Global cycle of bad policies? The paradox of global thrift and macro prudential policies

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Lower rates and at the zero bound quantitative easing are used to boost economy  - Result in excessive borrowing and leverage – Leads to macro prudential policies to curtail the excesses of debt and speculation – Translates to weaker aggregate demand (higher savings) which means that rates have to be further lowered – Leads to excessive borrowing  – Leads to macro prudential policies to curtail debt and speculation  – Leads to weaker aggregate demand which means that rates have to be lowered or more liquidity pushed into economy –  Leads to excessive borrowing - Repeat again ....

When macro prudential policies are used to curtail aggregate demand and thus increase savings, there will be a spillover effect to other countries which are impacted by the increased savings in the prudential country. Simply put, prudential policies will offset some of the very effects that are desired from quantitative easing. We are not arguing that prudential policies should be ignored. Macro prudential policies attempt to smooth the extremes and thus reduce the potential for deeper downturns; however, their very existence creates macro friction when economies are trying to get out of liquidity growth traps. 

Hat tip to Steve Green of Baylor University for pointing out the recent macro paper in the November 2019 American Economic Review "The Paradox of Global Thrift" The idea behind this paper is a simple global macro model where one country will attempt to curtail aggregate demand relative to others in a liquidity trap. The internal policies of one country to increase savings will spill-over and create a paradox of thrift across all countries. A result from these rational polices is that more monetary or fiscal policy will be needed to offset this savings imbalance. This, of course, may further increase the need for macro prudential policies to reduce any speculative response to low rates. The behavior can go around and around for any number of rounds. "Secular stagnation" is institutionalized through policies. 

The shapes and forms of secular stagnation can be varied. Any new slowdown or crisis may come from something completely unexpected, or the slow growth of today is being driven by policies that were not considered in the past.

Trade uncertainty continues to grow - A lower discount rate will not change this uncertainty

Stanley Baldwin, UK prime minister in the 1930s said: “Business can flourish with tariffs. Business can flourish without tariffs. Business cannot flourish where there is uncertainty.”

It is hard to disentangle the impact of tariff uncertainty on business decisions, but there has been a clear downturn in global manufacturing at the same time as the increase in uncertainty. Business are not sure whether to move operations to another country, bring operations back to the US, or hold off on any investment decision. This investment problem is faced by any country interacting with China trade, and the US is not the only country increasing trade barriers. 

Tariffs have ratcheted higher between the US and China with a spillover to all of the countries that are intermediaries in this trade. Exports have declined from highs near the end 2017 and exports from China have sharply declined from 2018 highs. The drag on trade and investment is real and is unlikely to change with a decrease in discount rates.  

Robeco long-term asset forecasts - It is not pretty

Robeco Asset Management issued a good forecasting piece on the expected returns for traditional assets over the next five years called "Escaping the Hall of Mirrors 2020-2024 Outlook". It is thoughtfully done although any forecast are sure to a large forecasting error terms. They provide a well-researched process for arriving at their conclusions, so these numbers are grounded in current best thinking on expected returns for equities, bonds, and credit. 

There will be surprises in what will happen over the next five years, but Robeco provides a good benchmark for discussion. Their expectations are not assuming any forecast for the business cycle. They use current modeling of forward rates, term premium, expected inflation, and carry for fixed income. Current conservative valuations in equities are used to extrapolate expected risk premia. Robeco's views on equity and bond overvaluation is actually tempered versus many other asset managers.

The likelihood that investors will get anything close to an expected discount rate of 7% is very low. Even a 4-5% number for a combined stock bond portfolio may be a stretch without takings risks. The only way a strong portfolio return can happen is if equities show a strong jump to higher valuations and bonds move to further negative levels and investor get a capital gain. This only means is that the day of revaluation reckoning is pushed into the future. 

The only approach to avoid this low return scenario is to engage in further diversification and have some strategy for reducing tail risk. The Robeco high returning assets are emerging market equities, emerging market bonds, commodities, and real estate. They do not forecast at hedge fund or alternative risk premia. This may seem obvious, but the cutting loses through active hedging is the only way to protect against low expected returns given current high valuations.  

Explaining trend-following dispersion - Standardize volatility

Trend-following has seen explosive positive returns in 2019. This has been the best year for performance since 2014 although current increases in global yields are cutting into performance.  Many have been surprised by the wide dispersion of returns across managers, but there are some simple and obvious reasons for these differences. The two most relevant reasons are differences in volatility and differences in exposure to bonds. 

Look at performance differences based on a standardized volatility. Take any set of managers for comparison and just standard to a desired volatility level. The wide dispersion across managers in 2019 does not look so great after the adjustment. In fact, the level of dispersion for a high return year like 2019 does not look much different than 2018. 

The large CTAs have a bias toward financial futures which have served them well. The managers who allow for less volatility equalization have done better. Those managers that have constrained bond exposure have shown more modest performance. 

Adjusting for volatility and accounting for market exposure will go a long way for explaining differences in performance. 

Monetary policy creates fragility - Now policymakers have to solve the problem

There are a few concepts that everyone should takeaway from their economics 101 class. One, economic agents response to incentives. Two, there will always be unintended consequences when incentives are changed. Change the incentives and behavior will change. Unfortunately, we don’t always know what will be the behavioral change. Perhaps the greatest problem in economic forecasting is trying to figure out how behavior adapts when faced with new circumstances. 

Given the law of unintended consequences, any policy should be crafted with care for the simple reason that the market response will not always be clear. This is especially the case for financial markets where capital is fluid. Policymaker then have to adjust to the response by markets to their initial action. These thoughts are forefront in my mind after reading the IMF World Economic Outlook Report and Global Financial Stability Report.

Global economic growth is slowing and central banks are again responding through an aggressive monetary policy of lowering rates. There is now worry that rate cuts will be less effective than fiscal policy, but there is little questioning in the minds of central bankers for this need. 

However, reading the IMF Global Financial Stability Report describes an environment filled with financial excesses. In this world, low interest rates have been the fuel for excessive leverage and an ongoing reach for yield by investors that must be addressed with macro prudential policies to curb behavior.

Financial stability is affected by three factors: size, valuation, and vulnerability. While not at excessive levels in some sectors, non-financial firms, non-bank financing and sovereigns are all at elevated exposure levels at or above levels from the Financial Crisis. Valuation in both credit and equity markets are high, which increase risks to investors. The markets may not be vulnerable given relatively loose financial conditions, but any downward change in financial conditions will place the borrowers and lenders in a difficult state. 

Central banks lowered yields to offset the risks from the Financial Crisis, a balance sheet recession. Nevertheless, leverage has not declined but has actually grown over the last decade. Many firms have gone on a binge of borrowing sustained by savers willing to take on risks to offset low yields. Bank leverage may have been curtailed but alternative sources of funding have arisen to offset any bank void.

Now governments are suggesting more aggressive macro prudential policies to offset the effects of aggressive monetary policy. The incentives put into place caused a change in borrowing and lending behaviors which now have to be curtailed through new constraints.

Monetary policy is a blunt instrument  that can create fragility that now has to be solved with new policies imposed on the market. This is just the next phase of further financial repression. For investors, there is a need to assess sector risks and start to adjust risk positioning before financial fragility is discounted in prices. 

Artificial Intelligence and Investment Management - It's Happening

Artificial intelligence is actively being used by a growing set of asset managers. For managers that already a quantitative shop, this should not be a large stretch. Artificial intelligence is not just advancement in data modeling. It is a natural progression for those managers searching for an edge and have exhausted older more well-known data analysis techniques. 

A recent white paper from Meketa Investment Group called "Artificial Intelligence" walks through some of the basics of artificial intelligence and discuss how these techniques are being used in asset management. As well as providing some basic information and definitions, this paper provides context for how artificial intelligence fits within overall data analysis. AI techniques are clear extensions of simpler techniques. The concepts of deep learning and machine learning are just subsets within the greater field of artificial intelligence.

Innovation is about pushing the boundaries for what is possible. Once the existing techniques have been exhausted for analysis new ideas have to be tried. In quant investing, the normal process of hypotheses and testing has given way to unsupervised learning and more complex ways to examine data. If you cannot think of anymore ideas, let the data speak for themselves. Artificial intelligence arrives when existing learning is at an impasse. 

The firms that are actively using artificial intelligence techniques have in common a history of using quantitative analysis. In the case of the trend-followers, there existence is based on searching for data patterns. With the market environment become more competitive and recent periods of poorer performance, artificial intelligence and machine learning are being used to search for new return opportunities. Competition and failure coupled with a desire to succeed provides the impetus to try new techniques. From failure and new questions comes the desire for new learning and the use of new techniques for analysis. Of course, cheap computing power helps. 

Active Use of Machine Learning in Finance - It's Here Already

Machine learning is here and being used by a broad array of firms. This is the strong conclusion from a recent survey report by the Bank of England and the FCA called "Machine Learning in UK Financial Services". Two thirds of the respondents have machine learning tool in use. This is not just the study of the processes but actual usage across a wide set of problems. Firms must like the results because there is a strong development pipeline for more machine learning applications. 

The places where the greatest number machine learning applications are in full deployment include risk management, compliance and customer engagement. 

However, there are constraints with using machine learning applications. It is not a regulatory issue but legacy systems that may not be able to handle the computing and data issues.

All of these firms follow similar processes with how models are developed.

The set of techniques that have been classified as machine learning is vast; however, it seems that tree-based models that can handle non-linear relationships are the front-runner for applications. 

If you are not at least looking at how to incorporate machine learning in your business processes, you are falling behind your competition.

"Stay in your circle, bro!" Better decision-making through understanding limitations

Charlie Munger and others have written about the circle of competency with respect to investing. The circle idea is simple. There are things you know and there are things you don’t know. You are unlikely to have a comparative advantage in things you do not know, so focus on your areas of expertise.

If you are an equity investor, you are unlikely to have a competitive advantage in fixed income markets. You may think you have an absolute advantage in everything. You may be right, but that is not the same as comparative advantage. A discretionary investor is unlikely to turn into a good quant. Some one who has focused their thinking on firm valuation will not become an immediate expert in real estate. Of course, crossover knowledge is possible, but realize that switching competency takes time as institutional knowledge is gained. A very good equity retail analyst can become a good real estate investor. The real question is whether that very good retail analyst can become a very good real estate investor. The issue is whether someone can maintain a high level of success across discipline.

Many think the circle of competency is trite. Focus on what you know which is a subset of what is knowable. However, there is a critical danger surrounding the circle. The danger zone is the circle around your competency that consists of what you think you know but you actually do not know. There are a number of behavioral biases, for example, overconfidence, associated with the danger circle of what we think we know. Investors should want to increase their knowledge circle and reduce their circle of what they think they know. If you cannot distinguish between these two, then keep your circle small and decisions focused. 

The biggest investment mistakes occur when competency is perceived but it does not actually exist. The Dirty Harry character had a clear view on this issue, "A man's got to knows his limitations." 

Yield Curve Uninverts - Now What?

Less than six months ago, the market was buzzing with the information that the yield curve inverted. As we all know, when the curve inverts there will be a recession. The time between inversions and recession is variable, but it will happen. It is a lock. Unfortunately, there can be false positives or more precisely, changes in the likelihood of a recession.

So, what do we do now? The curve has moved from inverted to being positive. This positive yield curve however is slight. The 3-month Treasury bill versus 10-year treasury bond yield is now positive 12 bps. The combination of Fed rates cuts and the announcement of Treasury bill buying to increase the Fed balance sheet is pushing rates lower. The Fed seems to be successfully offsetting fund tightness on the front-end of the curve, and some positive tariff news has pushed up yields on the long-end of the curve.

We can say is that the threat of a recession has been lowered. Most of the work on yield curve inversion and recessions has used logistic regressions to measure the probability of a recession event. The last reading from the New York Fed was slightly above 30 percent for September 2020, but that was with data from July. This likelihood measured while the curve was still inverted. That number will go down.

We are left with a measured response. The probability of a recession has declined. The Fed action and forward guidance has been enough to reduced the threat. Recession fears have diminished so holding a riskier portfolio is appropriate.

Current macro situation - Working through tariff supply shocks

Cutting through the rhetoric about tariff wars and the global growth, it is important to walk through a simple macro narrative that takes us to the current environment. 

Tariffs are supply shocks to the economy. They shock the cost structure for importers. Importers have to pay the price of the tariff and determine whether to pass-through the cost or reduce their margins. Exporters will see their product demand change given the cost of their goods have increased to their buyers. They have to lower their prices to help offset tariff costs. The supply chain is disrupted and import firms have to determine whether they change where they get their goods. This process will take some time, so the tariffs of last year are just now impacting growth. 

The Fed has responded to the supply shock by reversing its tightening policy. The impact of this reversal will also take some time to work through the real economy. The hope is that Fed rate reductions will offset the tariff shocks in the US and the rest of the world. However, the timing between shocks and monetary policy response may be off.

Unfortunately, there is also a higher uncertainty shock. Given uncertainty in policies and politics, the policy uncertainty index from the University of Chicago has exploded to the upside. This uncertainty will cause a delay with investment decisions. Who is going to commit to a longer-term project if the environment is unknown? Again, the hope is that a lower cost of capital from the Fed dropping rates will offset this uncertainty. 

  

During this environment we have seen the ISM diffusion index fall below 50 and global PMIs falling or at levels below 50. The tariff wars have had an impact on manufacturing, although the service indices are still holding up better on a relative basis. Generally, a rising ISM above 50 will represent a risk-on environment. A declining ISM will represent risk-off and a declining ISM below 50 risk can be viewed as a risk aversion environment. The bond rally corresponds with a switch to risk-off and risk aversion. 

The impact of these shocks will be seem in forward earnings. Earnings will  also become more disperse as firms in manufacturing will be hit harder than the service sector. These earning declines will lead to a reversal in equity prices. The financial markets push-pull will be between a further impact from the tariff shocks and uncertainty and the impact of Fed rate cuts. We are seeing downward revision of current global growth, but expectations of increases in 2020. The key question is whether global monetary policy has enough power to offset these shocks. 

Liability Driven Investing (LDI) could gain a boost through ARPs

Many pension funds that engage in liability driven investing (LDI) use the Bloomberg Barclay US Long Government/Credit Index as a benchmark, (LGC). This index is comprised of just over 40% in long government bonds and the remainder in credit sensitive bonds. To beat the index generally requires pensions to hold more corporate debt, especially lower rated bonds. 

Pensions that try and match the benchmark are taking risk in one dimension, credit exposure. We suggest that there are simple ways to diversify LDI matched portfolio while still gain the advantage of long duration instruments.

Pensions can use alternative risk premia as an overlay on a long Treasury bond portfolio. The investor will get the long duration exposure from the Treasuries while gaining return from the risk premia. However, instead of getting taking on risk in the form of credit carry through corporate debt, the pension can diversify into other risk premia. This type of overlay alternative is especially useful when credit spreads are tight. Since credit spreads can be replicated through equity and bond exposure,  the overlay can be  structured to hold similar but cheaper risk exposures. The overlay also can be structured to provide higher stand-alone return or returns that are less correlated with the credit cycle. In either case, this can reduce the pension's cost of liability matching. 

Inflation - Is it really worth following?

Remember when inflation used to be a critical number to track? If you now talk about following inflation to young portfolio managers, they will look at you as the old guy who raves about some by-gone era. The new monetary politics of MMT says that inflation may be something we will see in the future but don't bet on it. The same could be said about the secular stagnation crowd. Just focus on growth. Worrying about inflation is showing concern about a past problem that is irrelevant in today's environment. Inflation concerns from an 70's and early 80's experience is like the concerns of the generation scared by the Great Depression. One big past crisis clouds the economic events of today. 

It is easy to warn about the hidden dangers of inflation, yet that warning has provided to be false for a decade. Someday inflation may appear and you can say to all that you predicted it. The real issue is determining what to do if inflation stays well-behaved with core values between 1.5 and 2 and headline below 2.5 to 3 percent. 

It is hard to forecast higher US inflation when the rest of the world shows stable prices and there is no Phillips Curve trade-off. The reality is that local inflation is more closely linked with world price behavior and there is no inflation in either developed or emerging markets.

The number of countries with inflation above 2 percent is limited. Inflation as an emerging market problem is also limited. Now this may change given the move away from globalization and the reduced amount of slack in the economy, but recession fears and controlled inflation expectations make for an environment that is extremely inflation stable. 

The big winners over the last few years have been investors who have discounted inflation fears early. The continued winners may be those that continue to discount the threat of inflation.