Risk Update – January 2022

Back in our May 2021 Update https://convex-strategies.com/2021/06/17/risk-update-may-2021/, we noted that past historical spikes in CPI, similar to what we were seeing then, had indeed all generally been transitory in nature. They had also all aligned with Federal Reserve tightening regimes and subsequent equity/asset market sell-offs. We went out on a limb and opined “that ‘tightening’ is, as of now, not currently a factor, in fact quite the opposite and particularly if one includes the Fed’s balance sheet in the analysis; still growing at $120bn per month. Far be it from us to use the old catch phrase that maybe ‘this time is different’ but maybe this time is different.”

It seems that we may have been on to something and, after months and months of arguing otherwise, even the folks in the Ivory Towers are coming around. The narrative around economic circumstances has started to shift. In the most recent round of central bank meetings the language to describe their respective economies has taken a notable turn.

From Jerome Powell after the Fed’s meeting on January 26, 2022.

  • “Inflation remains well above our longer-run goal of 2 percent.”
  • “Wages have also risen briskly”
  • “This is, by so many measures, a historically tight labor market, record levels of job openings, of quits. Wages are moving up at the highest pace they have in decades.”
  • “..this is a very, very strong labor market.”
  • “..there’s really a shortage of workers.”
  • “Right now we have inflation running substantially above 2 percent and, you know, more persistently than we would like. We have growth – even in forecasts, even in the somewhat reduced forecast for 2022, we still see growth higher than, substantially higher than what we estimate to be the potential growth rate. And we see a labor market where, by so many measures, it is historically tight.

And what was the Fed’s policy announcement? Unchanged from what they had announced in the previous meeting; “…the Federal Open Market Committee kept its policy interest rate near zero and stated its expectation that an increase in this rate would soon be appropriate. The Committee also agreed to continue reducing its net asset purchases on the schedule we announced in December, bringing them to an end in early March.”

Figure 1: US Unemployment Rate (white – inverted), CPI yoy% (blue) and Fed Funds Rate (orange)

Source: Bloomberg

From Christine Lagarde after the ECB’s meeting on February 3, 2022 (we are extending our January update into the first few days of February given the linkage of these meetings to the topic).

  • “Inflation to remain elevated longer than expected.”
  • “Inflation has risen sharply in recent months and it has further surprised to the upside in January.”
  • “Output reached pre-pandemic levels at end of 2021.”
  • “Global recovery contributes to positive outlook.”
  • “Price rises have become more wide-spread.”
  • “Labour market conditions improving further.”
  • “Risks to inflation outlook tilted to upside.”

And what was the ECB’s policy announcement? Unchanged from what they had announced in the previous meeting; “The interest rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility will remain unchanged at 0.00%, 0.25%, and -0.50% respectively.”

Figure 2: Euro Unemployment Rate (white-inverted), HICP yoy% (blue) and ECB Deposit Rate (orange)

Source: Bloomberg

From Philip Lowe after the RBA’s meeting on February 1, 2022.

  • “Our economy has weathered the pandemic much better than was expected, jobs growth is strong and unemployment is low, household and business balance sheets are generally in good shape and wages growth is picking up.”
  • The economy performed significantly better last year than we had expected…”
  • “…stronger GDP and labour market outcomes have translated into higher inflation than we were expecting.”
  • “Australia has not experienced unemployment rates this low in the past half century – the last time we had the unemployment rate below 4 percent was in the early 1970s.”
  • In Australia, the share of working age Australians with a job has never been higher than it is now.”

And what was the RBA’s policy announcement? “At its meeting today, the Board decided to maintain the cash rate target at 10 basis points and the interest rate on Exchange Settlement balances at zero percent. It also decided to cease further purchases under the bond purchase program, with the final purchases to take place on 10 February.”

Figure 3: Australia Unemployment Rate (white-inverted), CPI yoy% (blue) and RBA Policy Rate (orange)

Source: Bloomberg

From Andrew Bailey after the BOE’s meeting on February 3, 2022.

  • “Living costs crisis would be worse without rate hike.”
  • “We are seeing an extreme terms of trade shock.”
  • “Bank of England is not behind the curve.”
  • “There is a debate in policymaking about whether to take gradual steps or do a larger move now to send a message.”

And what was the BOE’s policy announcement? In a surprise 5-4 vote they hiked their Bank Rate by 25bp to now stand at 0.50%. The “surprise” wasn’t the 25bp hike but rather that the 4 dissenting voters wanted a full 50bp hike!

Figure 4: UK Unemployment Rate (white – inverted), CPI yoy% (blue) and BOE Bank Rate (orange)

Source: Bloomberg

As ever, few say things with quite as much clarity as the British, in general, and maybe the BOE, in particular. Our broad view of this latest round of central bank commentary and action is best summarized by the lucidity on the BOE’s website https://www.bankofengland.co.uk/monetary-policy-report/2022/february-2022 where they lay it out as thus:

“The UK economy is recovering, and we expect inflation to rise further to around 7% in the spring. In response, we have increased interest rates to 0.5% to support inflation returning to our 2% target.”

We need dig no further than our own Update from last month https://convex-strategies.com/2022/01/17/risk-update-december-2021/ for an appropriate quote as to the circumstances we seem to be in with all of these esteemed central bankers. As we posited last month:

““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.”

We poked some fun at the BOE when they choked on their widely signalled initial rate hike in November, despite their forecast of CPI topping out at 5% in April. We teased them a bit further when they powered ahead with the 15bp rate hike in December, along with raising their forecast for peak CPI to 6%. Now, finally, they have truly jumped on board with a full 25bp hike to go along with raising their peak inflation forecast yet again to 7%. The four dissenting voters have only whetted our appetite for what may come next!

Figure 5: Bank of England Revised Inflation Forecasts

Source: www.bankofengland.co.uk

Interestingly, we did engage in a bit of conversation prior to the BOE meeting. As is a very common discussion, at the moment, there were some opining that maybe the market was building in a bit too much tightening into the front end of the interest rate curve. In the case of the BOE, prior to their meeting, something in the region of 125bp of implied tightening over the next 12 months was implied by the front-end slope of the curve. One astute follower rightly pointed out that that was at the extreme end, indeed greater than any, of the initial 12 months’ worth of hikes from past BOE hiking cycles going back to 1990.

While it is an interesting point, we thought it lacked a certain relevance as to the respective starting points of past hiking cycles compared to where the BOE (and the rest) find themselves today. We noted that all of the BOE hiking cycles between 1990 and 2008 commenced with the real policy rate (Bank Rate – CPI yoy%) somewhere between positive 2-4%. The subsequent tightenings increased real policy rates by circa 2%, raising real rates into the region of positive 4-6% before they terminated the hiking cycles. Their current hiking cycle is commencing with the real policy rate in the region of negative 5.15%!

Figure 6: UK Bank Rate and UK CPI (top panel). UK Real Policy Rate (bottom panel)

Source: Bloomberg

This obviously raises the question we have so often posed – what level of negative real rates do these central bankers think will start to act as a constraint on their price stability targets? Is the Bank of England justified in claiming that a 0.50% nominal policy rate will “support inflation” returning from their 7% forecast back down to their 2% target? Will real policy rates in the region of negative 6.5% prove to be an effective inflation fighting tool? This isn’t just a BOE problem, it is universal.

This is the point we have been harping on about, namely they have all chosen (we believe intentionally) to fall very far behind. Ever since the move to “Average Inflation Targeting” by the Fed you could see the risks of this building.

Figure 7: Introduction of Average Inflation Targeting

US Fed Fund Rate and US CPI (top panel). US Real Policy Rate (bottom panel) White Vertical Line = August 2020

Source: Bloomberg

As we have been pointing out, the ECB has been a leader in the pack of deniers as to their price stability issues. Only as of the most recent post policy meeting press conference has the ECB conceded that “inflation” might be an issue in their determination of monetary policy. It could be argued that they are a bit late to the game.

Figure 8: ECB Deposit Rate and Eurozone HICP (top panel). ECB Real Policy Rates (bottom panel)

Source: Bloomberg

Now that the ECB has admitted that they might have some role to play in the price (in)stability issues in the countries that use the EUR currency, it leaves the RBA as the lone central bank standing in the denier’s corner of the classroom.

Figure 9: RBA Policy Rate and Australia CPI (top panel). RBA Real Policy Rate (bottom panel)

Source: Bloomberg

RBA Governor Lowe gave a broadly encompassing speech the day after their February 1st policy meeting – https://www.rba.gov.au/speeches/2022/sp-gov-2022-02-02.html. To Governor Lowe’s credit, he nicely displayed the prowess of the RBA’s forecasting chops with this simple little matrix. In his own words: “The picture is pretty clear. The economy performed significantly better last year than we had expected…”

Figure 10: RBA 2021 Economic Outcome vs Forecast Table

Source: ABS, RBA

Of course, for 2022, his presentation went on to forecast even stronger growth, historically tight labour markets, rising wages yet, surprisingly, falling measures of inflation. That last forecast, presumably, is what then justifies the continuation of the all-time low of policy rate setting, 0.10%, into the foreseeable future. Brings us back to the same old question: are they the world’s most incompetent forecasters or are they intentionally misrepresenting forecasts to try to justify their policy choices, or to somehow “manage” public expectation? Which is worse?

To reiterate the quote from Governor Lowe: “Australia has not experienced unemployment rates this low in the past half century – the last time we had the unemployment rate below 4 percent was in the early 1970s.” Australia CPI peaked at 17.7% in early 1975, with an average annual change of over 9% for two decades.

Again, we can turn to the guy who went through it back in the 1970s, Arthur Burns, and lean on the wisdom he gleaned from his experiences.

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.

Stephen Roach, a former Federal Reserve staffer under Chair Burns, penned another excellent piece on just this topic.

“With a -7% real federal funds rate putting the Fed in a deep hole, even a swift deceleration in inflation does not rule out an aggressive monetary tightening to re-position the real funds rate such that it is well-aligned with the Fed’s price-stability mandate.”

https://www.project-syndicate.org/commentary/federal-reserve-mad-scramble-to-control-inflation-by-stephen-s-roach-2022-01

To Stephen’s point, here is a look at the market price for the 1yr forward 3mth interest rate, compared to the NY Fed Median 1yr Expected Inflation Rate. Even with the adjustment in market interest rates, even if the Fed undertakes the hikes currently being priced in the market, current inflation expectations would leave things with still significantly negative real rates.

Figure 11: USD 1y3mth Forward Swap Rate vs NY Fed Median 1yr Expected Inflation

Source: Bloomberg

What on earth is going on? Why are central banks stuck on absolute maximum accommodative policy settings even as their reputed target metrics of price stability and employment are at peak historical extremes on the opposite side? We went through this in some detail back in our June 2021 Update https://convex-strategies.com/2021/07/23/risk-update-june-2021/, noting the 100th%tile of divergence between policy settings and economic circumstances, since when the position has only worsened.

We all know why the central banks are neglecting their officially mandated responsibilities. It comes down to their true focus/mandate, what they would call “financial stability” or what we might call a “debt trap”. Others might use a term like “asset bubbles”.

Raghuram Rajan penned a nice note on the topic.

“The Fed thus assured traders and bankers that if they collectively gambled on similar assets, it would not limit the upside, but it would limit the downside if their bets turned bad.” Raghuram Rajan, Jan 31, 2022.

https://www.project-syndicate.org/commentary/end-of-free-lunch-economics-by-raghuram-rajan-2022-01?utm_source=Project+Syndicate+Newsletter&utm_campaign=d585ad7407-sunday_newsletter_02_06_2022&utm_medium=email&utm_term=0_73bad5b7d8-d585ad7407-107443098&mc_cid=d585ad7407&mc_eid=1f5b7d9d1f

It is pretty clear the needle that central banks, led as always by the Fed, are trying to thread. They need to do something about the broken narrative that, as long as they convince everyone to ignore and exclude asset prices, their policies have not caused inflation. Their decades of money and credit creation has now leaked into their misrepresentative measures and hit the consumers (voters) where they really feel it. Yet the wealth effect of their policies is exceedingly fragile, imperilling circumstances for the operators of the financial system and the owners of assets (donors).

Policymakers desperately want to believe that they can impose some constraint on their price stability measures through an adjustment in nominal yields, while simultaneously maintaining the credit creation necessary to keep the economy and asset prices from collapsing by having sufficiently negative real rates.

They want to be seen to be fighting “inflation” through nominal yield adjustment, while aggressively stimulating inflation through maintaining significantly negative real rates.

It is really just the same thing all over again. We linked to this note back in June that has Janet Yellen making the case for real wage debasement as the underlying premise of the Fed’s targeting of a minimum of 2% annual price increases.

https://www.independent.org/news/article.asp?id=13623&mc_cid=66d6c8ab66&mc_eid=f68f74b3db

Ms Yellen is quoted as saying “a little inflation lowers unemployment by facilitating adjustments in relative pay in a world where individuals deeply dislike nominal pay cuts.”

We have no better idea than anybody else how well the central banks will navigate this process. Will they find religion and get sufficiently aggressive in duelling with the skyrocketing price stability measures and, as has historically always been the case, crash the everything bubble that they have incentivized the markets to build? Or will they continue with their recent practices of all bark no bite policy enticing the sandpile ever higher, heedless of the societal costs as the side-effect of inflation rampages those least able to protect themselves from it?

Any readers that are unclear on how we look at it, should re-read our August 2021 Update https://convex-strategies.com/2021/09/22/risk-update-august-2021/. The circumstances that central banks find themselves in is best understood through the lens of Self-Organized Criticality, aka sandpile theory. Central banks can continue to prop up the sandpile and we all live with the perennial negative externality of inflation and destabilizing wealth distribution. Alternatively, they can stop the extreme measures to prop up the ever more fragile sandpile and allow the inevitable phase transition back to some sort of equilibrium state.

It is, no doubt, a complex investment environment. As always, we would advocate for solutions that address the compounding objective of end capital owners. We believe that is best achieved through adding convexity to one’s investment portfolio, through constructing a portfolio that most efficiently “participates and protects”. As we often do, we turn to a quote from convexity guru Nassim Taleb.

“…it remains the case that you know what is wrong with a lot more confidence than you know what is right.”     Nassim Taleb, “The Black Swan”.

In that spirit, we were presented last month with a pristine example of “what is wrong” in compounding focused investment strategies. We saw the following strategy proposed by an alternative fund manager (ie. a Hedge Fund) as a top trade for 2022. The premise was that a put selling strategy, as represented by the CBOE PutWrite Index (PUT), had delivered roughly similar performance to outright ownership of S&P for less risk in 2021 and the manager was dubbing it to be a top position for their portfolio for 2022. He provided this sort of picture in support of his claims.

Figure 12: PUT Index (purple) vs SPX Index (gold) 2021 Performance

Source: Bloomberg

Just as a starter, we would suggest it better to use the SPX Total Return Index (SPXT) for the comparison on the assumption that investors go ahead and collect their dividends, but that is just nit-picking.

Figure 13: PUT Index (purple) vs SPXT Index (gold) 2021 Performance

Source: Bloomberg

We mention it over and over, and laid it out again last month very clearly:

“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.”

This proposed strategy touches on all of these points. Said manager is using 1yr returns, sans any real compounding effect for his comparison. He is presumably measuring “risk” as the Volatility of returns, not factoring the obvious implications of the scale of potential risk inherent in the position, or the obvious skewed nature of the potential returns – ie bounded upside vs unbounded downside. This, presumably, leads him to the conclusion that his put selling strategy has a superior Sharpe Ratio and is therefore the superior strategy.

In the world of the fiduciary, the PUT strategy is a clear winner! Fill the book!

What about in the world of the end capital owners? For starters, his chosen time period is far too short to show the compounding effect of his strategy. Likewise, the chosen period masks the obvious potential risk of the strategy. Just because you didn’t realize that risk, doesn’t mean it wasn’t there. Further, as we always note about Vol as a risk measure, it is rewarding the fiduciary for reducing upside! An obvious non-winner for the capital owner that desires compounding.

Looking at the strategy over a two-year horizon, 2020-2021, paints a very different picture.

Figure 14: PUT Index (purple) vs SPXT Index (gold) 2020-2021 Performance

Source: Bloomberg

Even on the nonsensical fiduciary’s metrics, things have changed quite significantly.

But what happens if we apply metrics that, while not perfect, make some corrections that better target the compounding desires of the end capital holder. Below is the same two-year period again but this time we have added the equivalent CBOE PutProtect Index (PPUT) that replicates the ownership of the underlying S&P and the systematic put buying that is the exact inverse to the systematic put selling applied by the PUT Index.

Figure 15: PPUT Index (blue) vs PUT Index (purple) vs SPXT Index (gold) 2020-2021 Performance

Source: Bloomberg

Now, interestingly, one would certainly be more “accurate” in claiming that PPUT Index performed on par over the period with SPXT Index with less risk. Expanding our metrics grid, it looks like this. We have added in here the respective Max Drawdowns and the Days to Recover (DTR) the previous peaks.

This is a great example of our Race Car analogy. The Barbell Racer, PPUT Index, has the superior brakes thus allowing it to navigate the unexpectedly sharp turn in March 2020 and come out the other side accelerating into the immediate upside of April 2020. It is going to take the PUT Index race car, with its forever bounded upside and brakeless downside strategy, a very very long time to catch up and will require an unnaturally long stretch of track that has neither sharp turns nor fast straight aways. We wouldn’t like his chances.

You could, of course, accuse us now of being the ones that cherry-picked a favourable time period for the comparison, and you would be partially correct. We have captured a period where the superior convexity of the PPUT strategy truly shines. But even if we go back to March 2009 and capture the entirety of the post GFC bull market, we still find the PPUT index performs just fine in what is in essence the periods that don’t really matter, then separates itself during the trickiest and fastest parts of the race. Just what one would want from a convex driver.

Figure 16: PPUT Index (blue) vs PUT Index (purple) March2009-2021 Performance

Source: Bloomberg

The relative performance during the ordinary years is trivial, particularly given that right throughout you know that you have superior downside protection, not just rubbish smoke and mirrors risk measures, and far more upside potential.

We have shown this many times before with our Scattergram tool.

Figure 17: PPUT Index (blue) vs PUT Index (red) March2009-2021 Scattergram and Return Skew

Source: Bloomberg, Convex Strategies

Figure 18: PPUT Index (blue) vs PUT Index (red) March2009-2021 Performance

Source: Bloomberg, Convex Strategies

Things get even worse, from the perspective of the end capital owner, for the manager’s proposed put selling strategy when you factor in the fees charged by the manager! Why people continue to pay fees for correlated, bounded topside, unbounded downside risks is truly beyond us. If you roll in a 2/20 fee model to the put selling strategy the relative performance looks like this.

Figure 19: PPUT Index (blue) vs PUT Index + 2/20 (red) March2009-2021 Performance

Source: Bloomberg, Convex Strategies

Even last year, when the PutWrite strategy had a particularly good run, as shown by the manager in their comparison chart, if you adjust for their fees, the PutProtect strategy outperforms it in a year with no notable sharp turns. It may not show up in the ex-post measures of realized return volatility, but you know definitively that the PutProtect strategy has far superior risk protection in the event of a sharp tail risk event.

Figure 20: PPUT Index (blue) vs PUT Index + 2/20 (red) 2021 Performance

Source: Bloomberg, Convex Strategies

For a proper comparison we should risk adjust the strategies. If we risk adjust, by de-risking exposure to the PUT, to align to the Downside Volatility of the PPUT Index over the March 2009-2020 bull market time series, we end up with something like a 75% allocation to the PUT Index with 25% held in our Cash Proxy, the SHY ETF.

Figure 21: PPUT Index (blue) vs 75% PUT Index + 2/20 (red) March 2009-2021 Performance

Source: Bloomberg, Convex Strategies

Some readers might sense a certain familiarity with the “red line” above. It looks surprisingly similar to the historical performance of commonly seen indices of Hedge Fund performance. Just as a quick example, we can run it on a 2005-2021 time series, and adjust to the Downside Vol of the two strategies over that period, giving us only a 50% allocation to the PUT Index.

Figure 22: HFRXGL Index (blue) vs 50% PUT Index + 2/20 (red) 2005-2021 Performance

Source: Bloomberg, Convex Strategies

Amazingly, the risk and fee adjusted PutWrite strategy still manages to slightly outperform the Hedge Fund Index, but the point is that they are essentially the same thing. They are strategies that are run under metrics that are targeted at the objectives of the fiduciary, not the end capital owner.

As the final comparison, let’s bring in a preferred Barbell Racer, our reliable ‘Always Good Weather’ (AGW) portfolio with 40% in SPXT, 40% in XNDX, and 40% in the CBOE Long Volatility Index (LongVol). Again, we will risk adjust to Downside Volatility of the longer time series leaving our fee adjusted PutWrite strategy with just a 55% allocation and we will show it across all of the various time horizons.

Figure 23: AGW 40/40/40 (blue) vs 55% PUT Index + 2/20 (red) 2005-2021 Performance

Source: Bloomberg, Convex Strategies

Figure 24: AGW 40/40/40 (blue) vs 55% PUT Index + 2/20 (red) March2009-2021 Performance

Source: Bloomberg, Convex Strategies

Figure 25: AGW 40/40/40 (blue) vs 55% PUT Index + 2/20 (red) 2020-2021 Performance

Source: Bloomberg, Convex Strategies

Figure 26: AGW 40/40/40 (blue) vs 55% PUT Index + 2/20 (red) 2021 Performance

Source: Bloomberg, Convex Strategies

As Nassim said, it is very difficult to prove what is “right”, but you can at times prove what is “wrong”. We can’t provide definitive proof, ex-ante, that variations on our proposed convex strategies will always provide superior returns through what are sure to be complex market environments. All we can do is show, ex-post, that it has thus far indeed been the case and make the strong argument that having protection against unknown, even unrealized, risks is better than the alternative. We think, however, that handing over your capital to a fee charging hedge fund manager that is running a short put strategy is definitively NOT the way to compound capital. Partial participation on bounded upside and full participation on correlated unbounded downside is a guarantee of compounding destruction.

If you are a capital owner/allocator, we strongly suggest finding ways to garner the upside returns for the risk that your capital alone is taking: try to avoid paying away upside to people that are gambling with your capital. Giving away upside and getting handed all of the downside seems a very poor compounding strategy. Imagine a strategy where you as the capital owner get to keep all the upside from the risk you assume, while singularly paying to protect YOUR downside. One such strategy might look something like the above Always Good Weather portfolio we have proposed. Those hypothetical returns are after the fees of the Long Vol managers that make up that index. In some circles, folks might refer to their performance as “alpha”, but we like to think of it as the power of convexity.

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