First Quarter 2018
Over the past few months the market has been hit by a wave of volatility and losses in both equities and government bonds. In fact, the first quarter of 2018 was the first negative quarter for the S&P 500 in over two years. US equity market implied volatility as measured by the VIX index rose from around 9 at the beginning of the year to 20 today, after hitting 37 at one point. Some of the selling and rise in volatility seem to be attributed to the massive losses by short volatility ETFs, such as XIV and SVXY. Leading up to this “volmageddon”, our firm was pitched this short volatility trade by banks, hedge funds, and prop traders in many forms. The trade essentially consisted of selling out-of-the-money call and put options on the S&P 500 and collecting premiums. Most of the time these options would expire worthless and the seller kept the premium. However, the track record of these strategies rarely (if ever) predated the financial crisis, which led us to believe many didn’t survive the 2008 crisis. These were self-evident “picking up nickels in front of a steamroller” type trades, where one takes large risks for small profits. We passed and watched them make money consistently over the past two years only to lose it all, if not more, in a span of days.
While it is hard to forecast future performance of broad markets, we are monitoring several risks to long only portfolios which we think are important for investors to understand. We detailed many of these risks in our past investment letters:
- US equities are clearly priced richer than normal in historical terms. We have historically high price-to-earnings ratios in the US, while earnings may also be at a cyclical peak.
- In our opinion, bond yields do not provide adequate return for investors in an environment rich with factors that could drive inflation.
- These factors include low unemployment rate with rising wages, weaker US dollar, and rising commodity prices.
- Bond yields could also be impacted by increases in the supply of bonds to the market, including higher deficits from the recent tax cuts and selling by the Federal Reserve as they seek to unwind quantitative easing.
- Unwinding of carry trades, including:
- Covenant light junk bonds and leveraged loans,
- Short volatility ETFs and Vol selling strategies that use bond portfolios as collateral, and,
- Risk parity strategies which lever up in low volatility environments.
All that being said, volatility, in and of itself, tends to be mean reverting; it won’t stay high forever, nor will it stay low forever. Equity volatility was historically low going into the recent selloff, so we suspect we are in for a period of high volatility as markets transition and begin to accommodate for higher interest rates, wage pressures, faster global growth, and political noise. Finally, despite the inflation concerns, the global economy is in a decent shape, so it would likely take a much bigger event than an increase in volatility to steer world economies off course. In addition, we doubt US markets completely priced in the full effect of the significant corporate tax rate reductions. All these factors give us some reasons to be optimistic in the next year. However, the unwinding of the Federal Reserve’s balance sheet and increased Fed funds rates will be headwinds for security prices.
On top of these well documented risks, we would be remiss without mentioning the risk from missteps in international trade negotiations. At this point, its appears to us that President Trump is laying the ground work for an aggressive renegotiation of terms of international trade. While it’s possible that this is all noise, the fact is that free trade is normally considered a win-win for all parties.
Trade deficits don’t arise out of thin air. Trade deficits tend to occur when there is a lack of savings, not because of cheating or manipulation. Let’s revisit Economics 101 for a second. Gross Domestic Product (GDP) measures the economic performance of a country and is calculated using the following general equation:
GDP (Y) = Private Consumption (C) + Investment (I) + Government Spending (G) + Net Exports (Exports – Imports)
Solving for Net Exports:
Net Exports = Y – C – I – G
Assuming Y is constant, if you want to make Net Exports higher, you need to invest less, or save more. How do you save more? You do so by consuming less or by the government spending less; i.e. you spend less than you earn. Therefore, an economy spending more than it makes will tend to run a trade deficit (like the US), and one saving a bunch (like China and Germany) will tend to run a trade surplus. It’s just math.
There is no doubt that someone has explained this to our President, so likely the end goal is not really to improve the trade deficit. It is probably a tactic to get China to the negotiating table over some things that are truly bad for the US. For one, we want our patents and intellectual property (IP) to be legally protected internationally, and we don’t have much protection in China for our IP. It would be a tragedy to allow new biotech drugs developed by years of research and development in the US to be ripped off without recourse by Chinese competitors. In addition, China does benefit from some international agreements regarding reimbursement rates for postage between the China Post and US Postal System, to the degree that it’s often cheaper to ship from Shanghai to Boston than it is to ship from Philadelphia to Boston using the USPS . That certainly seems unfair. The good news is that China also now has intellectual property to protect, so they may see some value in negotiating on that issue. China is actually ahead of the US in some areas of intellectual property, especially in self-driving cars and artificial intelligence .
In addition, many international trade rules that govern the US-China relationship were struck long before the current boom in Chinese exports to the US. Finally, the US, while generally running a trade deficit with China, also benefits in that our deficits are financed by the countries that save more than they spend. For example, China is a large purchaser of US treasuries, so they essentially provide vendor financing for the prolific spending habits of the US. Should they stop financing us, their exports would likely dry up as well.
Free trade has been a bedrock of Republican policy for decades, and Democratic politicians reluctantly accept the benefits as well. Free trade books were best sellers back in the early 2000s and pretty much every Thomas Friedman book on trade was a required reading on Wall Street. The Lexus and the Olive Tree and The World is Flat are just a couple examples. Thomas Friedman is a big fan of globalization, as you can see from his quote from The Lexus and the Olive Tree:
“Indeed, for all the churning that global capitalism brings to a society, the spread of capitalism has raised living standards higher, faster and for more people than at any time in history. It has also brought more poor people into the middle classes more quickly than at any time in human history. So, while the gap between rich and poor is getting wider — as the winners in today’s globalization system really take off and separate themselves from everyone else — the floor under the poor has been rising steadily in many parts of the world. In other words, while relative poverty may be growing in many countries, absolute poverty is actually falling in many countries. According to the 1997 United Nations Human Development report, poverty has fallen more in the past fifty years than in the previous five hundred. Developing countries have progressed as fast in the past thirty years as the industrialized world did in the previous century. Since 1960, infant mortality rates, malnutrition and illiteracy are all significantly down, while access to safe water is way up. In relatively short periods of time, countries that have been the most open to globalization, like Taiwan, Singapore, Israel, Chile and Sweden, have achieved standards of living comparable to those in America and Japan, while the ranks of the middle class in countries like Thailand, Brazil, India and Korea have swelled, due partly to globalization.”
The juxtaposition of the Lexus and the Olive Tree addresses the tension of globalization versus the human tendency to protect our culture, geography, tradition, and community. This tension still lives on, almost 20 years after the book was written. We see this tension in populist leaders around the globe. We see the rise of protectionist governments in Italy, Greece, Hungary, United Kingdom, Philippines, and even in the US, to name a few. Each is worried about the threats to its cultural heritage from immigration and the loss of traditional jobs. Each has used fear of “foreign invaders”, whether they are from North Africa, Syria, or Mexico, as justification for their policies. The reason for these migrant flows is mainly the failure of their governments and little is being done to address this issue. As long as there is massive corruption and drug wars in Central America and Mexico, there will be people looking to flee. As long as Assad keeps pounding the villages of Syria with chemical and conventional weapons, people will try to escape. Finally, if you cannot educate workers to do the jobs of tomorrow, they will feel victimized by the erosion of jobs from technological progress. Populist politicians will take advantage of these fears, making for some spiteful and perhaps dangerous politics.