IT’S ONLY JUST BEGUN – November 2020
A 1970’s hit classic from the Carpenters; a song that started life as the theme tune to a TV advert for Crocker National Bank. Like the Carpenters, Crocker had a chequered existence having started life in the 1860s railroad boom, it was sold to our very own Midland Bank – itself subsumed into HSBC. After steadily losing money on the transaction, something UK banks are wont to do when venturing overseas, it was sold to Wells Fargo.
Well Biden has amassed enough electoral college votes to get him over the line, but the legal shenanigans have only just begun. The Senate race wont be over until January as electoral rules in the state of Georgia require a second ballot where the winning candidate receives less than 50% of the vote. It’s looking like a Republican senate but if Trump refuses to go quietly the Republican vote may dwindle away. In that event the blue wave will have arrived via the “Backdoor” (something of an awesome wave in Hawaii for surfing aficionados).
Biden has assembled a transition team, something Trump didn’t really take seriously (setting the style for his presidency), but we don’t yet know the details of his legislative agenda and probably wont for sometime. There will be much bargaining- not least of all around a stimulus bill which the House failed to provide pre election and which the economy desperately needs. At his press conference last week after the Fed’s FOMC meeting Powell suggested the economy was improving just fine as a result of QE which is a fiction; it has propped the market up not the economy, that’s the job of fiscal policies which he was loathe to say should be a priority. Central bankers rarely say what they mean or indeed mean what they say…
What we do know is the world has changed in an extraordinarily short space of time from an historical perspective and those changes have only just begun. In the majority, change is not something readily embraced, certainly not at this pace, and the reverberations can be felt manifestly and will carry on for a very long time. There will be no going back to the “old” world so we will need to think about changing our investment strategy.
The old 60/40 equity/bond model looks set for a revamp. The huge bond issuance is going to be a drag on returns and the traditional negative correlation between the two asset classes won’t provide the downside protection that bonds once afforded us. We need another way of looking at portfolio “insurance”.
Given what we currently know, it would be safe to assume that much more fiscal and monetary stimulus is coming; there is no alternative. That leads us to two possible outcomes; not immediately but something we should be positioned for ahead of the event.
The first is an inflationary boom which initially will be good for equities, particularly emerging markets and mining companies and the precious metals themselves, but not very good at all for bonds. The amounts of debt to be issued are so large that it will be impossible to repay them. The Fed’s balance sheet is quite likely to reach $50 trillion and then there are the unfunded healthcare and pension liabilities which could be a whole magnitude higher than that. Eventually there will be a reckoning and we could well see the Fed printing money to bail out the pension funds and coming to a debt jubilee arrangement with the government. The trust in fiat currency will by that stage start to evaporate and unless there are holdings of real assets in the portfolio, gold for example, or index linked securities then future will look pretty bleak.
This is not as unlikely an outcome as it may sound. Public pension funds in the US are operating on the basis that, over the next 10 years, they need and will get a 7.5% annual return on their overall investment portfolios, which are typically comprise 70% in equities, 20% in bonds and 10% in private equity. The private equity component is what they anticipate will drive returns to the desired levels mainly on the assumption that they will perform as they have in recent history; recency bias is a well documented phenomenon for leading investors astray. What they don’t have is any protection against market volatility. In the market correction in March both equities and bonds fell together. Private equity looked OK, but only because it wasn’t being repriced. Volatility during that period rose strongly and that is what tail risk hedging is all about. In its simplest form having put options in the portfolio provides gains when everything else is going south.
Federal Reserve quantitative easing in March appeared to save the day but the Fed’s balance sheet had been expanding since the beginning of the Q4 2019 as liquidity issues in the interbank market surfaced, which, in fact, were solvency issues in disguise. When the March dénouement hit, the already precarious position of some of the big bank and hedge fund players threatened to seize up the markets, so the Fed had to act and fast. This was a bail out of the financial system and had nothing to do with supporting the economy. As we mention above the narrative told by the central bankers was exactly the opposite. This quote from Henry Ford is still relevant today. “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” Given the widening gyre in politics and social tolerance around the world, exacerbated by the wealth gap and encouraged by monetary policy, you have the makings of the proverbial storm.
The second outcome which we have already alluded to, and likely to be a more immediate threat, is a serious solvency crisis. Monetary policy has thus far just put off the day of reckoning for many zombie companies, which should have been allowed to go to the wall a long time ago. The ability of corporates to borrow at generationally low rates has kept them afloat but pushed corporate debt to GDP ratios to record levels. The current combination of very low rates and low inflation weighs down on a resurgence in economic growth that is needed to enable these companies to service their debts, whilst productivity and profitability are declining.
The oil sector has already seen some notable casualties, but with a stimulus bill still some way off the economic malaise will spread to other sectors and the quote from Hemmingway’s book – the Sun Also Rises – becomes relevant. “How did you go bankrupt?” “Two ways. Gradually, then suddenly.” In a deflationary bust we can expect more monetary stimulus, but it is much harder to solve a solvency crisis than one driven by lack of liquidity. Here again managing tail risk hedging is going to be crucial. Any fall out from such an event may be short lived, but it will be brutal.
Then in all likelihood we will be heading towards the inflationary boom period where we will need to consider inflation protection. Along with an efficient tail risk hedging component, precious metals and linkers we can also consider trend following strategies. In an inflationary environment, trend following has an edge as trends tend to persist. For the last 10 years, if not longer, we have seen the reliance on reversion to the mean highlighted by the well know phrase, “buy the dips.” In an inflationary period, market trends persist and the dip buyers lose their mojo. The trend of course can and will work both ways; for now most likely in an upward regime.
So in summary, for the past 40 years we have been, in the jargon, short volatility and long GDP. In “new” world that is unlikely to work anything like as well especially given where equity valuations and bond yields find themselves. 40 years ago, the market was on a P/E of 6, bond yields were 15% and property which had been trashed in the 70s was a steal. The baby boomers were starting to earn real money and the investment markets boomed along with them. Today those same boomers are drawing down their pension funds, the market is on a P/E north of 20, bond yields are effectively zero and large parts of the property market are uninvestable. Long volatility – tail risk hedging in one form or another – is going to be a very important component in portfolios going forward from here along with many other changes we suspect; and it’s only just begun.