Saturday, October 30, 2021

The effect of inflation on equities - Trouble ahead


Inflation will have an impact on equity returns. While it is often stated that equities, unlike bonds, will gain with inflation, the reality is more complex. OSAM, the equity management firm, reviewed a long history of close to one hundred years and found that equity nominal returns will always be positive regardless of the inflation environment; however, nominal and real returns will decline in higher inflation periods. 

During high inflation periods, the price earnings ratio declines. The valuation compression harms total return. It is also found that momentum and value factors show higher excess returns in the higher inflation quantile. There is a way to tilt portfolios to offset some of the negative inflation effects; however, a judgment must be made on whether current inflation will be rising or abating, still the key question. 

Stagflation - not the same as the 70's, but it is here - "Cyclical Stagflation"

US stagflation - slower growth, 2% annualized for third quarter, with higher inflation, annualized core PCE price index 4.5%. The third quarter growth would have been worse if not for an odd increase in inventories which does not show up in inventory to sales ratio. Inflation is worse if you consider headline levels.

Michael Bruno and Jeffery Sachs in the 1980's developed a generalized framework for stagflation that rests on two key conditions: (1) a large and unexpected increase in prices for inputs produced externally requiring a reduction in the standard of living for importing countries (a supply shock), and (2) wage inflexibility that reduces demand for labor and thereby increases unemployment. We do not currently fit the framework on both conditions, but we have an environment where markets are not clearing and causing a growth/inflation dislocation. 

We have an unexpected increase in prices from an oil shock, goods congestion, and labor shortages. There is a clear supply shock caused by the pandemic that is causing a slow adjustment on the real economy that is not solved by fiscal policy supporting the demand side of the economy.

The labor market is not clearing at current prices. The number of jobs offered is greater than supply, labor participation is below expectations, and unemployment is low. 

The pandemic effect on the economy is still a drag from fear, industry adjustments, and mandates requirements. The markets are now realizing that we are far from normal. This is not a demographic problem. It is a policy problem because the supply shocks were self-induced; however, it is not solvable through more expansionary fiscal and monetary policy.

The bottom-line "cyclical stagflation" be present at least through the first half of 2022 based on a slow adjustment scenario. There is no quick policy fixe being discussed. Earnings will start to see a negative impact as operating costs grow and risk assets will fall out of favor. Flows to safe assets will increase even with higher expected inflation.  

Thursday, October 28, 2021

Choosing between correlation diversification and option hedges

As we enter a period of higher market uncertainty, there is increased demand for tail risk control for the simple reason the likelihood of a tail event increases. While portfolio diversification is critical and the best first line defense, there are other more focused ways to protect from these tail risks events. 

Diversification is the best approach if an investor does not have a view about the direction of markets. It is the agnostic hedge. At the other extreme is a clear view of direction which will require asset rebalancing conditional on the view. The problem is that most investors live in a world of maybe. Equities may go down and I may be leaning in that direction but my odds for a decline are not strong, and I cannot handicap the strength of the adjustment. We live in a world between diversification based on not having a view and a strong view that generates clear allocation biases.

The same problem also applies to downside protection. Investors can have a diversification tilt or hedge with an instrument that has focused protection. These downside choices can be classified as either correlation hedges or structural hedges. 

Correlation hedges offer protection because of their statistical properties across assets. Call it extreme or targeted diversification. The correlation hedge may be an investment uncorrelated with equities or even better, a negative correlation during a down event. In the simplest case, it has been holding bonds. For hedge fund investing, it could be trend-following.

A structural hedge is one that offers a different return stream because of their specific pay-off rules; an option trade. The structural hedge over time may differ from the ultimate pay-off, but at the terminal date of the hedge there will be a clear formulaic answer to the hedge cost and return.

The advantage of a correlation hedge is that the cost may be lower than an option trade. For example, holding bonds that may be negative correlated with stocks can protect a portfolio and provide a positive return although that value has diminished under the current low-rate environment. The disadvantage is that you may not get the historic correlation desired. You are betting on the past repeating.  

An option trade will cost the premium paid to gain the protection which will be associated with the strike chosen. That premium will change with volatility and the likelihood of the strike being in the money at expiration. You must get the strike right to match the size of the move. Protecting against a 5+% move is greater than the cost of a 20+% move. The out-of-the-money strike is cheaper, but investors don't get protection for a 10% down move.

Protecting against downside risk is timed closely with having a view - a view of cross market relationships and the magnitude of any downside event. Forecasting cannot be avoided.

Wednesday, October 27, 2021

Oil Company Returns and Oil Prices - Do not always move together

Oil price behavior embedded in futures markets will not translate to oil company stock behavior. This should not be surprising. The relationship over the short-run may be very different than longer-term relationships. This should also not be surprising. Yet, long and short-term relationships are often confused or misunderstood.

The oil price - equity relationship tells very different stories between the long and short-run. For the year 2021, oil and exploration companies have moved together. Integrated oil has not moved with price. Reserve valuation will closely move with price that has a strong trend and the expectation of staying at high levels. Integrated companies will subject product demand and refining margins. 

Over the longer-run (5-years), the gains in energy stocks have been muted relative to the oil price shocks. Oil ETFs are still below prices five years ago even though oil prices are up 60 percent over the same period. The longer-term trend is to price lower valuation for traditional oil regardless of price. Investing in traditional energy companies is not the same as investing or taking advantage of the oil price move.

Tuesday, October 26, 2021

ECB inflation review - No skill at predicting inflation - mistakes with structural issues

The ECB produced a deep study of Euro area inflation and why the central bank persistently got their forecast numbers wrong. (See "Understanding low inflation in the euro area from 2013 to 2019: Cyclical and structural drivers  Occasional Paper series No 280.) It consistently over-predicted inflation for the 2013-2019 period. It is not clear that they will be better at forecasting in the future; however, this is an important piece of self-reflection and will be useful for other central banks. Overall, our ability to understand inflation drivers is poor and the implication is that policies will make inflation mistakes. Perhaps this decade will be a problem of under-predicting inflation.

The reasons for the poor predictions are numerous; however, the key may have been an inability to properly measure economic slack. The Phillips curve is alive and well; albeit with a different slope and structural factors that are not included in the model. Currently, central banks have an inability to measure economic tightness. Of course, the lower bound problem is discussed but an inability to forecast inflation makes the bound problem moot.

The slack problem is associated with structural trends like globalization, digitization, and demographics which provided strong headwinds against inflation. The twin crises over the last fifteen years also provided shocks that created persistent slack. The ECB also notes the disconnect between the bank's goals and inflation expectations, the anchoring problem. Put another way, the market's expectations were better grounded than the ECB's view.

No investor should be surprised by the poor forecasting of inflation by central banks. Poor forecasts leads to policy mistakes. 

Sunday, October 24, 2021

Hampel outlier identification - Reducing the sensitivity of standard deviation

Outlier identification is important for investors as a systematic means of finding prices or returns that are abnormal. Outliers are a reality, but they also cause distortions in any time series or cross market correlation that may lead to erroneous investment conclusions. 

There is the general view that data should never be thrown out and data should not be adjusted for outliers, but reality is more complex. Smooth data and you will soon be explaining away all periods of stress and crisis. Leave data untouched and you may have price series distorted for years. There is no easy answer, yet looking at the differences between smoothed versus rough data is a core part of the job of a good data analyst.

The first task is to identify outliers. Instead of using standard deviations, an alternative is to use median absolute deviations, what is called the Hampel identifier. The median can be tracked over a rolling time period with outliers identified as outside a range. It is noted that the median absolute deviation (MAD) is close to the standard deviation for a Gaussian distribution if an adjustment of 1.48 is multiplied by the MAD. Outliers are suggested to be 3 times the adjusted MAD. In general, this measure will be less sensitive than a traditional standard deviation tool. 

Looking at an index like the SPX will show periods of market stress as measured by outliers. The return series will have a different interpretation than a Hampel outlier analysis of price, but it does provide a simple and easy to calculate tool to help isolate data issues. 

We can take a time series and create an envelope around it using a rolling MAD value. Outliers can then be identified and replaced. The usual replacement is with the median. Outlier detection also can be useful for mean reversion trading and for focusing on announcement event dates associated with outliers.

There is value from finding outliers and adapting to market extremes. There is no single approach that is best, but outlier analysis can be helpful for effective data reviews. 

Saturday, October 23, 2021

Group dynamics - Madness or Wisdom of Crowds

"Madness is rare in the individual - but with groups, parties, people and ages it is the rule" - Friedrich Nietzsche 

Group madness may seem to be everywhere, yet there are two interesting strains of group psychology research at odds with each which should give investors pause. Groups dynamics can have two sides, a positive and negative; the delusion and wisdom of crowds.  

One research direction shows the value of crowd thinking. There is wisdom in crowds. The aggregate opinion of the group is better than the opinion of the individual. The average of the group through blending of diverse views can outperform the opinion of an individual. 

The other group research or view focuses on the delusion or madness of crowds. The rationality of the individual is lost in the anonymity of the group. Group dynamics will reinforce common views and lead to extremes. Bubbles are the result of crowd extremes and not the behavior of individuals. Although the crowd may just be individuals thinking the same, the group dynamics can reinforce common beliefs. In the group, there is a loss of responsibility that causes extreme behavior.

Upon looking at crowd psychology, I can say that this is an area that needs more research. The narrative of crowd irrationality has been longstanding, yet theories that can explain crowd dynamics are conflicting and have not tested well. It is not easy to run a crowd experiment and observation alone may not be convincing. The wisdom from crowds and aggregating diverse opinions is compelling and has intuitive appeal but needs some strict assumptions which limits its universal appeal. 

The simple view for investors - average diverse opinions, you will get closer to the truth; avoid crowd dynamics, exuberance is likely to be reversed.

Tuesday, October 19, 2021

Forget the headline inflation focus on the core and median - Look what happened

The premise of transitory inflation is that headline inflation numbers are driven by some outliers that are associated with logistical failures and congestion. Once the economy is back up and moving from the pandemic these relative price outliers will dampen and inflation will settle at a number that may be above 2% but not unreasonable. Allowing these fluctuations are the foundation of Flexible Average Inflation Targeting (FAIT) or Temporary Price Level Targeting (TPLT). While the headline may move around, investors should focus on the core or the median inflation. These will be more stable and representative of the true inflation.

We got the latest median CPI as measured by the Cleveland Fed, and it has now printed a level that is the highest since the 1980's. This is not supposed to happen. This is not in the Fed playbook, yet this is the reality. The response has been quick by investors. The expectations of a rate rise have been moved forward. The expectations of tapering sooner have also moved forward. Rebalancing away from inflation sensitive assets has increased. The world has changed since the summer.  

Deposits up and loans down - Is this a healthy bank environment?

C&I loans at banks are only 3% higher than before the pandemic and have fallen 20% from the peak levels in the second quarter of 2020. Banks are flush with deposits from Fed QE purchases, yet the money is not going to new loans. Banks can hold the excess reserves and get paid low rate, or they can hold longer-term Treasuries. They can also package loans and securitize them. Loans do not seem to be a high priority given the environment. 

The deposits at commercial banks have exploded and continue to grow. Deposits up and loans down; what does this tell us about bank lending health?

The commercial and industrial loans are likely a better indicator of smaller business that do not have access to capital markets. We have argued that we are in a supply-shocked environment, but these numbers suggest that business and banks do not see a bright future for profits and growth. Banks don't like the loan prospects and business are either not borrowing or getting the credit they need. This is a downside risk.

Not your 70's stagflation - Just slow growth and higher inflation

There is no need to make comparisons with the 1970's. The current environment is not like that period of stagflation. However, there are lessons to be learned so there is no repeat.

The employment numbers are good, there are plenty of job openings, and quit rates are abnormally high. The issue is that growth, after a strong rebound, looks to be lower than expected. The long-term growth rate in the US is expected to be slightly above 2%. We are following that path plus the residuals associated with congestion and COVID restrictions. The net forward effect is something lower than 2%. The Atlanta Fed is nowcasting an estimate between 1-2% which is half the forecast from the Blue Chip consensus. 

Global growth is trending to longer-term averages and China is showing a surprisingly low third quarter estimate based on property development issues and energy shortages.

The inflation environment is higher than expected and some policymakers are responding that this is a "high-class" problem that we should be thankful for. There is no problem here given it is transitory and perhaps necessary. An overreaction to a supply shock problem is wrong; however, there is a demand component that can be better managed with guidance and action.

Can the situation worser? Right now, the risks are on downside: an energy crisis, COVID slowdown, reduced monetary liquidity, lower fiscal policy, and a congestion logistical shock. What this economic environment has in common with the 70's is a shorter-term supply shocked world (not demand right now) with potential for policy mistakes.

Overall, the risky asset markets will need to correct and fixed income will recalibrate to higher higher nominal rates. This is a not a good environment for a classic passive 60/40ish portfolio.

Sunday, October 17, 2021

Decision-making - Do you change behavior based on social setting?

Most investment managers are taught to act as if their clients are in the room when decisions are being made. It should make managers feel more like fiduciaries. Yet, there is an interesting question of whether economic actors will change their behavior if they are being observed or perceived they are being observed. In a simple case, does social setting change behavior; working together, observing others, or being observed.

This question is based on the Hawthorne effect from early industrial analysis of factory workers. It was noted that workers became more productive when they thought they were being watched. Behavior changes when being observed. The newer research on this effect is mixed, but it is an important question especially when focused on risk taking with investments.

This is an issue for decision making when there is more transparency or a social setting with the decisions. Research in Judgment and Decision  Making, "Observing others' behavior and risk taking in decisions from experience" suggests that when working on a task with a pair versus alone, there will be more choosing of risky selections. Social pressure will lead to greater risk taking. This is especially the case if there are rare-loss conditions. Social conformity and greater risk taking is stronger when the risk is less likely.

Extending the research, the paper found that when someone is said to be watched, the greater risk-taking effect is not present, but the decision-maker will make riskier selections when watching the behavior of others. So, there is a Hawthorne effect, albeit mixed.

Social setting for decisions matter. You will not get this social effect with systematic investing. I think this is an issue that should be further explored. Does the group lead to greater risk-taking or are extremes tempered? This initial work says that you should beware of social dynamics. People change when not working alone and the bias is toward more risk taking.

Latest facts on uncovered interest rate parity premium (forward bias)

A useful working paper has provided an extensive summary and new facts concerning the risk premium (forward bias) associated with uncovered interest rate parity. The working paper "Five Facts About the UIP Premium" provides new insights on issues that have been plaguing currency markets for decades. This is a long piece, so we have provided a summary table for the key conclusions. 

The key take-aways are twofold: one, do not treat developed markets the same way as emerging markets, their UIP behaviors are different; and two, the risk premia are associated with VIX and country risks that should be included in any measure of UIP. These issues have been discussed in other papers, but the authors proved a unified analysis that addressed the key drivers of UIP.

Saturday, October 16, 2021

John Kenneth Galbraith and the "bezzle" - It is a global issue

"At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks."

 from - The Great Crash of 1929 by John Kenneth Galbraith

Galbraith idea of the bezzle is often quoted but has never really been internalized by investors. Galbraith wrote about the concept of hidden embezzlement in 1961, yet we still seem to suffer from the same problems of ignoring the bezzle during good times. We can think of Chinese property developers as the current poster child for "mismanagement". These property development house of cards did not just arise in 2021. There may not be direct embezzlement rather there has been an attempt to leverage deals for the gain of a few with risk placed on the many through creative ambiquity.

There was no sudden shock to the system although the pandemic started to cause China growth adjustments that we are still just beginning to feel. Some of problem comes from new China redline policies, yet again this is a shock that is impacting an economic stricture already overextended.  

If the bezzle is large in China, you should believe it is also large in some tech sectors and other overvalued equity markets. The search for embezzlement should be redoubled as a clear way to protect wealth in the current market. Deals too good to be true should be avoided regardless of the great investment narrative.

Friday, October 15, 2021

PPI and CPI - The difference is at all time highs

The difference between PPI and CPI has shown a distinctive pattern of rising before recessions only to fall as slack in the economy increases. Supply shocks impact growth. Now we are facing an extreme in the difference between PPI and CPI with levels never reached before over the entire time series. 

The data suggest that CPI will likely stay elevated, and a swift decline will only occur if we have a strong growth slowdown. 

The correlation between PPI and CPI is high but has fallen from high levels earlier as described in "The Wedge of the Century: Understanding a Divergence between CPI and PPI Inflation Measures" by Shang-Jin Wei and Yinxi Xie. The decline is associated with lengthening of global production chains.

Geopolitical risk - Not getting enough attention?

A low value for the BlackRock Geopolitical Risk Index (BGR) suggests that these macro risks are not getting much investor attention. It could be that these risks are just low, or it could be that there is a lack of attention on important global issues. Either way, geopolitics are currently just not important to investors, and that is problematic. 

Geopolitical risks can be isolated to a specific regions or sectors, but more often, it is a common factor that will directly impact market risk. The potential price impact will be stronger if key markets are overvalued. Whether China-US tensions, or new Middle East issues, these will have a common impact that will serve as a valuation catalyst. 

The BGR index has been falling since the change in US administrations, yet the leading geopolitical risks have not changed and policies have not significantly changed. However, perceptions that there is policy clarity in the face of geopolitical risks have fallen. The current ambivalence to geopolitical risks is worrisome and should require action. However, taking risk off the table is never rewarded during the waiting period before a crisis.

Thursday, October 14, 2021

Growth vs Value - Still in a sideways environment


There was a huge divergence between growth and value that took off during the early stage of the pandemic. It was believed that value would improve earlier this year as rates rose. There were stronger value returns earlier in 2021, but the outperformance did not last. 

The S&P growth/index ratio and value/index ratios have been within a 5 percent range. Growth is on the high-end of the range and value is on the low-end of the range. Actual performance for the year is the same across growth, value, and the overall index; however, it should be noted that growth will do better in a higher inflation environment.

Wednesday, October 13, 2021

Corporate bond indices reflecting relative risk

Changes in corporate bond flows will impact any investor looking at global fixed income opportunities. For the first time since 1998, the Asian emerging markets investment grade OAS index has exceeded the US high yield OAS index. The investment grade Asia - US OAS index spread difference is widening. This is the Evergrande, Chinese property developer, effect weighing down the Asian bond markets. As more developers delay payments, this spread will get worse.

Earlier widening last year occurred when US spreads dropped faster than Asian spreads because of Fed policy action. This widening is occurring because of high-risk perception in Asia. US high yield is rising slightly but investment grade has been stable. The essential fixed income question is whether there will be a spill-over to higher quality credits in the US and Europe. There is no fundamental reason to believe this, but contagion can change everything. 

Monday, October 11, 2021

Powell reappointment - It is not the money, it is the regulation

The chances of J. Powell being reappointed as Fed Chairman is a key focus for current monetary policy discussions. It is adding to market uncertainty. President Biden can choose the devil he knows or get someone different who better aligns with his economic vision. Unfortunately, the vision beyond minimizing the cost of debt financing is not clear.

The reappointment discussion is not as clearly focused about rates, inflation, or quantitative tightening, as one would expect but seems to be centered on the role of the Fed as a regulator. The Fed Chairman is supposed to be a better bank and financial markets cop and not just a monetary controller of the macroeconomic environment. The current bank regulation scheme is too complex and beyond the understanding of any average banker, investor, or policy-maker. Some "simple" diagrams show the current regulatory complexity.

It is unclear whether the Fed should be the top bank regulator; however, under the current environment, it has that role. In fact, banks may not be the location of greatest financial risk, so the fed also has responsibility for all significant financial institutions. Does the Fed need to know the workings of the banking system? Absolutely. Does that mean that all bank regulation should be conducted by central bankers? No. Can there be conflict between bank regulation and monetary policy? Yes.

Macro-prudential policies have been a critical area of focus for the Fed as it should be given the impact of crises on the macroeconomy; however, the operational goals and oversight for these macro-prudential policies is unclear. More important than being a bank regulator is having clarity with the scope of its macro-prudential responsibilities.

The reappointment by Fed Chairman Powell should be based on his ability to meet the mandate of full employment and controlled inflation and the protection of financial markets if that is the desire of Congress. There is enough here for discussing whether he has done an effective job without adding the issue of bank regulation. 

Sunday, October 10, 2021

Stagflation - Upside Inflation and Downside Growth


The timeframe for stagflation has never been well-defined, nor is the definition of stagflation well understood. It is more complex than being a shortfall in growth from long-term trend with inflation. It is also more than a productivity shortage.

Yet, as a google trend search topic it is currently quite popular. Most economists would suggest that it is a long-term structural issue that can last a decade; however, our only strong stagflation experience in the US was in the 1970's. Some would point to macro events in the 1940's and 1950's, but the growth and inflation numbers were not near the levels of the 1970's.

We can have short-term stagflation when there is strong inflation upside but strong downside growth risks. There can easily be divergence between growth and inflation. There is no reason that high growth and inflation always have to be positively correlated. 

Of course, there can be supply shocks that contribute to slower growth, but a supply shock is not the same as a general increase in prices. Currently, the global economy is facing two supply shocks, energy and trade congestion. In that sense, we are facing growth constraints and higher prices.  

The US economy is facing a supply shock through trade bottlenecks while demand is still high from loose fiscal and monetary policy; two key conditions for stagflation. It may not be a long-term situation, but it is real and can create policy and investor confusion. It is not clear policy-makers have tools for solving the supply shocks, It is not clear whether investor should react to the immediate dislocation or focus on longer-term expectations. 

The value of history for economics from Charles Kindleberger

“Economics needs history more than history needs economics.” - from Charles Kindleberger’s great work, Manias, Panics, and Crashes

This quote from Charles Kindleberger is one of the more insightful recent comments on economics I have seen. I was rereading Manias, Panics, and Crashes and this line jumped off the page. History is important. It provides context.

Economists generally have a high opinion of their science versus the other social sciences and the liberal arts. It would like to consider itself in the same league as physics. It is not. Economics need historical clarity because it generally cannot run experiments. 

I would say that the best investment analysts are students of history. To understand today needs a deep sense of where we have been and the path to any current situation. Central bankers are slaves to past monetary crises. Consumers are constrained by their past fears. Businesses fight the last strategic battle and usually don't see the threats of the future. Forward expectations are tempered and biased by the past. Yet, a poor understanding of the past leads to the wrong conclusions.

Economics always need to ground theory, tests, and narrative to the time, place, and structures of the past. History looks to make sense of a wide set of events and tries to find commonality and causality. Lessons from the past are wrongly learned through the misinterpretation of history.

Friday, October 8, 2021

New Zealand central bank raises rates 25 bps - A start, but not a constraint on speculation

The New Zealand Reserve bank raised rates 25 bps to a new level of 50 bps this week, the first increase in seven years, yet this action will not change the NZ inflationary picture. Real rates are still just inside negative 3 percent because current inflation is above 3 percent and still rising. Speculation will continue when real rates are so negative.

The move by central banks to normalization has begun around the globe with a push raise nominal rates and limit the real rate extremes. However, given the high inflation in many countries like New Zealand, there is no real change in the monetary liquidity situation. There are no binding constraints on money, so housing bubbles will continue. 

Wednesday, October 6, 2021

Inflation dispersion and skew creates inflation uncertainty that cannot be controlled by Fed

Supply shocks. Demand shocks. Logistics shocks. Pandemic shocks. The big recovery and reflation. You can pick one or several reasons the dispersion of prices in the inflation indices have exploded. Of course, for the mean inflation to be higher, dispersion has to be skewed to the upside. Big changes for small components in the price basket create noise and inflation volatility. It also means that high inflation could just be the skewed adjustments of prices within the selected basket of goods. As the businesses and consumers get their production and buying decisions right, inflation will recede. 

Transitory inflation could be another way of saying that as skewed dispersion closes, inflation will move back to some central tendency slightly above the 2% target. This wishful thinking is less likely if we are living in a logistical congestion nightmare. 

In this product congestion world, the Fed is helpless at controlling current inflation. Of course, this does not let the Fed off the hook as a cause of the problem. The Fed could use its power to slow demand in order to allow supply and logistics to normalize. Given this choice is not at all preferred, the other alternative is just saying the problem will fix itself and hope it goes away. This seems to be the current approach. Given time, logistical issues will be solved, and inflation will normalize. 

"Transitory" inflation, the failure of imprecise language, and unanchored expectations


There are two major inflation themes or questions currently being discussed. 

One, what the heck does transitory mean in terms of forward guidance for investors? The Fed started this discussion and has been unable to stop it. When will inflation come down, and if it mean-reverts, what is the new normal?

Two, do we have any idea of how inflation works in the economy? The Jeremy Rudd Fed paper has exploded in the macro discussion marketplace with the provocative view that no knows how inflation moves through the macro economy and no one know the link between inflation and inflationary expectations. See "Why do we think inflation expectations matter for inflation? (And should we?)". We can add to this issue the introspective work by the ECB that concludes it does not have any skill forecasting inflation. 

These discussions are more that inside ball between macroeconomists. The failure of imprecise language with respect to transitory inflation is creating uncertainty. If there is uncertainty, investors should be paid a premium to hold risky debt instruments. Forward guidance for central banks should be simple. if you cannot be precise in your language, don't say anything. 

If inflation numbers are not grounded in a well-define theory with variables that can tell us something about the future direction of prices, it is hard to understand why investors should again hold risky debt instruments in a rising inflation environment.  

Without beating a drum, if the underlying variables that drive inflation cannot be articulated and if the Fed cannot define transitory for the variable it is responsible for managing, investors should only focus on market opinion driven by dollar votes. Follow the price trend action. The fundamentalists may not like it, but the burden is on them to give a good reason why this should not be the rational choice.

Monday, October 4, 2021

Alternative Risk Premia (ARP) timing - Use macro factors for your advantage

Alternative style risk premia exist across all asset classes, equities, fixed income, currency, and commodities. The ARP returns are highly variable but generally positive. The correlations across these ARPs are generally close to zero with only a few showing significant values. It has been found that macro factors can be explain the variation in the times series of the risk premia. 

In a practical paper on the link between macro variables and ARPs, "Time-varying Factor Allocations", the authors show that tilting exposures based on signals from macro predictors can add significant value to any ARP portfolio. These macro predictors include business cycle indicators, inflation, and short-term rates. Carry, value, and momentum styles are all sensitive to macro predictors.

The tilting strategies using different macro variable generate significant excess returns relative to a naive basket portfolio.

The predictors that serve to tilt the ARP portfolios show significant value-added relative to a naive strategy.

 Alternative risk premia returns will change with the macro environment. Investors who want to create portfolio improvements can use macro now-casts to adjust their exposures to asset class styles. 

Sunday, October 3, 2021

Inflation expectations and anchoring to actual inflation - Who knows?


Inflation is a global problem. More than have the economies of the world are seeing accelerating inflation. The US is one of the few that has seen some deceleration in the last three months, yet US inflation has been at a higher level than many other countries. Transitory currently does not seem to have strong meaning for economies.

Beyond the transitionary issue, the real focus for many investors is on the expectations of inflation and whether these expectations impact actual inflation. A recurring view is that the Fed should focus on controlling inflation expectations because these expectations are what influence and drive current price behavior. 

A provocative paper from a Fed staff economist, Jeremy Rudd, states that any link between expectations and actual inflation does not have strong support. See "Why do we think inflation expectations matter for inflation? (And should we?)" Rudd argues that what we assume about how inflation dynamics work is questionable and is not the simplest explanation. Any link between inflationary expectation and how people act when setting prices and negotiating wages should not be given as a normal. If we don't know or understand the process of how prices rise, then it will be difficult to control. The Fed cannot give forward guidance on policy and inflation and expect it to be useful if the process for how inflation moves is unclear. 

When we look a current inflation, we can easily draw a conclusion that many prices are set outside any expectations about central bank behavior. Port congestion, energy logistics, health costs, and wage negotiations for many employees are not influenced by expectations embedded in Treasury break-evens, TIPs, or forwards. We still don't know a lot about the inflation process.

Macro uncertainty and an energy shock generates a September correction


September was a bad month for risky assets, so we have seen better bond returns and a flight out of overvalued US equities. The reasons were varied: China Evergrande contagion, COVID cases, and Fed taper issues coupled with a negative energy shock. A close look at the US market shows that the largest declines started after the Fed FOMC meeting which solidified taper action by year-end. 

The good news is that COVID cases are falling, the worst Evergrande fears have not manifested, and the real effects of a Fed taper problem is still in the future. 

The energy shock, however, is front and center around the world and does not seem to have an immediate solution. Energy supply logistics are hard to adjust quickly. An economic recovery only exacerbated the demand for energy which pushed prices higher. The supply side, unfortunately, cannot be solved even with higher prices in the short-run. Inflation may be less transitory, but energy shocks effect the entire global economy. Any energy shock will have weaker real effects than in the past but that does not change the potential drag on real income and the economy when supply is just not available.

The impact of this price correction is still small. Equity prices are still above their 10-month moving average and September, the worst seasonal month by average monthly return from 1964-present and lowest percentage positive returns, has passed. Nevertheless, fiscal and monetary policy uncertainty not just in the US will make for a difficult environment for risky assets.

postive flows inot stocks and bonds as mesured by ETFs