsay Politi has stepped in. She is launching a fund focused on emerging opportunities in inflation-related markets that will complement One River’s existing Long Volatility and Systematic Trend funds. We see the world in a period of major economic and political transition, with the investment landscape shifting in ways that will make the coming five years look profoundly different from the past five. Our strategies are built to prosper from this environment and provide strong diversification benefits to traditional investment portfolios. So in the holiday spirit, Lindsay has devoted these three weeks to an arc focusing on the past, present, and future. Here goes -- Ghosts of Investments Future (see below).

Week-in-Review (expressed in YoY terms): Mon: Queen of England publishes Christmas message calling on her subjects to overcome “deeply held differences,” Trump resumes Twitter attack on Fed, Trump appoints new Def Secretary to replace Mattis, Mnuchin attempts to calm markets by assuring banks have adequate liquidity (has opposite effect), S&P -2.7%; Tue: Japanese stocks fall -4.9%, S&P closed (Christmas); Wed: China to have banks issue perpetual bonds to boost capital adequacy ratios, Japan quits whaling body (restarting commercial hunting), Iran 2019 budget forecast -3.7% revenue decline as US sanctions bite, UK Boxing Day sales -3.0%, Trump makes surprise visit to Iraq, S&P 500 posts largest gain since 2009, S&P +5.0%; Thur: Chinese industrial profits decline 1.8% (1st decline in 3yrs), China’s Huawei reports 21% revenue jump in 2019 to $109bln despite US tension, 33 Chinese IPOs in US in 2018 (8yr high), Saudi King Salman names new ministers (leaves MbS as designated heir), UAE reopens Syrian embassy in move to normalize relations, European banks trade at 0.6 book (US top-6 banks trade at 1.1 book), UK business confidence 18mth low, talk of pension portfolio rebalance away from bonds into equities credited with historic US equity rebound, S&P +0.9%; Fri: Chinese developers report home sales decline for 6th mth (consumer confidence hits early 2017 low), Iraq’s Moktada al-Sadar call for US troop withdrawal after Trump’s visit, UK issues warning as immigrants cross English channel in inflatable boats, Mexico moving to legalize marijuana, US government shutdown appears set to last into 2019, high-yield bonds and loans on track for worst month since 2011 (spreads +110bps to 8.0%), US leveraged loan index -3.1% in Dec to 94 cents, S&P -0.1%; Sat/Sun: Trump holds talks with Xi and “deal moving along well,” Trump threatens to close Mexico border if Democrats refuse his $5bln request for a wall.

Weekly Close: S&P 500 +2.9% and VIX -1.77 at +28.34. Nikkei -0.8%, Shanghai -0.9%, Euro Stoxx -0.1%, Bovespa +2.6%, MSCI World +1.5%, and MSCI Emerging -0.5%. USD rose +0.9% vs Russia, +0.3% vs Canada, +0.2% vs Chile, and +0.1% vs Indonesia. USD fell -19.8% vs Ethereum, -1.4% vs South Africa, -1.4% vs Mexico, -1.1% vs Bitcoin, -0.9% vs Yen, -0.8% vs Turkey, -0.6% vs Euro, -0.6% vs Brazil, -0.5% vs Sweden, -0.4% vs Sterling, -0.4% vs China, -0.3% vs India, and -0.1% vs Australia. Gold +1.9%, Silver +5.1%, Oil -0.7%, Copper +0.4%, Iron Ore +1.3%, Corn -0.9%. 5y5y inflation swaps (EU -1bp at 1.56%, US -6bps at 2.16%, JP flat at 0.07%, and UK flat at 3.62%). 2yr Notes -12bps at 2.52% and 10yr Notes -7bps at 2.72%.

2018 YTD Equity Indexes: UAE +9.8% priced in US dollars (+9.8% in dirham), Saudi Arabia +7.2% in dollars (+7.2% in riyals), New Zealand -1.2% (+4.6%), Brazil -1.8% (+15%), NASDAQ -4.6% (-4.6%), India -5.8% (+3.1%), Norway -6.6% (-0.5%), S&P 500 -7% (-7%), Russia -7.5% (+11.8%), Malaysia -7.9% (-5.8%), Hungary -8.5% (-0.6%), Indonesia -8.8% (-2.5%), Japan -10.4% (-12.1%), Thailand -10.8% (-10.8%), Colombia -10.8% (-2.9%), Switzerland -11.2% (-10.2%), Taiwan -11.2% (-8.6%), Israel -11.3% (-3.7%), Singapore -12.3% (-10.3%), Finland -12.5% (-8%), Portugal -12.7% (-8.2%), Russell -12.9% (-12.9%), Czech Republic -13.6% (-8.5%), HK -15% (-14.8%), Netherlands -15.4% (-11.1%), Mexico -16% (-16%), Australia -16% (-6.8%), France -16.2% (-11.9%), Poland -16.5% (-9.5%), Philippines -17% (-12.8%), Denmark -17.4% (-13%), UK -17.8% (-12.4%), Sweden -18.5% (-10.7%), Chile -18.6% (-8.3%), Euro Stoxx 50 -18.9% (-14.8%), Canada -19.4% (-12.3%), Spain -19.5% (-15.4%), Italy -20.2% (-16.1%), Korea -20.5% (-17.3%), Germany -22.2% (-18.3%), Belgium -23.2% (-19.3%), Austria -23.6% (-19.7%), South Africa -23.7% (-11.5%), Ireland -26.2% (-22.4%), Greece -28.4% (-24.7%), China -28.7% (-24.6%), Turkey -43.7% (-21.6%), and Argentina -50.2% (+0.8%).

The Environment: “I think of the markets like an ecosystem,” the fund manager told me. “The environment causes some strategies to flourish and multiply, while others die off. The abnormally long, QE-fueled bull market killed off anything that wasn’t, at its core, a short volatility strategy. Now, whether it’s risky credit, levered equities, or risk parity, almost all strategies are taking similar risks. QE has done something much more damaging than the Fed could have imagined. It changed the very nature of the market, destroying the diversity of the market ecosystem, and making it incredibly vulnerable to the smallest change in the macro environment.”

Yields: “Bond guys think they know what they want, but they’re wrong,” my first boss told me. “They think they want lower yields because they drive up bond prices. But that’s a short-term gain collected at the expense of future returns. Client inflows surge, chasing those high returns, but they’re not repeatable unless yields continue falling. What bond guys should really want is high yields, the kind that create long term returns that are attractive to clients. Rising rates are painful in the short-term but higher rates are better in the long run.”

Fed Put: “Why did Powell reset the Fed put lower?” he asked. “I don’t think Powell saw it that way,” I responded, “but I’m surprised people think a central bank put still exists.” If we have a recession with over-night rates at 2.50%, what can the Fed do? They can’t ease 500bps like in past recessions, there’s no room. Coordinated easing with the ECB and BOJ is off the table - their rates are negative and they’re running out of assets to buy for QE. At least the Fed won’t have that issue. With surging budget deficits, the Fed will have plenty of Treasuries to buy. And that’s only just begun, because the next put for markets is really from fiscal, not monetary policy. 

Assume: “What do you think about big data models?” the analyst asked. “There’s a fascination with having ever more data, but quantity can’t make up for quality,” I responded. Some things are easy to model but others are much harder because there’s just not good data. Anyone can build a decent model with great data. The hard part is knowing what to do with bad or incomplete data. The hardest yet is knowing when to pull your model because the data it was built with isn’t representative of the current environment. How would you build a robust model for a bond bear market? There’s just not great data. Most quants compensate by creating a data series and then treating this made-up data as real. But to create a data series you must make assumptions. Success will come not to those who build the best machines but those who make the best assumptions. 

Anecdote: “The problem they face is that inflation will increase their liabilities while simultaneously deflating the valuations of their assets,” said Eric. We were discussing the unenviable plight of pensions and endowments in a world of rising prices -- their cost of living adjustments and operating budget increases. “But the status quo won’t deliver the 7.5% returns they require, and deflation will devastate their portfolios – so they’re stuck.” Quantitative easing ended one crisis while ensuring another. This monetary innovation suppressed interest rates across the entire yield curve, which in a world mesmerized by the concept of secular stagnation, led to a one-time surge in the price of every asset on the planet. But you only get to create such a rally once without restoring balance. The unnatural valuations that resulted from QE became a trap unto themselves. And so the Fed wisely began to normalize policy. We should not mistake a slowdown in their pace of rate hikes for a reversal of their attempted exit. In this new world of quantitative tightening, there will be many losers. The process will be long and has only just begun -- Deutsche Bank writes that 93% of global financial markets have had negative returns in 2018, the worst such performance in their 117yr dataset. Throughout the QE era, beta was king, passive portfolios prospered. So intoxicating has been the allure of passive investing that most active investors quietly adopted these strategies. Their 2018 losses will restore sobriety. From these valuations, there will be no way to passively position a portfolio for what comes next. And it won’t simply be specific assets that struggle, it will be entire investment strategies that suffer. Index funds dominated when liquidity was plentiful, volatility was low, and all assets were rising. Reverse those conditions and it will be the active managers who rule the day.

Good luck out there,

Lindsay Politi

Head of Inflation Strategies

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.