World trade back to the expected trend level, but what is next?

Global growth and emerging market growth are closely tied to world trade. The trend in world trade has never returned to the old growth rates as measured by the CPB World Trade Monitor. The pandemic created a huge decline in trade, but the trend was already pointed lower. The data shows a return to trend, the great reflation. 

However, a look at growth rates after the Great Recession shows an overshoot and then a return to the long trend. The question is whether this will be above the 5% range or in the below 5% range. we expect something in the low end of the 2-4% range given current geopolitics, transportation costs, and the reversal of just in time inventory practices.  

China decoupling in investment world

Chimerica no more? One of the great investment events for any country is the inclusion of your equity and debt in major global benchmark indices. Index inclusion is a game changer. You have arrived. Index inclusion means that every global investor must hold your assets in his portfolio. To not hold a position is a bet against the performance of that country. This index effect for China especially in fixed income over the last two years has generated significant foreign investment flow not just from China experts but from passive investors. There is a time delay between any announcement, the actual rebalancing, and the impact on financial markets, but the longer-term effects are real. 

The inclusion of China equites in benchmarks has been established for several years. The MSCI global equity index added Chinese A shares in 2018 and mid-caps in late 2019.  The inclusion of China debt in the JP Morgan EMB benchmark was announced in 2019 for inclusion in 2020. 

Firms have ramped up their equity and debt exposure, and now we are having a great decoupling of financial regulatory policies which has created a large disconnect country performance disconnect.

The difference between EEM and EEM x China is over 6% this year as of yesterday. The differential between the US and Chinese equity benchmarks is over 30% (SPY vs MCHI) this year. What should have brought the countries closer together is now having negative financial impact on global investors as the rules have the game change. Holding Chinese financial assets were considered a country and global trade play and was not viewed as a strong play on regulatory and political systems. The world has changed.

Hard to believe that terms like "Chimerica" - the Niall Ferguson and Moritz Schularick word for the symbiotic relationship between China and America seem so outdated.   

Collateral shortage and reverse repo

The US is different from other financial markets because so much of financing is outside the banking system. Bank lending is more important in other countries. Capital markets are the driver of finance in the US which means there are special needs for collateral with lending and leverage.

The capital markets cannot work efficiently if there is a shortage of collateral regardless of how much excess reserves are in the banking system. The spike in reverse repo, while an overnight offset to the impact of QE as measured through changes in the Fed balance sheet, is a reaction to changes in the micro plumbing of financial markets. Recent increases in reverse repo have been a response to the elimination of SLR (Supplementary Leverage Ratio) relieve for banks, the drawdown of the TGA (Treasury General Account) at the Fed, actions to the debt ceiling statutory ceiling at the end of July. 

In general, structural changes cause changes in the demand and supply of deposits at banks. At times banks want to hold less deposits for regulatory reasons. This constraint by banks causes money to flow to other short-term investment like money funds. The overall flow to other parts of the financial system creates collateral shortages which generates rate stress. 

In the case of collateral shortages, rates can spike because there is inelastic demand for necessary collateral especially early in the day. If risk increases, flow to safe assets increases, or there is a price dislocation which creates the demand for collateral, the available safe assets are constrained even with the Fed balance sheet (QE) increasing. 

Investor should care about plumbing because disruptions in the most liquid market for safe assets, Treasuries, will create the perception market dislocations. Increased risk perception concerning collateral will generate a build-up for portfolio safety and risk-taking should diminish. Hence, we should see a portfolio rebalancing out of risk assets. A collateral repo disturbance will increase the desire for a safety reserve.  

The fundamentals of value investing - "Use knowledge to reduce uncertainty"

 

We have been so influenced by quantitative approaches or screening to value investing that we have forgotten how value is created through research. Many have become knee-jerk value investor who only think of it as a matter of sorting names by some value criteria like P/E ratios. It is just a factor. Reading an older book on value investing suggests that there has been on over-emphasis on single quant measures, See, Value Investing from Graham to Buffett and Beyond 

The authors refer to a foundational Graham and Dodd canon, "Use knowledge to reduce uncertainty". If you cannot or do not have the requisite knowledge, do not invest. 

Value investing is about understanding the company to find or unlock value relative to peer companies. The skill of unlocking knowledge is what creates an investment edge. It is about observing or seeing what may not be apparent to others through a closer analysis of accounting numbers, the market environment, and competition. 

Can this be done through single factor sorting? Perhaps as a start, but the current great divide between value and growth may have more to do with economic uncertainty and the changing dynamics of industries during a period of excess liquidity and pandemic than with the failure of quant measures. 

This is not an argument for dropping factor investing, but a reaffirming of the core principle of creating an investment edge - form methods to reduce uncertainty. 

Alternative risk premium - A liquidity choice continuum

Alternative risk premia can be categorized along a liquidity continuum into two major groups. At one extreme are liquidity providers which are risk aversion strategies, and at the other extreme are the liquidity takers which are based behavioral premia.  

The risk aversion strategies are negatively convex or convergent strategies that underperform during market extremes. The behavioral premia are positively convex and like market divergences. The behavioral premia are often associated with market anomalies caused by behavioral biases which should not last. Behavioral biases associated with trend or momentum need liquidity given they will buy into strength and sell into weakness. Risk aversion strategies will buy into markets where there is higher risk aversion. In these cases, investors will be compensated for skewness or risk from expected extremes. 

Investors who believe there is a greater likelihood for market divergences must act early with buying behavioral premia because the liquidity costs will be higher if you buy late. Risk aversion investor must make the judgement that markets will be or remain calm. Negative market moves will generate underperformance. The choice is a play on uncertainty which impacts liquidity. 

 

"Peak Recovery" and business cycle calculus

 

Starting with simple concepts and then adding complexity is a good way to address difficult problems. Many pundits have started to talk about "Peak Recovery" as some newfound concept, yet the discussion focus is just about business cycle calculus. Any business cycle can be described by the level, trend, and acceleration of GDP or its components, yet these simple concepts get lost in macro discussions. 

Peak recovery focuses on the second derivative of growth. Reflation is a combination of positive trend and acceleration; first and second derivatives. The point of peak recovery can be described as when the economy is still growing, positive trend, but switches to a slower rate, albeit positive. This concept becomes slightly easier if you think of the business cycle as a sine wave. The derivative of the sine wave is a cosine. The inflection point or peak recovery will be when the cosine, the derivative, has a maximum value.   

When the US economy started to open, there was positive acceleration in growth. Now that most states are open and the catch-up of spending is being achieved, acceleration will slow although growth may still be strong as measure by the positive trend.  

Hitting peak recovery is the inflection point between early recovery to the normalcy of mid-cycle growth. The economy is growing but with less acceleration. There can be disagreement on whether this is occurring, but there is no question that the changing signs of GDP derivatives is a useful for determining where you are in the economic cycle. If acceleration is slowing, upside surprises are less likely. We are seeing this effect with Citibank and Bloomberg surprise indices. 

Our basic macro adage is that you cannot predict where you are going until you know where you are at. You cannot get strengthening financial price trends if macro acceleration is declining. 

Yet, the basic question of determining where you are at is not often easy - just ask policymakers and investors. Consensus does not often exist. Definition of terms may also be contested. 

Risk Premium (Skewness) Crashes, Opportunistic Trading, and Crowdedness

Carry trading in many asset classes will be subject to crashes when there is a change in the risk regime. Momentum trading also will be subject to crashes when there is increased crowdedness and a change in expectations. Other risk factors can be subject to sharp reversals when they are isolated as target long/short risk premia. This is an overlooked fact concerning alternative risk premia that is sometimes masked when describing its long-term performance. Long-term performance may seem high, but as risk premia are further isolated there is the potential for performance behavior with sharp declines. These crash reversals may be often bundled under the common theme of crowdedness, when the weight of opinion is skewed in a similar direction.  

A more well-defined and selective risk premium will more likely be subject to crashes. For example, G10 carry is well-defined and highly selective. A change in carry opinion will lead to a strong reversal of returns. A strategy risk premia that is more diversified across asset classes and harder to define will have less likelihood of crashes. For example, a carry strategy that is applied across asset classes will have smoother returns with lower return and risk. The market portfolio as a combination or bundle of long-only risk premia provides diversification from the crashes of a single premia. 

Crowdedness and crash likelihood can explain the higher risk premium for many strategies. Hence, it is critical to focus on crowdedness through flow and narrative consensus. Opportunistic trading will focus on determining how to identify and avoid maximum crowdedness. If that cannot be done, then the best alternative is to ensure any risk premium investment strategy has stop-losses to offset the potential for crash surprises. A stop-loss does not change the underlying risk strategy distribution but reduces the tail risk that is embedded in these strategies which may be the core reason for higher compensation. While not always easy, actions that cut the tail (negaitve skew) will maintain the strategy return. 

Uncertainty and Treasury yields - Forecast disagreement impacts yields

Focusing on the disagreement of yield forecasts from leading economists can serve as a useful factor for improving the accuracy of model-driven Treasury yield forecasts. Disagreement in Blue Chip forecasts has unique and stronger predictive power than the well-known traditional factors like inflation and growth. The positive predictive effect of forecast disagreement is especially strong following recessions. 

This disagreement risk factor was explored in the recent Journal of Finance (February 2021) paper, "Learning from Disagreement in the US Treasury Bond Market". The authors use a Bayesian learning model that updates the parameters driving bond yields within a dynamic term structure model. Including the disagreement among economist forecast improves the accuracy of the model relative to a model that only uses yield information. The authors also find that fundamental factors like output growth and inflation can be viewed as redundant once the model conditions on forecast disagreement. Additionally, the systematic model even without using the disagreement factor is more accurate than the consensus Blue Chip forecast. 

The conclusion is simple. Use the disagreement of forecasts as an added risk factor, but don't use the actual forecasts of economists. Disagreement is a unique factor and helps with the adjustment of model parameters. Disagreement can better explain excess returns when there are transition economic regimes. 

Donald Rumsfeld will always be known as the "unknown unknowns" guy

 

There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know. Those tend to be the difficult ones. 

- Donald Rumsfeld 

Donald Rumsfeld, best known as the former US defense secretary, died last month. Smart, arrogant, and a man who would not suffers fools gladly, Donald Rumsfeld will always be connected with one of the all-time great quotes on uncertainty. Love him or hate him, he will be known as the "unknown unknowns" guy. I cannot count the number of times I have used the quote and have applied it to a sticky decision problem. It is important to often step back and determine what is known, unknown, and could be known.  

Most recently, I posted about the uncertainty gap, the distance between what we know and what we need to know. Good decision-making focuses on closing the unknown gap. (See - Uncertainty - the gap between what we know and what we need to know)

He could have followed at key times his own advise on unknowns, yet he likely made those around him smarter especially if they were willing to face the unknown challenge. 

Real rates and inflation expectations drive any currency regime and trend

Changing real rates and inflationary expectations will have different effects on currency, commodity, and equity markets. While more localized patterns within an asset class may be different, tracking past behavior provides a set of well-defined priors. Investing against prior will require a special narrative to overcome the likely relationships.

We have been in a regime of low and declining real rates and inflation expectations rising which is often associated with dovish monetary policy. This is generally a poor dollar environment. If there is a Fed reaction that suggests a rising real rates, the dollar will move to a regime consistent with tightening policy. The higher real rates will have a more important impact on G10 currencies while higher inflation expectations will signal a better environment for EM currencies that may be commodity exporters to the US. Rising inflation and real rates would still be a risk-on environment.

If there are rising real rates suggested by Fed tightening and weakening inflation expectations, we will likely see a stronger dollar regime. The final combination of declining real rates and falling inflation expectations will signify a recession environment which will suggest a flight to dollar safety. The safety flight will dominate EM currency movement but will have a less clear effect G10 currencies. 

The switching in currency trends is all about changing regimes associated real rates and inflationary expectations. The simple 2x2 table is not a substitute for a specified model but it does focus any asset allocation discussion. 

 

Treasury yield curve dynamics - It does not require large yield changes to have a big move

 

The yield curve as measured by the 10-year minus 2-year Treasury spread has seen a significant reversal from the big reflation trade to a flattening move under the expectation of a Fed who will push policy action slightly forward (six months) and will be conduct more normalized behavior to tame inflation. There is also a view that inflation is transitory, and we have reached peak growth. Whether these themes continue is subject to debate and will dominate the fixed income narrative.  

Before significant judgments are made on what is the correct curve moves, there needs to be some historical context. The one-week changes in the 10-2 spread are not at extremes. What is at extremes are the combination of one week changes across the last 4- and 8-weeks. As a measure of extreme, we calculated the 4- and 8-week changes since 1976 and gave each a percentile rank. We used percentile measures given the non-normality of curve changes which have very fat tails. Earlier this year, we have had some of the largest curve steepening by rank for both 4- and 8-week periods. In the last few weeks, that extreme has completely reversed. We now have some of the greatest flattening moves. What is clear is that fixed income sentiment has moved from a reflation extreme to a possible "peak growth" extreme. 

However, these switches between extremes are not unusual and the size of the 10-2 spread move to be in an extreme are actually quite small. For example, the 36-bps flattening over the last two months (July 12, 2021) places it in the 7th percentile while a 50-bps steepener is in the 95th percentile of moves and occurred in early April 2021. It does not take much to reach what would be called big moves in the curve trades. 

Nevertheless, investors should remember that yield curve trades can bounce between extremes in the short run (inside two months) but have very long-term trends based on long-term monetary policy.

Is it time for an inflation futures contract?

It has been tried before and failed, but is it time for an inflation futures contract? Transitory inflation may last longer than we think, and transitory does not mean that we get that purchasing power back. Real wealth has been eroded. In a stable world of 2% inflation targeting, a futures contract may not serve an economic purpose but now may be different.

Bond futures have a strong expected inflation component, but there may be a need for an exchange cleared product. There is an active TIPS markets albeit no TIPS futures. However, a hedge or method of trading CPI over the short run is not direct or exactly easy. Of course, we have a strong inflation swaps market. An inflation swap can be cleared through an exchange so some of the futures benefit can be received without a futures contract. However, investors who want a direct inflation hedge may like more choices. 

Previously, I was an economist for a futures exchange working on contract development and I will tell you it is not easy to launch a new futures contract. Most will be failures. A contract success will be based on a strong set of active buyers and sellers as well as a high level of volatility and uncertainty that must be hedged. 

Many will say that you will be able to get close through buying a commodity basket, gold, or oil futures, but any close look will show that the variation between inflation and commodities can be volatile and the correlation has declined as the US economy has changed to be more service focused. For businesses and investors, an inflation futures market could be useful and the cost of managing a contract in an electronic world is substantially less. This is worth a more serious discussion.    

Food inflation is not just a US problem

The Food and Agriculture Organization (FAO) of the United Nations publishes an index of international food prices based on a basket of food consisting of the average of five commodity groups weighted by their average export shares. June was the first monthly decline over the last twelve months, but the trend is still upward with real food prices at the highest levels since the mid-1970's. 

This will have a clear impact on purchasing power for other goods and services in less developed countries. Spikes in real food prices have been associated with increased government protests and riots. 

The hope is that these increases are transitory based on current stocks to use ratios being stable, but a bad harvest this year will provide further support for price increases and food uncertainty.  

 

Fed tapering sooner - Does it matter?

All the Fed talk and investor buzz has been about tapering, but the discussion should be divided into two parts: one, the signaling of future monetary policy as either being hawkish or dovish, and two, the impact on credit expansion and economic activity. The economic impact of a tapering may be minimal. The signaling issue of bringing an end to QE and sooner increases in rates can be consequential for financial markets, less so for real markets. 

It could be argued that with the significant amount of reverse repo, excess money is being drained from the system and thus offsetting Fed purchases. There are technical and curve components to the reverse repo activity, but there are just excess funds without a home at a current level of approximately $800 billion a day.

Another way of thinking about the limited impact of QE in the current environment is to look at the difference between the monetary base and reserves. The difference has had remained constant for the last year. While liquidity was needed in March, it is less clear whether it is necessary to support the bank lending channel now. The issue is now centered on whether there are good investment projects not whether there are funds available. 

With mortgage rates at five-month lows and housing prices reaching highs, there is even less reason for the Fed to be purchasing mortgages. A scaled reduction will not impact economic activity and provide some rationality to the MBS market. Fiscal policy and regulation will have more impact on sustaining economic growth than more money from the Fed. 

The signaling that the Fed will provide less liquidity yet is not tightening is a different issue. Perhaps the reflation trade was overdone, but wording and signaling on intention with respect to inflation will have a greater impact on forward expectations. There may be an immediate negative reaction to tapering, but for the real economy and loan activity, it will be a non-issue. Pushing forward Fed rate increases will have a very different and negative impact.

The Fed would like to walk a fine line and start tapering but assuring markets that low rates will continue.  

OODA revised - Still an effective core approach to decision-making

Idea generation can be structured into a repeatable process. A process allows for more creativity because there is a formal way of focusing on idea content. Creativity with investment ideas is foremost about observing and seeing what others do not but seeing is just one component of successful idea generation which is why using a framework like the OODA is useful. 

Observing is only the start of the idea generation process. Any observation must be placed in context which is a form of orientation. However, while observing and orienting is critical, there has to be a decision on what to do, and then idea execution. Many investors are good market observers, but money is only made when a decision is made, and the decision is executed. 

For macro investing, analysis should be made on both a top-down and bottom-up basis with added focus on determining what is unique based on investor experience. Idea generation can be structured as a form of OODA or recognition primed decision-making.

Sweating the details matters for investors

Preparing for the annual Russell reconstitution announcement is second nature for passive index managers, but it should also be a natural part of any active manager discussion, even for global macro managers. The reconstitution problem is not just a Russell index issue. 

It should be obvious that the characteristics of equity and bond benchmarks today and not the same as a few years ago. They will be similar but not the same, so all the factor sensitivities to these indices will be slightly different. There will be error in any beta calculation to macro factors given index characteristics are changing. For example, the sector weights for an equity index may vary, so growth or inflation betas may differ through time. For fixed income, duration changes will impact rate sensitivities. 

Investment skill must sweat the structural details. There is no room for the dilettante who is not versed with market details because knowing the details converts into "loose change" and the summation of these pennies becomes real in a low-rate environment. Knowing the details is not a matter of being able to engage in market conversation but understanding that the craft of asset management requires a focus on getting all the structuring associated with a trade idea and execution correct. 

A good idea executed badly may generate less return than an average idea executed well. 

Knowing what will come next in 2021 - Macro disagreement

Macro investing was relatively easy for the first two quarters of 2021. Note, of course, nothing is easy with investing. The first two quarters represented the reflation trade coupled with higher inflation. With the global vaccine roll-out and expected opening of businesses, economic growth expectations were high. Differences in the reflation trade were a matter of degrees. With Fed action pushed into the future coupled with a desire to run the economy hot, inflation forecasts were also higher. 

Now global macro traders will have to earn their fees for the second half of the year. Continuing to follow the reflation trade coupled with not fighting the Fed seems to be a reasonable base strategy, but there is more room for disagreement over the next two quarters. The current areas of disagreement:

- What does a more hawkish Fed really mean for    markets and the economy?
- Is inflation transitory, and will we see an inflation pullback in the second half of 2021?
- Growth reflation has occurred, but will it continue at the current pace?

- Is there more US fiscal stimulus to come in the second half of the year? 

- Will a great growth rotation occur in the rest of the world?

- Are markets ready for a change in risk sentiment?

Fading reflation may be the key theme for the second half of 2021. Market reaction is more than responding to growth. It is often focused on acceleration, the second derivative. A slowing of growth expectations may explain a bond rally a stall in equity returns.     

Hedge funds drive Treasury market - Their behavior may create market dislocations

Solve one supposed problem and you may create another, the law of unintended consequences. Banks used to be the key driver of trading in Treasury, but that has changed with Dodd-Frank and other bank regulation. In its place, hedge funds have become the dominate player in active trading. A change in players with different capital commitments and trading objectives will spill-over to issues of pricing and liquidity. This switch to hedge funds has not been an overnight change, but hedge fund gross Treasury exposures have risen to $2.4 trillion in 2020 with a large focus on relative value arbitrage between cash and futures supported through repo funding. Treasury trades by hedge funds were crowded before the March pandemic. 

New analysis has found that hedge fund Treasury exposures declined significantly in March 2020 as returns from basis trading and RV trading declined. See "Hedge fund Treasury trading and funding fragility: Evidence from the COVID-19 Crisis". The threat to market liquidity from changes in hedge fund exposures is significant. Highly levered hedge fund trading will be sensitive to performance and will impact the trading of other Treasury market players when there are large position adjustments. The Treasury market may be more sensitive to macro surprises that impact the yield curve and financing. This places greater pressure Treasury dealers and increase risk premia especially for off-the-run Treasury issues. 

Market structure is a critical component for understanding the changing sensitivities of prices to market information.

Stock-bond positive return correlation a reality

The stock/bond return correlation has turned positive which is the largest threat to any diversified manager. Whether this relationship lasts is now the important question since a large correlation flip does not happen that often. We have been in a 20-year period of negative correlation after a 35-year period of positive correlation. Nevertheless, we have signs to help us answer the diversification question.

A breakdown of the drivers of the covariance between stock and bond can be seen in three major components: the variance of the discount rate, the covariance between cash flows and rates, and the covariance between equity and bond risk premia. The impact of rising rates is positive on covariance. A rise in rates will reduces the discounted value of cash flows for any investment. The relationship between cash flows and rates is ambiguous because it depends on the relationship between economic growth and interest rates. The growth and rate relationship is tied to economic policy reactions and growth. The final key driver of covariance is the relationship of risk premia between stocks and bonds which changes with volatility and risk aversion. A shock and flight to safety will force the relationship to turn negative, but that may not be a permanent relationship.

These covariance factors will be affected by the interaction between monetary and fiscal policy and economic activity, so this should be where we focus our time. If monetary policy is used to combat inflation in a rules-based approach as described by the Taylor Rule, then rates will rise with economic activity to stop inflation which will lead to a negative correlation between equity and bond returns. On the other hand, if monetary and fiscal policy are coordinated and used to enhance growth over inflation there will be a positive stock/bond correlation.  

The macro policy regime will define the stock/bond correlation and this is forward-looking and not just a function of past history. 

 

Commodity traders in "The World for Sale" are still a mystery

 

The World for Sale: Money, Power, and the Traders who barter the Earth's Resources by Javier Blas and Jack Farchey dishes the details on the success of the top commodity trading firms over the last few decades. They will go where other will not and take huge risks that other will pass over to find deals and match buyers and sellers for large profits. 

The book is filled with interesting characters, but overall, I am left without many details of how these traders were able to assess risks and gain a trading advantage. There is also too little on how these firms were able to exploit information dislocations in a competitive marketplace. Is it just greater risk appetite? Clearly, global upheaval and geopolitical restrictions allow for traders to profit from uncertainty, but there seems to be more to the story. 

As an economist and investor, I want to learn about how profitable traders assess risk, deal with uncertainty, structure trades, and form repeatable success. Near the book's end there is an afterthought about information advantage, but the authors do not tie all the pieces together on how these commodity trading firms are successful. I enjoyed the stories, but I don't really know or care about these wildly successful traders. 

Dispersion in central bank behavior - No one size fits all

Everyone focuses on Fed activity, but there are growing policy differences and opportunities in other countries. Looking at June monetary policy changes and focusing on larger market, there are clear differences in central bank responses to inflation. We are not counting central banks that have announced no changes. Differences in policy mandates are now leading to increased rate differentials. 

Central banks in countries where foreign capital flows are more sensitive to real rates are showing a strong and quicker response to inflation surges regardless as to whether they are transitory than G7 countries. While this may not put any pressure on the Fed, it does offer investors with a focus on EM a chance to find potential carry and flow trades. The interaction between real rates, exchange rates, inflation, and capital flows can be complex; however, these central banks all desire to stabilize and manage current inflation.