wknd notes: Parallels with the 1960s

“Michael’s steady intensification over the past 48 hours in the face of 20-knot westerly shear defies traditional logic," announced the National Hurricane Center, supercomputers humming, models smoking. “Either the shear calculations are unrepresentative, or Michael has become more inertially stable due to its large eye.” The Cat 1 storm jumped to Cat 4 within 24hrs, drawing energy from rising Gulf temperatures, accelerating as it made landfall with 155mph winds. “This is the longest streak of small business optimism in history, evidence that tax cuts and regulatory rollbacks are paying off,” reported the National Federation of Independent Business. “Our members say business is booming, prospects continue to look bright.” Consensus 3rd quarter GDP is +3.3%, the Atlanta Fed estimate is +4.2%, more than double potential GDP for earth’s largest economy. “It’s a correction that I think is caused by the Federal Reserve,” declared Trump, the S&P 500 plunging. “I think the Fed is out of control.” Reporters asked if he would fire Powell, because you see, Jay is attempting to cool an economy that Trump is trying to superheat. And America’s President can fire the Federal Reserve Chairman for cause. “I'm not going to fire him,” answered Trump, the topic now subject to speculation. “We’re against the enemies of Europe, shut away in the Brussels bunker,” said Deputy Prime Minister Salvini. “The politics of austerity of the last few years have increased Italian debt and impoverished Italy.” Rome will either break the back of EU austerity or leave it. Either way, the status quo is no more. “The required reserve ratio is now 100 basis points lower,” announced China’s central bank, its 4th cut this year, unleashing another $109bln in new lending. But Shanghai stocks still plunged 7.6% on the week to new 4yr lows. As the global tempest builds, swirling in unknowable ways, sweeping aside economic orthodoxy.  

Week-in-Review (expressed in YoY terms): Mon: China cuts RRR 100bps (4th cut in 2018) yet Shanghai stocks fall nearly 4%, Chinese services PMI +1.6 to 53.1 (3mth high), Indonesia rupiah hits 20yr low, EU investor sentiment slides, Bolsonaro wins Brazil’s presidential 1st round elections with 46% (Haddad 29%), US 10yr yields hit 3.23%, S&P flat; Tue: Japan economy watchers index 2yr lows, IMF lowers 2018/19 global GDP forecasts on trade war concerns, Pakistan seeks IMF bailout, South Africa appoints new finance minister (rand rallies), Turkey calls on stores to cut prices 10% to relieve inflation, German trade surplus jumps on declining imports, Canada housing starts -13.8%, Nikki Haley resigns as UN ambassador, Blackrock’s AGG bond ETF suffers record $2bln 1-day outflow, S&P -0.1%; Wed: Chinese agent charged by US for stealing GE Aviation trade secrets, Seoul considers lifting Pyongyang sanctions, Turkish officials conclude Saudis killed journalist Khashoggi and dismembered him, US expands scrutiny of foreign investments in American technology companies, Hurricane Michael makes landfall as Cat 4, Manhattan new home sales -39% (median prices -9%), Mnuchin warns China re currency manipulation, Trump “I think the Fed is making a mistake. They’re so tight. The Fed has gone crazy,” S&P -3.3%; Thur: Chinese stocks hit 4yr lows (back to levels first hit in 2007), Turkey posts first mthly current account in 3yrs, Swedish CPI +0.4 to +2.5% (core +0.4 to +1.6%), Italy issues debt at 5yr-high yields, US CPI -0.4 to +2.3% (core CPI +2.2%), Trump increases trade war rhetoric “Chinese lived too well for too long,” Trump blames Fed for stock market declines but says he won’t fire Powell, S&P -2.1%; Fri: IEA “oil demand to be curbed by trade tensions,” Turkey releases US pastor (diffusing crisis), IMF warns Italy over rising budget deficits, UK government warns UK/EU train service and Northern Ireland electricity supply would cease on a hard-Brexit with no bi-lateral agreements, EU industrial production rebounds, Archbishop of Washington steps down over abuse scandal, US consumer sentiment slips, S&P +1.4%; Sat/Sun: Trump vows “severe punishment” if Saudis are behind Khashoggi murder.

Weekly Close: S&P 500 -4.1% and VIX +6.49 at +21.31. Nikkei -4.6%, Shanghai -7.6%, Euro Stoxx -4.6%, Bovespa +0.7%, MSCI World -4.9%, and MSCI Emerging -4.6%. USD rose +13.7% vs Ethereum, +5.2% vs Bitcoin, +0.8% vs China, +0.7% vs Canada, +0.3% vs Chile, +0.2% vs Mexico, and +0.1% vs Indonesia. USD fell -4.2% vs Turkey, -1.7% vs South Africa, -1.6% vs Brazil, -1.3% vs Yen, -1.2% vs Sweden, -0.9% vs Australia, -0.8% vs Russia, -0.3% vs Euro, -0.3% vs India, and -0.3% vs Sterling. Gold +1.2%, Silver -0.3%, Oil -3.7%, Copper +1.9%, Iron Ore +2.3%, Corn +1.4%. 5y5y inflation swaps (EU flat at 1.69%, US flat at 2.40%, JP flat at 0.27%, and UK +2bps at 3.56%). 2yr Notes -3bps at 2.86% and 10yr Notes -7bps at 3.16%.

2018 YTD Equity Indexes: UAE +12.9% prices in US dollars (+12.9% in dirham), Norway +11.8% in dollars (+11.8% in euros), NASDAQ +8.6%, Saudi Arabia +3.7% (+4.2%), Colombia +3.7% (+7.6%), S&P 500 +3.5%, Russell +0.7%, Israel +0.4% (+5.2%), Japan +0.2% (-0.3%), Mexico flat (-3.9%), Russia -1.1% (+13.9%), New Zealand -3.4% (+5.3%), Thailand -3.9% (-3.3%), Portugal -4.1% (-0.3%), Brazil -4.6% (+8.5%), Finland -4.6% (-0.8%), Czech Republic -4.7% (+0.1%), Malaysia -6% (-3.7%), France -7.7% (-4.1%), Canada -8.7% (-4.9%), Netherlands -8.8% (-5.2%), Switzerland -9.3% (-7.7%), Taiwan -9.4% (-5.6%), Austria -10% (-6.4%), Sweden -11.1% (-2.6%), UK -11.5% (-9%), Australia -11.5% (-2.8%), Euro Stoxx 50 -12.3% (-8.8%), Singapore -12.5% (-9.8%), India -13.8% (-0.6%), HK -14% (-13.8%), Germany -14.2% (-10.8%), Spain -14.8% (-11.4%), Hungary -15.1% (-7.7%), Italy -15.2% (-11.9%), Belgium -15.3% (-11.9%), Chile -16.1% (-7.5%), Denmark -16.2% (-12.6%), Ireland -16.7% (-13.4%), Korea -17.2% (-12.4%), Poland -17.3% (-11.3%), Indonesia -19% (-9.4%), South Africa -23.5% (-10%), Philippines -24.4% (-18.2%), Greece -24.7% (-21.7%), China -25.9% (-21.2%), Turkey -46.5% (-16.2%), and Argentina -49.6% (-1.6%).

Groundhog Day: “Starting in the mid-1960s several significant policy changes, made in the context of a belief that inflation wasn’t a concern, all but caused the outcome that was considered impossible,” wrote Lindsay Politi in her latest thought piece. “The first proximate catalyst to the great inflation was the Tax Reduction Act of 1964. At the time, it was the largest tax cut in American history. The Act slashed income taxes, especially on higher income households, by reducing income taxes by 20% across the board in addition to reducing corporate rates. The expectation was that the tax cut would ultimately increase total tax revenue by lowering unemployment, increasing consumption, and increasing the incentive for companies to invest and modernize their capital stock. The tax cut did increase growth, but it also pushed unemployment very low, to one of the only sustained periods of unemployment below 4% in the post war period.”

Groundhog Day II: “The 2nd policy change was how employment was considered,” continued Lindsay. “In the mid-1960s, there was concern about a cultural divide. The US social critic Michael Harrington spoke about “The Other America”: the unskilled Americans in mostly rural areas who had a “culture of poverty” and were being left behind by the post war economic boom of the 1950s. In that context the drop in the unemployment rate after the tax cut was welcome. The belief was that pushing the unemployment rate to very low levels would help transfer wealth from the prosperous urban and suburban areas to “The Other America.” They thought that, while very low unemployment might increase inflation, the increase would only be modest, and the social benefits of modestly higher inflation and lower unemployment were desirable. At the time, there wasn’t a uniform theory for the relationship between inflation and unemployment, so when inflation started to increase with very low unemployment rates it wasn’t a concern.”

Groundhog Day III: “A 3rd proximate cause of The Great Inflation was the failure to appreciate a significant, structural productivity decline. Capital deepening for WWII and the Korean War had boosted productivity. However, much lower peacetime capital spending had caused productivity growth to slow. Despite the relative lack of capital spending, productivity declines were generally dismissed. It became clear at the end of the 1960s into the early 1970s that inflation has a self-reinforcing trend. Stability in inflation can reinforce stability, but acceleration also reinforces acceleration. As inflation increases, all else equal, it lowers real interest rates which stimulates growth, creating higher inflation. It’s part of why anchored inflation expectations are so critical to inflation staying low, but also why expectations of higher inflation can be hard to fight.” Click here for the paper: Lessons from the Origins of The Great Inflation for Today – What the mid-1960s Can Teach Us About Trading Current Markets

Anecdote: The future is unknowable. Yet never has capital been so concentrated in strategies that depend on the future closely resembling the past. The most dominant of these strategies requires bonds to rally when stocks fall. For decades, both rose inexorably. And a new array of increasingly complex and illiquid strategies depends on a jump in volatility to be followed by a rapid decline of equal magnitude. They appear uncorrelated until they are not. Virtually every investment portfolio measures risk by utilizing some combination of volatility and correlation, both of which are backward-looking and low. But the present is knowable. The past too. And the multi-decade trends that carried us to today produced levels of inequality rarely seen. Low levels of inflation, growth, productivity, and volatility are features of this cycle’s increasingly unequal distribution. But cycle extremes produce pressures that reverse their direction. On cue, an anti-establishment political wave washed away the globalists, with promises to turn the tide. Such change is nothing new, just another loop around the sun. Now signs of a cycle swing abound; shifting trade agreements, global supply chains, military dynamics, immigration, wage pressures, polarization, nationalism, tribalism. To an observer, it’s neither right nor wrong, it simply is. Some see parallels between today and the late-1930s, which led to World War II. We also see parallels with the mid-1960s, which led to The Great Inflation. What comes next is sure to look different still. But investment strategies that prospered from the past decade’s low inflation, growth, productivity and volatility will face headwinds as this cycle turns. Those strategies that suffered should enjoy tailwinds. That’s how cycles work. And we know the 1940s was a strong decade for Trend performance. The 1970s was the best decade for Trend in 150yrs. And following cycle turns in both the 1930s and 1960s, the world became a profoundly volatile place. 

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.