Feb 14. Imagine
Themes:
- Yellen disappointment
- Institutional bias and lack of conviction/imagination
- China/ Kyle Bass and the roadshow
- Declining faith in policy makers
“Imagination is more important than knowledge. For knowledge is limited, whereas imagination embraces the entire world, stimulating progress, giving birth to evolution.” Einstein
Given this week’s discovery that yet another of Einstein’s theories was correct, gravitational waves, I thought it appropriate to start with one of his quotes. This first section of this week’s note is written more for me than for you. It’s a reminder to myself about trading strategy. I’ve now seen a few quotes from famous investors, one just this weekend from Horseman’s Chief Investment officer, Russell Clark, “I spend most of my time, while looking at current prices, thinking about and trying to live six months to one year in the future. Thinking about what will be the reaction to what is happening now, and then thinking about what that means future prices might look like. Generally that has worked well for me.” I have seen this theme expressed repeatedly by star investors. For example Druckenmiller, ” Try and imagine the world 18-24 months from now and not the way it is today. Then think about where securities prices will be to reflect that view.” Julian Robertson says the same thing.
———————————————————————————————————-
Markets were somewhat disappointed with Yellen’s testimony last week as it wasn’t seen as dovish enough. She repeatedly said that monetary policy isn’t on a preset course. Clearly all central banks are grappling with similar problems, and the tone appears to have shifted to one of less confidence in policy makers. Japan is a prime example, where the Nikkei has lost 25% since the beginning of December and the yen has strengthened appreciably. The efficacy of negative rates is being openly questioned.
One of the goals of negative rates is supposed to be increased consumer spending. But forced consumer spending, even if central banks are able to spur it, will fall flat without underlying confidence. In the US, QE was supposed to generate low rates and low risk premiums that would cause businesses to invest in capex. They didn’t, instead engaging in stock buybacks and financial engineering. Now negative rates are supposed to make consumers spend. If QE didn’t spark the preferred theoretical outcome, why should sub-zero rates? The prospect of bank bail-ins across Europe as financial stocks crumble is probably a more visceral reason to pull money out from banks (and spend it?) than a small negative rate. But an uncertain future deters spenders.
Much of this uncertainty emanates from China. Many are calling for further devaluation of the yuan, which will likely cause global tremors, but appears unavoidable. For example, Kyle Bass is now appearing on media outlining the problems, and a friend told me he is visiting other investors to make the case against China. This isn’t like subprime where it’s one big investor against another. It’s against a country that doesn’t necessarily play by the same rules. That’s why the case must be built airtight and repeated incessantly to build the pressure. Note: G20 meeting in Shanghai is Fed 26/27.
Going back to the Fed, I think Yellen just isn’t strong enough. She should just say, ‘the Fed knows there are international uncertainties. We think therefore, that assets have to bear an increased risk premium to reflect these risks. AND…we think the adjustment is either well under way or has substantially occurred.’ She should say that policy isn’t on a predetermined course, but should categorically rule out negative rates. That would send a message to all central bankers and the markets as a whole, and would also perhaps put the US gov’t on notice that fiscal investment policies to spur the economy might be necessary.
Instead she cites things like strong auto sales. A long time ago I read a book titled Beating the Street (1993) by Peter Lynch (famous Fidelity Magellan mutual fund manager) who referred to Chrysler’s research on auto sales vs trend, which identified sales under or over trend based on a statistical model incorporating demographics, previous sales, etc. I looked for the research currently and couldn’t locate it. The point is though, auto sales have been on a steady and strong increase for 6 years; 18 million units is likely the top of the cycle. The Fed seems to show little imagination about the future apart from extrapolating forward. This institutional bias was also reflected in some of the bullet points from Dudley Friday: DELEVERAGED HOUSEHLDS MUCH BETTER ABLE TO ABSORB SHOCKS and HHLD SECTOR IN GOOD SHAPE, FINCL SYSTEM MUCH STRONGER. Right, the household sector is in better shape than 2008. But the Fed is focused on the last battle. Now it’s the business and corporate sector, not households, that we’re worried about. Just because the hh sector is in good shape, doesn’t mean households will consume more and in the same way as before. And, as shown last week, US consumption as a % of GDP is near a record high.
Here are a couple of quotes from Neil Howe:
Fun fact: From 2014 to 2015, the dollar value of global GDP actually declined. Historically, this doesn’t happen often. But when it does, it typically sets up a global recession year—like 1983 and 2009. If you’re a poor country, it means that hard-currency liquidity is disappearing. If you’re American, it means no one else can afford what we sell. Either way, it’s not a good sign.
The world has fundamentally shifted over the last decade, especially since we’ve emerged from the Great Recession. We are seeing slower demographic growth, overleveraging, a productivity slowdown, institutional distrust, policy gridlock, and geopolitical drift. But the professional class has been very slow to understand what is going on, not just quantitatively but qualitatively in a new generational configuration that I call the Fourth Turning. They don’t accept the new normal. They keep insisting, just two or three years out there on the horizon, that the old normal will return—in GDP growth, in housing starts, in global trade.
But it doesn’t return.
It was a wild week in interest rate markets. From the end of December EDH’18 rallied over 100 bps (over 110 to Thursday’s spike high). Implied vol screamed higher. Eurodollar calendar spreads imploded. During the day on Thursday I saw EDZ16/EDZ17 as low as 13.5 bps. It ended Friday at 22.5. In Fed Funds, the one year spread June’16/June’17 was briefly offered as low as 3.5 bps, it settled at 14.0 on Friday. Some nearby FF spreads actually inverted, and March’16/April’16 (FFH6/FFJ6) ended the week at -0.5, pointing to a higher chance of an ease in March then a hike. The Fed wonders why the market has dismissed its dot plot, but at the same time timidly indicates it might follow other central banks down the rabbit hole of negative rates.
_______________________________________________________
| 2/5/2016 | 2/12/2016 | chg | |
| UST 2Y | 72.2 | 69.4 | -2.8 |
| UST 5Y | 124.8 | 119.9 | -4.9 |
| UST 10Y | 184.6 | 174.5 | -10.1 |
| UST 30Y | 268.2 | 260.2 | -8.0 |
| GERM 2Y | -49.5 | -50.8 | -1.3 |
| GERM 10Y | 29.6 | 26.1 | -3.5 |
| EURO$ H6/H7 | 20.5 | 14.5 | -6.0 |
| EURO$ H7/H8 | 30.5 | 25.0 | -5.5 |
| EUR | 111.58 | 112.56 | 0.98 |
| CRUDE (1st cont) | 30.89 | 29.44 | -1.45 |
| SPX | 1880.05 | 1864.78 | -15.27 |
| VIX | 23.38 | 25.40 | 2.02 |
______________________________________________________
