Given the global backdrop of strong U.S. equity markets, increased political stability and growth in Europe, and nascent signs of growth in Japan, why isn’t the bond market softer and why haven’t we seen an increase in inflation? We think technology, in particular the Internet, has been a meaningful driver of the current dynamic between inflation and the bond market. Further, we believe that the Internet is changing the way economic health should be measured and, accordingly, the way investors should position their portfolios.
Today’s asset prices have been propped up by years of easy liquidity and most credit and equity instruments are rich by historical measures. Investors have been chasing yield and do not appear sufficiently focused on risks to current valuations. We believe that investors would be wise to consider a number of factors and ideas as central banks start to remove liquidity from the system:
• Stock-picking and credit selection are likely to outperform broad indices – a focus on investments that can withstand a period of stress is warranted
• Quantitative macro models that rely on consistency across asset classes may be challenged; so too may cross-asset class relative value strategies
• Assets with weak underlying fundamentals that have been supported by yield chasers may suffer as central banks reduce liquidity in the market
• ETFs, particularly those focused on high yield bonds and loans, may sell off significantly because of limited liquidity in corporate bonds
• The time is ripe to shift portfolios to become more “all weather”
Financial markets entered 2017 with high hopes the Trump administration would provide a strong growth stimulus. Post-election bond yields rose, equities rallied (especially small caps), emerging market currencies got crushed, and inflation expectations showed some signs of life. By mid-2017, the bond market had quickly changed course: 10-year yields have fallen 20 basis points while the 2/30 curve has flattened by 50 basis points.* Many believe the bond market rally is due to a lack of success in the implementation of fiscal policy. However, the equity market rally has continued with large cap stock indexes trading at all-time highs. Even the Russell 2000, which initially gave up most of its late 2016 gains on the lack of new tax initiatives, has reversed course and delivered solid YTD performance.
It is easy to side with the bond market’s reaction to the lack of fiscal progress. So far the new administration’s key agenda items have not materialized (e.g., making the U.S. tax code more competitive, rebuilding infrastructure and repealing Obamacare). Bond market caution was further justified recently by North Korea’s multiple missile launches, and earlier in the year by the uncertainty within Europe leading up to Macron’s election victory.
Then why have stocks done so well? Initially, equities took the cue from President Trump’s victory and the idea that parts of his agenda would be quickly implemented given the Republican majority in congress. Further support came from European political stability following the French elections in May and emerging signs of steady growth on that continent for the first time in many years. Asia has also played a part as global stimulus has taken hold in Japan where the economy is finally growing, albeit at a very gradual pace. Lastly, the fears of U.S. protectionism appear to have been overhyped and emerging market equities and currencies have both appreciated materially with many showing gains over 30%+ in USD terms.*
Given the positive global backdrop why isn’t the bond market softer? Given the tightening labor market in the U.S., shouldn’t inflation be rising? Or has the Phillips curve permanently flattened? What about the bond vigilantes, have they all died off? Is it possible to continue to have steady economic growth without stoking inflation? Is there something bigger at work causing inflation to remain subdued despite a tight labor market? Our answer is that yes, something bigger is at work. We think technology, in particular the Internet, has been a meaningful driver of the current dynamic between inflation and the bond market. Further, we believe that the Internet is changing the way economic health should be measured and, accordingly, the way investors position themselves.
Current Monetary Policy: The Risk of FOMO
Before we address what may be causing this apparent conundrum, let’s also highlight some of the current risks associated with maintaining an accommodative monetary policy. The current abundance of liquidity continues to push up asset prices around the world. Most developed stock markets and several emerging markets are at all-time highs and traditional valuation metrics are also well above their long-term averages. Equity market corrections of even a few percent are bought heavily. Anything with a yield is in demand while markets are not keenly focused on the underlying credit risk and/or creditor protections of bond issues. This is clearly a backdrop of excessive optimism about the future without an appreciation for risk that may be on the horizon.
One of the most blatant examples of this mania is playing out in the world of crypto currencies. It is hard to ignore the potential power of Blockchain technology to eliminate the middleman in financial and real asset transactions. This technological development will likely disrupt many industries, just as the Internet did over the past two decades. However, we question the need for the existence of 800+ crypto currencies, the top 10 of which have a total valuation in excess of $100 billion. Clearly some crypto currencies will be needed to transact using the “chain” and others as an alternative for a potential store of value, á la gold, but the frenzy created by this new “innovation” further supports our view that investors are currently not sufficiently factoring in risks.
Environments that lack a sufficient appreciation for risk often lead people to disregard the underlying investment they are making for fear of missing out (FOMO). As a result, investors feel the need to jump on the band wagon of every hot stock, market, or trend. In addition, the glut of global liquidity has helped fuel the proliferation of ETF (exchange-traded funds) and index products. As downside risk hasn’t really appeared in almost a decade, the comfort investors feel in taking market beta risk to a broad benchmark may be misguided. After all, this has been an environment in which monetary policy has intentionally supported asset prices. As we are now in the early innings of that support being removed, the outlook for these products is unclear should the risk environment shift to a more cautious one, or, worse yet, one in which investors become flat-out scared.
In the past few years there have been three incidents of note that have tested the market liquidity: the taper tantrum in 2013, the flash crash in equities in May of 2015, and the flight to quality in bonds in October of 2015. These incidents are stark reminders of how quickly market liquidity can evaporate. The apparent liquidity that is present during bull markets can quickly evaporate in a bear market and prices can (and often do) gap down quickly.
Lastly, investors are reaching for yield of any sort because of the assumption that the bullish environment will continue. This is most pronounced when looking at recent sovereign debt issues in emerging markets. Recently, new issues by Iraq, Ukraine, and Tajikistan came circa 7% for 10-year debt. Would a pension fund that needs to earn a 7% return really entrust their pensioners’ future to the ability and willingness of these countries to repay? Insatiable demand for long-term bond debt exists, almost without regard for risk of repayment of principal, as long as a yield meets a certain threshold return.
A Connectivity Conundrum
Is this bond-equity distortion – or conundrum as Fed Chair Greenspan called it two decades ago – concerning to central bankers? After all, employment and inflation – not asset price targeting – are the focus (and mandate) of central banks. Further, I proffer that our classic monetary metrics are doing a poor job of evaluating the health of the economy, as the digital economy is very hard to measure in monetary terms. Technology, particularly the Internet, has created significant increases in utility absent any real inflationary uptick. In fact it can be argued that much of the technological development to date and even on the horizon is deflationary. This is likely to continue as the next big wave of innovation, the Blockchain, strives to eliminate middlemen in many areas of the economy. This mismatch between the metrics and what is really going on in the economy could be causing central bankers keep their foot on the gas longer than needed.
Technological innovation may cause inflation expectations to be permanently lower. Further, advancements in technology may mean that traditional measurements of economic health also need to advance and evolve, particularly monetary aggregates. Modern economic theory is based on the idea that money is the ultimate measure of economic activity. Compensation, trade, commerce and investments are all measured in monetary terms. What if one could create a store of wealth that is different than money, as is occurring with crypto currencies? Initially our economies were based on bartering, then we used tokens resembling coins, later gold and then paper currency backed by gold. Then, in 1971, we finished the process of unlinking our paper currency to gold. For decades we have accepted the value of simply paper currency. Why couldn’t data encryption also become a store of value? After all, if enough people agree that data encryption has value as a medium of exchange (not unlike paper currency) then it becomes a currency. The challenge for central bankers is that their classic economic tools are unlikely to measure this potentially momentous change until it is very far along in the process of adoption. Therefore, the current policy prescription of low interest rates may be misdirected.
It is unlikely that the central bankers of today, most of whom are classically-trained economists, will publically lead a change in thinking. But they do appear to be concerned with the asset price “bubble” and may choose to allow real interest rates to rise without seeing the classic measures of inflation rise. Comments following the September FOMC quickly reversed the markets’ expectation of a minimal chance of a move in December to one in which Fed Chair Yellen expects that, despite the low inflation readings, they are still on course for a December hike.
There will always be value to be found in the markets but, thanks to years of easy liquidity, most credit and equity instruments are currently rich by historical measures. Investors need to be scrupulous to find opportunities that can perform well while withstanding a potential period of stress brought about by an eventual change in risk perception. Investors would be wise to consider a number of factors and ideas:
• Focused stock picking and credit selection should – over the intermediate term – do much better than the broad indexes whose performance is agnostic to fundamental valuation.
• Historical cross asset correlations may have changed and equity and bond performance so far in 2017 represents to many a conundrum. Further, the USD reflects the fact that the U.S., once the model of stability given the steadfastness of our leadership, is now a source of global instability. We should prepare for a prolonged period of USD weakness despite the actions of the Fed. If this is the case, many of the quantitative macro models that rely on consistency in cross asset class behavior could be challenged. Also relative value strategies that trade across asset classes will be more difficult to assess and focus should thus be on those within asset classes.
• We are on the doorstep of a reduction in the Fed’s balance sheet and the ECB is starting to reduce its QE activity (though any moves will likely be measured and well telegraphed). Acknowledgement by central banks that new forces in the economy are dampening inflation readings might lead to the realization that higher yields are necessary to inject a dose of reality about risk into the markets. With the end to QE unfolding, the liquidity tailwind could quickly become a headwind for asset prices, putting pressure on equity and credit prices (particularly investments to which yield chasers have flocked despite weak underlying fundamentals).
• Index strategies are concerning in that they are agnostic to valuation. The more overpriced an asset becomes, the bigger its share of the index, and the more the investment strategy which follows the index must own of the overvalued asset. Such a pattern can easily reverse itself if active investors decide to sell overvalued assets en masse. Therefore, passive index strategies may be hard to beat in good times but active management is likely to prevail when the cycle moderates or turns.
• Finally, ETFs have given apparent liquidity to a sector of the market in which the underlying assets are not that liquid. Of particular concern are credit ETFs that focus on high yield bonds and loans. Should the economy cycle downward, and investors decide to shed credit risk, the selling of these ETFs will quickly test the limited liquidity of the corporate bond market.
The time is ripe to shift portfolios to become more “all-weather” and to balance risk. For the months ahead, we believe that a neutral weighting (at best) is appropriate for credit strategies with a beta tilt and equity strategies with a lot of beta. We are becoming a wealthier society given our increased technological utility but one with low inflation due to the Amazon, iPad and, potentially, Blockchain effects. The transition from the classic approach to monetary policy to a more “new age” approach will clearly take time. Most of our central bankers are well versed in classic economic theory and may be resistant to changing their traditional approaches. Furthermore, the outgoing Fed governors are unlikely to make any near term changes leaving measurement of “iPad iNflation” to a new Fed leadership. Technology will continue to change the inflation and utility outlook. Monetary policy must soon adapt to this “Internet of Stocks and Bonds” or risk stoking greater asset bubbles to deal with in the future.
*As of mid-September. Bloomberg.
Basil Williams is a Managing Director and Head of Portfolio Management at PAAMCO. He is responsible for the firm’s completeAlpha approach to hedge fund investing and is the Chief Investment Officer of Horizons, the firm’s fixed-income investment solution. Basil is also a member of the firm’s Investment Oversight and Management Committees. During his career, he has built and led teams in institutional investment management including equity and fixed income trading, research, risk management, and business development. Most recently, Basil was the Co-Chief Investment Officer at Mariner Investment Group, where he managed internal trading teams, led three of Mariner’s multi-strategy mandates, spearheaded the firm’s incubation and seeding business, co-authored Mariner’s Quarterly Investment Views publication and helped set the firm’s business strategy. Prior to Mariner, he spent nineteen years with Concordia Advisors and held the role of CEO for the last six of those years. Basil started his career at Merrill Lynch in 1980 and played a key role in the development of its financial futures and options business. Basil received his MBA from New York University and his BA in Applied Math from Brown University.
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