Thursday, September 29, 2022

Conference Board LEI flashing red - A strong macro indicator

I am a close follower of the leading economic indicator indices. If the index turns down, there should be a concern. If it turns negative, there is a warning, and if it falls below 5% there is a recession signal. The Conference Board uses the 6-month growth rate annualized at its recession indicator. A faster or slower model will give similar results. 

For investors, the key is not the recession signal but the warning. It is the warning that causes a market return adjustment. Regardless of the Fed policy, the LEI, which incorporates a credit index, gives a good growth picture both for the US and other countries. Follow the LEI and you will have a good macro market indicator.


Wednesday, September 28, 2022

Fixed income "volatility vortex" - Can this macro-prudential risk continue?

Bond markets moved to extremes with yields touching for the 10-year only to see a 15-bps reversal in a day. Treasury futures were oversold and the BOE intervention in the gilts markets gave the market a reason to cut risk positions. With inflation numbers coming out at the end of the week, bond traders may want to square risk given an inflation surprise could see traders wrong-footed. Nevertheless, the overall conditions for the Treasury market are near crisis levels.

1. Market volatility is at crisis levels. The MOVE index is at the same levels as March 2020 and just below the 2008 crisis.
2. Treasury liquidity, as measured by yield error, is just below March 2020 levels and way above levels for a safe asset.
3. Fixed income performance is nothing like a safe asset. This is the worst year-to-date performance recorded for the Global Aggregate index, and there is little reason to expect a rally.
4. The drawdowns across different maturity spectrum are the worst recorded. For example, the 10-year Treasury drawdown is beyond 20% and the 30-year drawdown is closing in on 40%. 

Call this the end of the long-term bond rally and the era of repriced bond risk. The question is whether the Fed will hold its resolve in the face of macro-prudential risks within the Treasury markets.


Sunday, September 25, 2022

Equity risk factors - The volatility regime may dominate the business cycle environment


Equity risk factors are sensitive to changes in the business cycle, yet beyond the business cycle are regimes based on volatility. These longer-term regimes not only influence return but may dominate the impact of the business cycle. See "Do factors carry information about the economic cycle? Part 2: New thinking: Rebooting the investment clock for the new normal and QE regime".

The researchers find the US economy can be classified as either high, moderate, or low volatility. The high volatility period was 1970 though 1982 period which includes the Great Inflation and the high interest rates of the early 1980's. The moderate inflation and growth period has been described as the Great Moderation and Goldilocks period. The low volatility environment includes the QE and new normal period through the pandemic. 

The investment clock defined by the business cycle will have a different framework based on boom and bust with high, moderate, and low economic cycle volatility.

The economic cycle or regime is based on three levels of volatility and make for a different conditional environment. Value and momentum do well in high volatility while the market risk factor will do well in the low volatility environment. 

Investors should not only focus on business cycle dynamics, but also have an idea of the overall economic environment or regime. Currently, we are moving out of the low volatility regime and are entering the high volatility environment with greater real economic risks and higher inflation. This economic volatility regime may dominate the business cycle. 

Equity factor risks and the business cycle - Changing dynamics offer opportunities


Equity risk factors are tied to the business cycle. Condition on where we are in the business cycle and returns will be markedly different. The researchers at FTSE Russell show this relationship in "Do factors carry information about the economic cycle Part 1: The Investment Clock: Linking factor behavior to the economic cycle"  They start their analysis by breaking up the economic environment into four phases that represent the business cycle: expansion, slowdown, contraction, and recovery. These can be identified through using a measure of inflation against a long-term average and growth through the ISM survey.

Equity risk factors do not all act the same, and each will perform differently over the business cycle. Quality will do well during the peak of the business cycle and into contractions. When the market hits a trough, value, size, and momentum will perform better. Size and momentum will do well during an expansion. This information provides investor valuable information on market headwinds and tailwinds associated with the business cycle.

Some equity risk factors provide information on future economic growth. Size and value have a strong positive relationship with economic growth while momentum has a negative relationship.

The gain from making equity risk factor adjustments conditional on the business cycle can be substantial. The market risk will perform the bets across the full business cycle; however, switching will offer upside and protection especially during slowdowns and contractions. 

Saturday, September 24, 2022

EM risk and points of inflection from a Fed rate rise


We classify current EM risks as points of inflection; the issues that should be closely watched and exacerbated by a hawkish Fed.

1. China is the big elephant in the room when discussing EM. It is hard to even classify China as EM given its size; however, country classification is a different question. The global economy needs a growth driver - a large economy or group that will lift other countries. US monetary policy is working in the opposite direction. The same can be said for the EU, so the focus is on China which has not tightened monetary policy and is attempting to boost growth; however, with a major real estate problem and rolling lockdowns, China has little ability to drive the world economy. In fact, CNY is closing in on 5-year lows.

2. The oil shock has sent massive capital flows to the Middle East. Oil exporters are in a great economic shape, but it is less clear that this money will be reversed into global investments that boost other parts of the world. Oil prices have pushed through $80 per barrel, so the oil flow excesses are slowing. 

3. Current account deficits are not as large as past recession periods, and foreign currency reserve coverage is greater for most countries. This minimizes crisis risk, but there are still some countries that will be crisis hotspots even in the EU. 

4. EM bond spreads have widened already and have some distance from US high yield, so there is less risk of a future EM bond shock. However, there is still room for EM HY yields to reach double digit levels.

5. Geopolitical risk both in Eastern Europe and Asia is still high. Lengthened hostilities in Ukraine are more likely to lead to extreme action to break any deadlock. The spillover effect across Europe is high. The China-Taiwan issues have simmered, but there is still high risk which will spillover the surrounding countries. 

6. The Brazil general election on October 2 and the Presidential runoff on October 30 has cast a shadow over the largest economy in Latin America and the president will impact the investment climate. The shift in politics across the continent places downward pressure across capital markets. 

7. The overall decline in international trade places downward on many of the economies that have depended on globalization. While EM domestic growth has surged, economies are still dependent on G7 growth.

Friday, September 23, 2022

EM risk from Fed tightening - Is this time different? Yes, but ....


The hawkish Fed policy is bad for EM financial markets, but there has not been an EM financial crisis for some time. EM markets are in much better shape than in the 1990's, yet that does not mean they will be immune to a significant rate shock especially if the purpose of the rate rise is to cut aggregate demand. There may be opportunities with holding EMB bonds, but we may not be there yet as the market reprices global interest rate risk. See "Emerging Markets and the Hiking Cycle: This Time, Really, May be Different" for this more optimistic perspective. 

The EM equity and bond indices have changed significantly over the last 20 years. The EM bond benchmark is much more diversified with less exposure to Latin America where past crises have been centered.  The MSCI EM equity index has moved to greater concentration in Asia, but these countries have stronger foreign reserves to protect form any currency crisis. The sector allocations have also changed over the last 20 years. EM is less dependent on energy and materials and more diversified across consumer companies and IT. This does not mean less sensitivity to a global slowdown. It does mean the points of risk are different.

Gross public debt has increased, but the growth has come from domestic public debt and not external public debt. FX reserves as percentage of GDP have increased significantly and are almost double levels from 2001. Greater reserves provide countries greater protection for their currencies if there is a crisis. 

We are worried about EM exposures. Fed rate increases have a spillover across global financial markets; however, EM financial markets may be more resilient than the environment of the 1990's.

Kruglanski - the need for closure and decision-making - Important for trading


If Col Jessup from "A Few Good Men" opined on uncertainty, he would say most investors cannot handle uncertainty. Investors may say they can deal with uncertainty and risk, but they often avoid engaging with the messiness associated with uncertain environments and decision-making. We know this from extensive analysis of people's need for closure. Most like finality and not decisions or actions that are open-ended. Trading decisions are open-ended because with each mark-to-market there is another decision. Each new piece of information requires another decision, hold or fold. In an uncertain world, many will avoid action and wait. Waiting can be the appropriate action but taken to access it will be costly.

The desire for closure has a significant impact on decision-making. This desire can be another explanation for behavioral biases. Someone who needs or wants closure will look at decision-making differently from those who are comfortable with uncertainty. A person who wants closure will likely suffer from regret and may hold losers over winners. A person who wants closure will likely make decisions based on recent information and will not look for more data. Those who embrace uncertainty will be willing to be more open-ended in their use of information. Closure sensitivity will also impact whether someone is willing to change their mind and adjust their decision.

Arie Kruglanski, a well-known psychologist, has extensively studied the problem and has created questionnaires to measure the degree of closure that we may desire. See the Need for closure scale (NFCS). If applied to traders, we can determine whether an individual can be overly sensitive to uncertainty. Those who desire a high degree of order will not do well when markets are volatile or less orderly. 

The use of rules for investment decisions is an attempt to gain closure. Once a set rule is hit, action is taken, and the decision is closed until the next rule is triggered. Just because someone wants closure does not mean he will be a bad investors and someone who is open-ended will not always be a good trader. The important point is that each of us has a different sensitivity to closure and we should account for this sensitivity with our decision-making. Someone who is very closure sensitive should stop and determine whether he is being too hasty with action. Someone who is open-ended should ask whether he has enough information to act as opposed to waiting for more information. 

Determine your sensitivity to closure and adjust your decision-making to account for any bias. You will be a better investor from this process. 

Thursday, September 22, 2022

The hawkish Fed - Nothing good for emerging markets

The Fed's hawkish policies of raising rates will have more than just an impact on the US economy it will impact emerging markets. We have already seen a significant divergence between EM and US equities as measured by the difference between SPY and EEM. There has historically been a strong negative link between increases in the Fed Funds rate and EM, but it looks as though this relationship has not been as strong over the last two decades. Work from the Fed shows there is a reason for this difference in sensitivity. See "Are Rising U.S. Interest Rates Destabilizing for Emerging Market Economies?".

The analysis shows that there is a difference in the EM response based the reason for the rate rise. If rates are increasing because there is higher economic growth, there will be limited impact on EM. On the other hand, if the rate increase is caused by a hawkish Fed policy to combat inflation, there will be a strong negative impact. 

Growth news is different than monetary news. Growth news occurs when SPX index returns and 10-year Treasury yields move in the same direction after a FOMC or employment announcement. The FOMC announcement or employment data conveys monetary news if equity returns and Treasury yields move in opposite directions. Based on this classification, it can be determined what will be the reaction in EM through looking at panel data for a large set of EM countries.

If the Fed is trying to cut aggregate demand, there will be a spillover effect to other countries. This current environment is more like the early 1980's than anything seen in the last two decades. While the test is over short horizons, it provides investors some insight on what to expect around the globe. This time will not be good for EM investors. 


FOMC announcements and left-tail uncertainty - The real issue


There is a high uncertainty surrounding FOMC announcements.  Upon the announcement the uncertainty is resolved. There has been found a risk premium associated with the period prior to announcement. See our post "FOMC Risk and Resolving Uncertainty"

Additional research has further decomposed the risk prior to FOMC announcements and finds that there is a sizable left-tail premium that is unique to FOMC announcements and is not found in other macro announcements. See "Fed Tails: FOMC Announcements and Stock Market Uncertainty" This left-tail uncertainty predicts rate decisions and is a concern with FOMC members. Researchers suggest that this premium is attributed to supply shocks in the crash insurance market.

Investors worry about downside risk from an FOMC announcement and will go to the options market to buy protection. This protection cost is then embedded in prices and is be displayed in premiums. The size of the premium is related to whether there is expected a positive or negative announcement shock. 

Investors should be able to see the market premium tilt and determine the expected FOMC action. When faced with downside risk from monetary uncertainty, investors will seek protection which disrupts prices prior to the announcement. Someone must take the other side of crash insurance. Watch option behavior and you can measure investor downside fear.  

CTAs - Performance and replicating signals - Trend identification works

A recent strategy paper from a large bank quant group focuses on the benefit from holding CTAs in a portfolio and the signal generation from CTAs. Diversification is enhanced and drawdowns are reduced when CTAs are added to an equity portfolio and to a lesser extent fixed income portfolios. CTAs show consistent long-term performance albeit there will be periods of negative return. Of course, this work does not make the key distinction between CTAs and trend-followers. Trend-followers are CTAs, but CTAs are not always trend-followers. Nevertheless, the research further documents the value of trend-following when added to a portfolio.

These conclusions are well-known and reinforce the value-added from CTAs; however, this is not the main purpose of this research. This quant group attempts to engineer CTA signals in order to help investors better manage asset class exposures. Take what CTAs do and convert the strategy into signals on flow and crowdedness so that investors can use these signals without investing directly into a CTA. 

The quants suggest that these signals provide a better tool for investors that trying to determine CTA positioning from commitment of traders reports as generated by the CTFC or making the direct investment. Follow CTA signals and you may get the best of both worlds, signals that enhance returns and offer diversification. 

This type of signaling research can be useful, but the analysis presented will generate reader confusion. First, the research does not define terms correctly. Trend and momentum are not the same, and this research does not focus on this difference. Second, the presentation of signal development is not clear; consequently, the quality of the signal is suspect. Trend followers may be similar, but there are large differences in the look-back period and processing of data. Without clarity on trend identification, the signal does not tell us clearly what is being modeled. Third, the signals are structured to replicate the thinking of trend-followers and not find the best trend signal for markets. The signals are a combination of exponentially weighted moving averages adjusted by market volatility and converted in signals between 1 and -1 while accounting for liquidity and portfolio volatility. They then assume that these signals represent the trading positions of CTAs.

Nevertheless, we can learn from this work. Trend signals have forecasting power and do not serve as just indications of flow from CTA strategies. Second, trend signals are noisy indicators of crowdedness just like the commitment of traders information. Strong identified trends like large trader commitments do not reverse but show continuity. We cannot make judgments on reversals. 

The bank quant group spends significant time linking CTAs (trend-followers) with their CTA trend identification model when what they are just doing is providing trend signals that can allow investors to replicate the behavior of trend-followers. All they had to do was say that they generated a good trend signal model that is similar to a classic trend-following manager. 

Wednesday, September 21, 2022

FOMC risk and resolving uncertainty


FOMC days haver high uncertainty. We saw that yesterday. There is the unknown of what the Fed will do and say, and it becomes the focus of market attention and expectations. On these days, uncertainty is also resolved at the announcement. We may not have known what the rate increase will be with certainty, but the announcement solves this unknown. We also obtain clarification quarterly on Fed forecasts through the SEP and dot-plots. Risk is repriced on these key calendar dates.

Research has found that prior to the announcement from the FOMC, the stock market will yield higher returns without an increase in normal measures of risk. While this has been viewed as a puzzle, recent research suggests that this is excess return before announcement is associate with the resolution of uncertainty. The same behavior to a lesser extent occurs with other macro announcements and after high spikes in the VIX index. see "Premium for Heightened Uncertainty: Solving the FOMC Puzzle".

The important point is that high uncertainty exists around macro release days especially FOMC dates. Uncertainty is resolved and there is a premium with holding risky assets before the announcement. Everyone must be a macro trader around these important periods; however, holding risk is rewarded as uncertainty is resolved. Once again uncertainty is resolved and now, we have information on how to reprice assets.

Tuesday, September 20, 2022

Global tightening increases the odds of global recession

The Global Monetary Policy Tracker from the Council of Foreign Relation and Benn Steil tells the current story of global monetary tightening. We must go back to 2006-07 to see the same level of central bank tightening and we know what happened less than 2 years later.

While the focus is often on the Fed, other central banks are also fighting inflation through raising rates. Central banks also have to respond to the Fed's action as US inflation is exported to the rest of the world through currency markets. A stronger dollar from higher relative interest rates means that foreign countries must import goods at higher prices or raise their rates to stabilize currencies.

The coordinated reduction in rates from the pandemic shock is now being reversed even with a backdrop of an energy shock. The actions of 2020 which created global inflation is now being reversed regardless of the impact on local or global aggregate demand. Unfortunately, the rate shock will not fully impact the real economy until 2023. At that time, the global economy will not be in a slowdown but in a full recession. 

In this correlated but uncoordinated monetary world, rates around the global may move too high as countries try and keep up with their neighbor's monetary policy. A global monetary summit may help to address some of these issues, but it requires a new global monetary order based on mutual support and policy actions. It is not clear that this can be achieved in the current environment. Right now, central banks are behind the curve and fell forced to act with singular focus on inflation not global growth, trade, and common monetary policy.


Gold - No inflation support for investors

Hold gold in case there is inflation. Hold gold in case there is a geopolitical shock or uncertainty. Hold gold if there is an inflation surprise. Hold gold if there are negative real interest rates. Take your pick, but none have applied to the gold market over the last year. We are in a gold bear market from the highs in 2020. 

There is an almost 20% decline since the highs in 2022 after the initial invasion of Ukraine. There is no fear embedded in the price. If you looked at the gold chart without any other knowledge, you would think inflation is low and falling, real rates are positive, and there is not a lot of geopolitical risk. You cannot even say that gold was just a flat investment that protected principal. 

Of course, looking at the price of gold in other currencies may paint a different picture. The drawdowns for GBP and EUR are less than the bear market in dollars. The price of gold in Yen is much higher but the price is still off highs. Investor must focus on alternative ways to diversify and stay away from this precious metal.

Monday, September 12, 2022

The permanent scaring of the energy crisis - a need for rethinking energy policies

The industrial revolution was based on cheap energy both from a sourcing perspective and from the technology. There is the energy input and the efficient conversion into power. The industrial revolution was explosive in those areas that cheap energy. As time passed, a critical part of the economy was the logistics associated with the transportation and delivery of cheap energy. It was cheap because the delivery and logistics were cheap and efficient.  Plastics, autos, materials, and chemicals, to name just a few, were all driven by cheap energy.  

When the foundation of cheap energy is altered, the result is an economic slowdown. It can be investment or geopolitical. It does not matter. Cheap and uninterrupted is disrupted. The real operating leverage of an economy is driven by energy even more so than credit. 

The Russian energy disruption is a permanent scar on the developed world, especially Europe. The cheap and uninterrupted power is moving to other parts of the world which is altering the center of gravity for economic production and power. Given the importance of energy for living standards, the geopolitics of energy logistics have to be addressed. This is a country policy issue and not a corporate policy. Energy policy is fundamental for providing a standard of living.

The Green revolution cannot occur if the current system cannot provide uninterrupted power. The efficiency of wind and solar is lower and there is the issue of production fluctuations. This may be solved but not currently. 

Standards of living and the focus of production are being altered beyond just a high-priced cold winter. Energy policies must be rethought, and new solutions must be proposed. The current system is broken, and the Russian cut-off just serves as a signal. Transitions and adjustments of complex systems are never easy.