Global real rates and the consumption/wealth ratio - Hard to figure we are headed to higher real rates

Real rates are exceptionally low. We have discussed the trend in real rates in a previous post, "What should be the real rate of interest  - don't expect a positive value in the near-term". The historical view of a 2% real rate should not exist. The low negative real rates will continue not just because of monetary policy also because of secular trends in the consumption/wealth ratio. This secular effect was researched in the BIS paper "Global Real rates: A Secular Approach".

Fluctuations in the consumption/wealth ratio can predict real rates as well as equity risk premia through looking at simple present value calculations on future consumption and wealth. A large fall in the ratio which means a high increase in wealth and will likely indicate a fall in real rates in the future to move the ratio back to the long-term average. The extreme low consumption/wealth ratio cases occurred before the Great Depression and the Great Financial Crisis. Calculating the consumption/wealth ratio is not exactly easy and will be affected by such factors as productivity, demographics, deleveraging, and risk appetite, but even simple measures of consumption to market capitalization suggests that we are at extreme levels.

If you follow the logic, there should be concern about future declines in real rates. Monetary policy today is leading to the conditions that will impact rates and consumption/wealth ratios tomorrow. Conventional wisdom may suggest that real rates are too low when below long-term GDP growth, but there are several factors that suggest that a trend to higher real rates higher in the near-term will be very difficult.

What should be the real rate of interest - don't expect a positive value in the near-term

The long-term history of real interest rates has centered around long-term growth rates and has often been judged to be 2 percent. If we expect a 2 percent real rate, current rates for developed countries are way too low and still suggest very accommodative monetary policy. Clearly at sub-2% US inflation last year, long US real rates were around zero and much higher than for other developed, but the current inflation surge puts US real rates near developed market lows.   

A good analysis of real rates trends can be found in "Global Trends in Interest Rates", a NY Fed research paper from a few years ago. Any updating of their work will only reinforce their thesis on continued low real rate trends. Calculating the real rate and creating a historical real rate series is not easy. Their work shows that the real rate trend has been lower and on a long slide, but real rates are also subject to high variation based on several broad macro factors. These trends are applicable to all developed markets.

Current inflation expectations and actual inflation are pushing real rates to significantly low levels. We are now averaging sub-zero real rates for years. The flight to safety or convenience yield, demographics, slower growth, as well as monetary policy have all pushed long-term real rates lower which suggests that it is hard to handicap nominal rates at much higher than long-term inflation and a term premium. However, even by this measure, yields should move higher, yet continued Fed policy makes any of these forecasts for higher yields suspect. The market distortions will continue as long as QE continues.  

Yield curve term premia for 2021 - From negative to a positive and possibly back again

Term premia have had a wild ride in 2021 as measured by the NY Fed ACM model. The 10-year premium priced in a negative value even for long rates earlier in the year only to see a huge reversal in February and then a decline starting in late May. The premium hit a low surrounding the June FOMC only to bounce back in the last week. The key question is whether the premia should move higher or stay at the current levels. Term premia are not the real yield or expected inflation but the risk of holding a longer-dated bond versus a set of Treasury bill short rates.  

Higher uncertainty about policy, growth, and inflation will all be embedded in the risk premia. Given the changing expectations on the components of yields, it is likely that the premium will increase regardless of real yields and expected inflation.  This should lead to higher yields even if expectations and policy remain stable.

Taylor Rule and rate valuation - Suggesting rates should be higher

Should rates be higher or lower than current levels? Many can provide narratives associated with reasons for rates moving in either direction. The phasing will go something like this, "rates have not priced in all of the inflation we are seeing", or "rates should be pricing in the chance of sooner Fed action, therefore...". To some degree, these are just guesses. If rates are falling, then the weight of market opinion is changing toward lower inflation expectations. If rates are rising, the opposite is occurring. To provide some concrete value decision, we need to have some valuation model that can get into the specific for why rates should be higher or lower.

The Atlanta Fed provides a nice Taylor Rule tool that can be used to estimate what could be the equilibrium rate. They provide more than one specification for the Taylor Rule and the investor can change the weights. There is no "feeling" about rates but some specifics that can be debated based on the model and input assumptions. 

The conclusion from looking at a number of specifications is that rates should be higher based on the modeling provided. Of course, Taylor Rules have been suggesting negative rates during the pandemic and have also pointed to higher rates over the last decade. The Taylor Rule, as a valid tool, can be questioned, but it provides a foundation for discussion. The Fed is not following numbers or past policy. It is targeting inflation at higher level and looking to close all of the output gap from excess unemployment. Under more normal conditions rates should be rising but we are far from normal. 

This discussion at least generates a focus for valuation. we will continue this discussion with a look at r-star and the NY Fed term premium model in another post.    

Hayek and the business cycle today

 

Friedrich Hayek lost the battle for explaining business cycles. Keynes and his story surrounding the impact of aggregate demand won the day and lead to the monetary and fiscal policy revolution which dominates our thinking today. Hayek's views on capital theory are more acceptable, but it should not be forgotten that the premise of much of Hayek's thinking was focused on the coordination problem across a large number of workers and businesses. 

For Hayek, prices are the key to coordination and also the place where there will be business cycle dislocations. If prices are distorted from adverse market shocks or governments, then there will be a failure in market coordination, business will fail, consumers will make wrong choices, workers will not know how to price their services. 

There are supply chain issues and there are issues with measuring the baskets of goods that consumers buy. These shifts and bottlenecks lead economic agents to make bad decisions which will impact the success and failure of firms. Distortions from the pandemic are not often easily reversible. Policy has flooded money through monetary and fiscal policy into the economy. Regulations have changed incentives and behavior. All of these make it harder to price good and services and for consumers to make effective buying decisions. Mistakes will occur. Purchases will be delayed. 

There will be a period of time necessary for the coordination to work itself out. Even if there is government support through fiscal and monetary policy, there can still be coordination failure. More money cannot solve the problem of poor knowledge. We have seen the initial reflation, but the relative adjustment process will now dominate growth. 

Ask yourself a simple question. Is there a lack of aggregate demand in global economies or is there a price coordination problem?   

Prices and incentives - Cannot separate the two

 

"A price is a signal wrapped up in an incentive."  - Tyler Cowen and Alex Tabarrok 

Prices reveal preferences. Prices reveal incentives. This is even the case if there are distortions from government intervention. With government intervention, prices reveal the preferences and incentives of the government. 

Price changes, the adjustment of market opinions and preferences, generate actions or responses from markets. If the price of lumber rises, there will be an impact on housing from builders and potential buyers. In the short-run, consumers will try and get ahead of prices changes, but eventually they will respond to the incentives placed before them and change behavior. 

An investor should not impose his narrative on prices but look to understand what prices are revealing about mass opinion. Of course, prices are noisy in the very short-run. Those short-run prices are revealing information but only about short-run behavior. That is why prices have to be smoothed to create more meaningful signals. 

The trend-follower focuses on price and incentives and does not assume he has as what Hayek would say is the "pretense of knowledge". There is a limit to knowledge so the focus should be centered on the meaning of prices. 

Uncertainty - the gap between what we know and what we need to know

 

"...with respect to decision-making, uncertainty refers to the gap between available knowledge and the knowledge decision-makers would need in order to make the best policy choice."  -from Decision-making under Deep Uncertainty: From Theory to Practice

I like this definition. Uncertainty is a knowledge problem. Investors can work at trying to close the ignorance gap; however, the cost in time and money may mean that investors will always face a degree of uncertainty. 

There is a difference between decision-making under risk which can measured and decision-making under uncertainty. Yet, there is a continuum of uncertainty that can range from complete certainty to complete ignorance (inability to even frame the issues). Over this continuum, there exists different levels of uncertainty as described by those studying deep uncertainty:

Level 1 - represents situations where one is not absolutely certain but one does not see the need to measure the uncertainty in any explicit way. There are no guarantees that you will not be surprised by something unanticipated, but it may not be worth measuring. 

Level 2 - models or inputs can be described probabilistically and choices can be assigned probabilities. Choices are based on expected outcomes and levels of acceptable risk. This may be the traditional uncertainty most often discussed. 

Level 3 - there is a limited set of plausible futures and probabilities cannot be assigned to them. There is a focus on scenario analysis or what can happen in different worlds. This level of uncertainty often describes longer-term investing out beyond a few years.   

Level 4 - there may be many plausible futures, but they cannot be handicapped, or we are in situations where we know that we do not know what is likely, black swan problems. We can only try and protect ourselves from the unknown.

The job of a good investor is to try and manage their ignorance over different horizons. If the knowledge gap is too large, walk-away or take action that will limit downside. If the uncertainty can be controlled versus others, take more risk.  

Are you getting paid enough to hold corporates?

Corporate spreads should be the yield compensation for the risk taken with holding a debt instrument. The spread should pay investors for taking a certain probability of default over the life of the bond as well as the liquidity premium relative to a comparable risk free asset. If defaults or the probability of firm failure increases, there should be an increase in spread compensation. 

Default rates are rising, albeit during a pandemic, yet spread levels for investment grade and high yield have continued to move lower. Investor may be looking through the pandemic to better times and there is the continued reach for yield. Still, low spreads, the threat of inflation, higher company leverage, and an increase in selected defaults make for a less attractive credit environment. 

Defaults have been centered with the lowest quality firms and within specific industries like energy and consumer goods; however, credit markets are more susceptible to any credit surprises when spreads are lower. Equity prices, the residual value of the firm, have continued to move higher so there is no signal of credit weakness, but investors should still focus on credit as a potential risk flashpoint - limited excess return for potentially increasing risk.  

 

Housing starts - look at the shortfall from the pandemic, a lot of catch-up

Housing prices have exploded to the upside since the beginning of the pandemic. A key reason is the shortfall in housing starts. We took the trend in starts for the two years prior to the pandemic and extrapolated to the most current data. This trend was .88% per month. We then measured the difference between actual and trend. We then calculated the cumulative shortfall in thousands of homes. The shortfall is large. We are talking millions of units.  Without these new homes, existing homes will see upward pressure from buyers. 

Materials will also see upward pressure. One futures contact of lumber equals a railcar which has enough wood for 6-7 homes at 2,000 square feet. A back of the envelope calculation says that to close the shortfall there is needed 632,000 railcars or lumber contracts. While this is a gross simplification, it provides some context for the higher prices in housing.  

Inventory to sales - this cannot be solved with Fed forward guidance

 

Take a look at the inventory to sales ratio and you will see that we have a way to go before returning to normal. If there are shortages, there will be price increases. Consumers will pay for immediacy, what they want today. We see this in the used car market. Less cars and higher prices. This problem will not go away if workers are not producing. 

Is this a transitory problem? Yes, but the transition may be longer than six months, so we can expect higher inflation into next year regardless of what the Fed says or does. Inventory increases can only come from production. 

Inflation comes in different forms - some transitory and others longer-lasting

Some speak as if inflation is monolithic. There are actually different types or forms of inflation based on where we are in the business cycle or what could be a possible supply shock. These forms can be intertwined, yet it is important to think through the primary drivers. By looking at the forms of inflation, it may be easier to distinguish what is transitory, and what is permanent. 

For discussion purposes, we have outlined five forms of inflation. Each will have a different impact on equities, rates, currencies, credit, and commodities. 

There is classic demand-push that will be very relevant when there is limited slack in the economy. We are in a reflation, but demand-push may not fully engage with the US economy. The output gap is closing or has closed and unemployment is falling. However, the current reflation may be coming from other causes. That said, the natural rate of unemployment is not stable. What is full employment may be subject to change. A demand-push inflation may be good for equities because increased demand will allow for price increases. It is clearly negative for rates. 

Wage inflation, which we are likely experiencing, is a dangerous form for equities since companies have to pay-up for labor. Margins will be squeezed, and revenue share will move from capital to labor.

We separate cost-push from wage inflation and classify it as the operational costs of business which may include stock-outs, transportation costs, inventory, and regulatory issues. These all cut into profit margins but will impact sectors differently.

Commodity inflation can be viewed as mainly transitory, but if shortages are a function of underinvestment, these costs can be higher for an extended period. This would be foundation of a super-cycle.

Liquidity-driven inflation is associated with excess money balances, the classic monetary inflation often expressed in monetary theory. Excess money balances will be reduced through the purchase of goods or financial assets. This inflation, in the longer-run, will debase the dollar.

Granted this is a simple framework, yet discussion of the form inflation will help serve as focus attention on portfolio decisions.   

Mapping styles in a macro world through partial correlation maps

Global macro trading is not easy, but it can be supported through simple tools that provide some conditional probabilities of success for asset classes and risk premia through measuring partial correlations on a grid between two factors. An investor's forecast skill may not be strong, but tilts can be created to exploit likelihoods for gains. See the older paper, "Mapping Investable Return Sources to Macro Environments" from AQR.

Directional as well as relative value macro trades are based on identifying and measuring the macro regime. Where are we in the business cycle? What is the inflation environment? Returns for asset classes as well as style premia are time varying and conditional on the macro regime. For example, commodities are positively correlated with growth and inflation. At the same time, bonds are negatively correlated to growth and inflation. Asset class tilts are possible to exploit the current regime.  Unfortunately, the partial correlations for style premia are more difficult to map because partial correlations are lower with respect to growth and inflation. Nevertheless, momentum and trend are both correlated with growth and inflation.

The 2x2 mapping for global macro can be extended to other macro variables like real yields, volatility, and illiquidity. In these cases, the investor is still burdened with identifying the macro environment. Conditional on the macro assessment, the investor can improve his odds of success through matching macro factor partial correlations with style premia and asset classes.    

Inflation and sector returns - Investors can exploit the differences

The impact of inflation on equity markets is not uniform. Theory suggests that equities should be neutral to inflation but reality is different. Without going through all of the reasons, sectors will have significant differences in inflation sensitivities. There are also different responses between inflation sensitivity levels and inflation surprises. These differences allow for construction of inflation sensitive and insensitive portfolios based on the inflation forecasts of investors or their desire to hedge inflation risk.

One of the broad factors for equity sensitivity is the level and acceleration of inflation, and currently we are in the worst market conditions, inflation greater than 3% and rising. The equity response to inflation is non-linear. In the current environment, the chance of the rolling 12 month return being positive is slightly less than a flip of a coin. Nevertheless, sector performance allows for portfolio tilts that will create some inflation protection.    

 

Fed comments - Don't focus on dot-plots, we have this under control

I needed some time to digest Fed Chairman Powell's comments, and it all comes to the same conclusion. The Fed is behind the curve with respect to monetary policy. 

1. The dot-plots have moved forward into 2023 with two increases. However, Chairman Powell told us not to look too closely at these numbers and "take them with a grain of salt". The producer of the numbers tells us that they are likely wrong. Ouch. Is this supposed to be forward guidance?

2. The Fed raised reverse repo rate and the rate paid on reserves held at the Fed. These are technical issues, but it tells us that there is just too much money floating around in the system. Without technical support, rates would fall lower. 

3. Inflation forecast for 2021 have moved significantly higher relative to March. So much for transitory inflation in 2021. Inflation in 2022 and 2023 are supposed to be tame; however, market expectations are not being well-behaved especially with consumers.

4. The Fed is now talking about tapering not "talking about talking about tapering".

Lookout for Eurodollar curve trading. We will get a wilder market on "go - no-go" trades. 

 

Inflation, equity performance, and portfolio structure

 

How should we look at inflation-focused portfolios? A recent webinar, "Macro-Tilted Equity Indices Protecting your equity portfolio against inflation", from the researchers at Scientific Beta does a good job of looking at this question. 

First, looking at break-even inflation levels does not tell us much about how to tilt an equity portfolio; however, focusing on a robust measure of inflation surprises will provide very useful information. Surprises matter. The level is backward-looking.

Second, inflation surprises generate a strong impact on the sector choices. A focus on financials and small caps will do better than just holding the market portfolio. Additionally, holding stocks that have an inflation focus tilt can do better than the overall market.

Third, diversification in other sectors can help with protecting against inflation; however, commodity and REITs do not have an advantage even in a positive inflation surprise environment versus the market portfolio or an inflation-tilted equity portfolio. Some of there results are conditional on how the report measures and tracks inflation surprises, but it is useful to know that holding commodities or REITs are not a "no-brainer" inflation protection trade. Care should be taken with inflation-tilted portfolios. 

Inflation surprises and the expectation catch-up in 2021

 

It is not just inflation that is important but inflation surprises. In fact, the surprises usually have a more significant impact on asset returns. Most of the research on inflation and asset prices notes that the responses of asset classes with respect to actual inflation, expectations, and surprises are different. Asset prices are forward-looking. Inflation is backward-looking. Expectations and surprises generally matter more. 

A simple method for looking at inflation expectations is to track the Treasury breakeven time series. Note that the 10-year Treasury break-even is a long-term measure for expectations of inflation over the next 10-years. The 5-year Treasury breakevens provide a shorter-term outlook. Both have peaked albeit real rates are still declining. 

We compare Treasury break-evens versus a moving average of break-evens to measure inflationary surprises. Surprises have been both positive and negative over the last decade with a large negative spike in March 2020 from the pandemic. We measure the cumulative error to account for the direction of surprise and the catch-up. If adaptive expectations were unbiased, the cumulative error would center around zero.

It is noticeable that after the pandemic shock, inflation expectations rose and showed a positive surprise. The cumulative error or surprise moved from negative to positive levels. Break-evens have peaked and actually signal that inflation expectations are moderating which suggests that the transitory inflation story may be the base case.  

PPI, CPI, and inflation portfolios - Focus on relative value can create opportunities

The current PPI numbers for finished goods continue to surprise to the upside with a gain of 6.6 percent YOY.  The PPI index for all commodities is even higher. Both increases suggest a lift in CPI. The PPI moves in 2021 have not been see in the last decade and by some measures these increases have never been seen since the Great Inflation. 

Inflation shocks have different impacts on equity sector performance. Energy and industrials as extractors and originators of product do well when there is a growing gap between PPI and CPI. Final sellers like consumer stables and discretionary are negatively correlated with this gap. Gains can be crated through focusing on inflation relative value.

 

Upside-downside capture in hedge funds - you want a high ratio of up to down capture

 

There are many ways of measuring the value of hedge funds. One useful indicator is the ratio of upside to downside capture. When the ratio is high, there is more positive convexity. Investors will receive more return when the overall market is rising versus falling. 

A simple analysis of upside and downside capture was done in a recent research piece on hedge fund descriptions, see "Investing in Hedge Funds: Why Hedge Funds?" from Mercer. However, Mercer did not note the value of the upside to downside ratio. Our figure takes the same upside and downside data and forms the ratio to show the value of macro and relative value trading.

To understand hedge funds, you need to better define alpha

Hedge funds are supposed to be alpha producers; however, the definition or description of how alpha is produced is often poorly defined. Alpha is measured as excess return after accounting for market risk, a manager's edge, yet alpha does not tell us what is the tool kit used to generate excess return. It is a measure but not a description of excess return generation.

A hedge fund tool kit list, a set of methods for return generation, provides insight in the ways that alpha can be achieved. These tools can be coupled with a description of alternative sources for return which provides a good list of the richness of choices for managers. See "Investing in Hedge Funds: Why Hedge Funds?" from Mercer.

Each hedge fund style can be discussed or measured through its alternative risk sources. For example, a managed futures fund focuses on cross-asset and variable beta for return generation while distressed debt focuses on complexity, deal, and liquidity risk premia. Using this framework  helps to focus our attention on what makes a hedge fund style unique. A hedge fund's edge comes through it tools and sources of return which is manifested in measured alpha.

 

New survey results suggest business inflation expectations are not well-anchored

 

A new survey of inflation expectations suggests that there is a large difference between professional forecasters, consumers, and business inflation forecasts. The professionals have well-anchored expectations while consumers and businesses have expectations that can change rapidly. In a low inflation world, this may not matter, but in the current environment, the impact of changing inflationary expectations can have a real economic effect unforeseen from focusing on professionals. 

Recent inflation surveys suggest that businesses are not well-informed about inflation and monetary policy. Businesses engage in large revision of their expectations. They are not well anchored around the Fed target of 2%. CEO do not seem well-informed about monetary policy or inflation. They have a high level of inattention. They also show more disagreement than professional forecasters albeit less than households. See “The Inflation Expectations of US firms: Evidence from a New Survey”. 

If this is all true, the real effects of a rise in inflation may be much stronger than expected. The Fed focusing on financial professional may have discounted the behavior of consumers and businesses who change expectations and behavior quicker than generally perceived. If expectations are more sensitive, inflation impacts will become more severe. Of course, if the Fed is right about transitory inflation, expectations may also adjust quickly. Nevertheless, any inattention to inflation may change rapidly and this will have real effects on pricing and profit margins.

Current inflation is a Fed choice, but businesses and consumers are becoming less tolerant

"Because the monetary authority in most economies can prevent - or choose not to create - inflation, any theory of inflation either implicitly or explicitly involves a theory of - monetary authority behavior."  - Steve Green, Baylor University "Theories of Inflation - A Review Essay"

While this comment is from the 1980's, it still places any inflation discussion in perspective. Many have stated that the monetary authority lost its power to effectively target inflation during the period of sub-2% inflation and low nominal rates, yet now we are supposed to believe that inflation can be easily controlled. The current inflation spike is a choice by the Fed.

With the latest CPI release, it is important to focus on the core issue. Policy-makers ultimately control inflation. They may not do it well. They may have competing objectives. There may be a lag between action and response, but they are the driver of inflation and inflationary expectations. If there is wealth destruction and declines in real wages from inflation, it is because they accept this inflation. 

The investor question is the level of Fed tolerance for inflation, and this tolerance will fall as confidence and pain from businesses and consumers increase. The current CPI acceleration pulls Fed action forward which will impact yield curve shapes and rate trades.  

Commodity prices long-term - The long decline is over

The concept of value in commodity markets is not well-defined. Many have viewed value as the deviation from longer-term prices, for example, the 5-year moving average. I always view long-term value in the context of production or replacement costs relative to demand.  As prices fall, marginal production is cut and there is the potential for supply and demand imbalances. Low prices solve the problem of low prices - and markets will mean-revert. Commodity markets have been on a strong up move. Prices are now above the 5-year rolling average and the average itself is turning higher. Looking at the divergence from the long-term average prices are cheap, but there is room for upside and the highs of 2014 have yet to be reached. In an inflationary world, commodities are still a good location for capital.

Secondary Market Corporate Credit Facility wind down - One easy form of tapering

The Secondary Market Corporate Credit Facility (SMCCF) wind down - one easy form of tapering through selling the Fed's ETF holdings. The SMCCF program ran from March 23, 2020, to the end of the year, and the Fed has announced that it is willing to exit its positions. The total dollar value is around $13.7 billion, so this is a drop in the bucket relative to the $120 billion per month in monthly purchases by the Fed. 

Corporate spreads are tight so there is no underlying reason for the program, and it eliminates the credit exposure on the Fed's balance sheet. The economic impact is low given the high volume of trading in corporate ETFs. If it wants to get this done, the sale can actually be relatively swift. Any signaling will be associated with the speed of action.  

Could this be a signal of something more? Could the Fed be getting ready to reduce asset purchases? Certainly, this action makes sense and sends a broader signal, albeit a weak signal. The Fed should tackle the big issue of tapering because the excess cash and large purchases continue to create distortion in money markets and along the entire Treasury curve. However, the focus of investors is not on whether the Fed should follow a policy but what is the action and potential market impact.