Thursday, 17 March 2016

Thoughts from a snowy refuge



One of the of the greatest pleasures of not being confined to a dealing room is finally enjoying the pleasures missed whilst being confined to a dealing room. That may sound odd, but when I started my career as a "junior probationary assistant dealer", back in the days when titles reflected the true nature of your post rather than today's director, VP nonsense attributes to the most mundane of today's investment bank desk jockeys, I used to aspire to going out for lunch at 12 and returning, hammered, at 4 to then put a bin on my head and pretend I was a Dalek whilst trading USD/DEM, as my ’superiors’ did. By the time I reached the level of seniority that would have permitted such behaviour, the days of fun long lunches were gone, replaced by formal events with clients involving a methodical business conversation with a glaze of social pretence.

I was once on a business trip to New York and foolishly agreed to allowing my wife to accompany me, with the express purpose of a shopping trip, whilst I plied my financial wares. It all went swimmingly until my New York host, knowing my wife, insisted that she join us for drinks before dinner with one of our prestige clients. Now Mrs P is not of the financial world and can be described as wonderfully cynical towards the pretences of business practices, preferring a no bullshit approach to relationships, so when the maitre d’ of the China Grill informed us that our table was ready, instead of excusing herself she eagerly took up the client offer to join us for the meal. Now at this point you are thinking ‘well why should she not?". But my concerns were confirmed when Mrs P’s brutal honesty left my colleague and I stunned when, whilst we were discussing macro economic effects of Bank of Japan policy, she started laughing. When the client enquired as to her mirth she replied “I’ve always thought that P traveled around the world going to important meetings and dinners, when all he does is take you out and pretends to be your best friend”. The 10 seconds of stunned silence were luckily broken by the client erupting in uncontrollable laughter and the two becoming great friends, but wow, can you imagine that always being the case? Yet the client risk was not the issue. Since then my career, in her eyes, was classed as fun, and as such I owed her for the pleasure of my 5.15am starts and 14 hr days.

But today is different. I am out of the 'day to day' rat race of corporate phoney schmooze and I choose my company without fear or favour of the corporate overlord. I am my own man. So today’s lunch, up a mountain in the Italian Alps, ran on with the conversation driven by interests and wine rather than corporate pretence.

One of the subjects discussed was inflation. Inflation is a strange beast, so strange that I sometimes consider it to belong in the realms of Dungeons and Dragons, a game reserved for branding geeks as geeks, yet probably played by more than are willing to admit. If I were to pick the creature inflation were to be it would be the Cockatrice. In our student games we had invisible cockatrices that were only visible to certain character types and whose weapon was a stare that turned the victim to stone. In the case of inflation cockatrice those who can see it are you, me and anyone else who has to manage a household budget, whilst those that it appears completely transparent to are central bankers and whoever compiles the historical reports that central bankers rely upon.

So here’s my concern. The Fed have done nothing and have downgraded their inflation expectations just when core inflation is running hot and we are about to experience the base effects of rising oil prices together with a host of other commodities. Meanwhile the ECB have unleashed a bazooka of stimulus and accompanied it with a series of inflation expectations running out to years that are as flat as a pancake. Now if these forecasts are spot on then fine, policy suits, but my new fear is that confidence in Central Bank actions is not the problem, but the forecasts on which they are based.

Why should I question the forecasts? I would love to now include a raft of alternative analysis but I can’t. Put it down to gut feel and a concern that none of what I would consider obvious inputs are being reflected in future forecasts. My concern is that the land of forecasting is based in an academia of old rules that rely on past data and will not be responsive enough to what I would consider inflation cockatrices in the room.

The Fed has added the final ingredient to the ECB and BoJ’s brew of a monetary primordial soup nurturing the rapid evolution of a T. Rex of an equity rally. They are getting behind the curve and cannot see the cockatrice before them. If I am wrong and they have seen it then I can only deduce that it’s too late as they have been turned to stone.

Now down to trading this. The first casualty is the sad slaying of the last of the ’sure fire' trades of 2016 - the poor ‘Long Dollar’ (supporting my theory that no ‘trade of the year’ publication should be scribed before the end of March). Commodities get a double lift through low rates and a falling USD giving them a headlining rally in USD terms. Emerging Markets are supported through reduced pressure of higher USD funding costs, a falling USD and commodity rallies that many EM countries are dependent upon. With that as a background I cannot think of a more perfect environment in which equities should rally. Granted, earnings going up would be a big help, but this is countered by corporates currently issuing huge amounts of debt at very low coupon. I would much rather buy the issuer, i.e. their stock, than the person who buy's their debt.

Which indices to buy? My favourite DM market that encompasses all of the above interests is the UK’s FTSE and indeed I have been looking for it to break the 6220 top that it has twice flirted with and rejected despite the US markets punching new highs. Yes GBP/USD rallying is a factor holding it back for competitive terms and more importantly international valuation terms.Yes too, Brexit fears overhang the pure UK components, but I am still anticipating an upwards breach.


Onwards and upwards. Inflation is coming and the central banks will be slow to respond.

10 comments:

Anonymous said...

Any timeframes in mind ? Similar thoughts here but dont thinj we go straight up.

I Will Never Accept The Terms of Service said...

Cockatrices turn you to stone by touch. Medusas do it with a stare. Your DM sucked.

Also there's something deliciously offensive in yelling "exterminate!!!" while doing anything associated with Germany.

Inflation uncontrolled and USD down seems to suggest "buy gold", no? Especially with GLD as the marginal consumer in a tight market.

I Will Never Accept The Terms of Service said...

Cockatrices turn you to stone by touch. Medusas do it with a stare. Your DM sucked.

Also there's something deliciously offensive in yelling "exterminate!!!" while doing anything associated with Germany.

Inflation uncontrolled and USD down seems to suggest "buy gold", no? Especially with GLD as the marginal consumer in a tight market.

Polemic said...

IWNATTOS -
Well i am gad to say it has been years since I played so bow to your judgement but in defence refer you to Romeo and Juliet Act 3 Sc 2

Hath Romeo slain himself? say thou but 'I,'
And that bare vowel 'I' shall poison more
Than the death-darting eye of cockatrice:

I am not sure on gold, in usd terms yes but a stock run higher would be considered risk off and defuse gold,

anon 19.46
I am sort of thinking straight up actually. The risk to all of this is Fed/ECB/BoJ come out with some intra-meeting comments re inflationary base effects.


I Will Never Accept The Terms of Service said...

https://en.wikipedia.org/wiki/Cockatrice_(Dungeons_%26_Dragons)

Unknown said...

Interesting post.

Inflation is anyone's guess. Models have no place for money, and Phillips' relationship has mostly dried up. Central banks say inflation is "global", but there is no indication from where it is imported.

No one really knows what drives inflation, nor how to forecast it. The only thing that everyone seems to agree on is that expectations play a role. Perhaps, inflation lifts itself by its own bootstraps.

Me thinks that everyone is behind the inflation curve, because no one knows what the curve looks like anymore.

Unknown said...

Interesting post.

Inflation is anyone's guess. Models have no place for money, and Phillips' relationship has mostly dried up. Central banks say inflation is "global", but there is no indication from where it is imported.

No one really knows what drives inflation, nor how to forecast it. The only thing that everyone seems to agree on is that expectations play a role. Perhaps, inflation lifts itself by its own bootstraps.

Me thinks that everyone is behind the inflation curve, because no one knows what the curve looks like anymore.

theta said...

Very short term an equity rally in the wake of inflation could happen especially because people associate inflation with growth and attribute a positive correlation with equities. Plus, positioning is still relatively bearish (although obviously not as much as a month ago).

Medium term however, the combination of wage-driven inflation and slightly tighter monetary conditions would lead to weaker corporate earnings as margins will shrink and financial engineering won't be able to cover up the slack. In that environment equities returns should be underwhelming. No crash, especially with the economy picking up steam, even with higher rates, but no wild rally either.

The asset class of choice in that scenario would probably be real estate. Even with higher interest rates that would naturally compress multiples, the higher rents driven by wage inflation should more than compensate. At the end of the day when you invest in equities you need earnings growth. If equities don't deliver it but real estate does (i.e. higher rents in the latter case), you may want to invest in the latter instead (but probably not in the UK!)

theta said...

Another supporting factor for the above thesis is the growing realisation that monetary policy has reached its limit, and the implicit or explicit acknowledgement that fiscal policy should follow. This would also contribute to pickup in inflation, wages, and rents, with questionable outcome for corporate earnings.

Corey said...

Seems reasonable but not sure how much has already played out. The next surprise will then be the realization that they are behind the curve and an aggressive hike path crushing all the aforementioned. Reminded of your Fed/ECB expectations model where we just bounce from one extreme to the next, w/ Bullard already seemingly talking down the dovishness of the dots post meeting. It's almost as if they want to introduce some uncertainty into their forward guidance or something..lol..of course they do!