‘Volatility Volcano’ Erupts…

Changes in the real Fed funds rate have historically led realised equity volatility by about two years, due to the lags between official rate moves and risk-taking (the Fed started hiking in December 2015, albeit at a glacial pace). Low realized volatility feeding into quant based theoretical models has always fuelled the intellectual hubris of finance PhDs (think LTCM etc.) and ultimately proved toxic. The pre-crisis period shows that misplaced correlation assumptions can lead to a far more benign assessment of overall asset risk than is prudent.’  Weekly Insight ‘Sitting on the Volatility Volcano…’ Oct 12th 2017

‘That issue of deteriorating market depth and the proliferation of highly correlated factor based strategies which are de facto short volatility/long equity beta (including long duration corporate credit as an equity proxy) will become a big story next year…the value at risk models are in this sustained low realized volatility environment at maximum exposure to (particularly US) equities. A shock to consensus positioning, be it from inflation, policy or politics could see an ‘air pocket’ liquidity event. Overall, it looks wise to look for ways to trade against to trade the prevailing bias that growth, inflation and interest rates are anchored permanently lower.’ Weekly Insight, 18th December 2017

Our view coming into 2017 was that market structure rather than macro was the biggest risk and to prepare for both higher rates and volatility. That meant underweighting rate duration, being long equity reflation winners and finding volatility hedges. The importance of this selloff is to signal a shift to more nuanced risk appetite after the simplistic ‘melt up’ hype. As highlighted in those Q4 notes referencing the ominous LTCM precedent, the quant/factor investing boom was vulnerable to a paradigm shift in its input variables. While the financial engineers tinkering with factor models suffer a reality check, it’s unlikely that the multi-year bull market is over with earnings growth momentum still accelerating in many markets. Most systematic momentum following funds which soared in January are now down YTD, but given limited leverage overall, this doesn’t look a systemic event like LTCM threatened to become.

However, the role of ultra-low interest rates as a discounting mechanism and low realised volatility as a driver of equity appetite for factor-based strategies such as risk parity has belatedly come into focus for the consensus. If Q1 16 was about investors stress testing portfolios for deflation risks, this time the adjustment is to a higher risk-free discount rate; the 2-year bond overtaking the S&P dividend yield last month was a cautionary signal. When we initiated a VIX long in our tactical portfolio in October, it was one of the most glaring anomalies across markets and generated a 2.6x return when we took profits in this week’s panic.

The length of this correction will be determined by whether a ‘buy the dip’ mentality prevails among an influx of new Millennial investors evident in recent statements from online brokers like TD Ameritrade, as much as whether 10-yr yields will top out at 3% term. It’s unclear if some have been buying stocks on their credit cards, as they clearly were crypto coins in Q4 according to MasterCard’s latest results call (and watch for a spike in card delinquencies in Q2).

The rise in long-term US rates so far is less about Fed policy or inflation expectations as it is a looser fiscal stance. As highlighted in that December note, the supply of US bonds will rise sharply this year at the same moment that demand potentially ebbs as real economy demand for capital in Europe/EM rises. Meanwhile, the Fed will buy $420bn fewer Treasuries than it did in 2017 and in 2019 will reduce purchases by another $600bn. It certainly helps that the ECB and Bank of Japan will be buying nearly all local sovereign issuance and the jump in yields may encourage some active multi-asset managers to re-weight fixed income over equities, as well as the automatic risk-parity rebalancing.

Exposure to key secular themes such as autonomous vehicles/robots, the shift to ‘biological software’ in the drug industry etc. should be opportunistically accumulated into weakness. Earnings momentum globally remains strong;  the scale of guidance upgrades in Japan which has a dominant position in several emerging technology supply chains such as Lidar, vision sensors, monoclonal antibodies and EV batteries should offer support once markets settle. Meanwhile, active investors can take some comfort from the humiliation of the quants whose share of the market has risen to unhealthy and potentially destabilising levels.

 

Tech Barbarians at the Gate?

As the global economy rapidly digitizes, the threat from radical new business models is critical for investors to understand. Plans to attack sectors from energy to banking are advancing rapidly and on my trips to Silicon Valley I’ve noted that the smartest software coders and entrepreneurs are often driven by an almost messianic libertarian zeal to overthrow the existing order. The top down, centralized paradigm from utilities to telecoms and banking will be gradually eroded by these new models which only have to take a tiny market share to create disproportionate damage on incumbent margins and valuations. Indeed, the smarter companies in vulnerable sectors like banking are already trying to co-opt Silicon Valley to improve their relative competitive position.

However, most corporate boards are thinking like French generals as they huddled behind the Maginot line in 1939, oblivious to the risk that German generals would simply outflank them. The role of rapid shifts in technology as a driver of macro trends in recent years remains largely overlooked, but as noted previously it has been a key factor driving weak corporate capex (as fast deflating IT gains a larger share – more data servers, fewer fixed structures to generate incremental revenue) to disinflation and weak wage growth/rising inequality.

In this new era, an unprecedented amount of economic power is concentrating in no more than 20-30 global tech companies through whose servers the key raw material of the information age passes i.e. consumer profiling data which can be process via proprietary algorithms to do anything from inferred credit scoring to targeted location based advertising. They’re driving tanks at breakneck speed while much of the non-tech corporate world is still digging trenches…
With the explosive growth in cheap smartphones and ubiquitous Wi-Fi bringing hundreds of millions of emerging economy consumers online every year for the first time, we’re entering an era when messaging platforms may dominate, as ubiquitous smartphones/free Wi-Fi mean that operating systems and carrier networks matter far less. The gatekeepers are companies like Tencent and Facebook collecting behavioural data on approaching 2bn potential customers between them. It’s not a question of if but how these huge audiences will be monetized.

The biggest issue for investors outside the tech sector to ponder on a 3-5 year view remains the trend toward tech enabled ‘unbundling’ in many sectors i.e. the value proposition underpinning many blue chip non-tech companies is disassembled and rebuilt as supposedly impregnable barriers to entry tumble (from wireless bandwidth to utility grids). The hugely complex logistics of ‘sharing economy’ models like Uber or Air BnB are only possible because of ever more advanced smartphones and fast advancing artificial intelligence and ever cheaper cloud based data analytics – those models can be extended to many more sectors as what works for taxis will also work for say parcel/food delivery.

In many ways, the popular  ‘secular stagnation’ thesis is largely missing the point as much innovation is now focused on radical new business models to optimize the utilisation of existing resources and the software platforms that support them, which thanks to the smartphone boom can explode to global scale at astonishing speed and low cost.  Like the horsemanship and mobility of the Barbarian tribes ravaging the outposts of the late Roman empire, that will eventually change everything…  

US Demographic ‘Mean Reversion’ Supports Growth Outlook…

If we stand back from the endless noise in markets, the demographic shift to lower fertility/longer lifespans underway globally is having a macro impact on several levels. For instance, the shrinking working-age population dragged down Japan’s potential GDP growth by an average of over 0.6 percentage points a year since 2000 and that drag will reach a full percentage point through end decade (the impact on the Eurozone, where the working age population is now also declining, is likely to be at least half a point off already anaemic trend growth). Another impact is on capital flows – demographic decline as a deflationary force boosts the inherent attraction of fixed income, while risk aversion as retirement looms drives inflows into bonds over equities.

Fewer workers means the economy needs a smaller capital stock while an ageing population has less need for more housing or consumer durables and more for services, such as health care or tourism. Furthermore, the price of technology investment (a growing share of corporate capex as the economy digitizes) has seen dramatic and sustained deflation from storage to bandwidth – companies struggle to productively invest the record free cash flows they are generating given a declining need for fixed structures versus new data servers to generate incremental revenue. Secular demographic and technology shifts in combination are pushing investment down and saving up. The central bank policy response fixated on inflation targeting is perversely exacerbating the impact of ageing i.e. one of slowing trend growth, excess saving and historically low interest rates, by forcing over 50s to save more to achieve their target incomes.

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Source: BLS, Census Bureau, Entext Economics

The US population is aging much more slowly than that in Europe and Japan – indeed the median age of an American will fall below that of a Chinese citizen with a decade, thanks to a surge in ‘Millenials’ as the population in the peak consuming age group is increasing again after a decade long slump. There were 3.8m fewer Americans aged 30 to 44 in 2012 than there were in 2002, but by 2023 there will be almost 6m more in this age cohort, suggesting that underlying demand patterns for housing and consumer durables such as autos will have a structural tailwind (you can’t easily Uber the kids to a ball game, after all). On Census Bureau data, the 25-44 age cohort in the US spend the most per capita on food, housing services and furniture which is in line with the classic ‘life cycle’ theory of consumption taught in Economics 101.

Meantime, the sluggish post crisis economy has created pent-up demographic demand for housing – there are over 2.5m young Americans living with their parents who would on pre-crisis trends by now have moved out. The average annual household formation rate since 2008 is the lowest since records started being kept in the late 1940s. About 45% of 18- to 30-year-olds are currently living with older family members, at least five percentage points higher than long-term trend (although now showing signs of peaking). Even gasoline sales have been impacted  – the number of prime-driving age Americans plunged by 2.8m from 2005-13 as baby boomers aged i.e. it peaked with average miles driven per capita. Aside from low gas prices boosting mileage and an aging vehicle fleet underpinning a replacement cycle, the looming demographic ‘mean reversion’ implies a buoyant auto market in the 16-18m annual sales range for several years. As much as the shale energy revolution, the US will soon enjoy a demographic windfall that supports relative economic outperformance through end decade…

The ‘Sharing Economy’ Shock…

The bedrock of economic exchange is trust, and technology now allows a reliable degree of ‘crowd sourced’ trust to be established between total strangers in order to share resources, which has profound implications for investors. As I’ve highlighted many times, a range of new online services are reducing slack and redundancy in the economic system – the internet from its inception has been about reducing search costs and price asymmetries between producers and consumers i.e a fundamentally deflationary force. These ‘sharing economy’ business models are typically zero marginal cost in terms of adding inventory, simply acting as a marketplace brokering transactions between individuals and thus have a potentially exponential growth path, explaining heady venture capital valuations.

Opportunities for these business models to tap into idle or underutilized inventory abound – the average car in a large Western city sits unused 90% of the time, and the opportunity to tap into that unused transportation capacity is the target of numerous start-ups. One of the most interesting I’ve seen recently is a grocery shopping service, that for a small fee sends a freelance ‘personal shopper’ and their car to the supermarket of your choice, to be delivered to your home. No new depots or delivery vans as captured by conventional capital spending measures and yet incremental productive capacity unleashed – this trend will make the US and other advanced economies inherently ‘lighter’ over the next decade.

We are seeing hundreds of similar ‘sharing economy’ apps from parking space rental in unused urban front drives to appliance sharing (does every garden shed really need a lawnmower?). Aside from the incremental impact of underutilized capacity being monetized over the next few years (implying fewer new hotel rooms/cars etc.), we are seeing an interesting cultural shift among the under 30s in the desirability or need for ownership, whether of a property or consumer durable.

Meantime, drivers of London’s iconic black taxi cabs (the ones that spew out noxious diesel fumes and often equally noxious political opinions if you’re unwise enough to engage in conversation with the driver) are planning to paralyse the city next month in protest against Uber’s expansion to London with its smartphone app based private car hire service. With average earnings of £40-60k depending on hours and whether they own or rent their cabs, taxi drivers pull in up to twice national average earnings for a skill which was rendered obsolete by technology a decade ago i.e. memorizing a map of London. They are likely to go apoplectic when US service Lyft (which is more of a pure sharing economy model allowing private individuals to become ad hoc taxi drivers) inevitably arrives in the UK. It’s a bit like dockside stevedores fighting the advent of containerization back in the 1960s, the hopeless battle of a closed shop against technological innovation and another bastion of premium semi-skilled incomes being demolished by Silicon Valley invaders – the overachieving geeks love nothing more than blowing up barriers to entry with some clever code.

The original sharing economy shock hit the music and media industries a decade ago, as consumers dis-intermediated the industry giants to become producers of their own content, creating huge value for platforms that rode the trend like YouTube. As covered in previous posts, the financial world is now in the cross hairs of the tech giants monetizing messaging apps as well as innumerable well-funded start-ups; we’re seeing a surge in innovation from peer-to-peer lenders such as Lending Tree to angel VC funding. Fund managers won’t be immune – for instance, online brokerage start-up Motif Investing offers professionally weighted stock baskets based on crowd sourced top-down thematic asset allocation ideas.

I’m in Silicon Valley next month visiting VC and hedge funds and looking at the next wave of these disruptive business models, which bear close watching for their impact on established industries and the confusion they are already creating in interpreting increasingly outmoded economic statistics (e.g. the freelancing/self-employment trend distorting employment data). We’re entering a world where anyone in a major city can use these platforms to freelance as an amateur landlord, taxi driver, tutor etc. and derive multiple income streams but also in the early stages of a technology driven economic shift which will have major implications for trend inflation, capex and profit margins over the next decade and should be a key investor (and indeed policymaker) focus.