[The following is my Markets commentary for the week of January 5, 2015, Issue 5.01]
Happy New Year! The nice thing about taking a little time away from the markets is that it lets you develop some perspective.
My main takeaway is this – I cannot remember a time when there were so many potentially huge tangential factors affecting the curve. Back in the day, Fed policy was so simple all you needed was a growth variable and an inflation variable to predict the path of rates (nod to John Taylor). It is starting to become very difficult separating out the noise from signal. Any combination of these factors could alter the path of the US economy and FF rates. The list below is long, but still probably not complete:
- Key provisions start going into effect this year – in particular the penalties for companies with 100 or more employers who do not offer health insurance to over 70% of its staff. It is not clear to me if some of the strong economic performance in 2014 was in anticipation of changes in 2015. Maybe. The law expands to companies with 50+ employees in 2016. This will be a continued headwind for employment going forward.
- Higher minimum wages. Various states and cities have enacted higher minimum wage provisions for 2015. The inclusion of healthcare while at the same time increasing minimum wages could make the hiring of lower income workers doubly unattractive. I am not a believer that you can give away healthcare and higher wages, with no negative side effects. This could be a continued headwind for employment, BUT average wage growth may increase.
- I got my MBA from NYU Stern, which means I took Damodaran’s corporate finance class. I’m no expert. But I’m pretty sure that if you took the discounted cash flow of all the companies in the S&P (even with these low rates), you don’t get anything remotely close to 2060. Sure – it’s possible we get to 2300. But one day the party will end and it could end very hard.
- Oil. Since we are still a net importer of oil, lower oil prices should be good for consumption on the margin, but may be a drag on capex, manufacturing and possibly employment in the coming year.
- Stronger Dollar. Lots of buying of US assets, higher export prices, lower import prices and a headwind to inflation.
- Real Estate. The lack of housing recovery is somewhat perplexing. Or maybe we have recovered and this is it. How many houses do you expect people to buy when they aren’t making much more money? This may also be a structural change as baby boomers retire.
- The retiring baby boomers are causing a demographic shift that is making the data very difficult to read. Some examples include: labor force participation, consumption patterns (i.e. housing), and even on investment mix (i.e buying more fixed income).
- Everything from credit downgrades, to economic collapse, to war.
- Middle East + SW Asia. Everything from credit downgrades, to economic collapse, to war.
- (Other) Oil Countries. Everything from credit downgrades, to economic collapse, to default.
- Everything from credit downgrades, to economic collapse, to default.
- Negative yield on 5 year bunds is pretty scary. Surely the world of investments in not such that you would want to pay some government to hold your money for 5 years?
- The global growth engine is slowing. This can’t help any of the above.
- The #3 economy in the world has a debt to GDP ratio of over 220%. By 2060, the number of Japanese is expected to fall from 127 million today to about 87 million, of whom almost 40% will be 65 or older. Levering up to jack up prices when they have way too many (presumably fixed income) retirees as compared to workers could end well. [sarcasm alert]
- Emerging Markets. The IMF said last week the FOMC should refrain from selling portfolio to help EM economies. They also suggested selling at a predetermined pace. I suppose this is another way of saying, “EM is quite fragile right now.” This is not going to be good news for people in the “curve is too flat camp” (i.e. me).
When you add up all of the above, there seems to be a lot of downside risks. Of course the new Bond King, Gundlach, was out this weekend saying he thought tens could test the 2012 low of 1.38%. Shocking a bond fund manager would say something like that. I suppose this is possible. But the FOMC are acting like they need to hike… a lot… and soon. And this is where the “does not compute” part comes in. The long end rallying while the front end is pricing in hikes is basically saying… the FOMC is wrong. Because when you have all these downside risks, and inflation is nowhere in sight, hikes may not be appropriate. I fear stupidity can no longer be considered a tail probability. It appears to be upon us.
So my New Year’s Resolution is… let’s not get in the middle of this tussle between the FOMC and the markets. While I believe in curve consistency (between the short end and long end) in the long run, it feels like we could start decoupling in the short run. The prudent path for the near future is to focus on a balance of good relative value trades that capture value from both opposing views.
The butterflies in the blues have gotten crushed. The 6mo flies in the back of the blues are about the same as the flies in the front of the golds. Any time you can pick up a double fly for 0 in this environment is very attractive. I think these types of trades are more attractive than buying flies outright (another curve reflation trade), as the latter trades will suffer on further flattening.
The second area of focus is in the “hump”. It’s rather strange that the fronts-reds year spreads have come down while the flies in the hump have remained somewhat bid. That’s being a little too fine. And whenever the curve starts getting too fine, I like fading the timing. I will send out the trade later today via email.