The Most Crowded Trade
Wise investors hate crowded trades. Good, high-alpha trades tend to be out-of-consensus and uncomfortable. Bad trades tend to be ones that everyone wants to talk about at the cocktail party. Think “Internet bubble.” That doesn’t mean that you can’t make money going along with a consensus trade, at least for a while; what it means is that exiting from a consensus trade can be very difficult if you wait too long, because you have a bunch of people wanting to go the same direction as you.
So what is the most crowded trade? In my mind, it has got to be the bet that inflation will remain low and stable for the foreseeable future.
This is a very crowded trade almost by default. If you want to be long momentum stocks and short value stocks, and no one else is doing it, then it can get crowded but this takes some time to happen. Other investors must elect to put on the factor risk the same way as you do.
But the inflation trade doesn’t work that way. When you are born, you are not born with equity risk. But you are born with inflation exposure. Virtually everyone has inflation risk naturally, unless they actively work to reduce their inflation exposure. So, from the day of your birth, you have a default bet on against inflation. If there is no inflation, you’ll do better than if there is inflation.
It’s a consequence of living in a nominal world. And the popularity of this bet at the moment is a consequence of having “won” that bet for more than three decades. Think for a minute. When you find someone who thinks that inflation is headed higher – and let’s cull from our sample all the nut-jobs who think hyperinflation is imminent – what is “higher” to them? When I tell people that our forecast is for 3% median inflation by year-end, they look at me like I’m from Mars, like three percent is so unfathomably exotic that they can’t imagine it. Because, for the most part, they can’t.
This month marks a full twenty years since the last time that year/year core inflation exceeded 3%. Sophomores in college right now have never seen 3% core inflation. (Median inflation has gotten somewhat higher, up to 3.34% in 2007, but hasn’t been higher than that since 1992). So truly, for many US investors 3% inflation is exotic, and 4% inflation is virtually hyperinflation as far as they are concerned.
So this is a very crowded trade. And this crowded trade is expressed in numerous ways:
- Bonds of course do very poorly in inflationary outcomes. Floating rate bonds do slightly better. Inflation-linked bonds do the best. And inflation-linked bonds, while richer now than they were, are still vastly preferable to nominal bonds in a real risk sense and still quite cheap in an expected-return sense.
- Equities do poorly in inflationary times. While earnings tend to keep up with inflation, the P/E multiple is usually at a maximum when inflation is between 1% and 2% and tends to decline – severely – when inflation moves out of the butter zone.
- While Social Security has a cost-of-living adjustment, very few private pensions do. Some annuities have “inflation adjustment” features, but with very few exceptions these are fixed escalators and not sensitive to inflation at all. There really aren’t any inflation-linked annuities to speak of.
- What about the structure of our workforce? Unions tend to be stronger in inflationary periods because it is during these times that their power (as monopolists in the local labor market) to keep wages moving up with the cost of living is deemed more valuable by potential union members. The chart below is from a presentation I made several years ago.
There are many other examples; most of the ways we express this trade are unconscious since we are so accustomed to living with low inflation that we don’t give our default choice – to face down the possibility of inflation while hedgeless – a second thought. This is, without a doubt, the most crowded trade. And why should investors care? Investors should care for the same reason you want to avoid all crowded trades: when it is time to exit the trade – which in this case means buying commodities, buying inflation-linked bonds, buying other real assets, selling nominal bonds and equities, pressuring futures markets to offer hedging tools (such as CPI futures), borrowing at low fixed rates for long tenors, and so on – investors may find that it is very hard to do at levels they once considered a God-given right. Or in the sizes they want.
Some readers may note that this is the “Most Crowded Trade,” while I just wrote a book about the “Biggest Bubble of All.” Why don’t I just call the “inflation stability trade” the “biggest bubble?” The difference is in emphasis. A crowded trade can be crowded even if it isn’t a bubble (although a bubble also tends to be crowded), and it is no less problematic for not being a bubble. The fact that it is a crowded trade just means that the door to escape is smaller than the crowd that may need to pass through it. In this case, the crowd consists of almost everyone on the planet, aside from the tiny cadre of people who have hedged to some meaningful degree. But it is possible that the trade never has a forced-unwind, a panicky run for the exits. It is possible, although I deem it unlikely, that inflation may stay low and stable forever. And, if it does, then the crowded nature of the trade is no issue. But the trade is indeed crowded.
In the 1970s, investors could be forgiven for not hedging their natural “I was born this way” inflation exposure. There weren’t many ways to do so. One could buy gold, but when the client asked what else the investment manager had done to immunize their outcomes against inflation he could shrug and say “what else could I do?” But this isn’t the case any longer. Investors who want to hedge explicitly against the risk they have implicitly been betting on all along have many options to do so. And, in a low-return world, they don’t even have to give up much in the way of opportunity cost to do so. For now.
So if the crowded trade unwinds…what will managers tell their clients this time?