Regime Change?

The Great Short Vol Unwind has left a number of market participants and commentators wondering if this is a signal of a return to some “normal” level of volatility, a regime change that could perhaps fully remove the feeling of complacency in the market. Indeed, typing in “return of volatility” into Bing Google:

Is it so? I don’t think so. While equities are ridiculously overvalued I suspect they’ll become more overvalued before the reckoning. First, let’s put the vol spike in context of other asset classes. Here’s a Composite Volatility measure of implieds from equities (the VIX), along with the Ten Year Vix, Euro Vix, and Swap Rate Vix:

So, yes, a spike, but not a crazy spike. And note the calm after the previous spikes. Why am I so complacent? Look, there’s always tail risk-a crisis in China, war with North Korea, some unforeseen systemic issue, etc. But the fact is the US, EU, UK, Japan, EM-so yes, the whole world-is firing on all cylinders. The consumer is back, PMIs are at all time highs, unemployment is low, and the central banks are tightening at their characteristically slow pace. Will there be another recession? Sure! Probably sometime in 2019, if I’m pressed to guess. But until then a couple of scares isn’t going to be enough to stop real money allocations to US equities. What about a rise in rates causing managers to reallocate? 1) The Fed Model is a terrible predictor of equity returns (See Asness, Clifford (2003). “Fight the FED model” Journal of Portfolio Management), and 2) Managers, following longstanding tradition, won’t reallocate until equities are at their lows and bonds at their highs.

Am I telling you to JBTFD? No. I can’t in good conscience carry positive equity deltas at these levels. But I wouldn’t be short either. I would, however, sell small delta neutral vol on vix spikes above 75% IVR.

 

Stocks Sold Off Because They Are Expensive

There’s a lot out there about the selloff in equities, from those pointing to inflation fears to speculation about the role of risk parity funds. I have another explanation: Prices are too high. I’ve been sitting on this post for a while, and although I appear less prescient writing it today than I would have last week, I’m still not making a timing call–stocks could end the year dramatically higher or lower, I really have no idea. But let’s get into things. Like most people I find the analysis put together by Robert Shiller to be very compelling. However, something is missing from his model, namely rates. Shiller’s contribution was that we should average earnings over the course of the business cycle, and he does this by taking a rolling 10 year average of earnings. And that’s great, but there’s a secular component that can be captured by discounting those earnings by the interest rate. Without further adieu, here’s the standard Cyclically Adjusted P/E (CAPE):

CAPE is in red, the blue line is 10 year ahead earnings, and the green and purple are the fitted and forecast values from a simple OLS linear model. The standard line lately when this chart is trotted out is “… shows that markets are more overvalued than any point in history except for the run-up to the great depression and the dot-com bubble”. And sure, that’s exceptional. But what happens when we add interest rates?

Look at that! Now equities are more overvalued than at any point since data begin in 1881. And surely that’s insane.  The forecasted 10 year return is actually negative, rather than low and positive as forecasted by the CAPE. Oh, this model fits much better as well. So once this trend is over, and it might be now, sell them until your hands bleed.

A Yen for Yen in My Portfolio

 

Yes, I know the expression is actually from the Chinese “yan”, but when one puns as hard as I do, one can’t be a stickler.

Getting into some of my trades for 2018, the US ten year/Yen correlation finally broke down and made the Yen a much more interesting trade:

Although the long-term classic Phillips Curve for the US isn’t  particularly inspiring, and there’s no obvious reason the relationship shouldn’t be constant across countries, the original research concerning England between 1861 and 1957 was compelling. Similarly, the CPI Phillips Curve for Japan shows an interesting relationship:

The non-linearity is striking and really starts to present itself in with unemployment in the mid-to-low twos. And unemployment has been trending solidly lower for quite some time. Here’s with a linear extrapolation:

While Kuroda has communicated a desire to maintain stimulus for a time after inflation returns, we can see how the BOJ has behaved in the past:

Indeed, back in 2006 the Bank hiked while inflation was still negative.

But this is all prelude to the real reasons I’m bullish Yen, namely PPP analysis and the twin surpluses. For the current account, I prefer to analyse the country in question relative to the quote currency. For JPYUSD (again, I trade the futures):

The blue line on top is the differential.

For the budget, I like to look at the base country in isolation.

Finally, while currencies don’t trade on PPP on any small time frame, over larger time scales PPP matters. In the case of JPY, we’re far below levels suggested by my model and a large move up is sustainable:

 

Charts to Watch in 2018

Along with my trades for 2018, there are some charts that I believe will be key for determining how the year unfolds.

First, wages are a key metric of the monthly NFP, perhaps as closely watched as the headline number. As I’ve mentioned before AHE is led by the Atlanta Fed’s Wage Growth Tracker. There’s been a slight pullback in the momentum of AHE, and my view is that the WGT will stay at or above its growth rate and that AHE will move upward toward it as it did in the previous cycle (the 90s play out this way as well, as is illustrated by a longer time series).

If this occurs the Fed will be forced to turn more hawkish and the front end will move up more quickly than what’s priced in.

What makes me think wages will move up? That takes us to our next chart:

Housing starts. As not-esteemed-enough professor Edward E. Leamer notes “Housing IS the Business Cycle”. Only two post-war recessions were not precipitated by a housing decline–the dotcom bust and the DOD recession in 1953. As long as starts keep on trucking, the music will keep playing.

The yield curve.

A fairly reliable recession predictor, though usually several years out, I think it’s likely the curve inverts this year. I’ll have follow-up posts on the two and the ten separately and suffice it to say that flattening will solidify the regime in which we find ourselves, and set up trades for next year. And although Yellen is out and Powell is in, I have a feeling her view that yield curve inversion isn’t a harbinger is consensus within the Fed, which means they’re not likely to fight it.

Finally, China.

Above is the Caixin PMI. If this stays above 50 expect commodity currencies, copper, global DM equities to continue to rally. Expect the opposite if there’s a move below 50. Which way is it going to go? I have no idea. The size and complexity of China coupled with the dearth of quality data and opacity of their credit markets make it a trade for none but a few true experts, and none of them is writing this blog post.

Trades for 2018

2017 saw the dollar decline, vol nearly completely absent (i.e. equities grinding ever higher), yield curve flattening, and macro funds putting up positive single digits on average. Without further ado, here are trade ideas for 2018:

Short dollar via long EUR, JPY; commodity currencies if you don’t mind the tail risk. I expect a significant further move down in the dollar. Don’t pay attention to rates (a subject for a follow-up post), but rather the US twin deficits versus other DM twin surpluses, and then look at relative PPI changes over the past several years, both of which will continue to exert downward pressure. I prefer EUR, and will be buying dips. JPY is a bit tougher because it’s been so tethered to the Ten Year, but I expect the BOJ to lean more hawkish as inflation picks up a bit and for these to decouple. Still, I’m in wait-and-see mode in JPY. Longer term I’m targeting 1.35 in EUR, 11112 in JPY (I trade the futures), and similar moves in GBP in CAD, with smaller moves in AUD (waiting for a pullback), NZL, and CHF.

Short the US two year; put on a 2s/10s flattener if you want to hedge. My models suggest a move to as high as ~2.9% for the two year, but probably something in the mid 2s by the end of the year. Last week it sold off on the ADP number, which came in above expectations, and when NFP came out weaker than expectations, it still ended the day lower after the initial algo-driven rally. That is, it’s looking for any excuse to go lower. Sell every rally. If you want to hedge duration, buy the Ten. I expect the curve to invert by 2H.

Short Russel vs S&P: My initial thought was short Nasdaq vs S&P based on valuations but if we get a selloff I expect small caps to share the pain roughly equally with tech stocks, and if there’s a cyclical move lower in equities I expect the smarter small cap markets to lead, as they traditionally do. So, if Russel-S&P works it will work about as well as Nasdaq-S&P, and if it doesn’t work it won’t be as painful when Amazon goes to $2,000. This is my lowest conviction trade. I’m really torn on equities here because while I don’t see the business cycle precipitating a bear market this year it’s hard to ignore the ridiculous valuations. But as long as earnings are growing it’s difficult to see an end to the daily grinding higher.

Good luck this year. Happy hunting.

Keep pounding on Sterling?

Over at Macro Man, Macro Clown wonders if it might be time to go long GBP or at least close out shorts. Though he points readers away from GBPUSD because of dollar risk, I think it’s OK to look at how the major has evolved to see where Cable might be going. Quickly, as far as the PPP theory of exchange rates is concerned I’ll start and finish with a quote from Rudy Dornbusch “…strict versions (of PPP theory) are demonstrably wrong while soft versions deprive it of any useful content.”

For context, after its post crisis peak of about 1.71 in July of 2014 GBPUSD has been a steady decline.

Looking at rate differentials going back four years, the divergence that opened in late 2014 has persisted and indeed is at its widest at its present rate of 1.65%.

Equities tell a similar story. I indexed the S&P 500 and FTSE 100 to 100 at March 14, 2013.

Here is a table of Sharpe ratios for three time periods:

FTSE 100 S&P 500
4 Year 0.28 0.88
1 Year 1.38 1.62
Since US Election 2.64 4.60

The forward p/e of the S&P 500 is a little higher than that of the FTSE–18.27 to 13.37–but the difference doesn’t indicate a revaluation would deliver convergence. The punchline is that further portfolio flows should drive further weakness.

Last but certainly not least, the UK current account deficit is at its lowest level since data begin in 1955, and it’s not showing signs of rebounding as quickly as it did at previous local minimums. The first order effect is persistent weakness in Cable.

Finally, market positioning is net short (via the CFTC CoT reports) but at a rate that suggests there’s room for more shorts to pile on before we’re in danger of a big squeeze on a rally.

So where do we go from here? Take a simple rate differential model using the 5s back to July 2014. Here’s the scatter plot with the r-squared:

The current value of 1.65% implies about 1.11 (rounding so as not to convey a false sense of precision). Combine this with the equity return differential and the current account deficit and it’s reasonable to think we’d see a test of the 1985 low of 1.05; maybe we could even see parity. Technically, the pair has been making lower lows and lower highs in the trading range from October 2016 to present, with the recent rally looking to make a new lower high, and a following push below 1.20 could precipitate the move I’m expecting.

Rates: The Long and Short of it

A great post over at globalmacrotrading on long term global rates. We indeed have seen a large move down in bonds over the entire curve and it appears consensus that “rates are going to rise” and the market is “rotating into risk assets”. And when there’s consensus there’s usually little reason to hop on board. Here’s a longer term chart of the ten year with a back-of-the-envelope fundamental model – rolling 10 year average nominal growth plus the term premium (here I’m using Kim and Wright, 2005):

(Source: FRED/Author’s calculations)

The r-squared is about 0.92 and the current reading of about 2% suggests the ten year is a little high. And indeed it had worked it’s way down from the December 15th high of 2.6% down to about 2.3% before shooting up again yesterday on comments San Francisco Fed’s Williams, and we’re sitting close to 2.5% as I write this.

Thinking about the long term value of the ten year, we have to think about long term nominal GDP and the term premium. Decomposing nominal GDP into the real and inflation components, we see that if we assume that monetary policy has reached a state of technology that enables the Fed to control inflation, then the degree of freedom is real GDP. What does that look like long term?

I built a simple Cobb-Douglass-inspired model of real GDP growth as a function of productivity growth, growth in the capital stock, and growth in the labor force. The data go back to 1951 and the r-squared is 0.73. Here’s a table of the data for the whole period and the last 10 and 20 years:

RDGP TFP K L
1951-2014 3.18% 2.13% 3.53% 1.47%
Last 20 2.44% 2.08% 2.39% 0.88%
Last 10 1.51% 1.41% 1.76% 0.48%
Forward? 1.80% 1.43% 1.19% 0.50%

For the forward estimate of TFP and K I projected forward the recent recovery. For labor growth I used the BLS’s projection to 2022. Then if we assume an inflation rate of 2% going forward we come to a nominal GDP estimate of 3.8%. Plugging this back into our model, assuming the small term premium of today and we get about 2.6%. So most of the move might already be in. It all depends, of course, on assumptions about future growth and the term premium. I’m frankly not certain how to think about long term forecasts of the term premium, but it seems to correlate with the rate itself. For growth and inflation, if you think we’ll be stuck at 1.5% real GDP and 1.5% inflation then the 10 year moves below 2%. Think we’ll return to the nominal growth rates of the late 1990s, printing 6% per year? Then the 10 year goes above 4%. But with productivity growth averaging about 2% long term, and seeing as how we’re not likely to get a surge in immigration, skilled or otherwise, over the next eight years (yeah, I said it), and seeing as how the BLS is pretty good at what they do, any additional growth has to come from a huge increase in K. That’s another post, but the spoiler is that it’s not likely.

The Deal with US Wage Growth

Nick Bunker over at equitable growth wonders what’s the deal with US wage growth, citing the absence of “expected” growth given the unemployment rate. That is, he’s wondering why the “Wage Phillip’s Curve” isn’t holding. Here’s an illustration using the most commonly cited wage figure, Average Hourly Earnings (AHE):

(Source: FRED/BLS/Author's calculations)
(Source: FRED/BLS/Author’s calculations)

I don’t think this is too surprising. Here’s wage growth regressed against unemployment rate going back as far as the BLS data go:

(Source: FRED/BLS/Author’s calculations)

Not impressed? Me neither. However, over at the Atlanta Fed’s macroblog, there’s an interesting post about their so-called wage growth tracker (WGT). Rather than looking at average hourly wages in aggregate and tracking the growth in that figure, they use the Fed’s Current Population Survey to track wages of people who had a job the last time they were surveyed. The data go back to 1997. Here’s that regression:

(Source: BLS/Atlanta Fed/Author’s calculations)

Not bad. And just to make sure we’re not cherry-picking the data, here’s a regression for the 1997-2016 period using the data from the first regression:

(Source: FRED/BLS/Author’s calculations)

So, it’s a little better than the first regression, but not nearly as good of a fit as the WGT data. Let’s now replace the AHE data in the first chart with the WGT and see what happens:

(Source: FRED/BLS/Atlanta Fed/Author's calculations)
(Source: FRED/BLS/Atlanta Fed/Author’s calculations)

Look at that! Finally, I ran Granger causality on the WGT and AHE series and there’s evidence below the 5% level that WGT Granger-causes AHE but not that AHE Granger-causes WGT.

So, what’s the deal with wages? We might induce that if unemployment keeps falling then wages of those already employed will keep rising and this will raise the average rate of wages as popularly measured. The next question is how the Fed will react to the coming wage growth, but that’s another post.