So much has happened since the Presidential election – and almost none of it very obvious.
The plunge in equities on Donald Trump’s victory was foreseeable. The bounce was also foreseeable. The fact that the bounce completely reversed the selloff and took the market to within a whisker of new all-time highs was not, in my mind, an easy prediction. I understand that Mr. Trump intends to lower corporate tax rates (and he should, since it is human beings – owners, customers, and employees – that end up paying those taxes; taxing a company is just a way to hide the fact that more taxes are being layered on those human beings). And I understand that lowering the corporate tax rate, if it happens, is generally positive for corporate entities and the people who own them. I’m even willing to concede that, since Mr. Trump is – no matter what his faults – certainly more capitalism-friendly than his opponent, his election might be generally positive for equity values.
But the problem is that equities are already, to put it generously, “fully valued” for very good outcomes with Shiller multiples that are near the highest ever recorded.
I think that investors tend to misunderstand the role that valuation plays when investing in public equities. Consider what has happened to the economy over the last eight years under President Obama: if you had known in 2008 that growth would be anemic, debt would balloon, government regulation would increase dramatically, taxes would increase, and a new universal medical entitlement would be lashed to the backs of the American taxpayer/consumer/investor, would you have invested heavily in equities? Yet all stocks did was triple. The reason they did so was that they started from fairly low multiples and went to extremely high multiples. This was not unrelated to the fact that the Fed took trillions of dollars of safe securities out of the market, forcing investors (through the “Portfolio Balance Channel”) into risky securities. By analogy, might stocks decline over the next four years even if the business climate is more agreeable? You betcha – and, starting from these levels, that’s not terribly unlikely.
I am less surprised with the selloff in global bond markets, and not really surprised much at all with the rally in inflation breakevens. As I’ve said for a long time, fixed-income is so horribly mispriced that you should only hold bonds if you must hold bonds, and then you should only hold TIPS given how cheap they were. Because of their sharp outperformance, 10-year TIPS are now only about 40-50bps cheap compared to nominal bonds (as opposed to 110 or so earlier this year), and so it’s a much closer call. They are not relatively as cheap as they were, but they are absolutely less expensive as real rates have risen. 10-year real rates at 0.37% aren’t anything to write home about, but that is the highest yield since March.
Some analysis I have seen attributes the large increase in market-based measures of inflation expectations on Mr. Trump’s victory. For example, 10-year breakevens have risen 20bps, from about 1.70% to about 1.90%, since Mr. Trump sealed the win (see chart, source Bloomberg).
I think we have to be careful about blaming/crediting Mr. Trump for everything. While breakevens rose in the aftermath of the election, you can see that they were rising steadily before the election as well, when everyone thought Hillary Clinton was a sure thing. Moreover, breakevens didn’t just rise in the US, but globally. That’s a very strange reaction if it is simply due to the victory of one political party in the US over another. It is not unreasonable to think that some rise in global inflation might happen, if Trump is bad for global trade…but that’s a pretty big reach, and something that wouldn’t happen for some time in any event.
In my view, the rise in global inflation markets is easy to explain without resorting to Trump. As the previous chart illustrates, it has been happening for a while already. And it has been happening because global inflation itself is rising (although a lot of that at the moment is optics, since the prior collapse of energy prices is starting to fall out of the year-over-year figures).
The bond market and the inflation market are acting, actually, like the Great Unwind was kicked off by the election of Donald Trump. We all know what the Great Unwind is, right? It’s when the imbalances created and nurtured by global central banks and fiscal authorities over the last couple of decades – but especially in the last eight years – are unwound and conditions return to normal. But if pushing those imbalances had a soothing, narcotic effect on markets, we all suspect that removing them will be the opposite. Higher rates and inflation and more volatility are the obvious outcomes.
Equity investors don’t seem to fear the Great Unwind, even though stock multiples are one of the clearest beneficiaries of government largesse over the last eight years. As mentioned above, I can see the argument for better business conditions, even though margins are still very wide. But I’m skeptical that better business conditions can overcome the headwinds posed by higher rates and inflation. Still, that’s what equity investors are believing at the moment.
A couple of administrative announcements about upcoming (free!) webinars:
On Thursday, November 17th (aka CPI Day), I will be doing a live webinar at 9:00ET talking about the CPI report and putting it in context. You can register for that webinar, and the ensuing Q&A session, here. After the presentation, a recording will be available on TalkMarkets.
On consecutive Mondays spanning November 28, December 5, and December 12, at 11:00ET, I will be doing a series of one-hour educational seminars on inflation. The first is “How Inflation Works;” the second is “Inflation and Asset Classes;” and the third is “Inflation-aware Investing.” These webinars will also have live Q&A. After each session, a recording will be available on Investing.com.
Each of these webinars is financially sponsored by Enduring Investments.
As the evening developed, and it began to dawn on Americans – and the world – that Donald Trump might actually win, markets plunged. The S&P was down 100 points before midnight; the dollar index was off 2%. Gold rose about $70; 10-year yields rose 15bps. Nothing about that was surprising. Lots of people predicted that if Trump somehow won, markets would gyrate and move in something close to this way. If Clinton won, the ‘status quo’ election would mean much calmer markets.
So, we got the upset. Despite the hyperbole, it was hardly a “stunning” upset. Going into yesterday, the “No Toss Ups” maps had Trump down about 8 electoral votes. Polls in all of the “battleground” states were within 1-2 points, many with Trump in the lead. Yes, the “road to victory” was narrow, requiring Trump to win Florida, Ohio, North Carolina, and a few other hotly-contested battlegrounds, but no step along that road was a long shot (and it wasn’t like winning 6 coin flips, because these are correlated events). Trump’s victory odds were probably 20%-25% at worst: long odds, but not ridiculous odds. (And I believe the following wind to Trump from the timing of Obamacare letters was underappreciated; I wrote about this effect on October 27th).
And yet, stock markets in the two days prior to the election rose aggressively, pricing in a near-certainty of a Clinton victory. Again, recall that pundits thought that a Clinton victory would see little market reaction, but a violent reaction could obtain if Trump won. Markets, in other words, were offering tremendous odds on an event that was unlikely, but within the realm of possibility. The market was offering nearly-free options. The same thing happened with Brexit: although the vote was close to a coin-flip, the market was offering massive odds on the less-likely event. Here is an important point as well – in both cases, the error bars had to be much wider than normal, because there were dynamics that were not fully understood. Therefore, the “out of the money” outcome was not nearly as far out of the money as it seemed. And yet, the market paid you handsomely to be short markets (or less long) before the Brexit vote. The market paid you handsomely to be short markets (or less long) before yesterday’s election results were reported. And, patting myself on the back, I said so.
This is not a political blog, but an investing blog. And my point here about investing is simple: any competent investor cannot afford to ignore free, or nearly-free, options. Whatever you thought the outcome of the Presidential election was likely to be, it was an investing imperative to lighten up longs (at least) going into the results. If the status-quo happened, you would not have lost much, but if the status quo was upset, you would have gained much. As I’ve been writing recently about inflation breakevens (which was also a hard-to-lose trade, though less dramatic), the tail risks were really underpriced. Investing, like poker, is not about winning every hand. It is about betting correctly when the hand is played.
At this hour, stock markets are bouncing and bond markets are selling off. These next moves are the difficult ones, of course, because now we all have the same information. I suspect stocks will recover some, at least temporarily, because investors will price a Federal Reserve that is less likely to tighten and the knee-jerk response is to buy stocks in that circumstance. But it is interesting that at the moment, while stocks remain lower the bond market gains have completely reversed and are turning into a rout. 10-year inflation breakevens are wider by about 9-10bps, which is a huge move. But there will be lots of gyrations from here. The easy trade was the first one.
 And certainly not “the greatest upset in American political history.” Dewey Defeats Truman, anyone?
So I see today that former Fed Chairman Alan Greenspan says this is the worst crisis he has seen. Bigger than the 1987 Crash? Bigger than Long Term Capital? Bigger than the internet bubble collapse? Bigger than the Lehman (et. al.) collapse? Really?
As humans, we tend to have short memories and (ridiculously) short planning horizons. Greenspan, especially in his apparent dotage, has a shorter memory even than he had previously – maybe this is convenient given his record. I don’t want to comment on his planning horizon as that would seem uncharitable.
Why is Brexit bad? The trade arrangements and treaties do not suddenly become invalid simply because the UK has voted to throw off the shackles of her overlords and return to being governed by the same rules they’ve been governed by basically since the Magna Carta. But Jim Bianco crystallized the issue for me this week. He pointed out that while Brussels could let this be a mostly painless transition, it has every incentive to make it as painful as possible. In Jim’s words, “if it isn’t painful then hands shoot up all over Europe to be the next to leave.” That’s an astute political observation, and I think he’s right. The EU will work hard to punish Britain for having the temerity to demand sovereignty.
But Britain survived the Blitz; they will survive Brexit.
Indeed, Britain will survive longer than the Euro. The sun is beginning to set on that experiment. The first cracks happened a few years ago with Greece, but the implausibility of a union of political and economic interests when the national interests diverge was a problem from the first Maastricht vote. Who is next? Will it be Greece, Spain, Italy, or maybe France where the anti-EU sentiment is higher even than it is in the UK? The only questions now are the timing of the exits (is it months, or years?) and the order of the exits.
As I said, as humans we not only have short memories but short planning horizons. From a horizon of 5 or 10 years, is it going to turn out that Brexit was a total disaster, leading to a drastically different standard of living in the UK? I can’t imagine that is the case – the 2008 crisis has had an effect on lifestyles, but only because of the scale and scope of central bank policy errors. In Iceland, which addressed the imbalances head-on, life recovered surprisingly quickly.
These are all political questions. The financial questions are in some sense more fascinating, and moreover feed our tendency to focus on the short term.
A lot of money was wagered over the last few weeks on what was a 52-48 proposition the whole way. The betting markets were skewed because of assumptions about how undecideds would break, but it was never far from a tossup in actual polling (and now perhaps we will return to taking polling with the grain of salt it is usually served with). Markets are reacting modestly violently today – at this writing, the US stock market is only -2.5% or so, which is hardly a calamity, but bourses in Europe are in considerably worse shape of course – and this should maybe be surprising with a 52-48 outcome. I like to use the Kelly Criterion framework as a useful way to think about how much to tilt investments given a particular set of circumstances.
Kelly says that your bet size should depend on your edge (the chance of winning) and your odds (the payoff, given success or failure). Going into this vote, betting on Remain had a narrow edge (52-48) and awful odds (if Remain won, the payoff was pretty small since it was mostly priced in). Kelly would say this means you should have a very small bet on, if you want to bet that outcome. If you want to bet the Leave outcome, your edge was negative but your odds were much better, so perhaps somewhat larger of a bet on Brexit than on Bremain was warranted. But that’s not the way the money flowed, evidently.
Not to worry: this morning Janet Yellen said (with the market down 2.5%) that the Fed stood ready to add liquidity if needed. After 2.5%? In 1995 she would have had to come out and say that every week or two. A 2.5% decline takes us back to last week’s lows. Oh, the humanity!
Just stop. The purpose of markets is to move risk from people who have it to people who want it. If, all of a sudden, lots of people seem to have too much risk and to want less, then perhaps it is because they were encouraged into taking too much risk, or encouraged to think of the risk as being less than it was. I wonder how that happened? Oh, right: that’s what the Fed called the “portfolio balance channel” – by removing less-risky assets, they forced investors to hold more-risky assets since those assets now constitute a larger portion of the float. In my opinion (and this will not happen soon), central banks might consider letting markets allocate risk between the people who want it and the people who don’t want it, at fair prices. Just a suggestion.
One final point to be made today. I have seen people draw comparisons between this episode and other historical episodes. This is refreshing, since it reflects at least some thoughtful attempt to remember history. Not all of these are apt or useful comparisons; I saw one that this is the “Archduke Ferdinand” moment of this generation and that’s just nuts. Europe is not a military powderkeg at the moment and war in Europe is not about to begin. But, to the extent that trade barriers begin to rise again, the idea that this may be a “Smoot-Hawley” moment is worth consideration. The Smoot-Hawley tariff is generally thought to have added the “Great” to the phrase “Great Depression.” I think that’s probably overstating the importance of this event – especially if everybody decides to respect Britons’ decision and try to continue trade as usual – but it’s the right idea. What I want to point out is that while rising tariffs tend to produce lower growth and lower potential growth, they also tend to produce higher inflation. The fall of the Berlin Wall and the opening of Eastern Europe is one big reason that inflation outcomes over the last few decades have been lower than we would have expected for the amount of money growth we have had. The US has gone from producing all of its own apparel to producing almost none, for example, and this is a disinflationary influence. What would happen to apparel prices if the US changed its mind and started producing it all domestically again? Give that some thought, and realize that’s the protectionist part of the Brexit argument.
We can cheer for a victory for independence and freedom, while continuing to fight against any tendency towards economic isolationism. But I worry about the latter. It will mean higher inflation going forward, even if the doomsayers are right and we also get lower growth from Brexit and the knock-on effects of Brexit.
In recent years, equities have been carried higher by several compounding effects: the growth of the economy, expanding profit margins, and expanding multiples.
These three things, by definition, determine equity prices (if we assume that gross sales are tied to economic growth):
Price = Price/Earnings x Earnings/Sales x Sales
When all three are rising, as they have been, it is a strong elixir for stock prices. Now, this explains why stock prices are so high, but the devil lies in predicting these components of course – no mean feat.
Yet, we can make some observations. It has been the case for a while that P/E ratios have been extremely high by historical measures, with the Shiller Cyclically-Adjusted P/E ratio (CAPE) roughly doubling since the bottom in 2009. With the exception of the equity bubble in 1999-2000, the CAPE has never been very much higher than it is now, at 26.4 (see chart, source Gurufocus). This should come as no surprise to anyone who follows markets regularly.
Somewhat less obviously, recently sales have been declining. However, on a rolling-10-year basis, the rise has been reasonably steady as the chart below (Source: Bloomberg) illustrates. Over the last 10 years, sales per share have risen about 2.85% per year.
Finally, profit margins have recently been elevated. In fact, they have been elevated for a long time; the 10-year average profit margin for the S&P 500 (see chart, source Bloomberg) has risen to 8% from 6% only a few years ago. Recently, however, profit margins have been receding.
Both the rise in profit margins and the current drop in them make some sense. Value creation at the company level must be divided between the factors of production: land, labor, and capital. When there is substantial unemployment, labor has little bargaining power and capital tends to claim a higher share. Moreover, labor’s share is relatively sticky, so that speculative capital absorbs much of the business-cycle volatility in the short run. This is ever the tradeoff between the sellers of labor and the buyers of labor.
I used 10-year averages for all of these so that we can use CAPE; other measures of P/E are fraught. So, if we take 26.4 (CAPE) times 7.84% (10-year average profit margin) times 1005.55 (10-year average sales), we get an S&P index value of 2081, which is reasonably close to the end-of-May value of 2097. That’s not surprising – as I said, these three things make up the price, mathematically.
So let’s look forward. Recently, as the Unemployment Rate has fallen – and yes, I’m well aware that there is more slack in the jobs picture than is captured in the Unemployment Rate, but the recent direction is clear – wages have accelerated as I have documented in previous columns. It is unreasonable to expect that profit margins could stay permanently elevated at levels above all but a few historical episodes. Let’s say that over the next two years, the average drops from 7.84% to 7.25%. And let’s suppose that sales continue to grow at roughly 2.85% per year (which means no recession), so that sales for the S&P are at 1292 and the 10-year average at 1064.15. Then, if the long-term P/E remains at its current level, the S&P would need to decline to 2037. If the CAPE were to decline from 26.4 to, say, 22.5 (the average since 1990, excluding 1997-2002), the S&P would be at 1736.
None of this should be regarded as a prediction, except in one sense. If stock prices are going to continue to rise, then at least one of these things must be true: either multiples must expand further, or sales growth must not only become positive again but actually accelerate, or profit margins must stop regressing to the mean. None of these things seems like a sure thing to me. In fact, several of them seem downright unlikely.
The most malleable of these is the multiple…but it is also the most ephemeral, and most vulnerable to an acceleration in inflation. We remain negative on equities over the medium term, even though I recently advanced a hypothesis about why these overvalued conditions have been so durable.
If you are an investor of the Ben Graham school, you’ve lived your life looking for “value” investments with a “margin of safety.” Periodically, if you are a pure value investor, then you go through long periods of pulling your hair out when momentum rules the day, even if you believe – as GMO’s Ben Inker eloquently stated in last month’s letter – that in the long run, no factor is as important to investment returns as valuation.
This is one of those times. Stocks have been egregiously overvalued (using the Shiller CAPE, or Tobin’s Q, or any of a dozen other traditional value metrics) for a very long time now. Ten-year Treasuries are at 1.80% in an environment where median inflation is at 2.5% and rising, and where the Fed’s target for inflation is above the long-term nominal yield. TIPS yields are significantly better, but 10-year real yields at 0.23% won’t make you rich. Commodities are very cheap, but that’s just a bubble in the other direction. The bottom line is that the last few years have not been a great time to be purely a value investor. The value investor laments “why?”, and tries to incorporate some momentum metrics into his or her approach, to at least avoid the value traps.
Well, here is one reason why: the US is the destination currency in the global carry trade.
A “carry trade” is one in which regular returns can be earned simply on the difference in yields between different instruments. If I can borrow at LIBOR flat and lend at LIBOR+2%, I am in a carry trade. Carry trades that are riskless and result from one’s market position (e.g., if I am a bank and I can borrow from 5-year CD customers at 0.5% and invest in 5-year Treasuries at 1.35%) are usually more like accrual trades, and are not what we are talking about here. We are talking about positions that imply some risk, even if it is believed to be small. For example, because we are pretty sure that the Fed will not tighten aggressively any time soon, we could simply buy 2-year Treasuries at 0.88% and borrow the money in overnight repo markets at 0.40% and earn 48bps per year for two years. This will work unless overnight interest rates rise appreciably above 88bps.
We all know that carry trades can be terribly dangerous. Carry trades are implicit short-option bets where you make a little money a lot of the time, and then get run over with some (unknown) frequency and lose a lot of money occasionally. But they are seductive bets since we all like to think we will see the train coming and leap free just in time. There’s a reason these bets exist – someone wants the other side, after all.
Carry trades in currency-land are some of the most common and most curious of all. If I borrow money for three years in Japan and lend it in Brazil, then I expect to make a huge interest spread. Of course, though, this is entirely reflected in the 3-year forward rate between yen and real, which is set precisely in this way (covered-interest arbitrage, it is called). So, to make money on the Yen/Real carry bet, you need to carry the trade and reverse the exchange rate bet at the end. If the Real has appreciated, or has been stable, or has declined only a little, then you “won” the carry trade. But all you really did was bet against the forward exchange rate. Still, lots and lots of investors make precisely this sort of bet: borrowing money is low-interest rate currencies, investing in high-interest-rate currencies, and betting that the latter currency will at least not decline very much.
How does this get back to the value question?
Over the last several years, the US interest rate advantage relative to Europe and Japan has grown. This should mean that the dollar is expected to weaken going forward, so that someone who borrows in Euro to invest in the US ought to expect to lose on the future exchange rate when they cash out their dollars. And indeed, as the interest rate advantage has widened so has the steepness of the forward points curve that expresses this relationship. But, because investors like to go to higher-yielding currencies, the dollar in fact has strengthened.
This flow is a lot like what happens to people on a ship that has foundered on rocks. Someone lowers a lifeboat, which looks like a great deal. So people begin to pour into the lifeboat, and they keep doing so until it ceases, suddenly, to be a good deal. Then all of those people start to wish they had stayed on the ship and waited for help.
In any event, back to value: the chart below (source: Bloomberg) shows the difference between the 10-year US$ Libor swap rate minus the 10-year Euribor swap rate, in white and plotted in percentage terms on the right-hand scale. The yellow line is the S&P 500, and is plotted on the left-hand scale. Notice anything interesting?
The next chart shows a longer time scale. You can see that this is not a phenomenon unique to the last few years.
Yes, the correlation isn’t perfect but to me, it’s striking. And we can probably do better. After all, the chart above is just showing the level of equity prices, not whether they are overvalued or undervalued, and my thesis is that the fact that the US is the high-yielding currency in the carry trade causes the angst for value investors. We can show this by looking at the interest rate spread as above, but this time against a measure of valuation. I’ve chosen, for simplicity, the Shiller Cyclically-Adjusted P/E (CAPE) (Source: http://www.econ.yale.edu/~shiller/data.htm)
Now, I should take pains to point out that I have not proven any causality here. It may turn out, in fact, that the causality runs the other way: overheated markets lead to tight US monetary policy that causes the interest rate spread to widen. I am skeptical of that, because I can’t recall many episodes in the last couple of decades where frothy markets led to tight monetary policy, but the point is that this chart is only suggestive of a relationship, not indicative of it. Still, it is highly suggestive!
The implication, if there is a causal relationship here, is interesting. It suggests that we need not fear these levels of valuation, as long as interest rates continue to suggest that the US is a good place to keep your money (that is, as long as you aren’t afraid of the dollar weakening). That, in turn, suggests that we ought to keep an eye on rates of change: if the ECB tightens more, or eases less, than is priced into European markets (which seems unlikely), or the Fed tightens less, or eases more, than is priced into US markets (which seems more likely, but not super likely since not much is presently priced in), or the dollar trend changes clearly. When one of those things happens, it will be a sign that not only are the future returns to equities looking unrewarding, but the more immediate returns as well.
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?
(**Administrative Note: My new book What’s Wrong with Money: The Biggest Bubble of All has been launched. Here is the Amazon link. Please kindly consider buying a copy for yourself, for your neighbor, and for your library! If you are moved to write a review, or if you wander across a review that you think I may not have seen, please let me know. And thanks in advance for your support.)
Yesterday I wrote about the crowded short trade that boosted energy futures 40-50% from the lows of only a few weeks ago. A related crowded trade was the short-inflation trade, and it also was related to carry.
TIPS, as many readers will know, accumulate principal value based on realized inflation; the real coupon rate is then paid on this changing principal amount. As a rough shorthand, TIPS thus earn something like the real interest rate plus the realized inflation (which goes mainly to principal, but slowly affects the coupon over time). So, if the price level is declining, then although you will be receiving positive coupons your principal amount will be eroding (TIPS at maturity will always pay at least par, but can have a principal amount less than par on which coupons are calculated). And vice versa, of course – when the price level is increasing, so does your principal value and you still receive your positive coupons.
This means that, neglecting the price change of TIPS, the earnings that look like interest – those paid as interest, and those paid as accumulation of principal, which an owner receives when he/she sells the bond or it matures – will be lower when inflation is lower and higher when inflation is higher. It acts a little bit like a floating-rate security, which is one reason that many people believe (incorrectly) that FRNs hedge inflation almost as well as TIPS. They don’t, but that’s something I’ve addressed previously and it’s not my point today.
My point is that TIPS investors behave as if this carry is a hot potato. When carry is increasing, everyone wants to own TIPS; when carry is decreasing no one wants to own TIPS. The chart below (Source: BLS) shows the seasonal adjustment factor used by the Bureau of Labor Statistics to adjust the CPI. The figure implies that prices tend to rise into the summer and then decline into year-end, compared to the average trend of the year, so we should expect higher increases in nonseasonally-adjusted CPI in the summer and lower increases or even outright decreases late in the year.
Now, the next chart (Source: Enduring Investments) shows what 10-year breakevens have done over the last 16 years, on average, compared to the year’s average.
Do these two pictures look eerily similar?
From a capital markets theory perspective, this is nuts. It says that breakevens expand (TIPS outperform) when everyone knows carry should be increasing, and narrow (TIPS underperform) when everyone knows carry should be decreasing. And from a P&L perspective, a 30bp increase in 10-year breakevens swamps the change in accruals that happens as the result of seasonal changes in CPI. Moreover, these are known seasonal patterns; one should not be able to ‘outsmart’ the market by buying breakevens in January and shorting them in May. Theory says that while you’re owning negative carry, you should make it up in the rise of the price of the bond to meet the forward price implied by the carry. Nevertheless, for years you were able to beat the carry, at least if you were a first mover. (Incidentally, an investor doesn’t try to beat the average seasonal, but the actual carry implied by movements in energy too – which are also reasonably well-known in advance).
But as liquidity in the market has suffered (not just in TIPS, but in many non-benchmark securities, thanks to Dodd-Frank and the Volcker Rule), it has become harder for large accounts to do this. More importantly, the market has tended to drastically overshoot carry – either because less-sophisticated investors were involved, or because momentum traders (aka hedge funds) were involved, or because investor sentiment about inflation tends to overshoot actual inflation. Accordingly, as energy has fallen over the last year-and-a-half, TIPS have gotten cheaper, and cheaper, and cheaper relative to fair value. In early January 2015, I put out a trade recommendation (to select institutional clients) as breakevens were about 90bps cheap. The subsequent rally never extinguished the cheapness, but it was a profitable trade.
On February 11th of this year, TIPS reached a level of cheapness that we had only seen in the teeth of the global financial crisis (ignoring the period prior to 2002, when TIPS were not yet a widely-held asset class). The chart below shows that TIPS recently reached, by our proprietary measure, 120bps cheap.
But, as with energy, the short trade was overdone. 10-year breakevens got to 1.20% – an almost inconceivable level that would signal a massive failure not only of Fed policy, but of monetarism itself. Monetarism doesn’t make many claims, but one of these is that if you print enough money then you can create inflation. Since then, as the chart below (source: Bloomberg) shows, 10-year breakevens rallied about 35 bps before falling back over the last couple of days. And we still show breakevens as about 100bps cheap at this level of nominal yields.
Yesterday I noted that the structural negative carry for energy markets at present was likely to limit the rally in crude oil, as short futures positions get paid to stay short. But this is a different type of carry than the carry we are talking about with TIPS. With TIPS, the carry is caused by movement in spot energy (mostly gasoline) prices; with crude oil markets, the carry is caused by rolling futures positions forward. The TIPS carry, in short, will eventually stop being so miserable – spot gasoline is unlikely to continue to decline without bound. But even if spot gasoline stabilizes, short futures positions can still be profitable if oversupply into the spot market keeps futures curves in contango. Accordingly, while I think energy futures will slip back down, I am much more confident that TIPS breakevens have seen the worst levels we are likely to see.
Unfortunately, for the non-institutional investor it is hard to be long breakevens. The CME has never re-launched CPI futures, despite my many pleadings, and most ETF products related to breakevens have been dissolved – with the notable, if marginal, exception of RINF, which tracks 30-year breakevens but has a very small float. It appears to be approximately fair, however. Other than that – your options are to be long a TIPS product and long an inverse-Treasury product, but the hedge ratios are not simple, not static, and the fees would make this unpleasant.
However, as I wrote recently what this means for the individual investor is that there is no strategic reason to own nominal bonds now. If I own nominal Treasury bonds, I would be moving into TIPS in preference to such a low-coupon, naked-short-inflation-risk position.