Risk Update – August 2020

The Federal Open Market Committee (FOMC) is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates. The Committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decision making by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.” (bold highlights added by us)

https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf

So reads the opening paragraph to the “Statement on Longer-Run Goals and Monetary Policy Strategy”. The original version of this statement was adopted January 24, 2012, and amended on August 27th, 2020, ushering in a new era of Federal Reserve (and likely many other Central Banks) policy aimed at Average Inflation Targeting and Maximum Employment. We couldn’t help but highlight the words in bold to note the Edward Bernays-esque nature of the introductory paragraph. Firstly, we are assured that the authors of this policy are all that one could want from a benevolent overseer in support of a functioning democratic society. The fact that they are unelected, virtually unaccountable, ivory tower elites, should not distract us from their good and just intent in the policy document to follow.

The freshly revised version, simplified, says that the Fed will no longer worry about “deviations” (the old version) from maximum employment, but only “shortfalls” from maximum employment. They will also target inflation that “averages” 2% over time, thus willingly allow inflation to exceed 2% for unspecified periods to bring the longer term average back into line. Accordingly, they will no longer pull back from stimulus, or tighten monetary policy, in anticipation of tightness in labour markets leading to inflationary pressures. The Phillips Curve is presumed dead!

Explanations of the new framework drowned the airwaves as the senior Fed mouthpieces put the word out, of course, led by the Chair Powell himself virtually at the Jackson Hole event, backed up by both Vice Chair Clarida and Governor Brainard.

https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm

https://www.federalreserve.gov/newsevents/speech/clarida20200831a.htm

https://www.federalreserve.gov/newsevents/speech/brainard20200901a.htm

They have left for themselves an even more impressive range of discretion. There are no rules to follow: no explanation of how average inflation will be calculated or over what period: no process on what qualifies as maximum employment. Simply the magic 2% target, still all these years on with no explanation or support for why 2%, and the continued random selection of Core PCE as the gauge for what they consider to be relevant measure of “inflation”.

We can see below that, going back to 1995, the annual rate of change of the Core PCE has run at 1.7% and has been remarkably steady other than the brief dips during such events as 9/11 in 2001, GFC in Q4 2008, and the recent
pandemic triggered market events in 2020. Without much explanation as to why or how, their intention now is to, for some unspecified period, get this line to rise “on average” at 2%, by allowing it to run at higher than 2% for some period to make up for the portion of the time that it has run below that level. Apparently, they intend to achieve this by doing the same things they have been doing for the last 25 years that has resulted in it averaging 1.7%, but somehow more of it?

Figure 1: US Core PCE Index

Source: Bloomberg

Interestingly, if they decided to choose CPI as their preferred measure, they would be overshooting their longer term average target. Figure 2 shows that that index has been growing at 2.16% annually going back to 1995. By this index, and the magical unexplained 2% number, the Fed should be fighting to get the longer term average down. Obviously not the case. There are a number of differences between the two indices, but the bulk of the divergence can be explained by differing weights in housing and medical care, both significantly higher weighted in the CPI (and in reality for median households).

Figure 2: US CPI Index

Source: Bloomberg

Showing the two indices together we see that they track one another pretty closely, but with the CPI growing at a higher rate and with more volatility (that housing weight again being the main contributor to both the rate of change and the volatility of it). We have split the Core PCE into its growth rate up through the GFC, 1.78% annually, and its post GFC growth rate, 1.60% annually. This, supposedly, is the problem! Such a problem that merely getting it back to its 25 year average of 1.7% isn’t good enough. They need to get it, somehow, to an average of 2%!

Figure 3: US Core PCE vs CPI (normalized)

Source: Bloomberg

If you are anything like us, you are already starting to suspect that the Fed is at best being silly, and more likely insincere. To make this point clear, we present Figure 4. The two lines squashed near flat at the bottom are the Core PCE and CPI indices, once we have normalized them with the scale of change of the Fed’s balance sheet and the S&P Index. We’ve also thrown in the Fed Funds rate over the period.

Figure 4: US Core PCE, CPI, SPX, Fed Balance Sheet (normalized) and Fed Funds Rate

Source: Bloomberg

It seems pretty likely that it isn’t the rate of change of either of the two inflation indices that they are managing. Nor is it likely that the rate of change of those inflation indices is somehow the “problem” that is driving the extreme evolutions of their policies in recent years. Their sharp moves to zero interest rates, extended periods at zero/very low rates, and explosion of balances sheet, have obviously made little relevant impact on the rate of change of their preferred Core PCE index. In fact, modestly, the opposite. One might surmise that their intent behind choosing the Core PCE 2% longer term average as their singular transparent objective is merely to give them de facto unlimited runway to continue with their extreme measures without constraint to achieve whatever it is that they actually want to achieve. Our cynical sides might lead us to propose that their policies are explicitly targeted at maintaining/expanding asset price inflation. We could be a bit more generous and claim they are arguably trying to avoid a crash of the asset markets that they unintentionally(?) inflated. Even Chair Powell raises the point in his speech, noting that in the post-Volcker era (the era of the Greenspan Put, our point, not Chair Powell’s) “a series of historically long expansions had been more likely to end with episodes of financial instability” as opposed to overheating and rising inflation.

To be unduly fair (because they really probably are targeting the wealth effect through asset prices), we could assume they are in fact targeting the below core problem of debt, cognizant that the avalanche of defaults will be catastrophic. Remarkably, though by no means unusual as it is universally the case, they manage to get through all of their “transparency” providing explanations without ever remotely touching on this subject. This is a FRAGILE economy, and to a reasonable extent it is their fault. They are the doctor that keeps prescribing more and more Snickers bars to the patient as a cure for his lack of energy, all the while scratching their heads at the surprising growth of obesity. There seems to be a complete lack of understanding of things like Complex Adaptive Systems, Self-Organized Criticality, second order effects, reflexivity, unintended consequences. They are the proverbial, as Nassim Taleb would bluntly put it, Intellectual Yet Idiots, with no skin in the game and no foresight for the damage they wrought.

Figure 5: US Total Debt vs GDP

Source: Federal Reserve Bank of St Louis

A much more worthwhile paper was recently published by our good friend Bill White, formerly Head of Research at the BIS, and all-round thoughtful guy, entitled “International Financial Regulation: Why it Still Falls Short”. Bill is trying to look at policy through the lens of Complex Adaptive Systems. It is a real shame that the current Ivory Tower glitterati aren’t gathered around his coffee table for regular lessons on how the world actually works. As Bill nicely puts it;

the regulators and central banks have both retreated into post-crisis policies that focus on cleaning up after a crisis (promoting resilience) rather than leaning against it (promoting sustainability). In effect, post-crisis policies have essentially been “more of the same” policies that put the economy on an unsustainable path in the first place”.

additionally, he notes;

the policy regime has encouraged the belief that economies face liquidity problems when the underlying problem is really one of insolvency” thus “the path we are on is unsustainable because the underlying problems grow worse over time while the solutions become more constrained”.

Touche!

https://www.ineteconomics.org/uploads/papers/WP_131-White.pdf

As with most things related to poor Central Banking, Japan tends to give a good long-term example. The BOJ has pursued the whole buffet section of supposed inflation producing innovative policies – ZIRP, NIRP, QE, QQE, YCC, loan facilities, asset purchases – for the better part of the last three decades. The results, just like the Fed’s efforts post-GFC, are an abject failure. This recent recap on Abenomics in the Financial Times, now that Prime Minister Abe has announced his retirement, lays it out very succinctly in answer to the question posed in the very first paragraph: “did Abenomics succeed? The simple answer is: no”.

https://www.ft.com/content/9f4b1656-95a2-41e0-9c86-70f5b063796d

Sadly, the article doesn’t stop there. It goes on to lay out six lessons, all of which can be quickly reversed by simply applying the Snickers bar analogy. Yes, the Snickers bar gave an initial boost of energy, but the patient became obese leading to even less energy over time, necessitating even more Snickers bars to get the same boost. Every time we tried to do something to dial back the obesity from too many Snickers bars, the patient lost energy, and over time the patient didn’t really believe the Snickers bar were helping. If you plan to fuel growth through artificially stimulated credit expansion on an economy with insufficient population and productivity growth to support and sustain the credit, you are very likely to find that the patient’s obesity (the stock of debt) overwhelms the short term boost of each subsequent Snickers bar. Common sense seems to have left the building.

Figure 6: Japan CPI and GDP YOY%

Source: Bloomberg

The BOJ didn’t get any sustained pick up in energy, either growth or inflation, but the patient did get fat. Fat patients, or heavily indebted economies, tend to be quite fragile and very susceptible to negative shocks. They seem unusually vulnerable to a whole range of unexpected negative events, none of which are well treated with more Snickers bars.

Figure 7: Japan Govt Debt to GDP

Source: Bloomberg

It is hard to not eventually become suspicious that these central bank policies may not actually be targeted at what they claim they are trying to achieve. There is no empirical indication over the last 25 years that extreme monetary policy measures have had any realistic positive impact in moving the respective “inflation” measures towards their targets, much less above them for some sustained period. It is really not a big leap to guess they might be using the inflation target, and now average inflation target, as merely an excuse to keep asset prices (collateral) elevated, and funding costs suppressed, so as to avoid the whole credit house of cards from collapsing on itself. This brings us back to what we keep writing about, our current market environment where policy makers have created the mother of all dichotomies: priced to perfection asset markets overlaid on economies in need of constant life support.

How then to cope with these challenges in managing long term (hopefully) compounding focused investment strategies? One of the most popular and successful strategies, over the course of the modern period of Central Bank prescription of Snickers bars, has been Risk Parity. It has relied significantly on leveraging the double benefit of returns and portfolio risk mitigation on fixed income allocations as yields have been pulled ever lower and lower.

Figure 8: S&P Risk Parity Index (10% Target Vol) and US Tsy 10yr Yield

Source: Bloomberg

Our discussions (again!) last month, as relates to the challenges of a traditional 60/40 Balanced Portfolio as interest rates approach zero, become even more relevant in the levered fixed income component of Risk Parity portfolios. Don’t take our word for it, the fathers of Risk Parity over at Bridgewater are even discussing the same thing!

https://www.bloomberg.com/news/articles/2020-09-02/bridgewater-s-risk-parity-shift-jolts-a-400-billion-quant-trade

Our favourite quote taken from the authors of the Bridgewater report has to be:

It is pretty obvious that with interest rates near zero and being held stable by central banks, bonds can provide neither returns nor risk reduction,

The article doesn’t mention any of the Bridgewater proposed potential solutions, but it does give some advice from another strong Risk Parity advocate, Edward Qian of PanAgora, who claims:

Risk parity can still be used in a way that’s consistent with the past, but you just have to not be afraid of leverage.

We’ve seen and heard quite a lot of discussion on this topic, and, to paraphrase, most proposals revolve around either replacing traditional sovereign fixed income with higher yielding securities (eg. corporate bonds, mortgage securities, REITs, preferred shares, etc) or with non-mark-to-market items like real estate or even private equity. So, in essence, reclassifying what you might previously thought of as “diversifiers” into your new “defensive” investments. Less liquid, more correlated.

None of our regular readers will be surprised to hear that we think the solution is better convexity! We can take the above Risk Parity index and plug it into our handy spreadsheet and compare it to possible portfolios of superior convexity looking backward during the period when Risk Parity reigned supreme. Just for fun we can match it against our theoretical ‘Dream Portfolio’ (60/40/20 SPX/Long Vol/Gold – always lever the hedge!) that we discussed in last month’s update.

Figure 9: ‘Dream Portfolio’ vs S&P Risk Parity Index

Source: Convex Strategies, Bloomberg

We used the S&P Risk Parity (10% Targeted Vol) as conveniently these two have fairly similar portfolio annualized volatility around 10%. The hypothetical ‘Dream Portfolio’, particularly through the recent interesting times, appears to have both potentially superior returns and far superior risk in terms of drawdowns and downside volatility.

We can quickly make it look silly by equalizing on peak to trough drawdowns at circa 31% (it is virtually impossible to equalize on downside vol because of the efficiency of the Long Vol weighting), which also somewhat aligns the leverage underlying the Risk Parity index at about 180%. This gives potential adjusted ‘Dream Portfolio’ weightings of 100/40/40 (note the allocation to Long Vol, for this example, stays the same, because raising it keeps pulling the risk down even as returns go higher).

Figure 10: Adjusted Dream Portfolio vs S&P Risk Parity Index

Source: Convex Strategies, Bloomberg

Pretty much jumps right off the page what the solution for foregone return and portfolio risk reduction is, and yet we so seldom see it discussed! The key to improving compounded returns is convexity. We don’t know if crazy ideas like Average Inflation Targeting will succeed as intended and continue to drive asset prices forever higher, or if they will fail and the house of cards will fall to rubble. The concept of Risk Parity was, in essence, to balance your portfolio regardless of whether we were in an inflationary or a deflationary environment; to take prediction out of the equation. Fantastic idea! It just so happens to turn out we think, even during the period of the greatest performance both in terms of returns and risk mitigation for fixed income, that long volatility as an explicit risk mitigant would seem an even better idea. The greater asymmetry and reliability of the risk mitigation seems to allow you to own more of the thing Central Banks are trying to inflate, convexity on the upside, and cut off more of the pain as and when they fail. That sentence right there is, give or take, the definition of how we believe it is possible to improve your long-term compounded returns.

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