Deflation and the Fed… what would Greenspan say?

September 24, 2015

For those of us that have been around a while, and can remember, back in May 2003 (in the aftermath of the burst of the greatest equity market bubble since 1929) Alan Greenspan, then Federal Reserve Board Chairman said the following:

  • “We at the Federal Reserve recognize that deflation is a possibility. Even though we perceive the risks as minor, the potential consequences are very substantial and could be quite negative”  (Alan Greenspan, Congressional Testimony, May 2003)

At the time, this came as something of a bombshell, for the Chairman of the Fed even to entertain the possibility of deflation was quite a surprise to markets.

We thought it might be interesting to look at the parallels between today’s US inflation picture and that of the Spring of 2003. The comparison is quite striking.

We looked at 180 individual line items in the total Consumer Price Index (CPI) and the 106 line items that pretty much make up the Core CPI:

  • The chart shows that currently 43% of the individual core inflation items are in annual deflation, that compares to 48% in the Spring of 2003 and 45% in late 2010
  • The annual core inflation rate is currently 1.8% versus 1.5% in 2003
  • We are currently seeing the same breadth of core deflation that we saw at the bottom of the cycles post 2000 and 2009 bear market crashes


We then looked at how annual core inflation for the 106 sub-components had changed over the last 6 and 12 months to see if there was any clear trend:

  • In the Spring of 2003 about 60% of the components had seen year/year inflation decline in the previous 6 and 12 months (a clear downward trend) compared to about 50% today


Interestingly, in 2003 we saw:

  • 48% of core inflation components in deflation and 60% with a clear downward trend

In 2015 we see:

  • 43% in annual deflation and 53% with a clear downward trend

Our thought is then, “What is so different?”

Greenspan was worried about deflation and yet now Janet Yellen appears to be itching to tighten. (Growth was strongly accelerating in 2003/4 and has been stuck at 2.5 – 3.0% in the last year or more, so that can’t be the reason).

Could it be the fabled “tightness of labour markets” argument, the so-called “Phillips curve” fed to generations of economics students purporting to link labour markets to inflation? (Along the way, countless economists seem to have lost sight of the fact that A. W. Phillips’ famous 1958 paper was titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957” and said nothing about unemployment and consumer price inflation).

Well, here is the relationship between the US unemployment rate level and US average hourly earnings over the last 50 years:

  • Clearly, even to an untrained eye, there isn’t one. A lower unemployment rate does not push up wage inflation…
  • There is, truly, nothing in the historical data to show that a lower unemployment rate (a “tighter labour market”) implies faster wage inflation (or, for that matter, faster price inflation)
  • Look at it with lags, as changes, whatever way you like, the “tight labour market/higher inflation” thesis cannot be substantiated… another case, to paraphrase our hero Thomas Huxley, of “a beautiful theory and ugly facts colliding”



  • If Greenspan was worried about deflation in 2003, why does Yellen not share the same concern (especially with the Chinese banking system in the state it is in and a Yuan devaluation on the way)? Would Greenspan be considering another round of QE here? We are inclined to think it would be foremost in his mind if he were still Fed Chairman.
  • Tight labour markets/faster inflation concerns just cannot be substantiated by the data; that is no reason to tighten.
  • US consumer inflation is determined exogenously (outside the control of the Fed) by the vast global overhang of global supply. Inflation in assets, inflation in balance sheets and surging debt are endogenous (inside the control of the Fed). They should tighten to address the latter and lay to rest old ghosts of Phillips curves. God forbid we get more QE, the consequences will be even worse when the rebalancing and re-pricing of risk takes place…
  • Because Central bankers are raised to believe that consumer price inflation is the target variable, they completely missed the consequences of inflation in asset prices and balance sheets in the last two cycles (confusing a positive supply shock from Chinese over-investment and low shop inflation with a miraculous surge in underlying productivity growth and hence trend GDP growth) and risk making the same mistake again…



The hidden drivers of hedge fund performance

September 22, 2015

At the beginning of the millennium, hedge funds were en vogue. Institutional and private investors could not quite get enough of them, as they thought that these funds had the ability to perform regardless of the market environment. The industry went through a phase of rapid growth, and the number of funds as well as assets under management ballooned. The valuation of most asset classes increased, making the life of hedge fund managers and that of the bankers lending them money, quite easy and sweet.

The party went on until 2008, when hedge funds in aggregate lost at least a quarter of their value according to the most widely followed investment benchmark (the HFR Global hedge fund index). Smaller funds started to shut down. The asset class attracted a lot of bad press. Scandals such as the Madoff Ponzi scheme exposed the danger of investing with hedge funds and the importance of proper due-diligence. Overall, as Simon Lack explains in his 2012 seminal work on hedge fund performance, “The Hedge Fund Mirage”, between 1995 and 2012 investors would have been better off invested in treasury bills, which have done better with essentially no risk. Yet the industry as a whole continues to grow, now reaching an estimated $3,000 billion of assets under management in aggregate.

At MONOGRAM, we are firm believers in Occam’s razor, which basically states that the simplest way to achieve a goal is the best. We also observe that the financial industry broadly disagrees with us, putting a large premium on complexity. Simply put, complicated investments should perform better or exhibit less risk. This of course, is directly contradicted by the facts. For example, a balanced portfolio invested 60% in Global Equities and 40% in Global Bonds has outperformed hedge fund indices every single year but one in the last ten.

Apparently, even hedge funds managers themselves believe in the superiority of simple investments since they have over time derived a large proportion of their performance from the simplest investment available to them – cash deposits. How do they do that? Hedge funds are mostly, as their name suggest, “hedged” vehicles. Schematically, this means that they borrow securities against a small fee from their prime broker (a bank typically), sell them, and buy other securities with the proceeds. This process leaves the fund’s cash balance largely untouched. Hedge funds can then decide to invest their cash balance in the money market and get paid an interest against that. When interest rates are at zero such as now, the effect is trivial. However, US short-term interest rates have averaged 4.2% between 1990 and 2008. This massive tailwind to hedge fund performance is gone and nowhere near making a comeback.

Secondly, as more hedge fund capital chases the same trading opportunities, competition increases and returns diminish. In the 1990s, traders could easily make 3 to 5% per annum with a simple “cash-and-carry” strategy – arbitraging two similar securities (typically in fixed income markets) trading at different valuations by selling the expensive one and buying the cheap one.  Adding to that, a decent amount of leverage makes for very decent profits without much risk or work. Today, these trading opportunities have been completely arbitraged away.

The hedge fund footprint on some markets has grown to levels that makes them risky and no longer profitable. Such is convertible arbitrage, which involves buying convertible bonds and hedging away the various market risks, a process that effectively leaves a hedge fund with a free option on the value of the issuing company. This worked very well at the end of the 1990s and the beginning of the 2000s, at which point hedge funds owned an estimated 80% of all convertible bonds outstanding (a market estimated at c. $500 billion in the US). In 2007, when they started losing money on the other strategies they had in their books, their prime brokers (i.e. their bank) forced hedge funds to reduce their leverage, which they had used to the tune of c. 3:1. Hedge funds had no choice but to sell their positions regardless of valuations. As everyone ran for the exit at the same time, convertible bonds valuation went in free fall, and investors in this strategy lost on average 60% of their money.

Against all odds, the disappearance of trading opportunities, the increasing competition, and the disappointing performance has not taken a toll on hedge funds fees. Rather, the contrary can be observed. According to a 2014 JPMorgan survey, fees have increased from last year to an average of 1.69% p.a. management fee and 19.13% of gains (1.64% and 18.99% in 2013). This comes in addition to various costs such as administration, custody, legal, prime brokerage, trading and even office rent and salaries on occasions. Given that, simple models show that a hedge fund making 10 to 15% before costs and fees would four out of five years leave investors with annualised returns in the region of 7 to 8% net at best. In the long run, hedge fund managers capture an estimated 50% of the profits generated with your money. No wonder there are so many hedge fund billionaires and so many disappointed investors.



UK inflation… where?

September 15, 2015

Although Annual Core Inflation slipped to 1% in August and Headline Inflation to zero, the devil, as always, remains hidden in the detail…

Look at the diffusion index of UK inflation – It looks at 80 individual sub-components of the UK inflation headline number and looks at what proportion are inflating (and at what rate) versus what proportion are disinflating (and at what rate).

If inflation rises sharply because, let’s argue, just 3 components surge higher while 77 plunge, that is less indicative of an underlying inflation problem than a broad-based/widespread increase in prices. The breadth of inflation/disinflation is as important, if not more so, than the level:

  • 52% of the index components have actually experienced deflation in the last 12 months.


  • 66% of the index components have an annual inflation rate below 1%.


  • 77% of the index components have an inflation rate below 2%.


  • And finally, 70% of the index components have seen annual inflation decline over the last 12 months.


  1. So, UK inflation is exceptionally low. The breadth of low inflation is unprecedented and the overwhelming majority of index components have seen inflation decline in the last 12 months. Nothing particularly concerning here for the Bank of England.
  1. As we have argued many times, UK inflation has “Made in China” stamped on it. In a world of increasingly open markets, where trade grows faster than production, where investment in fixed capital as a proportion of Global GDP is at the highest level in 30 years and where the world’s largest exporter, China, is still growing its manufacturing fixed capital stock at a rate almost 6% points faster annually than demand growth in the developed world, you get disinflation. In addition, with inevitable Chinese devaluation you get deflation. In this world, UK companies are price-takers and not price-setters. The price-setter is the marginal supplier of capacity and that is unquestionably China… whose main export will soon be deflation. Any company trying to fight that tide to be a price-setter will lose market share, profitability, employment and its business.
  1. UK real economy inflation, as measured by the CPI and RPI, really is out of the control of the Bank of England. The Bank should raise interest rates to reign in monetary sector runaway inflation (houses and financial assets) to arrest the dire consequences of QE sooner rather than later. If a price has to be paid, it is better paid today than tomorrow. The same is true for the Fed in the United States. The longer the delay, the worse the consequences.



The pain of volatility

September 10, 2015

The Chicago Board of Trade Volatility Index (the “VIX”) is a fabled measure of volatility in the US Equity Market. It is a measure of the implied volatility for options on the S&P 500 Index and has been labelled the “fear index”. It gives a measure of the market’s expectation for volatility in the US index over the next 30 days.

  • It tends to spike higher at times of “fear” – it hit 80 in the eye of the credit crisis in November 2008 and 48 in mid-2011 during the height of the Euro-crisis.
  • It tends to plummet at times of great confidence or “euphoria” – it was at 10 during the heady days of the 2005/6 boom period and was between 10 and the low teens from mid-2014 to mid-2015.

Since 1990, the median level for the index has been 18.

The VIX rises sharply when markets fall sharply and vice versa. It is, indeed, a great measure of fear and anxiety.

In the six trading days from the 14th of August to the 24th, the VIX Index jumped from 13 (“high confidence”) to 41 (“fear”). The S&P 500 fell 10% in the corresponding period, the UK Index fell 10% and non–US Developed Markets fell 13%. On the 24th of August, non-US Developed Markets fell 5% and the US Market fell 4%. It was hard to endure.

So, what does it all mean?

Well, a solid and central assumption in Modern Portfolio Theory (the body of knowledge that underpins all those “globally balanced diversified portfolios”) is that risk preference is stable; your attitude to risk is unaffected by periods of extreme market volatility.

Now, intuitively, many of us know that such an assumption is simply absurd based on our own responses to periods of high volatility (some of us take more risk, some of us clench our teeth and hang on, while some of us panic and sell).  It takes a strong will to endure volatility.

Finally, a fascinating paper by some Cambridge University academics has shown that risk preference is actually not stable in the face of volatility and that volatility/fear and pain have a substantial impact on the way we think, respond and behave.

The paper, “Cortisol Shifts Financial Risk Preferences”, by N. Kandasamy et al.” shows that:

  • Traders experience a marked increase in the stress hormone cortisol when uncertainty increases, measured by market volatility.
  • In a “double-blind, placebo controlled, cross-over test” they demonstrate that changes in cortisol levels are associated with changes in risk preference. Higher cortisol levels are associated with a lower risk appetite and vice-versa.
  • The effect is greater in men than it is in women (women handle stress more effectively).
  • They conclude “the stress response calibrates risk taking to our circumstances, reducing it in times of prolonged uncertainty, such as a financial crisis. Physiology-induced shifts in risk preferences may thus be an underappreciated cause of market instability

In layman’s terms, we become fearful and risk averse when volatility/uncertainty increases and become positive and risk seeking when volatility/uncertainty falls.

Our investment process, incorporating various measures of market momentum within a rules-based framework is evidently a good way to endure volatility and at the same time identify structural shifts in risk preference that associate with severe market drawdowns. An evidence-based, rules-driven investment approach fits with the way our minds respond to stress.



China’s problem… easy to see

September 8, 2015

Amidst all the furore around China’s market weakness and market declines, here is China’s problem in a nutshell:

  • China lost $94 billion in Foreign Exchange Reserves in August, taking the decline to $436 billion since June 2004.
  • Foreign Exchange Reserves have fallen 11% from the June 2014 peak level.



  • Global Foreign Exchange Reserves are down 4.9% y/y – the fastest decline since 1982.

Why is this important?

Historically, foreign currency has flowed to China and the PBOC has purchased those currencies (acquiring an asset) to stop the Yuan from appreciating. They exchanged Yuan for the foreign currencies (creating a domestic currency liability). The PBOC’s balance sheet grew with foreign exchange assets and their domestic currency liability counterpart.

Left unchecked, that explosion of domestic currency liabilities into the system fuelled speculation and credit expansion – foreign exchange reserve growth reflected extremely accommodative domestic monetary policy.

Now the whole cycle has gone into reverse.

Capital is flooding out of China as the PBOC exchanges Yuan back into foreign currency for investors to flee.

The decline in foreign exchange assets, therefore, represents a substantial tightening in domestic monetary conditions as the PBOC buys Yuan (reducing the liability on its balance sheet) and hands back Dollars/Euros/Pounds etc. (reducing the assets on its balance sheet). This is why the PBOC has cut rates and cut reserve requirements for banks – they are trying desperately to fight a huge monetary policy tightening.

What more can be done?

Our view remains that meaningful Yuan devaluation over the next few years is the only real solution here for the Chinese, leading to substantial global disinflation/deflation pressure at a time of extremely low starting inflation.

Japan and Germany are particularly vulnerable given their trade overlap, some Asian banking systems (e.g. Singapore and Hong Kong) are particularly vulnerable given their extreme debt growth.