Chronicle of a Crisis Foretold
We believe that Central Banks are trapped between inflation and bubbles too-big-to-fail, both problems they created with their reckless monetary and fiscal policies without limits. The damage, I am afraid, is already done.
In the immediate short term, Central Banks have no choice but to hike interest rates to fight inflation in order to restore credibility. As of writing, the market is pricing 67 bps for the July 27th FOMC meeting (89% probability of 75 bps), 121 bps for Sep22, 156 bps for Nov22 and 173 bps for Dec22, which bring Fed Funds to 3.32% by Dec22.
The path of hikes priced-in by the market is too complacent in our view and assumes that the economy and markets will cope with the hikes without blowing-up the economy and bubbles. Worth noting the 3.32% already priced-in for Dec22 is substantially higher than the 2.5% level we reached in 4Q18, when the markets blew-up and forced the Fed to aggressively intervene to contain the carnage across equity and credit markets.
We believe that delivering on the hikes that are already priced-in will invariably lead to a recession as a best-case scenario that will force the Fed to pause hiking path.
Central Banks around the world are running massively behind the curve, currently playing catch-up with long-overdue rate hikes that are coming at a time when the global economy is losing steam and facing immense inflationary pressures, which in our view are consistent with lower earnings, lower profits, lower multiples, and lower equity valuations.
Beyond the obvious risk of recession, we believe the aggressive catch-up of hikes (the normal path of hikes is 25bps per meeting, not 75bps as we are currently delivering and pricing) aggravates the pre-existing fragility of the system and will in our view lead to significant stress across equity and credit markets that will force the central banks to reverse the hikes and, yes, bring back more of the same monetary and fiscal policies that brought us to the problem we face today.
As a result, we believe the Central Bank hiking cycle of nominal rates is capped by unsustainably high levels of debt and believe the global system could/will blow up as/when Central Bank raise rates too much and too quickly.
The sell-off YTD across equity and credit markets is in our view a correction from grossly inflated artificial levels but has not yet reached distress levels, just yet.
How about Volatility and the VIX?
The price action and levels of implied and realized volatility market in general, and the VIX in particular, has been consistent with the scenario of an “orderly correction” that we have experienced thus far.
The Worth noting the recent VIX range of 25% to 30% implies daily break-evens in the SPX of roughly 1.5% to 2% daily moves, which seem appropriate with the implied vs realized price action we have seen, which explains the somewhat disappointing performance of the VIX (many investors were hoping/expecting a the VIX would protect them against the equity drawdown risk we have experienced).
The recent price action highlights the basis risk between long SPX puts vs long VIX. Long SPX puts provide insurance against lower prices and higher volatility, which is different from being long implied volatility via the VIX. Both are valuable defenders for the portfolio but, as we have seen, can behave very differently and have different risk-reward and carry profile.
Looking forward, however, we believe the VIX could perform very strongly during the hostile distress scenarios we anticipate. The problem with the VIX is the strong negative risk premia from the contango in the term structure of the futures and the steep call skew in the VIX options, which we partially mitigate by buying call spreads. During the month of June we added 40/60 VIX call spreads at approx. $1 which offer risk reward of 20x premium.
Hiking into a Recession
Macro data is starting to confirm a notable slowdown in the global economy. Europe and USA PMI/ISM have taken a mayor leg down, with ISM manufacturing new orders and employment dropping below 50.
Consumer confidence numbers are hitting all-time lows in Europe and lowest in a decade in USA, reflecting the damage done already through inflation, especially energy costs.
Leading research houses are reacting and downgrading growth significantly. We agree.
During the hiking expectations euphoria around mid-June, 3m USD LIBOR June23 was at 4.25%, dramatically above the 2.5% level that triggered the 4Q18 crisis. Over the past few weeks, it has corrected by 100 bps to 3.25% with market participants cutting aggressively rate hike expectations across entire curve down as markets start to price lower growth ahead. As of writing the market seems to be pricing a 50% probability of a US recession over the next two years.
Leading industry analysts are focused on the need for Central banks to aggressively re-establish their credibility towards their inflation mandate and thus why they expect the hikes to take place irrespective of weak activity data.
Jerome Powell has explicitly endorsed this hawkish view and seems willing to accept the hit to growth. At the ECB’s Sintra forum Powell said: “Is there a risk we would go too far? Certainly, there’s a risk…the bigger mistake would be to fail to restore price stability”. According to Goldman Sachs analysts “weaker growth does not mean less hikes, until inflation is much, much lower, around 3%…”
We agree Central Banks have no choice but to hike but disagree they will hikes solely on inflation. As discussed multiple times, we believe that the damage from fast aggressive could turn systemic very quickly. A repeat of 4Q18, but worse.
Hiking into a Debt Crisis
In our view, the world economy is more fragile and more sensitive to interest rate hikes than it was in 4Q18 due primarily to higher debt levels.
Interestingly, Goldman Sachs research seems to hold the opposite view. Research by Daan Struyven argues that “the rise in debt is mostly driven by the government sector, which likely has a lower marginal propensity to spend (compared to households which are actually net lenders), and the composition of GDP has actually shifted towards less rate-sensitive sectors. The analysis finds a fairly stable roughly 1-to-1 mapping between the funds’ rate and GDP growth and concludes that the economy has likely not become significantly more vulnerable to rate hikes”. We disagree.
In our view, the situation today is much fragile than in 2018 when the Fed was “auto-pilot” hiking path in 2018 that ended quite abruptly with the sell-off of 4Q18 but forced the Fed to reverse course and cut rates from 2.50% to 1.50%, a 180 degree from the steady hikes that were implied by the market and most research houses. The sell-off in 4Q18 was driven by the widening in credit spreads amongst leveraged players, such as GE or Ambev, which had pursued leveraged acquisitions and were not able to service their debt. A crisis that quickly expanded to equities globally.
We believe the situation today on multiple fronts 1) Equity and credit valuations imploding from bubble territory, much higher than in 2018, with plenty of hidden leverage yet to be become apparent, 2) Government debt is much higher following the pandemic, and more sensitive to rate hikes. 3) The “sugar rush” from Fiscal policies, cheques, and MMT was short term and temporary. 4) Inflation is much higher and more persistent than in 2018, 4) lower disposable income and lower confidence for consumers, 5) lower growth, earnings, and profit margins for companies, 6) headwinds from global growth, such as China real estate and credit bubbles are already imploding. 7) rising inequality, social unrest, amongst other by-products of inflation, 8) Geopolitical risks are on the rise, led by China and Russia. Watch out for unintended escalation, …
Weak Growth now. Weak Earnings ahead.
The poor equity performance year to date largely reflects falling valuations in line with rising interest rates, leaving equity risk premium close to where it started the year.
Looking forward, we believe earnings expectations are too optimistic, and are yet to correct lower. According to Goldman Sachs research, assuming no change in expected revenues, the margin compression due to higher commodity prices would reduce the median stock’s expected 2023 EPS growth from +10% to 0%. Not good news for equity valuations.
In other words, so far we have seen a correction of the “P” in the P/E ratio and now comes the time of the “E”.
Corporate Earnings: Likely to be reviewed much lower
Equity analyst expect S&P 500 earnings to grow by about 10% yoy in both Q3 and Q4 despite the slow-down in economic activity, as they expect a “soft landing” and the ability for corporates to pass inflation through to consumers. We disagree with the market consensus and see major risks to earnings and margins, which will have an impact on valuations.
Higher borrowing costs: Watch out for leveraged players
Rising interest rates mean higher borrowing costs, which will likely continue to pose a headwind for net corporate profits, even if S&P 500 companies generally have strong balance sheets and long-maturity, fixed-rate debt, rising interest rates will nonetheless put upward pressure on borrow costs.
Credit Spreads: Reality strikes again
Credit spreads have widened to levels similar to the worst of the pandemic, especially in Europe where the Itraxx Main is currently around 125 (vs 155 max during pandemic) and Itraxx Xover at 615 (vs 750 max during pandemic).
Scary that the distress in Europe is happening as we contemplate hiking interest rates to ZERO! The ECB has not even started to hike rates and already needed an emergency meeting to discuss periphery spreads. This could be the shortest hiking cycle in history.
How about Fixed Income?
Fixed Income markets have experienced one of the worst drawdowns in recent history. The massive sell off has been driven by panic hiking and complacent expectations, which are resulting in massive widening of government and corporate credit spreads.
Looking forward, we believe nominal yields are capped by excessive debt and current levels offer a good entry point for duration plays such as long dated US Treasuries, which can generate significant gains in absolute terms and offer negatively correlated alpha to equities.
Our preferred implantation is via long dated options which cap the maximum loss to the premium spent and offer potential appreciation both via rates and vega.
How about Housing?
By hiking interest rates aggressively to combat inflation, Central Banks are adding pressure to the housing market, one of the primary sources of wealth effect following massive increases over the past few years.
Whilst the path will be very volatile, my personal long term view on housing is constructive as I believe we are headed into a long period of deeply negative real rates, which favour real assets.
Wealth Destruction vs Wealth-Effect Destruction
I have been reading a lot about “Wealth Destruction”, but in many cases what we are witnessing is in my view “Wealth Effect Destruction”, as the valuations of many assets were artificially high due to artificially low interest rates.
Wealth Effect is the Central Bank’s “frenemy” as it can be their best friend during benign markets, but always turns around as their worst enemy as the wealth effect vanishes back where it came from: thin air.
Wealth Effect applies to multiple other areas beyond equity, credit, and real estate. The crypto-mania for example is in my view another market that generated extraordinarily high levels of wealth effect, which has quickly eroded YTD.
I have been and remain very sceptical of the crypto currency space, which as discussed in my article “Bitcoin: Bubble or Anti-Bubble”, I believe is 80% bubble and 20% anti-bubble.
Can Rate Hikes control Inflation?
Central Banks seem determined to fight inflation via higher interest rates. Beyond the obvious risk of a recession we just discussed, there are other major considerations.
Commodity inflation, as discussed in previous newsletters, is partially structural and will not be easily fixed via monetary and fiscal policies. Supply shortages, supply disruptions, supply bottlenecks, low inventories, low spare production capacity will take time and much higher prices to create enough supply and enough destroy demand and bring into balance.
To make things worse, Governments around the world, faced the double-whammy of higher prices and lower volumes, are introducing subsidies to consumers that are, guess what, financed by money printing and more debt, partially or totally offset the hikes… Crazy.
The best-case scenario for Central Banks is a recession that destroys demand in an orderly fashion. A soft landing. Wishful thinking in our view, as Central Banks may be left with the worst of both worlds: lower growth, distressed markets, and stubbornly high prices. Back to square minus one.
Orderly Recession vs Systemic Collapse
There are multiple variables that will impact how much and how fast Central Banks will be able to hike Interest Rates. So far, the market is expecting the fast and aggressive hikes will produce an “orderly recession”. Nothing systemic. We partially disagree.
We believe the markets are much more fragile that they may appear and believe distress could appear anywhere anytime. Credit stress and distress will be the real test for Central Banks resolve to hike, as troubles in credit markets are closely followed by lay-offs, bankruptcies and all sorts of domino effects that can snowball out of control.
As a result, ironically, the better equity and credits perform into the hikes, the faster and larger the rate hikes will be. The current dynamic has changed from the “buy the dip” mentality that has dominated global markets over the past few years to a “sell the rally” mentality that reflects the new reality of Central Banks forced to hike rates to fight inflation and see lower equity markets as collateral damage.
Chronicle of a Crisis Foretold: Volatility, Correlation, and Liquidity
The bubble vs anti-bubble relationship between the SPX and VIX remains very much alive. Should implied volatility and the VIX spike, we would see the vicious cycle of higher volatility.
During hostile markets, volatility tends to explode higher, correlations tend to polarize to plus one or minus one, and liquidity tends to dry-out, and the market becomes a risk-reduction machine. This “chronicle of a crisis foretold” is both a risk and an opportunity.
On the risk side, investors must watch out for hidden leverage and false diversification, whereby “investors confuse a portfolio with many things with a diversified portfolio”.
On the opportunity side, investors can take advantage and accumulate artificially cheap insurance during complacent markets (remember, insurance tends to be cheapest when we need it the most).
We recommend that investors embrace volatility (instead of fight volatility) by actively rebalancing a balanced portfolio of “strikers” and “defenders” to generate incremental returns. The idea is simple: buy cheap insurance during complacent markets and monetize it during hostile markets to buy distressed risk assets.
Investors may think that it is too late to buy insurance. Not necessarily true. Crisis follow both “domino” and “snow-ball” effects. Whilst some markets have already sold off, there are many others that are lagging or even giving better entry points. Look at US Treasuries or Gold for example, which sold-off aggressively and offers attractive entry for medium to longer term linear and option plays. In other markets, such as volatility or the VIX, which are already moderately high, the risk premia opportunities may be in the call skew, which offer attractive relative value via call spreads. Other markets are potentially massive hot spots for trouble, such as the Chinese Yuan or the Hong Kong Dollar, but are lagging on the moves. In some cases, the implied correlation is pricing a complacent regime change that could dramatically change during a crisis, which offers attractive value in hybrid options. Bottom line, irrespective of the market conditions, there are always opportunities in the long only insurance space. More on this later.
Catalysts for Hostile Markets: Watch Out for 27th July FOMC
Amongst the many potential catalysts that could trigger a substantial move higher in volatility and risk-off, we think the FOMC meeting on the 27th of July is among the key events to watch. First, because the materialization of another 75 bps hike would bring interest rates notably above the levels that triggered the hostile markets of 4Q18. Trouble. Second, because the very aggressive pace and size of the hikes will create additional stress as some sectors are not able to adjust.
Monetary Policy is meant to be used smoothly and gradually, not aggressively, but Central Banks are massively behind the curve as they complacently kept rates too low for too long. The damage, I am afraid, is already done.
Liquidity: Watch Out for August
The summer holiday tends to be a period of thin liquidity, in terms of the ability to liquidate positions in terms of 1) time, 2) size, and 3) price. Large players forced to liquidate positions in short period of time and in large volumes can massively impact the price, which could in turn create new sell signal and exacerbate the moves and expose the speculative positioning of the market.
Strong USD exports inflation
The USD has massively outperformed the EUR and JPY, low yielding currencies that will be unable to hike due to the massive debt and structural issues they face, which are exacerbated by the energy crisis and subsidies, as discussed before.
Unlike previous crises, where Currency Wars has taken the form of “beggar they neighbour”, this current inflation crisis could result in a period of more prolonged USD strength as effectively works as a tool to export inflation. Put differently, Europe and Japan are suffering the double whammy of higher commodity prices and higher USD.
A credit crisis could result in lower USD rates, as discussed before, but would have two way forced on the currency, and thus why the USD could remain stronger for longer.
Gold has been suffering from the USD strength, but in our view has the potential to reverse and perform strongly as/when the credit crisis deteriorates, and thus why our insurance portfolio is strongly positioned for both USD and Gold.
Commodities: Shortages vs Recession
Crude Oil prices collapsed more than 10% in a single day earlier this week due to a combination of recession fears, thin trading liquidity, and technical flows that exposed the long speculative positioning of the market.
Our view long term view on energy remains constructive but expect the extremely high volatility to persist as the market tries to balance short-term risks (recession) vs long-term (shortages), which are exacerbated by current deficits and inventories are still declining and approaching critically low levels.
Russian Natural Gas crushing Europe: Bearish EUR growth
Europe remains extremely dependent on Russian Natural Gas. Germany and Italy depend by 50%, France by 20%. With gas flow down about 70% YoY, the impact is massive across power generation, heating and industrial uses. The ability for Europe to substitute gas demand with coal or nuclear is limited in the short term. European inventories are already at critically low levels, less than a third than historical averages, which will exacerbate tail risks to prices and growth as the year progresses.
We cannot rule out the possibility of further escalation in the energy crisis and Russia cutting gas supplies to Europe, which would add significant volatility and risk to European growth and risk markets. The risk has increased significantly since June 14th, when Gazprom started slowing gas supply to Western Europe.
Needless to say, the bad inflation that Europe is experiencing will not be combated via higher EUR rates, pretty much the opposite, and thus why we expect the ECB to hike to 0% and possibly pause there.
Interesting how the political narrative is changing. Look at Strategic Petroleum Reserves (“SPR”), nuclear energy, Iran, or Venezuela. As expected, USA and Europe will do emergency releases of crude and products from their Strategic Petroleum Reserves “SPR” which are easing the pressure in the short to medium term but are tightening the balance further out. Nuclear power is becoming “green” after being evil for a long time. Finally, as I believe nuclear should be an important part of the energy mix. The politics around Iran and Venezuela will continue to change in the interest of the main players in yet another example that “the bad guy is the good guy from his own movie”. All these factors will in our view contribute to volatility across energy markets, which we expect to remain very high.
Inequality, Strikes, Social Unrest, Civil Wars, …
The inflation crisis is putting enormous pressure on food, energy and cost of living in general, which is likely to result in labour strikes at best and possibly riots/civil wars at worst.
Whilst I believe inflation is largely a monetary phenomenon (inflation is not about asset values going up, but about the value of money going down), we are currently experiencing additional externalities, such as the Russia-Ukraine war that if not resolved will continue to add massive pressure on inflation, inequality and its nasty derivatives.
Europe cannot print energy but can print EUR to subsidize it = Bearish EUR
We expect Governments around the world, and Europe in particular, to subsidize private and corporate consumers. The “solution” to - yet another - emergency is based on more of the same: money printing and debt. Europe will be unable and unwilling to hike in the current environment, adding to the negative interest rate differential and negative fundamentals for the EUR.
Onshoring and Deglobalization
We believe Globalization as we know it is over and reversing. The Pandemic showed the fragility of a system too reliant on global trade, with bottlenecks causing delays and lost production. It is clear to us that onshoring and de-globalisation are here to stay, and that resilience and self-sufficiency are now key objectives for all Western economies. The investment required to increase domestic production adds to efforts towards energy independence and shift to green energy, all of which require more debt.
Another way to look at the problem is a transition from “efficiency-economics” to “resilience-economics” (from “Just-In-Time” to “Just-In-Case”), a process that already started with Trump and has been accelerated by Covid and now the War.
China: Tail Risks and Yuan Weakness
We believe China is one of the greatest bubbles in history and a potential source of systemic risk. As discussed in previous newsletters, the crisis stems beyond the by now well-known troubles in the Real Estate market, which continue to result in defaults. China knows what it needs to do, but faced with trouble will always resort to “print, borrow, subsidize, bail-out” measure that in our view will result in a large devaluation of the Yuan.
Our bearish view stands in contrast to several respected industry analysts and managers who have very bullish China. Their view seems more tactical, supported by President Xi´s reinforced +5.5% growth target via more monetary and fiscal stimuli. Our view is more structural. We agree monetary and fiscal policies can support and stabilize equity and credit markets, but at the price of inflation and devaluation, which in our view is the ultimate degree of freedom.
Worth noting the Yuan is amongst the best performing currencies during the past couple of years, which has resulted in major outperformance vs the EUR or JPY, despite the interest rate differential and carry practically disappearing, in our view massively favouring UST vs Chinese Government Bonds.
Without failure, monetary and fiscal abuse will ultimately result in currency devaluation, and China in our view is one of the most extreme cases and expect the Yuan to devalue significantly due to its own demerits, particularly vs the USD and Gold.
Hong Kong: Watch out for the Peg
We have built a significant position via put options on the HKD. Our view stands on the paradigm shift faced by Hong Kong, which 1) used to be the 3rd largest harbour in the world as gateway to China, now challenged by its neighbour Shenzhen, 2) used to be a major financial hub in Asia as gateway to China, now challenged by Shanghai and Beijing, 3) used to be a stable state with rule of law, not so clear anymore, 4) the currency peg forces HK to follow the USD monetary policy and higher interest rates are going to hinder the economic weakness and expose the real estate market, one of the most expensive real estate markets in the world.
The primary argument in favour of a sustained peg are the large FX reserves of the currency board. We caution against this as 1) the outflows are accelerating and at the current pace will result in the depletion of the reserves within the medium term, 2) why spend precious USD reserves to defend the “indefensible”? The market expects HK to “fight” until the last USD of reserves is gone. I would challenge that view, specially if our bearish view on China and CNH materializes.
The term structure and implied volatility are very attractive for insurance plays that in our view offer more than 30x risk-reward with neutral carry and very limited downside.
Precious Metals suffering from a strong USD, for now
Precious metals as caught between two opposing forces: a strong USD and high inflation/risk. The price action remains very weak and has exacerbated forced liquidation and new tactical shorts, which keep gold in USD under pressure. The liquidation has been even more extreme in Silver which has recently broken key support levels.
Gold has performed notably better vs other currencies, in particular EUR and JPY. Longer-term we remain constructive and are positioned for higher gold AND higher USD, particularly vs the EUR and CNH.
The End Game: Stagflation
Should the recession materialize into something bigger, systemic, as we fear could the case, there is a non-negligible probability that we may see zero nominal rates, QE, and even Yield Curve Control “YCC” in response to distressed global markets. Faced with systemic collapse and inflation, Central Banks will always choose inflation.
Monetary and fiscal policies without limits do not resolve the problems but simply delay, transfer, transform and enlarge them even further, this time into stagflation.
Quadriga Anti-Bubble Strategies
Quadriga Igneo UCITS +29.7% YTD as of End June 2022 following a hostile and volatile month of June.
The strong YTD performance for the anti-bubble strategies comes from solid gains in the long-only insurance portfolio, +35% YTD as of End June 2022, more than offsetting the losses across the core Precious Metals, US Treasuries and TIPS portfolio.
Portfolio Restructure: Total Premium at Risk back to 20% Neutral Target
During the month of June we restructured the option insurance portfolio to 1) take profits on options expiring in 2022 that had performed strongly, 2) bring a total premium at risk back down towards our 20% neutral target, 3) extend and rebalance the maturity reducing 2022 and adding 2023, 4) add insurance protection in underlyings that offer attractive value, such as US Treasuries, VIX call spreads, gold calls, CNH puts, and HKD puts, amongst others.
The 20.2% AUM total premium at risk is very diversified across maturities, underlyings, and pay-offs, and is well-positioned to generate negatively correlated alpha during the hostile volatile markets we anticipate, as it has consistently done since its launch, with +12.7% 4Q18, +16.5% Aug19, +42.5% 1Q20, or +22.2% Feb22, amongst others.
The strategy remains its disciplined approach to accumulate and monetize insurance risk premia across the term structure, volatility, skew and correlation, actively taking profits, restructuring, and reinvesting in new insurance positions that meet our investment criteria of 1) worst-case capped at an upfront premium, 2) low upfront premium, 3) asymmetric risk-reward, 4) high conviction, and 5) contrarian positioning.
The following sections bring analysis from previous newsletters that remains highly relevant, such as “real real rates” or “the frogs in boiling water”.
1. MONETARY AND FISCAL POLICIES WITHOUT LIMITS
Monetary and Fiscal policies without limits have NOT resolved problems, but simply delay, transfer, transform and enlarge problems.
1.1) Delay problems via spending and debt. “Kick the can down the road”. A generational trade-off that benefits the current generation and the expense of future generations.
1.2) Transfer problems via Currency and Trade Wars. “Beggar thy neighbour”. Monetary policy is often portrayed as “domestic policy” but has played a key role in “foreign policy” via competitive devaluations that seek to attract investment, employment, and technology at the expense of inflation and bubbles. Trade Wars are de facto the mirror image of Currency Wars whereby Governments defend themselves via “if you devalue by 20%, I will tariff you by 20%”, which is only going to get worse as Globalization unwinds towards the current trend of bi-polarization. More to come.
1.3) Transform problems into Inflation and Inequality. Let´s not fool ourselves. Reckless and negligent monetary policies without limits are the primary reason for inflation. There are deflationary forces in the system (technology, demographics, overcapacity, etc) but these have been more than offset by money printing, creating an illusion of financial stability. There are also bottlenecks in the supply chains and investments that have contributed to shortages and price increases, many of which are more structural and persistent than the Governments and Central Banks have made us believe, but the fundamental reason for inflation (loss of purchase power of money) is and has always been, monetary. Inflation creates inequality between the “haves and have-nots”, which in turn leads to social unrest, populism, geopolitical conflicts, and worse. The Covid crisis was a game-changer as the money printing was put directly into the consumer´s pockets (instead of the banks’ balance sheets via QE), showing the close link between monetary and fiscal (“the left pocket lends the right pocket”).
Historia Magistra vitae and those who chose to ignore it are doomed to make the same mistakes as our predecessors. Really sad and infuriating, especially since those who suffer inequality are not aware of who is causing it and are to blame: Central Banks.
1.4) Enlarge problems via Bubbles Too-Big-To-Fail and Stagflation, or worse. It is very simple: artificially-low interest rates create artificially high valuations. At 0% nominal interest rates, the Present Value of $100 cash flow in 1 year, 10 years, 100 years or 1000 years is $100. No wonder all assets that are valued via discounted cash flow models have greatly benefited from the “duration” impact of artificially-low interest rates. The Wealth Effect (which I define as the illusion of wealth created by unrealized gains that cannot be realized) creates a virtuous reflexive cycle (fundamentals impact prices and prices impact fundamentals) on the way up, but a vicious reflexive cycle on the way down. We believe the normalization of monetary policy is “science fiction” as the burst of the debt and equity bubbles would create systemic havoc and thus why we believe Central Banks are trapped between inflation and bubbles and will invariably be forced to let inflation go in order to protect the bubbles.
2. NEGATIVE “REAL REAL RATES”
We believe Real Rates (Nominal Rates minus “Inflation”) will remain negative for the foreseeable future, and introduced the concept of “Real Real Rates” to differentiate the true dilution of purchase power faced by investors vs break-inflations which in our view massively underestimate “inflation” and therefore real rates.
Looking closer at the 3 levels of inflation and how they are likely to impact markets and consumer and investor behaviour:
1) Official Inflation. Governments conveniently use and abuse official inflation baskets as if "inflation was a single absolute number, the same for everyone” which is obviously not the case. These baskets are conveniently manipulated and, in our view, dramatically underestimate the loss of purchase power that we, consumers and investors, experience. Moreover, Official inflation such as CPI is used as a reference across many labour contracts may give the impression that employees are fully protected against rising inflation when the protection is partial and exposed to negative compounding, which is extremely damaging, particularly during periods of high inflation.
2) Break-Even Inflation. Derived from Nominal US Treasuries and Inflation-Protected Treasuries "TIPS”, and therefore not subject to a conveniently chosen basket. Break-even inflation is harder to manipulate since there is no index, but in our view is still massively underrepresenting the real inflation most of us face. The problem, in my view, is that Inflation Break-even reflects some kind of “institutional inflation”, somewhat similar to LIBOR, which represents some kind of “institutional borrowing rates”. So, just like private borrowers reference their loans to LIBOR + x%, private savers should reference their inflation at Break-Even + y%, where the y% spread can be very large.
3) Real Inflation, Defined as the true loss of purchase power we suffer in our pockets. Mindful that each person may have its own unique inflation basket, we believe as a proxy “guestimate” that Real Inflation is at least twice Official Inflation.
Based on our view that 1) Nominal Rates will increase, but not much, and 2) Real Inflation is likely to remain very high, we conclude that “Real Real Rates” (Nominal Rates minus Real Inflation) are likely to remain deeply negative for the foreseeable future.
THE NEW PARADIGM SHIFT IN THE INVESTMENT GAME: REAL RETURNS
If Investing were a video game, it would have 3 levels.
Level 1: Make money in NOMINAL terms. That is, “turn $100 into more than $100”.
Over the past few decades, most of us in the Developed World has been playing the investment game at Level 1, where our investment decisions were analysed, measured, and made in nominal terms. Inflation was perceived to be negligible. Not anymore.
The 2% official inflation target was 1) low enough that most investors neglect it, 2) high enough that over 10 years it would dilute our purchase power by 20% + compounding and over 20 years by 40% + compounding. A huge theft, especially at my age, 48 years old, when I can conclude that “20 years is not what it used to be”.
We are all frogs living in a monetary broth that has been steadily heated via money printing and debt whereby: i) official Inflation gives the illusion that inflation is one single universal number. It is not, ii) official Inflation is conveniently manipulated with a strong bias towards underestimation, and iii) the Loss of Purchase Power is at least twice Official Inflation, in our view. The weight of housing in the European index is for example 7% of the index, substantially lower than other parts of the world and the real impact in our cost of living.
Level 1 rewards savers via positive real yields, thus why fixed income, credit, and cash have played an important role in asset allocation and portfolio construction.
Level 2: Make money in REAL terms. That is, protect your purchase power by generating returns above your rate of inflation.
In Level 2 inflation is no longer negligible. In fact, when inflation is substantially higher than nominal rates, as is the case across most Developed Markets today, inflation becomes a critical component of investment decisions. The situation is aggravated by artificially low levels of nominal interest rates, as is the case today in the US or Europe, with nominal rates around 0% and inflation around 8%, levels not seen in decades.
Emerging Markets investors have been playing in level 2 for most of their lives and therefore have a big advantage over those who have not experienced extreme levels of inflation and/or currency devaluation.
Level 2 penalizes savers via negative real yields, and thus why the role of fixed income, credit, and cash dramatically changes from big winners to big losers during high persistent inflation environments, with and without nominal rate hikes.
Level 3: Make money in REAL terms, after wealth TAXES.
Taxes have always been an important component of our lives. As Mark Twain once said, “there are two certain things in life: death and taxes”. The reason why taxes feature as a new higher level is because, whilst they are high already, they will likely to get much worse on a global scale, especially wealth taxes and their derivatives like inheritance tax, mansion tax, etc. Ironically, taxes are the way in which Governments and Central Banks square the circle. As discussed in the following section, monetary and fiscal policies without limits do not solve problems, but rather they delay, transfer, transform, and enlarge them, whereby the inflation we suffer in level 2 creates inequality and bubbles that make the rich richer and the poor poorer, whereas the ever-increasing taxes from level 3 try to address inequality by applying taxes to the inflated assets their policies created on the first place, so there is nowhere to hide.
Level 3 incentivizes spending. How much of our wealth will be passed on to our children in a world of ever-increasing taxes? Who knows, but they better don’t count on it as they may never get it.
3. THE FROGS IN BOILING WATER: INFLATION VS INFLATION EXPECTATIONS
I believe we are all frogs in a monetary broth that has been steadily heated via money printing and debt. The boiling frog is an apologue describing a frog being slowly boiled alive. The premise is that if a frog is put suddenly into boiling water, it will jump out, but if the frog is put in tepid water which is then brought to a boil slowly, it will not perceive the danger and will be cooked to death. Same thing with inflation.
Who is heating the water? Central Banks and Governments fuel the misconception that Monetary and Fiscal policies without limits can solve problems. They don´t. They incentivize and reward debt and artificial valuations, which can only be sustained via ever-increasing money printing and debt, which they hope to dilute via inflation whilst boiling the frogs to death via inequality, taxes, and whatever it takes.
How much heat is applied? For decades, Central Banks made us believe that the heating rate was capped at a “negligible” 2% per annum, which many complacent frogs accepted and stayed in the broth of fixed income, credit, and cash.
Central Banks, taking advantage of “exceptional circumstances” and the complacency of frogs, decided to remove the 2% heating cap, increase the fire, and overheat the water under the narrative of “transient/temporary heating rates” that resulted in the accelerated loss of health/wealth. Quantitative Easing/Heating in the US was printing $120b per month, every month. Yield Curve Control in Japan is applying “whatever it takes” to keep the 10-year JGB at 0.10%. This month was historic, as for the first time since the introduction of YCC the BOJ was forced to intervene at 0.25% nominal yield to try to control the temperature/yield.
How fast is the water temperature rising? Important to note that inflation is subject to base effects, meaning the x% inflation is applied to a higher base, and therefore subject to compounding. Compounding at lower rates may seem negligible but adds up. As Einstein once said, “compounding is the most powerful force in the universe”. Compounding at higher rates is exponential and can lead to the loss of purchase power very quickly, effectively boiling the frogs to death.
Why do frogs jump out? Inflation expectations. Frogs jump because they 1) notice a large increase in current temperatures, and 2) expect temperatures to increase notably. It is therefore not so much the past heating but more about the current and forward-looking heating that may get the frogs to jump. Since Central Banks need the frogs to stay in the water, and frogs will reach mainly inflation expectations, it is therefore clear that Central Banks’ current actions (to increase interest rates and reduce liquidity/heating) are aimed at re-setting inflation expectations. The question is whether the interest rates will be enough to 1) control inflation and 2) prevent the frogs from jumping.
Why do some frogs never jump out? Benchmarks. Many frogs stay in the water despite the obvious rise in temperature because they are literally tied to the bowl with handcuffs called Benchmarks. To our surprise/horror, we are witnessing many institutional investors continue to hold disproportionately large amounts of fixed income and credit for two main reasons 1) they are still playing the game in nominal terms, by the rules of Level 1, and 2) even if they know/believe/agree we may already be in level 2, they can´t change their behaviour because of restrictions imposed by the Prospectus, Mandate, and/or Board, which are not easy to change. Sadly, in our view, those investors are the ones who are and will finance the “monetary party” that continues to dominate global markets. Some investors are able to adjust their holdings and effectively “underweight” (long position, but lower than benchmark) which I compare to “taking 4 cyanide pills instead of 5 prescribed by the Board”. Not a great idea, in my view.
Where do frogs jump? During a meeting last week, I was asked this question which made me think of the joke of the guy who wins a trip for two people to the Caribbean. “Who would you like to take along with you”? the presenter asks. “Option A is your wife”, to which the guy quickly responds “B, please, B”. Something similar happens with very high levels of inflation where, bad jokes apart, investors may be willing to jump from the boiling broth into other frying pans, such as equities, or colder surfaces, such as gold or real estate or other long-biased inflation alternatives.
What happens when frogs jump out? When we, frogs, decide to jump out of credit and fixed income, yields go up, which put pressure on those heavily indebted, which poses a risk to the credit and equity market and in our view will force Central Banks to print more money and buy the debt to prevent the collapse. As a result, we challenge the common belief that “long term yields go up because short term rates go up” and hold the contrarian belief that “long term yields go up because short term rates do NOT go up”. That is, by keeping short-term rates “too low for too long” Central Banks have fuelled inflation that can not be controlled and that forces the frogs to jump out. During low inflation, Central Banks are in control. During high inflation, Central Banks lose control. And thus why the Central Banks are forced to act now, even if they expose the bubbles and may need to unwind the hikes later.
4. BUBBLES VS ANTI-BUBBLES: THE END GAME
In case you are interested in our big picture global macro view in webinar format, please find enclosed the REPLAY link
“Bubbles and Anti-Bubbles: The End of the Game
at the recent JP Morgan Global Macro Conference
held in March 2022.
5. PORTFOLIO CONSTRUCTION AND DIVERSIFICATION
In terms of diversification and asset allocation, as discussed in previous newsletters, we view investment portfolios as football/soccer teams that must be composed of strikers, midfielders, defenders, and goalkeepers AT ALL TIMES.
The manager (you) defines the strategy of the team (offence vs defence), picks the individual players (internal and external), lets players do their job (“strikers score, goalkeepers save”), and actively rebalances the team (buy cheap sell high, sell high buy cheap) with the objective of enhanced capital preservation and high long term absolute returns.
Good asset allocation creates portfolios/teams where the team performance is greater than the sum of individual performances. As such, individual players must be analysed not only via their individual merits (stand-alone analysis) but more importantly via their contribution to the team (incremental performance and risk analysis). There are multiple examples in the industry, such as CVA trading (Credit Valuation Adjustment) or even in sports, as brilliantly presented by Michael Lewis in his book and movie “Money Ball”, where individual baseball players were judged on both standalone and incremental contribution to the team.
Good asset allocation seeks true diversification. True Diversification is the opposite of False Diversification, where all components of the portfolio fall at the same time during a crisis. False diversification is exposed to hidden leverage and forced liquidation during a crisis, the oppositive of what a manager wants. True diversification allows the manager to monetize expensive assets and buy cheap assets. Over and over and over again.
Good asset allocation generates incremental performance from rebalancing. Portfolio rebalancing is, in essence, a very systematic process. It is NOT about having a crystal ball to guess where the football will go. It is about building a team that will do well regardless of where the ball goes. Good asset allocation generates superior long-term returns due to the combination of 1) capital preservation (defence) and 2) compounding on capital preservation (offence). Yes, long-term returns are a team effort.
Good diversification generates incremental returns. The graph below shows how a team composed of the individual performance of Quadriga Igneo UCITS (“the goal-keeper”) vs SPX 500 US Equities with Dividends (“the striker”) and the benefits of combining both strategies into a single strategy, such as 50% long US Equities and 50% long Igneo with monthly rebalancing. Since the launch of Quadriga Igneo UCITS in July 2018, the SPX is +44.6% whilst Igneo is down to -4.7%. An equally weighted passive 50/50 basket would have therefore performed +19.9%. But a monthly rebalanced 50/50 basket would have performed +27.6%. The incremental return of +7.7% (27.6% vs 19.9%) comes from embracing volatility and actively rebalancing negatively correlated components back to their neutral 50/50 weights. During hostile markets, financial insurance performs strongly and can be partially monetized to buy cheap/distressed equities. In turn, during benign/complacent markets, equities perform strongly and can be partially monetized to buy cheap insurance. By picking positive expectancy negatively correlated players, the manager (you) has been able to generate valuable incremental returns to the team/portfolio.
Hope you find it helpful
Best regards and much health to all,