Risk Update – December 2021

“An ounce of prevention is worth a pound of cure.” Benjamin Franklin, circa 1736.

For those in the more advanced metric world, there are 16 ounces in a pound, or adjusted that would be “28.35 grams of prevention is worth 453.59 grams of cure.” Turns out the esteemed Mr. Franklin, like ourselves, was an advocate of convexity and compounding. His math may not be exact but, to put it in our F1 Race Car terms, he is trying to measure the contribution of the brakes.

Sadly, there has been scarce advancement on this quantification over time. As Nassim Taleb puts it in his 2007 masterpiece, “The Black Swan”:

“…everybody knows that you need more prevention than treatment, but few reward acts of prevention”

Would the Titanic be famous had the captain and senior crewmembers managed to miss the iceberg? What would we know about the likes of Ben Bernanke and Tim Geithner if they had guided the US economy and financial system such that we had managed to avoid the Great Financial Crisis? At the very least we would have been spared their revisionist self-aggrandizing novels; Bernanke’s “The Courage to Act”, Geithner’s “Stress Test: Reflections on Financial Crises”. Essentially, novels about how the guys steering the ship became heroes for getting the passengers (weighted heavily towards First Class) into life rafts.

Today’s central bankers would like us all to believe that they are faced with unprecedented complexities and extenuating circumstances that require the nimblest of discretion to thread the needle to achieve their highly evolved objectives. In reality, as Yogi Berra put it, “it’s déjà vu all over again”. Anyone that doubts this needs to jump in and read this incredible speech from former Federal Reserve Chair, Arthur Burns.

http://www.perjacobsson.org/lectures/1979.pdf The Anguish of Central Banking. Arthur Burns Sept 30, 1979.

Burns gave this speech just 18 months after departing his role as Fed Chair, and just a month or so after Paul Volcker had succeeded William Miller, who had replaced Burns. Per our opening comments, we might opine that it was, to no small extent, Chair Burns who had failed to provide the “prevention” that subsequently led to Volcker having to put the hammer down as the “treatment”. The speech from Chair Burns has statement after statement that, were we to mask the specific dates and names, we could easily pass off as being presented by today’s swath of central banking glitterati.

“Inflation came to be widely viewed as a temporary phenomenon – or, provided it remained mild, as an acceptable condition. ‘Maximum’ or ‘full’ employment, after all, had become the nation’s major economic goal – not stability of the price level.” Arthur Burns, 1979.

“The 12-month window we use in computing inflation now captures the rebound in prices but not the initial decline, temporarily elevating reported inflation. These effects, which are adding a few tenths to measured inflation, should wash out over time.” Jerome Powell, Jackson Hole August 2021.

“It therefore seemed only natural to federal officials charged with economic responsibilities to respond quickly to any slackening of economic activity ….. but to proceed very slowly and cautiously in responding to evidence of increasing pressure on the nation’s resources of labor and capital. Fear of immediate unemployment – rather than fear of current or eventual inflation – thus came to dominate economic policymaking.” Arthur Burns, 1979.

“With regard to the employment side of our mandate, our revised statement emphasizes that maximum employment is a broad-based and inclusive goal. This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities. In addition, our revised statement says that our policy decision will be informed by our ‘assessments of the shortfalls of employment from its maximum level’ rather than by ‘deviations from its maximum level’ as in our pervious statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.”         Jay Powell, Jackson Hole August 2020.

“As the income maintenance programs established by government were liberalized, incentives to work tended to diminish…..Thus the number of individuals counted as unemployed could rise even at times when job vacancies, wages and the consumer price level were rising.” Arthur Burns, 1979.

“The unemployment rate was 5.2% in August, and this figure understates the shortfall in employment, particularly as participation in the labor market has not moved up from the low rates that have prevailed for most of the past year.” Jay Powell, FOMC Press Conference September 2021.

Figure 1: US JOLT Job Openings (white). US CPI yoy% (blue). Atlanta Fed Wage Growth (purple). US Labor Force Participation Rate (orange). Post Great Financial Crisis

Source: Bloomberg

“…the Federal Reserve System had the power to abort the inflation at its incipient stage fifteen years ago or at any later point, and it has the power to end it today. At any time within that period, it could have restricted the money supply and created sufficient strains in financial and industrial markets to terminate inflation with little delay. It did not do so because the Federal Reserve was itself caught up on the philosophical and political currents that were transforming American life and culture.” Arthur Burns, 1979.

“To get the kind of very strong labor market we want, with high participation, it is going to take a long expansion….. To get a long expansion we are going to need price stability. And so in a way, high inflation is a severe threat to the achievement of maximum employment.” Jerome Powell, Jan 2022 Senate Confirmation Hearing.

“This testing process necessarily involved political judgements, and the Federal Reserve may at times have overestimated the risks attaching to additional monetary restraint.” Arthur Burns, 1979.

“The Fed’s monetary policy actions have been guided by our mandate to promote maximum employment and stable prices for the American people. In support of these goals, the Committee reaffirmed the 0 to ¼ percent target range for the federal funds rate. We also updated our assessment of the progress the economy has made toward the criteria specified in our forward guidance for the federal funds rate. With inflation having exceeded 2 percent for some time, the Committee expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.” Jerome Powell, December 2021 FOMC Press Conference.

“In principle, no matter how high the nominal interest rate may be, as long as it stays below or only slightly above the inflation rate, it very likely will have perverse effects on the economy; that is, it will run up costs of doing business but do little or nothing to restrain over-all spending……In many countries, however, these rates have at times in recent years been so clearly below the ongoing inflation rate that one can hardly escape the impression that, however high or outrageous the nominal rates may appear to observers accustomed to judging them by a historical yardstick, they have utterly failed to accomplish the restraint that central bankers sought to achieve.” Arthur Burns, 1979.

Figure 2: US 2yr Swap Rate – US CPI yoy%. “Real Rate” Proxy

Source: Bloomberg

“What is unique about our inflation is its stubborn persistence, not the behavior of central bankers.” Arthur Burns, 1979.

“During this decade alone, the Federal Reserve moved on at least two occasions to prevent financial crises that otherwise could have occurred.” Arthur Burns, 1979.

“In the United States a great majority of the public now regard inflation as the Number One problem facing the country, and this judgment is accepted by both the Congress and the Executive establishment.” Arthur Burn, 1979.

Figure 3: US CPI yoy% vs Biden Approval Rating

Source: BofA Global Research

We could go on and on in this vein. Possibly this sentiment was first, and best, expressed in Ecclesiastes, 1-9: “What has been will be again, what has been done will be done again; there is nothing new under the sun.” This is very likely the first written explanation of sandpile theory!

There was a great article out this month in Politico by Christopher Leonard, ahead of the release of his upcoming book, “The Lords of Easy Money: How the Federal Reserve Broke the American Economy”. Therein he details the decades of dissent from former Kansas City Federal Reserve President, Thomas Hoenig, to the easy money policies of the Greenspan/Bernanke era Fed. The article clearly sums up Hoenig’s ongoing dissent thusly:

“The historical record shows that Hoenig was worried primarily that the Fed was taking a risky path that would deepen income inequality, stoke dangerous asset bubbles and enrich the biggest banks over everyone else. He also warned that it would suck the Fed into a money-printing quagmire that the central bank would not be able to escape without destabilizing the entire financial system.”

Bingo!

https://www.politico.com/news/magazine/2021/12/28/inflation-interest-rates-thomas-hoenig-federal-reserve-526177

It would seem that various central banks are waking up to these issues. We have previously noted increasingly aggressive actions being taken by a number of emerging markets to withdraw highly accommodative monetary policies. Some of the more developed market central banks have started to at least slow down their pace of liquidity injection, eg. the Fed’s now accelerated taper or the RBA’s aborting of their YCC efforts. The Bank of England, having choked in November, stepped up to the plate with an actual rate hike in December, moving their target Bank Rate up all of 15bp to now stand at 0.25%. You can just barely see it in figure 4 paired with their CPI and RPI price stability metrics. If indeed the BOE has a role to play in combating rising consumer prices, one wonders if this initial step will make much of an impact (see above comments from Arthur Burns).

Figure 4: BOE Bank Rate (white) vs UK CPI (purple) and RPI (blue) yoy% (1989-2021)

Source: Bloomberg

One of the great things about the BOE is that they have data going way back! We can drag the above image all the way back to the early 1900s and get some impression about the policy rate setting over time. It is interesting to note that, through the 1930s and 1940s, the eras of the Great Depression and World War II, the Bank Rate was never moved below 2%. Apparently, economic fragility is far worse today. Not a great testimonial for the quality of job central bankers of the recent past have done in nurturing a stable system.

Figure 5: BOE Bank Rate (white) vs UK CPI (purple) and RPI (blue) yoy% (1911-2021)

Source: Bloomberg

As most will know, the BOE’s official measure of price stability is the CPI year-on-year change, and when it exceeds a threshold of +/-1% from their random 2% target the Governor of BOE and the Chancellor of the Exchequer (government Finance Minister/Treasury Secretary) must exchange letters, presumably as to “what is being done about it”! The links below house the last two rounds of back and forth between the Governor and the Chancellor and you can decide for yourselves the sincerity with which they go through this process. From the Governor’s letter written after the December 2021 meeting:

“At its November meeting, the Committee judged that, provided the incoming data, particularly on the labour market, were broadly in line with the central projections in the November Monetary Policy Report, it would be necessary over coming months to increase Bank Rate in order to return CPI inflation sustainably to the 2% target. Recent economic developments suggest that these conditions have been met. The labour market is tight and has continued to tighten, and there are some signs of greater persistence in domestic cost and price pressures. Although the Omicron variant is likely to weigh on near-term activity, its impact on medium-term inflationary pressures is unclear at this stage. The Committee judged that an increase in Bank Rate of 0.15 percentage points was warranted at the December MPC meeting.”

https://www.bankofengland.co.uk/-/media/boe/files/letter/2021/governor-cpi-letter-december-2021.pdf?la=en&hash=4BECD00DD7C46507804333F0AE472CA6C760F27A

https://www.bankofengland.co.uk/-/media/boe/files/letter/2021/chancellor-cpi-letter-december-2021.pdf?la=en&hash=89DB6D2258E7C584EB7F8A977C4E1D6C1261D17E

https://www.bankofengland.co.uk/-/media/boe/files/letter/2021/september/governor-cpi-letter-september-2021.pdf?la=en&hash=72EA4C295408124B9F55B4F04A9A9A646167B0DF

https://www.bankofengland.co.uk/-/media/boe/files/letter/2021/september/chancellor-cpi-letter-september-2021.pdf?la=en&hash=12662A8C1907065B9C02D88F8A46FB3EA7B52458

The one major central bank that stands out as still totally ignoring their role and responsibility in maintaining price stability is the ECB. Below we have strapped together their various recent quarterly forecasts for annual changes in their chosen price stability measure against the actual reported numbers through this month.

Figure 6: Eurozone HICP yoy% (blue) vs Quarterly ECB Forecasts

Source: ECB, Convex Strategies

When their chosen measure of “inflation” (as they would call it) was too low, they implemented extraordinary accommodative policy measures and forecast that such measures would, in short order, lead inflation back up to just below their target. Then, as the year-on-year changes in their measure of “inflation” began to rise, far more quickly than their forecasts, they were forced to adjust their forecasts targeting an ever-higher terminal point, from which, with the exact same extraordinary accommodative policy measures, the annualized changes would revert quickly back down to, yet again, settle at just below their randomly chosen target of 2%. This led us to ask in our October 2021 Update https://convex-strategies.com/2021/11/19/risk-update-october-2021/ – “Which, again, really begs the question, what is the point of their policies? If they believe their policies “work”, they should stop them right now and align policy settings to current economic circumstance. If they believe their policies do not work, as is indicated by their nonsensical forecasts (terminological inexactitudes?), they should end their policies right now and start explaining what the point of them was all along.”

If anybody bumps into the likes of Christine Lagarde or Philip Lane, could you do us a favour and throw out these questions?

  1. If you had correctly forecast HICP rises over the last 15 months, would you have adjusted policy?
  2. For how long, and at what scale, would your forecasts need to continue to fail for you to change your methodology and/or recommend policy action?
  3. What level of negative real rates do you think will lead HICP increases to moderate back to your forecasts/target?
  4. Most fundamentally, what is the intended impact on your price stability measure from your current extreme monetary policy setting?

Figure 7: ECB Policy Rate (white). EUR Wu Xia Shadow Rate (blue). EUR 2yr Swap (purple). HICP yoy% (yellow). EUR Taylor Rule (orange)

Source: Bloomberg

If Ms. Lagarde or Mr. Lane seem open to one more follow up question, maybe you could throw in something about how they see the passthrough of PPI into HICP and how that feeds through into their forecasts.

Figure 8: PPI yoy% Eurozone, Germany, Italy, France

Source: Bloomberg

We don’t, by any means, pretend to be predictors of the future, but we do know a sandpile when we see one.

More regular readers will know where we are going with this. How does an investor construct their investment portfolio in a world wrought with sandpiles? In a world where the mad scientists behind the curtain continue to implement wildly misunderstood prescriptions with little or no understanding of long term second order effects? The answer is undoubtedly convexity. Resilience. Robustness. Antifragility. The answer is active risk mitigation, not merely risk reduction. It isn’t about timing, other than the time to start improving you geometric compounding is ALWAYS as soon as possible. As we say, “it isn’t about timing the market, it is about time in the market.” The key to compounding is survival and time. Obviously, the two have a very close relationship!

The number one “risk management” strategy in the fiduciary/wealth advisory world is a combination of diversification and risk reduction, aka the Balance Portfolio. As we have discussed ad infinitum, it relies on known-to-be flawed mathematics (see our September 2021 Update for a more thorough discussion https://convex-strategies.com/2021/10/19/risk-update-september-2021/) based on the premises of Modern Portfolio Theory (MPT) which, as Nassim Taleb said in a recent note makes “neither empirical nor theoretical sense.”

Please go and take a look at Nassim’s recent technical note entitled “Pension Funds Should Never Rely on Correlation.” https://www.academia.edu/50833426/Pension_Funds_Should_Never_Rely_on_Correlation

It is a very straightforward note (he is the master of being straightforward IOHO) that lays out precisely the same points, though undoubtedly more succinctly, that we draft month after month in our Updates. He highlights three Comment boxes:

  • Comment 1: First Fallacy of MPT. Future returns and correlation – the two central parameters in MPT – are not observable in the real world.
  • Comment 2: Second Fallacy of MPT. Volatility of returns (as expressed in portfolio standard deviation) does not map to risk.
  • Comment 3: Correlation and association. Correlation, even if predictable (it’s not), is a poor measure of association between non-Gaussian variables or in the presence of nonlinear dependence.

Nassim concludes with “The so-called ‘optimal’ portfolio is in effect the worst of all worlds. It offers scant protection against tail risk and, at the same time, achieves an under-allocation to the riskier assets with higher returns in the long periods of economic expansion such as the past decade.”

We couldn’t have said it better ourselves.

For a slightly more technical discussion on correlation, we would refer you to Nassim’s paper “Fooled by Correlation: Common Misinterpretations in Social ‘Science’”. https://www.academia.edu/39797871/Fooled_by_Correlation_Common_Misinterpretations_in_Social_Science_

Our version of Nassim’s Comment 3 is “Participate and Protect”. Everything in your portfolio should be judged on those two simple parameters. All that dead capital that does neither needs to be weeded out and reallocated. It most certainly should not be levered! One simply is not going to achieve the objective of compounding by not participating in good markets (or only getting a portion of ‘participation’) and not protecting in bad ones (while always getting one’s full share on this side).

Annual arithmetic average return, volatility as a risk measure, and Sharpe Ratio as a performance standard are all tools targeted at the objectives (compensation structure) of the fiduciary. Long term geometric compounded returns and/or terminal capital values, downside volatility or drawdowns as risk measures, and Sortino Ratio as a performance metric are tools that can help to turn the focus to targeting the objectives of the capital owners.

We show it over and over again with our example of “Barbell” strategies (have good brakes and drive fast) vs “Balanced” strategies (drive slow enough that you probably won’t crash). On an unadjusted basis we can show an Always Good Weather (AGW) 40/40/40 version of a Barbell strategy against a 100% S&P Risk Parity 10%Vol version of a Balanced strategy (optimized to its target volatility with leverage). 

Figure 9: AGW 40% S&P/40% Nasdaq /40% CBOE Eurekahedge Long Vol vs S&P Risk Parity 10Vol Jan2005-Dec2021 – Scattergram View

Source: Bloomberg, Convex Strategies

The Scattergram clearly shows the superior convexity of the Barbell over the Balanced and the return distributions show the far superior positive skew of the returns. “Skew”, in a sense, is the missing third dimension in the flawed Sharpe Ratio (it can, in effect, be addressed by replacing volatility with downside volatility and generating the far superior Sortino Ratio). Sharpe Ratio is simply return over volatility. It is, by construct, penalizing a strategy for positive return skew! It explicitly rewards managers for foregoing upside to reduce downside. It is beloved by slow drivers! At the above weightings, we get the below approximate risk and return metrics.

The Vol and Sharpe of the Risk Parity strategy tell you nothing about what actually matters, ie that it doesn’t do a particularly good job of participating and protecting, particularly in the extreme periods when it matters the most.

We all know what that means in the compounding view.

Figure 10: AGW 40/40/40 vs S&P Risk Parity 10Vol Jan2005-Dec2021. Compounding View

Source: Bloomberg, Convex Strategies

For a like-for-like comparison we should equalize to one of the actual risk measures, we like to use downside volatility. This then puts us on the plane of the Sortino ratio. Equalizing to roughly the downside Vol of the AGW portfolio changes the weighting of the Balanced Risk Parity strategy to only 62% to the S&P Risk Parity 10Vol with the other 38% parked in cash (we use the SHY ETF as our cash proxy). This revises the metrics and respective charts as follows:

Figure 11: AGW 40/40/40 vs S&P Risk Parity 10Vol (62%) Jan2005-Dec2021. Scattergram View

Source: Bloomberg, Convex Strategies

Figure 12: AGW 40/40/40 vs S&P Risk Parity 10Vol (62%) Jan2005-Dec2021. Compounding View

Source: Bloomberg, Convex Strategies

It is difficult to make it clearer. If you or your fiduciary managers are using Sharpe ratios, Vol as a risk measure, annual arithmetic returns, and relying on correlation and slow driving for risk management, it might be worth pulling into the pits for a tune up. The above time-series encompass a period that could hardly have been more favourable for the implementation of Risk Parity as a Balanced investment strategy, ex post – and its performance was dominated by a simply constructed Barbell strategy. Given all that we harp on about in terms of the ever more fragile sandpiles, and all the excesses of policy targeted at forever propping the sandpiles higher, it is hard to imagine financial conditions getting any better for Balanced strategies looking forward, ex ante.

Build portfolios that are resilient to what you don’t know, not to what you think you do know. Compounding will be driven by how you respond on the Entropy distribution, think of it as prevention, not how you perform inside the Binomial Probability Distribution.

Figure 13: Entropy vs Binomial Probability Distribution

Source: Convex Strategies

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