wknd notes: Ghosts of Investments Present (Part II)

Wishing you and your family a wonderful holiday and a happy, healthy, prosperous new year. As you may know, I take late-Dec off from writing. Lindsay Politi is stepping 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 is devoting these three weeks to an arc focusing on the past, present, and finally her thoughts about the future. Here goes -- Ghosts of Investments Present (see below).

Week-in-Review (expressed in YoY terms): Mon: Corbyn tables no-confidence motion on May leadership, Mexico to hike minimum wage 16% to $5.10/hr, US homebuilder confidence 3.5yr low, Russell 2000 in bear market, Trump attacks Fed ahead of FOMC meeting, S&P -2.1%; Tue: Xi Jinping speaks on 40th anniversary of China economic opening (offers no new reforms), China cuts US treasury holdings for 5th mth, Japanese stocks hit 17mth low, Turkish retail sales -7.5% (record annual decline), German business confidence 2yr low, US housing starts 3mth high, FedEx slashes outlook on weakening global economy, US bans bump-stocks, S&P flat; Wed: Japan exports -8.3 to -0.1% (imports -7.4 to +12.5%), EU/Italy agree to budget compromise, German business confidence 2yr lows, UK CPI -0.1 to +2.3% (avg hourly earnings +3.3%), Canada CPI -0.7 to +1.7% (core -0.2 to +1.5%), Fed hikes rates 25bps to 2.25%-2.50% (Dots show 2 hikes in 2019 – down from 3 previously – leaves $50bln/mth QT unch), Fed cuts 2019 GDP forecast -0.2 to +2.3%, Trump declares victory and announces Syrian troop withdrawal, existing home sales rise for 2nd month, S&P -1.5%; Thur: China hackers accused by US of stealing IP, BOJ rates unch at -0.10% (YCC unch), HK hikes 25bps to 2.75% (following Fed hike), Sweden hikes rates 25bps to -0.25%, BOE rates unch at +0.75%, Gatwick airport closed due to multiple drone sightings, Mexico hikes 25bps to 8.25%, WTI crude $46/barrel (16mth low), US proposes lifting Rusal sanctions (aluminum 16mth low), Trump threatens gov’t shutdown unless he gets $5bln border wall funding, Nasdaq enters bear market, 2yr-10yr curve hits 9bps (then rebounds), Philly Fed index 2yr low, S&P -1.6%; Fri: China denies US accusation of mass cyber espionage, Japan core CPI -0.1 to +0.9%, Defense Secretary Mattis resigns (publishes principled letter against Trump and his policies), Senate fails to pass spending bill, core PCE inflation +0.1 to +1.9%, job openings exceed job seekers in 2018 for first time this century, Fed’s Williams on TV for post-FOMC damage control (insists the Fed considers markets as policy input), S&P -2.1%; Sat/Sun: US government shutdown (Trump insists he will not budge on $5bln for Mexico wall), US envoy involved in fight against ISIS quits following Mattis departure, Trump reportedly considering firing Powell (White House denies rumor).

Weekly Close: S&P 500 -7.1% and VIX +8.48 at +30.11. Nikkei -5.7%, Shanghai -3.0%, Euro Stoxx -3.0%, Bovespa -2.0%, MSCI World -5.5%, and MSCI Emerging -1.5%. USD rose +3.1% vs Russia, +1.9% vs Australia, +1.7% vs South Africa, +1.6% vs Canada, and +1.1% vs Chile. USD fell -24.3% vs Ethereum, -18.0% vs Bitcoin, -2.4% vs India, -1.9% vs Yen, -1.5% vs Mexico, -0.9% vs Turkey, -0.6% vs Euro, -0.5% vs Sterling, -0.4% vs Brazil, -0.2% vs Sweden, -0.2% vs Indonesia, and flat vs China. Gold +1.4%, Silver +0.4%, Oil -11.8%, Copper -3.1%, Iron Ore +8.1%, Corn -1.6%. 5y5y inflation swaps (EU -5bps at 1.57%, US -1bp at 2.22%, JP -13bps at 0.07%, and UK -7bps at 3.63%). 2yr Notes -9bps at 2.64% and 10yr Notes -10bps at 2.79%.

2018 YTD Equity Indexes: UAE +10.4% priced in US dollars (+10.4% in dirham), Saudi Arabia +7.2% in dollars (+7.3% in riyal), New Zealand -2.2% (+3.4%), Brazil -4.7% (+12.2%), Norway -6.1% (+0.4%), Israel -6.8% (+1.1%), India -7% (+2.1%), Russia -7.1% (+11.3%), Hungary -8.1% (+0.5%), NASDAQ -8.3%, Thailand -9.2% (-9%), S&P 500 -9.6%, Malaysia -9.7% (-7%), Indonesia -9.8% (-3%), Japan -10.4% (-11.4%), Switzerland -12% (-10.3%), Taiwan -12.3% (-9.1%), Finland -12.7% (-7.8%), Colombia -12.9% (-4%), Singapore -13% (-10.5%), Portugal -13.2% (-8.4%), HK -14.1% (-13.9%), Czech Republic -14.6% (-8.8%), Netherlands -15.7% (-11%), Russell -15.9%, France -16.3% (-11.6%), Poland -17.2% (-10.1%), Mexico -17.2% (-16%), Philippines -17.6% (-12.6%), Denmark -17.7% (-12.8%), UK -18.3% (-12.6%), Australia -18.6% (-9.9%), Euro Stoxx 50 -18.9% (-14.4%), Sweden -19.1% (-10.7%), Chile -19.2% (-9%), Spain -19.3% (-14.8%), Italy -20.3% (-15.8%), Korea -20.7% (-16.5%), Canada -20.7% (-14%), Germany -22% (-17.7%), Belgium -22.8% (-18.5%), Austria -24.8% (-20.6%), South Africa -26.5% (-13.3%), Ireland -27.5% (-23.4%), Greece -28.2% (-24.2%), China -28.3% (-23.9%), Turkey -43% (-20.4%), Argentina -53.6% (-5.4%).

Cold Sweat: “I’m a trader, not an economist,” I said to the PhD, “so you know monetary theory better than I. But I know what it feels like to wake up in a cold sweat when a big trade goes wrong. The extreme confidence that leads traders to super-size a trade flips to abject fear when that conviction wavers and we realize we’re way too big. Central banks (and numerous large investment strategies) went all-in on secular stagnation. They confidently plowed trillions into the idea. Now they want out and the exit is far smaller than they’d imagined. They lay awake. They’re not controlling the trade anymore; the trade is controlling them.”

Reality: Macron thought he had policy options. Reality was quite different. A decade of failed, painful austerity narrowed his tolerable policy options. Whether or not Brussels has heard the message, Macron has: austerity is dead. Draghi believed he would have choices. But years of asset purchases and negative rates failed to produce an expansion sufficiently robust to allow for policy normalization. And now the economy is slowing with rates at -0.40%. Powell inherited a legacy of choices, consequences. His predecessors left him with mission impossible. Yet he thought the massive tax stimulus had given him policy options. But reality is quite different.

Arguments: Hobson theorized that internationalism is an extension of secular stagnation. Declining domestic demand and capital returns led to a search for new markets. International returns were high due to political risk. So the economic elite lobbied national governments to expand their international influence to secure their foreign investments. Hobson thought the benefits of free trade failed to account for the expense of national governments protecting private investment abroad. Today’s debates about nationalism versus internationalism are old. And historically, a retreat from internationalism has signaled a shift away from secular stagnation.

Relationships: “So QE leads to inflation?” asked the CIO. “Perhaps, but that’s not the interesting relationship,” I said. After 10yrs of these policies, inflation now controls QE. Central banks explicitly or implicitly must respond to inflation, some with little flexibility. So inflation controls their reaction function far more than they control inflation. As they embark on quantitative tightening and the great unwind of the QE bubble, inflation will determine the fate of the $20trln+ central bank balance sheets and, by extension, the path of financial markets. That’s why, over the coming 5-10yrs, inflation will be the most important market variable.

Anecdote: “It’s just so obvious to us,” said Eric to the CEO and CRO over lunch. As I listened, the word ‘obvious’ gave me pause, but when so many people are painted into corners the outcome can appear predestined. Nearly every allocator we talk to needs to annualize at +7.5%, so they’re locked into some version of the same leveraged equity-centric portfolio. Everyone’s short inflation - some know, others don’t. Inflation has been so benign it’s fallen out of risk models. Powell is in a box his predecessors constructed. QE has entangled markets and monetary policy in ways that exceed anything ever seen. Powell’s starting to realize it, if he didn’t know already. QE depressed discount rates, inflating the present value of everything without improving fundamentals: the longer the duration of the cash flows the bigger the benefit. Bonds did better than cash, equities did better than bonds, tech did better than staples. QE fueled a bull market without the earnings to underpin valuations. Reversing this money illusion will be painful. But is sustaining the illusion an option? The political old guard is being voted out everywhere, and what voters want appears consistent. Whether from infrastructure spending, tax cuts and immigration crackdowns or universal health care, free college, and a green new deal; people want higher wages. If that requires bigger deficits and inflation, so be it. If politicians waver, the Yellow Vests take the streets, Go Fund Me campaigns spring up instantly. Growth won’t disappoint because it cannot, not anymore, not for long. Keynesian fiscal spending looms large on the horizon. But the economy and financial markets need not move in lock step. The transition from quantitative easing to quantitative tightening will be as painful as a recession to the financial markets, even if it is not to the real economy. But to investors, that distinction will feel irrelevant.

Next week I’ll discuss what the present path means for future investments, and what we think the quantitative tightening portfolio should look like.

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.