Yesterday, I mentioned the likelihood that a recession is coming. The indicators for this are mostly from the manufacturing side of the economic ledger, and they are at this point merely suggestive. For example, the ISM Manufacturing Index is at 50.2, below which level we often see deeper downdrafts (see chart, source Bloomberg).
Capacity Utilization, which never got back to the level over 80% that historically worries the Fed about inflation, has been slipping back again (see chart, source Bloomberg).
Now, we have to be a bit careful of these “classic” indicators because of the increased weight of mining and exploration in GDP compared with the last few cycles. A good part of the downturn in Capacity Utilization, I suspect, could be traced to weakness in the oil patch. But at the same time, we cannot blithely dismiss the manufacturing weakness as being “all about oil” in the same way that Clinton supporters once dismissed Oval Office shenanigans as being “all about sex.” Oil matters, in this economy. In fact, I would go so far as to say that while historically a declining oil price was a boon to the nation as a whole (which is why we never suffered much from the Asian Contagion: the plunge in commodity prices tended to support the U.S., which is generally a net consumer of resources), in this cycle low oil prices are probably neutral at best, and may even be contractionary for the country as a whole.
Whether we have a recession in the near term (meaning beginning in the next six months or so) or further in the future, here is one point that is important to make. It will not be a “garden variety” recession, in all likelihood. That is not because we have boomed so much, but because we are levered so much. There are no more “garden variety” recessions.
Financial leverage in an economy, just as in individual businesses, increases economic volatility. So does operational leverage (which means: deploying fixed capital rather than variable inputs such as labor – technology, typically). And our economy has both in spades. The chart below (source: Bloomberg) shows the debt of domestic businesses as a percentage of GDP. Businesses are currently more levered than they were in 2007, both in raw debt figures and as a percentage of GDP.
Investors fearing recession should shift equity allocations (to the extent some equity allocation is retained) to less-levered businesses. But be careful: some investors think of growth companies as being low-leverage but tech companies (for example) in fact have very high operating leverage even if financial leverage is low. Both are bad when earnings decline – and growth firms typically have less of a margin of safety on price. I tried to do a screen on low-debt, low-PE, high-dividend non-tech companies with decent market caps and didn’t find very much. Canon (CAJ), Guess? Inc (GES) to name a couple of examples…and neither of those have low P/E ratios. (I don’t like to invest in individual stocks in any event but I mention these for readers who do – these aren’t recommendations and I neither own them nor plan to, but may be worth some further research if you are looking for names.)
On the plus side, economically-speaking, relatively heavy personal income taxation also acts as an automatic stabilizer. On the minus side, this is less true if the tax system is heavily progressive, since it isn’t the higher-paid employees who tend to be the ones who are laid off (except on Wall Street, where it is currently de rigueur to cut experienced, expensive staff and retain less-experienced, cheaper staff). Back on the plus side, a large welfare system tends to be an automatic stabilizer as well. On the minus side, all of these fiscal stabilizers merely move growth from the future to the present, so the deeper the recession the slower the future growth.
And, of course – there is nothing that central banks can really do about this, unless it is to make policy rates negative to spur additional extension of negative-NPV loans (that is, loans to less-creditworthy borrowers). I am not sure that even our central bank, with its unhealthy fear of the cleansing power of recession, thinks that’s a good idea.
There is some good news, as we brace for this next recession: while overall levels of debt are higher for businesses, financials, and households, the debt burden compared to GDP is lower for households and especially for domestic financial institutions (see chart, source Bloomberg).
Our banks are in relatively good health, compared with their condition headed into the last downturn. So this will not be a calamity, as in 2008. But I don’t expect it to only be a “mild” recession, either – as if any recession ever feels mild to individuals!
Whoever is selling stocks these days is really appreciative of those who are pushing the market higher. Thanks to overnight rallies in China and Japan on Tuesday night, US stocks launched higher at the open on Wednesday. Now, neither the modest rally in Shanghai (led by official buying) and the bigger rally in Japan (on Prime Minister Abe’s pledge to cut corporate taxes next year) had the slightest thing to do with items that impact the US, but the rally led a wave that rolled through futures markets around the globe until about seven minutes after traditional stock trading hours opened in New York, when the high of the day was set. The next six-and-a-half hours saw a 440-point decline in the Dow and around 50 in the S&P to a net loss of about 1.4% on the day.
“Gee, thanks!” said the pension fund guys who got to unload stocks about 3% higher than they otherwise would have. Who says the fast money monkeys don’t have salutatory effects?
The clue that today’s rally was not going to be sustained was actually in the energy markets. Prior equity oscillations had been mirrored with quite reasonable fidelity in the last week or two, but this morning energy markets were noticeably flat-to-down. Equities soon joined them.
Now, yesterday I mentioned that real yields are near their highest levels of the last five years, and that nominal yields are essentially in the middle of that range. I didn’t illustrate the latter point; but see below (source: Bloomberg).
So it is clear, to me, where you would rather place your bets in fixed-income: with real yields around 65bps and nominal yields at 2.20, you only want to own nominal bonds if inflation is less than 1.55% for ten years. Note that if inflation is negative, then you do approximately the same with TIPS as with nominal bonds, since in both cases your nominal principal is preserved. So it is a narrow set of circumstances in which you do better owning nominals, and you don’t do much better. On the other hand, there are long tails on the other side: ways that by owning TIPS you will do dramatically better.
I mention this, even though both nominal bonds and TIPS offer poor prospective returns, because it is the time of year when seasonally it is difficult to lose by owning fixed-income. The chart below (source: Bloomberg) shows the average change in nominal 10-year yields over the course of a calendar year for the last 30 years (gold), 10 years (white), and 5 years (red). Note that this isn’t a pure seasonal chart because it doesn’t correct for the average drift over the course of the year, but it suffices to show that buying bonds after the early-September backup has been a good strategy for many years…really, until the last five years, and even then it was a push between mid-Sep and mid-Nov.
So what I want to do in a period of uncertainty, headed into the fourth quarter, is to own TIPS, either outright or via an ETF like TIP. If the market comes unglued, then all interest rates should decline; if the market drops because real growth is weakening, then real rates should fall more than nominal rates (and in any event, owning TIPS gives you the positive tail exposure I mentioned above). If the market turns around and rallies, then energy probably recovers somewhat and this will help TIPS compared to nominals. But in any event, I am reducing risk into a very risky period.
I am not one of those people who believe that if the Fed is dramatically easing, you simply must own equities. I must admit, charts like the one below (source: Bloomberg), showing the S&P versus the monetary base, seem awfully persuasive.
But there are plenty of counter-examples. The easiest one is the 1970s, shown below (source: FRED, Bloomberg). Not only did stocks not rise on the geyser of liquidity – M2 growth averaged 9.6% per annum for the entire decade – but the real value of stocks was utterly crushed as the nominal price barely moved and inflation eroded the value of the currency.
If you do believe that the Fed’s loose reins are the main reason for equities’ great run over the last few years, then you might be concerned that the end of the Fed’s QE could spell trouble for stocks. For the monetary base is flattening out, as it has each of the prior times QE has been stopped (or, as it turns out, paused).
But for you bulls, I have happy news. The monetary base is not the right metric to be watching in this case. Indeed, it isn’t the right metric to be watching in virtually any case. The Fed’s balance sheet and the monetary base both consist significantly of sterile reserves. These reserves affect nothing, except (perhaps) the future money supply. But they affect nothing currently. The vast majority of this monetary base is as inert as if it was actually money sitting in an unopened crate in a bank vault.
What does matter liquidity-wise is transactional balances, such as M2. And as I have long pointed out, the end of QE does nothing to slow the growth of M2. There are plenty of reserves to support continued rapid growth of M2, which is still growing at 6% – roughly where it has been for the last 2.5 years. And those haven’t been a particularly bad couple of years for stocks.
So, if liquidity is the only story that matters, then the picture below of M2 versus stocks (source: Bloomberg) is more soothing to bulls.
Again, I think this is too simplistic. If ample liquidity is good today, why wasn’t it good back in the 1970s? You will say “it isn’t that simple.” And that’s exactly my point. It can’t be as easy as buying stocks because the Fed is adding liquidity. I believe one big difference is the presence of financial media transmitted to the mass affluent, and the fact that there is tremendous confidence in the Fed to arrest downward momentum in securities markets.
What central bankers have done to the general economy has not been successful. But, if you are one of the mass affluent, you may have a view of monetary policy as nearly omnipotent in terms of its effect on securities and on certain real assets such as residential real estate. What is different this time? The cult.
I am no equity bull. But if you are, because of the following wind the Fed has been providing, then the good news is: nothing important has changed.
I want to talk about commodities today.
To be sure, I have talked a lot about commodities over the last year. Below I reprise one of the charts I have run in the past (source: Bloomberg), which shows that commodities are incredibly cheap compared to the GDP-adjusted quantity of money. It was a great deal, near all-time lows this last summer…until it started creating new lows.
Such an analysis makes sense. The relative prices of two items are at least somewhat related to their relative scarcities. We will trade a lot of sand for one diamond, because there’s a lot of sand and very few diamonds. But if diamonds suddenly rained down from the sky for some reason, the price of diamonds relative to sand would plummet. We would see this as a decline in the dollar price of diamonds relative to the dollar price of sand, which would presumably be stable, but the dollar in such a case plays only the role of a “unit of account” to compare these two assets. The price of diamonds falls, in dollars, because there are lots more diamonds and no change in the amount of dollars. But if the positions were reversed, and there were lots more dollars, then the price of dollars should fall relative to the price of diamonds. We call that inflation. And that’s the reasoning behind this chart: over a long period of time, nominal commodities prices should grow with as the number of dollars increases.
Obviously, this has sent a poor signal for a while, and I have been looking for some other reasonable way to compute the expected return on commodities. Some time ago, I ran across an article by Erb and Harvey called The Golden Dilemma (I first mentioned it in this article). In it was a terrific chart (their Exhibit 5) which showed that the current real price of gold – simply, gold divided by the CPI price index – is a terrific predictor of the subsequent 10-year real return to gold. That chart is approximately reproduced, albeit updated, below. The data in my case spans 1975-present.
The vertical line indicates the current price of gold (I’ve normalized the whole series so that the x-axis is in 2015 dollars). And the chart indicates that over the next ten years, you can expect something like a -6% annualized real return to a long-only position in gold. Now, that might happen as a result of heavy inflation that gold doesn’t keep up with, so that the nominal return to gold might still beat other asset classes. But it would seem to indicate that it isn’t a great time to buy gold for the long-term.
This chart was so magnificent and made so much sense – essentially, this is a way to think about the “P/E ratio” for a commodity” that I wondered if it generalized to other commodities. The answer is that it does quite well, although in the case of many commodities we don’t have enough history to fill out a clean curve. No commodities work as well as does gold; I attribute this to the role that gold has historically played in investors’ minds as an inflation hedge. But for example, look at Wheat (I am using data 1970-present).
There is lots of data on agricultural commodities, because we’ve been trading them lots longer. By contrast, Comex Copper only goes back to 1988 or so:
Copper arguably is still somewhat expensive, although over the next ten years we will probably see the lower-right portion of this chart fill in (since we have traded higher prices, but only within the last ten years so we can’t plot the subsequent return).
Now the one I know you’re waiting for: Crude oil. It’s much sloppier (this is 1983-present, by the way), but encouraging in that it suggests from these prices crude oil ought to at least keep up with inflation over the next decade. But do you know anyone who is playing oil for the next decade?
For the sake of space, here is a table of 27 tradable commodities and the best-fit projection for their next 10 years of real returns. Note that most of these fit a logarithmic curve pretty reasonably; Gold is rather the exception in that the historical record is more convex (better expectation from these levels than a pure fit would indicate; see above).
I thought it was worth looking at in aggregate, so the chart below shows the average projected returns (calculated using only the data available at each point) versus the actual subsequent real returns of the S&P GSCI Excess Return index which measures only the return of the front futures contract.
The fit is probably better in reality, because the actual returns are the actual returns of the commodities which were in the index at the time, which kept changing. At the beginning of our series, for example, I am projecting returns for 20 commodities but the 10-year return compares an index that has 20 commodities in 1998 to one that has 26 in 2008. Also, I simply equal-weighted the index while the S&P GSCI is production-weighted. And so on. But the salient point is that investing in spot commodities has been basically not pretty for a while, with negative expected real returns for the spot commodities (again, note that investing in commodity indices adds a collateral return plus an estimate 3-4% rebalancing return over time to these spot returns).
Commodities are, no surprise, cheaper than they have been in a long while. But what is somewhat surprising is that, compared to the first chart in this article, commodities don’t look nearly as cheap. What does that mean?
The first chart in this article compares commodities to the quantity of money; the subsequent charts compare commodities to the price level. In short, the quantity of money is much higher than has historically been consistent with this price level. This makes commodities divided by M2 look much better than commodities divided by the price level. But it merely circles back to what we already knew – that monetary velocity is very low. If money velocity were to return to historical norms, then both of these sets of charts would show a similar story with respect to valuation. The price level would be higher, making the real price of commodities even lower unless they adjusted upwards as well. (This is, in fact, what I expect will eventually happen).
So which method would I tend to favor, to consider relative value in commodities? Probably the one I have detailed here. There is one less step involved. If it turns out that velocity reverts higher, then it is likely that commodities real returns will be better than projected by this method; but this approach ignores that question.
Even so, a projected real return now of -2% to spot commodities, plus a collateral return equal to about 1.9% (the 10-year note rate) and a rebalancing return of 3-4% produces an expected real return of 2.9%-3.9% over the next decade. This is low, and lower than I have been using as my assumption for a while, but it is far higher than the expected real returns available in equities of around 1.2% annualized, and it has upside risk if money velocity does in fact mean-revert.
I will add one final point. This column is never meant to be a “timing” column. I am a value guy, which means I am always seen to be wrong at the time (and often reviled, which goes with the territory of being a contrarian). This says absolutely nothing about what the returns to commodities will be over the next month and very little about returns over the next year. But this analysis is useful for comparing other asset classes on similar long-term horizons, and for using useful projections of expected real returns in asset allocation exercises.
 In what follows, I will focus on the expected return to individual spot commodities. But remember that an important part of the expected return to commodity indices is in rebalancing and collateral return. Physical commodities should have a zero (or less) real return over time, but commodity indices still have a significantly positive return.
Come get your commodities and inflation swaps here! Big discount on inflation protection! Come get them while you can! These deals won’t last long!
Like the guy hawking hangover cures at a frat party, sometimes I feel like I am in the right place, but just a bit early. That entrepreneur knows that hangover cures are often needed after a party, and the people at the party also know that they’ll need hangover cures on the morrow, but sales of hangover cures are just not popular at frat parties.
The ‘disinflation party’ is in full swing, and it is being expressed in all the normal ways: beat-down of energy commodities, which today collectively lost 3.2% as front WTI Crude futures dropped to a 2-year low (see chart, source Bloomberg),
…10-year breakevens dropped to a 3-year low (see chart, source Bloomberg),
…and 1-year inflation swaps made their more-or-less annual foray into sub-1% territory.
So it helps to remember that none of the recent thrashing is particularly new or different.
What is remarkable is that this sort of thing happens just about every year, with fair regularity. Take a look at the chart of 10-year breakevens again. See the spike down in late 2010, late 2011, and roughly mid-2013. It might help to compare it to the chart of front Crude, which has a similar pattern. What happens is that oil prices follow a regular seasonal pattern, and as a result inflation expectations follow the same pattern. What is incredible is that this pattern happens with 10-year breakevens, even though the effect of spot oil prices on 10-year inflation expectations ought to be approximately nil.
What I can tell you is that in 12 of the last 15 years, 10-year TIPS yields have fallen in the 30 days after October 15th, and in 11 of the past 15 years, 10-year breakevens were higher in the subsequent 30 days.
Now, a lot of that is simply a carry dynamic. If you own TIPS right now, inflation accretion is poor because of the low prints that are normal for this time of year. Over time, as new buyers have to endure less of that poor carry, TIPS prices rise naturally. But what happens in heading into the poor-carry period is that lots of investors dump TIPS because of the impending poor inflation accretion. And the poor accretion is due largely to the seasonal movement in energy prices. The following chart (source: Enduring Investments) shows the BLS assumed seasonality in correcting the CPI tendencies, and the actual realized seasonal pattern over the last decade. The tendency is pronounced, and it leads directly to the seasonality in real yields and breakevens.
This year, as you can tell from some of the charts, the disinflation party is rocking harder than it has for a few years. Part of this is the weakening of inflation dynamics in Europe, part is the fear that some investors have that the end of QE will instantly collapse money supply growth and lead to deflation, and part of it this year is the weird (and frustrating) tendency for breakevens to have a high correlation with stocks when equities decline but a low correlation when they rally.
But in any event, it is a good time to stock up on the “cure” you know you will need later. According to our proprietary measure, 10-year real yields are about 47bps too high relative to nominal yields (and we feel that you express this trade through breakevens rather than outright TIPS ownership, although actual trade construction can be more nuanced). They haven’t been significantly more mispriced than that since the crisis, and besides the 2008 example they haven’t been cheaper since the early days (pre-2003) when TIPS were not yet widely owned in institutional portfolios. Absent a catastrophe, they will not get much cheaper. (Importantly, our valuation metric has generally “beaten the forwards” in that the snap-back when it happens is much faster than the carry dynamic fades).
So don’t get all excited about “declining inflation expectations.” There is not much going on here that is at all unusual for this time of year.
The stock market, the bond market, the commodities markets (to a lesser extent), FX markets – they are all experiencing a marked increase in volatility.
Some observers want to call this bearish for equities, mainly because they already are bearish. This is a very bad reason. While really bad equity returns almost always occur coincident with a rise in volatility – the old maxim is that stocks go ‘up on the staircase and down on the escalator’ – that does not mean that volatility causes bad returns. Or, put another way, there are also periods of increased volatility that do not precede and are not coincident with bad returns.
However, there actually is a reason that increased volatility might lead to poor short- to medium-term returns, that isn’t based on technical analysis or spurious correlations. Moreover, a relatively new phenomenon (the rise of so-called ‘risk-parity’ strategies) is starting to institutionalize what was already a somewhat natural response to volatility.
In ‘risk-parity’ strategies, the weight of an asset class (or a security within an asset class, sometimes) is inversely proportional to the risk it adds to the portfolio. Generally speaking, “risk” here is defined as variance, because it is easy to estimate and there are markets where symmetrical variance trades – i.e., options markets. But what this means is that when volatility (sometimes realized volatility, and sometimes option “implied” volatility) rises in stocks, then risk parity strategies tend to be shedding equities because they look riskier, and vice-versa. Right now, risk parity strategies are likely to be overweight equities because of the long period of low realized and implied volatility (even though the valuation measures imply quite high risk in the sense most of us mean it, in terms of the probability of return shortfall). Risk parity strategies are probably superior to ‘return-chasing’ methodologies, but by being ‘risk-chasing’ they end up doing something fairly similar when they are all operating together.
Note that while risk-parity strategies are comparatively new – well, not exactly because it is an oldish idea, but they have only recently become a big fad – this general phenomenon is not. The natural response to greater equity market volatility is to pare back exposure; when your broker statement starts to swing around wildly it makes you nervous and so you may start to take some profits. This is also true of other asset classes but it seems to me to be especially true in equities. Nobody who gets involved in commodities is surprised at volatility: the asset class suffers from a midguided belief that it is terribly volatile even though commodity indices are just about exactly as volatile as equity indices over time. But equity investors, contrariwise, seem perennially surprised at 2% moves.
So, while the recent volatility doesn’t mean that a move lower in equities is assured, it increases the probability of such because risk-parity strategies (and other investors reacting nervously to overweights in their equity exposure) will begin to scale back positions in the asset class in favor of positions in other asset classes, probably mostly bonds and commodities. At this point it would be good for me to point out that only the very short-term volatility measures have moved up dramatically; the VIX is well off its bottom but only up to 18.8 and it has been there numerous times in the last few years (see chart, source Bloomberg). But the longer the volatility continues like we have seen it for the last week or two, the bigger the chances that the asset-allocation boxes start to make important shifts (and the quant hedge fund boxes will probably move a bit before those asset allocation boxes do).
As an aside, the tendency for asset allocation shifts to follow volatility shifts is not the reason that the VIX displays a strong inverse directionality. Neither is the main reason for this inverse directionality because the VIX is a “fear gauge.” The main reason is that the VIX weights near-the-money options more heavily than out-of-the-money options. Because options skews almost always imply more downside volatility for stocks than upside volatility, when the market declines it tends to bring more “high volatility” strikes into play and so part of the VIX increase in a down market is simply mechanical.
I am not calling for a sharp decline in stocks, nor for an extended decline in stocks. My position and view is as it has long been, that the prospect for attractive real returns from equities over the next 5-10 years is quite small and beaten handily by commodities’ prospective returns at that end of the risk spectrum. I don’t think that most investors (me included!) should swing asset allocations around frequently in response to technical indicators or such things as “momentum”, but rather should focus on evaluating expected long-term returns (which are somewhat predictable) and invest for value. And I must admit I also think that “risk-parity” is a clever marketing gimmick but a pretty absurd way to assemble a portfolio for almost everyone. My point here is to highlight one little-considered aspect of herd behavior, and how that herd behavior may have become more institutionalized as late, and to consider the risks that herd behavior may create.
 This in turn is not due so much from the tendency of markets to have more downside volatility than upside volatility, but from the fact that buying protective puts and selling “covered” calls are both considered “conservative” options strategies. So, out-of-the-money puts tend to be too expensive and out-of-the-money calls too rich.