I hope this note finds you well and in good health.
Quadriga Igneo UCITS +35% YTD as of writing, rebounding from +24.5% as of the end of May 22.
The strong YTD performance comes primarily from solid gains in the long-only insurance portfolio, +40% YTD, which has more than offset losses across core Precious Metals, US Treasuries and TIPS portfolios.
The long-only insurance portfolio remains well-positioned to continue to generate negatively correlated alpha during adverse and hostile 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.
Notably, the long-only insurance portfolio is currently neutral/positive carry via the, in our view, artificially cheap insurance risk premia we are able to accumulate across the term structure, volatility, skew and correlation, which we actively accumulate, restructure, monetize, and reinvest.
INVITATION ZOOM UPDATE
You are cordially invited to the Zoom Update Call where I will share Global Macro Outlook and Positioning across Quadriga Anti-Bubble Strategies.
During the Zoom Call I will discuss both Quadriga Igneo UCITS and its sister strategy, Quadriga Aqua UCITS, liquid Protected Equity.
Date: Tuesday 14th June, two live sessions, one in English and one in Spanish.
ENGLISH: 2pm LDN, 3pm MAD, 9am NYC/MIA, 9pm SIN/HK, 11pm SYD
SPANISH: 3.30m LDN, 4.30pm MAD, 10.30am NYC/MIA, 10.30pm SIN/HK
Zoom Meeting ID: 569 587 8917 (no password)
The Zoom call will be recorded and available via REPLAY.
In the meantime, ahead of the Zoom Update, please find enclosed a more detailed analysis of 1. “Real Real Rates”, 2. “Insurance Risk Premia”, 3. “Opportunities and Risks from Volatility, Correlation, and Liquidity Trading”, and will also include 4. “Protected Equity”, and 5. The Frogs in Boiling Water" (first published in March 2022 newsletter, but very much alive and relevant today).
1. NEGATIVE “REAL REAL RATES”
We believe that Central Banks are trapped between inflation and bubbles too-big-to-fail, both problems they created in the first place with reckless monetary and fiscal policies without limits.
In the immediate short term, Central Banks have no choice but to hike nominal interest rates. So, for now, the path is for higher nominal rates. US Treasury curve is now pricing in 10 Fed rate hikes of 0.25% by year-end, and given there are 5 Fed meetings before year-end (starting with this week), implies a 0.50% hike every meeting… The current path of rate hikes is too complacent, in our view, and assumes that the economy AND markets will cope with the hikes without blowing up. Wishful thinking in our view.
In the short to medium term, we believe the hikes will invariably lead to stress in credit markets. At that point, we expect Central Banks to pause and reverse the current path of hikes as, unfortunately, the damage is already done as just a few small hikes will be sufficient to expose the fragility of the system and trigger the burst of the systemic bubbles across the system.
In other words, 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. In our monthly newsletter in January, we indicated trouble above 1.5% in front-end rates. We stand by our view, which stands in stark contrast to the current complacency with the path hikes implied by the markets, pointing to 2 years above 3%.
The sell-off YTD across equity and credit markets is in our view a modest and much-needed correction from grossly inflated artificial levels. 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.
We have not seen any major stress or distress in credit markets yet, which could start to appear anywhere at any time. Credit stress will be the real test for Central Banks’ resolve to hike, and in our view will surely result in a reversal of the hikes and a return to more monetary and fiscal accommodation, which will not resolve the problems but rather delay, transfer, transform and enlarge them even further, this time into stagflation.
The current dynamic seems to have 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. So, the higher equity and credits go, the faster and larger the hikes from Central Banks are likely to be.
It is important to remember the lags in the system. Just like solar or nuclear radiation, the effects of reckless monetary and fiscal policies become evident too late. This is true on both sides, on the way up with complacent Central Banks keeping excessive levels of accommodation for too long, but also on the way down with powerless Central Banks trying the collapse the system they artificially inflated in the first place.
Time will tell how much Central Banks will be able to hike nominal Rates, but in our view 1) will not hike as much as it is currently priced in 2) there is a non-negligible probability Central Banks will be forced to reverse course and unwind some of the hikes (similar to what happened in 2018, when the Fed was in "auto-pilot” hiking rates but had to reverse the hikes to contain the hostile markets of 4Q18), and 3) 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 risk and inflation, they will always choose inflation. More detailed analysis of previous newsletters and further below.
From the above, we believe Real Rates (Nominal Rates minus Inflation) will remain negative for the foreseeable future and have introduced the concept of “Real Real Rates” to differentiate the true dilution of purchase power faced by investors, vs the real rates computed using official and 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 and 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 implications of deeply negative “Real Real Rates” for asset valuation and portfolio construction are enormous and discussed in detail in a previous newsletter titled “The Frogs in Boiling Water” (enclosed at the bottom of this email, in case anyone is interested).
2. INSURANCE RISK PREMIA
Earlier this month I had the opportunity to attend a very instructive conference in Barcelona where the focus was on systematic risk premia. It was great to be able to meet in person again after so long and thoroughly enjoyed our discussions with both allocators, managers, and providers.
The discussions with systematic risk premia managers were particularly interesting and triggered some interesting debates, and hereby share some of the thought-provoking conclusions I came up with, which I hope will be of interest.
Asymmetry, Asymmetry, Asymmetry. I have always argued that successful investing in a game of asymmetry. Paraphrasing the old adage in real estate of “location, location, location”, I believe the investment game is about “asymmetry, asymmetry, asymmetry”.
There are 3 important sources of asymmetry that I look at closely: 1) asymmetry of conviction, 2) asymmetry of risk-reward, and 3) asymmetry of positioning. Whilst there are obviously other sources of asymmetry, I believe these 3 are the most important. Any
feedback and different perspectives are welcomed!
1) Asymmetry via Conviction (higher probability of winning than losing, also known as “Hit Ratio”). In my experience, specialists with a deep understanding of the fundamentals of an industry, sector, market, etc… (including volatility and insurance) can and should be in a position to identify high-conviction asymmetric opportunities.
At the same time, I also believe that high conviction can be a terrible risk manager as whilst we may be correct in our predictions most of the time (say 80%), we may find that when we are wrong (say 20%) the losses we incur could be fatal as overconfidence in our abilities can result in larger positions that we hold for longer. In addition, a high conviction could create a conflict with our ego and emotions, negatively impacting our discipline, ignoring stops, staying in a trade longer, and adding to losing trades, all of which can be fatal. As a result, whilst I believe in Conviction can be a valuable edge to identify asymmetric high conviction trades, I believe it must always be applied in conjunction with asymmetry of risk-reward and positioning.
Our approach to insurance risk premia (structural imbalance between supply and demand for insurance risk) is to understand “who pays who”, “why”, and “how much”. Not understanding the fundamentals and relying purely on back-tests (as some systematic strategies do) is as dangerous as driving a car while looking only at the rear mirror. I believe insurance risk premia must be dynamic and forward-looking and combine quantitative, qualitative, systematic and discretionary management, as we strive to do with Quadriga Igneo and Aqua.
2) Asymmetry via Risk-Reward (potential $ profit per unit of $ loss). Quadriga Igneo and Aqua have the self-imposed risk limit to only buy options, where the worst-case scenario (the loss of the premium) is known with 100% of certainty. Under no circumstances the loss can be greater than the premium spent. On the other hand, the upside tends to be uncapped and/or extremely asymmetric with an average risk-reward of 10 to 1 (10$ profit for every 1$ at risk).
Some managers and strategies, on the other hand, implement defensive alpha and risk premia via strategies with “open-ended risk”, where the asymmetry of risk-reward is impossible to calibrate with certainty.
One example is “long/short” (buy one asset and sell another asset), a pay-off that at first sight looks somewhat symmetrical and balanced, but that on closer look suffers from hidden leverage and risk as maximum gain in our short leg is capped at zero whilst the maximum loss in our short is uncapped at infinity. The manager will try to protect the position with a stop-loss, which is subject to “slippage” and/or “gap risk”, particularly during periods of stress, when the combination of 1) higher volatility, 2) polarized correlations, and 3) thinner liquidity can result in an exponential increase in the value at risk and forced liquidations that feed on themselves and result in much greater losses than originally anticipated.
Another example of open-ended risk is “short volatility and short options”, particularly naked calls, which produce the exact same risk profile of uncapped losses. No matter how unlikely the event may look, the open-ended uncapped risk is always a consideration.
Our approach to insurance risk premia is driven by risk management and asymmetric risk-reward, both of which we achieve by construction via long-only options. Our risk management framework at Quadriga Igneo and Aqua forces the discipline to identify and implement opportunities in a long-only format. Trust me, there is nothing easier or more tempting than selling options to “finance” a position. The reality however is that “Zero Cost” structures can be very, very costly. Long-only options can of course suffer from negative carry and expire worthless, but from a risk management perspective can´t blow up.
3) Asymmetry via Contrarian Positioning (trade against the consensus and speculative positioning of the market). We all know “the trend is your friend” and that “bubbles can last much longer and much higher than anyone anticipated”, but also know that “bubbles tend to collapse much faster and go much lower than most people expect”, and that “the exit door is very narrow for crowed positions”.
It is therefore important however that the insurance will perform when we need it, and thus why I warn against strategies with negative risk premia no fundamental risk premia (just a backtest), with open-ended risk (say, long/short or short options), and large crowed positions with narrow exit door which can result not only in ineffective hedges but, worse, the opposite behaviour to their original objectives and design. Look for example at Asia vs US vol in March 2020 which, if expressed in option format would have avoided unnecessary pain to many portfolios.
Our approach to insurance risk premia favours contrarian positioning as a complement to asymmetric implementation of high conviction trades. Our bearish view on China via the Chinese Yuan, for example, has all three components: 1) our high conviction that a large devaluation of the Yuan is the degree of freedom of the monetary and fiscal abuse of China, 2) our ability to implement the trade via options with 10x risk-reward, and 3) our contrarian positioning to the consensus of the market, including respected industry leaders such as Ray Dalio, who we respect enormously but on this occasion strongly disagree with.
3. OPPORTUNITIES AND RISK IN VOLATILITY, CORRELATION, AND LIQUIDITY TRADING
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.
Opportunities and Risks in Volatility, Correlation And Liquidity. It is well known that 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).
By embracing volatility (instead of fighting volatility) investors can rebalance their portfolios and generate incremental returns. The idea is simple: accumulate artificially cheap insurance during complacent markets and monetize the insurance to buy distressed risk assets during hostile markets.
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 +57.3% whilst Igneo is largely flat at -0.7%. An equally weighted passive 50/50 basket would have therefore performed +28.3%. But a monthly rebalanced 50/50 basket would have performed +34.7%. The incremental return of +6.4% (34.7% vs 28.3%) 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.
4. PROTECTED EQUITY, QUADRIGA AQUA UCITS
As discussed, Quadriga Aqua UCITS has been designed as a Protected Equity Solution for long-only equity investors that seek to maintain their exposure to US equity markets and enhance the capital preservation and alpha generation by adding a long-only insurance overlay. Quadriga Aqua UCITS effectively combines a core allocation of 100% US Equities and 50% Insurance Program from Quadriga Igneo UCITS, rebalanced monthly to their neutral weights of 100/50, with the following benefits and considerations:
- Switch Long Only to Protected Equity. Maintain 100% long exposure to equities.
- Enhance capital preservation at expense of potential underperformance in bull markets.
- Switch with zero net cash flow. Sale of Long Equity funds purchase of Protected Equity.
- Reduce “noise” from two volatile lines. Combine Protected Equity in one vehicle.
- Embrace volatility, buy cheap equities during hostile markets financed by profits on insurance and buy cheap insurance during bull markets financed by profits on equities.
- Incremental Long Term Returns via Active Rebalancing and Compounding.
- In our view, current market conditions and outlook offer an attractive opportunity to switch from passive long-only US equity to protected strategies like Aqua.
Quadriga Aqua UCITS is currently receiving orders via its main USD clean institutional share class has ISIN LU2357188049. The strategy is also available in EUR and GBP and with trailer/retro. Any additional information or clarification you may need, please let us know.
5. THE FROG IN BOILING WATER (as first published in the March 2022 newsletter)
1. THE THREE LEVELS OF THE INVESTMENT GAME.
If Investing were a video game, it would have 3 levels.
Level 1: Can you 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 have 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: Can you 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 inflation and/or currency devaluation levels.
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: Can you make money in REAL terms, after 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.
2. BIG PICTURE: MONETARY AND FISCAL POLICIES WITHOUT LIMITS
As I have discussed in previous newsletters, Monetary and Fiscal policies without limits have NOT resolved problems, but rather delayed, transferred, transformed and enlarged them.
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.
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.
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.
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.
3. THE FROG 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. MACRO OUTLOOK: HIGHER INTEREST RATES BUT EVEN HIGHER INFLATION, HIGH VOLATILITY, LOWER VALUATIONS
How high can USD yields go? The Federal Reserve maintains its very hawkish stance, which has been reinforced by the strong bounce in US equities. In our view, current high levels of equities are likely to result in higher and faster hikes, which could in turn put pressure on equities. As of writing, The US 10y yield is at 2.61% and the markets are pricing approx. 85% chance of a 50bps hike in May.
Has the economy become more sensitive to hikes given rising debt levels? This is by far the most important question we should be asking ourselves. In our view, the answer is YES, the world economy is more fragile and sensitive to hikes given unsustainable debt levels.
Interestingly, Goldman Sachs research seems to hold the opposite view supported by the work done by Daan Struyven and his team, who 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.
Will there be a repeat of 4Q18? For those old enough to remember, the Fed entered an “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 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.
Unfortunately, the situation today is much worse and more fragile than it was in 2018: 1) Equity and credit valuations are much higher than in 2018, with distorted valuations fuelled by artificially-low interest rates that in our view have inflated bubbles that are by now systemic, too-big-to-fail. Higher nominal rates expose artificial valuations and complacent positioning. 2) Debt is much higher now than in 2018, making the economy more vulnerable to rate hikes. 3) Inflation is also much higher and more persistent than in 2018. In addition to the unprecedented monetary and fiscal response to the Covid crisis, there are other contributors to inflation that are more structural and difficult to resolve, such as bottlenecks in the supply chains, or energy and commodity inflation, which reduce disposable income for consumers and reduce profit margins for companies, amongst other negative implications. 4) Europe is already immersed in a deep energy crisis with no simple or quick solution. The proposed solution? Same as always. Central Banks cannot print energy but can print money to subsidize it, yet another example of how monetary and fiscal policies do not solve problems but simply delay, transfer, transform, and enlarge the problems. 5) Economic activity and consumer confidence are slowing down. The sugar rush from Fiscal policies, cheques, and MMT was short-term and temporary. The debt and inflation they have created are however permanent and have created a higher “plateau” for both inflation and debt. 6) China’s real estate and credit bubbles are already imploding. Bad news for China, and for the rest of the world. We don’t think the market is paying enough attention to the size and implications for global growth, consumption, trade, and more, and hold the contrarian view that the Yuan will eventually suffer a meaningful forced devaluation. 7) Geopolitical risks are on the rise, led by China and Russia. Watch out for unintended escalation.
How about Real Yields? The current hiking path in nominal yields is in our view likely to remain substantially below inflation, thus resulting in negative real yields for the foreseeable future. The current inflation breakeven implied by the US TIP stands at 5 years 3.28% inflation breakeven (2.69% nominal vs -0.67% real), 10 years 2.86% (2.55% nominal vs -0.31% real), and 2.67% for 30 years (2.58% nominal vs +0.09% real), which in our view has significant room for further downside.
US elections: “Populism” now means fighting inflation. Worth noting that the US midterms will be held on 8th Nov 2022. Under normal conditions, the “populist” measure would be to support US equities. In our view, the tables have turned and believe that flighting inflation has become an even more “populist” measure, at least in the short term, with the risk skewed towards faster and higher hikes than implied, including the possibility of 0.50% in the next meeting(s).
Financial Conditions Index (FCI) has eased with a rally in US equities and a stronger USD, despite the recent hike. In our view, this puts more pressure on the Fed to hike faster and higher, as evident by the more aggressive hawkish forward guidance. The Fed and ECB have no choice but the pretend that they are doing something about inflation. Some members are proving to be particularly aggressive on the need for hikes.
Goldman Sachs research has done some interesting work on how much tightening is needed based on FCI and the implications for equity valuations: “It’s fair to say that looking at rates alone is imperfect given the Fed’s focus on financial conditions. A reasonable starting point is to assume that the Fed intends to bring growth back to slightly below trend (e.g., to 1.5%) to allow for some moderation in output/labour demand growth. Based on the Fed’s 2.8% growth forecast, and assuming that they want to engineer a deceleration of ~150bps to bring them a bit below trend, GSFCI would need to tighten by 150bps. The short rate alone has minimal impact, so you likely need a significant sell-off in equity markets as well as a rise in 10y rates… plugging in some rough numbers using our FCI weights suggests that to tighten FCI by 150bps you need to see equities -17% and 10y rates 150bps higher (assuming unchanged trade-weighted FX and credit spreads) in order to cool the overheating in the economy. This still feels underpriced. Whilst inflation remains stubbornly above target, the Fed will effectively need to limit how much stocks can rally by signalling more hikes in order to keep tightening FCI. Stay neutral equities… The Fed put has expired”.
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.
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.
Confiscation of Sovereign Currency Reserves: A game-changer for geopolitics. As pointed out by my good friend Bobby Vedral, the confiscation of sovereign currency reserves is, yet another, war-time innovation by the West, an act up until recently considered ‘unthinkable’ with important implications since our current monetary system is based on fiat money (‘Bretton Woods 2’) with the hint being in the name: ‘fiat’ = trust, a “trust” has now been destroyed. To secure financial resilience China’s vast holdings of US treasuries will be viewed in a new light and Central Bank Digital Currencies (“CBDC”) have lost enormous attraction vs gold or physical commodities or real assets.
Central Banks are trapped between bubbles and inflation. In short, the normalization of monetary policy via rate hikes presents an impossible task for Central Banks at a time of higher inflation, geopolitical conflicts, and high commodity prices, which add to an already evident slowing down of the economy, which is why we believe that Central Banks are trapped between bubbles too big to fail and inflation, and the most likely outcome will be stagflation, or worse.
5. ENERGY OUTLOOK: RISKS SKEWED TOWARDS HIGHER AND MORE VOLATILE PRICES, LOWER VOLUMES
The problem for Central Banks is that many components of inflation, such as commodity prices or global supply bottlenecks, cannot be resolved by printing money. Sadly, we cannot print oil.
Energy Security. The Russia/Ukraine conflict has further exacerbated the fragility of energy security in Europe. Russia is a major exporter of many commodities, including 8%+ crude oil and 10%+ natural gas, much of which flows to Europe, highly dependent on Russian resources. The war for natural resources continues and Ukraine is a major exporter of agriculture and other key commodities, including the largest reserves of Uranium in Europe.
Energy is everywhere, and cost pressures will reduce disposable income for consumers and squeeze producer margins. Important to note the US has a major competitive advantage vs Europe via natural gas. Current US prices are around $25/boe, which has been approx. 10 times cheaper than volatile Europe prices. And we can consider ourselves lucky because the winter has been rather mild, a problem as inventories were very tight going into it. No easy way for natural gas to flow into Europe in the medium term. Europe is a hostage in the short term.
Crude oil above $100 sounds high but is nowhere near the highs of 2008 in real terms considering the massive increase in nominal GDP and inflation. In our view, crude oil would need to go above $200 to inflict the same damage that $140 did in 2008. Bad news as prices can potentially get much higher. The price elasticity of crude oil is estimated as $20 per 1% demand destruction, so in the short term, we could expect massive price swings.
Interesting how the narrative is changing vs nuclear, Iran, or Venezuela, and 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. Either way, all these factors add volatility to the energy markets, which we expect to remain very high.
Europe is the main loser of the crisis. Every day that goes by, lower energy volumes and high energy prices are biting into its productive capacity and consumers. Europe is in trouble and the Euro is likely to remain under substantial pressure, thus why we have added insurance against both.
6. IMPLICATIONS FOR PORTFOLIO CONSTRUCTION
Long vs Short Volatility. I believe a portfolio is like a football/soccer team: it needs strikers, midfielders, defenders, and goalkeepers. A team with 11 strikers does not work. But neither does a team with 11 defenders. And we don´t believe in crystal balls that tactically predict the course of the match and where the ball will be at any point in time. In fact, we believe portfolio construction is the opposite of a crystal ball, as you need a team that will be well-positioned regardless of the market conditions.
Long vs Short Inflation. Not all strikers are the same. Some are long inflation, such as equities, whilst others are short inflation, such as credit (the purchasing power of the $100 that a bond will pay you back in 30 years will not buy much at all due to inflation, in our view, whereas equities will be able to protect the value better as the price of wheat may go up, but so will be the price of bread, and thus the baker may be able to protect its margin.
Important to note that not all equities are long inflation. Those companies able to protect or expand their profit margins are effectively long inflation, whereas companies that suffer margin compression as they are not able to pass on the impact of higher costs to their consumers are effectively short inflation.
So, we expect credit to suffer in real terms, and equity to show large divergence in real terms depending on their ability to protect their profit margins.
Is Duration still a good defender? Many investors question the apparent inconsistency between our bearish view on a fixed income in real terms vs our allocation via Igneo. Worth noting that our allocation has been via long-dated TIPS and not nominal UST, which have benefited from stronger real yields vs nominal yields, which have been massacred.
In addition, important to note that US fixed income offers substantially higher nominal yields than Europe or Japan and therefore has a significantly higher potential for capital gains both in nominal and real terms. Based on a 2.5% yield on 30-year UST, a move towards 0% nominal would imply a c75% price gain which, who knows, could take place over a very short period of time, therefore more than offsetting the loss in purchase power via inflation. Needless to say, the situation in Europe and Japan is very different, as nominal rates remain extremely low with much less room to protect investors in nominal terms via capital gains.
In case of interest, please find enclosed additional information about our contrarian ideas and framework:
We hope the ideas and strategies will be of your interest and remain at your disposal for any additional information or clarification you may need.
Best regards and much health to all,
Quadriga Asset Managers