April 6, 2018
It is without a doubt that Q1 2018 has been an eventful quarter. Economic health and the role of central banks, rising inflationary pressures, the collapse of the volatility complex, and growing US debt are addressed in the following report.
Recent Market Conditions
The year began with a fiery start when January’s one month return peaked over 7% on the S&P. Coincidently, we find that January 2018 saw the largest capital inflows to Passive ETFs in history, which may have been a major contributor to bolstering the market – and while the market increased, more people made an effort to get in, fueling greater inflows and higher prices. In the chart below, January 2018’s parabolic rise seems stands out more than any other – it was unusual to say the least. Perhaps too much, too fast and a clear indicator to put on a partial downside hedge to protect our investments thus far.
Chart of the S&P 500 leading to a parabolic rise to start the year.
February arrived and brought with it something that we haven’t seen since 2008, a near 95% single day increase in the VIX; nearly wiping out the short VIX ETF. Now for those who are unfamiliar with the VIX, it’s a market instrument that, for simplicity's sake, tracks the volatility in the market; the greater the ups and downs, the greater the volatility. So when we experienced that two-day market drop of 6%, volatility spiked upwards. Implying that anyone who was short volatility (hoping that volatility would continue to drop) - and there were many parties both retail and institutional players, including pensions funds who were short - suffered from large losses and may have gotten squeezed out of their positions.
A Potential Long-Term Change in Volatility
In looking at the distant past, volatility was common place in the market. It wasn’t unusual to see large swings at all. In fact, this is how traders made a living. Buying into the market on a small dip, leveraging up the long, and then selling when it corrects higher. However, over the past decade volatility has plummeted to historically low levels. This made a trader’s job more difficult and thus many began switching over to becoming long-term investors as the markets were on a consistent steady rise with low volatility. Now, it has been this way for such time (over 8 years) that investors may have forgotten what a high volatility environment used to be like.
With signs pointing to a potential reintroduction of volatility, investors are likely to fall victim to becoming fearful of taking new positions and possibly missing out on great investment opportunities, or worse, when invested in a position, they may suddenly become stopped out has the high price volatility leads to large price drops. This is where we believe it becomes paramount to take on a core investment position while being able to stay agile and trade around it; this is where real alpha is created.
A Strong Economy, So It Seems.
It appears that all the main US economic indicators are pointing to a strong economy, and from what you may be experiencing, it is. Unemployment is at an all time low, PMI indexes pointing up, GDP is growing steady, and inflation relatively in check. Now when everything is looking this great, we’re out trying to understand why and what gives.
It goes without saying that the US has been accumulating debt - perhaps a little too quickly and steadily - and generally this comes with a growing deficit. However, in strong economic periods, history has shown us that the rate of GDP growth will naturally outgrow the deficit, which speaks to a healthy economy. Only coupled with a recession has the deficit as a percent of GDP ever dropped.
Outlined in the chart below, it becomes a little clearer. The black circles show where the deficit grows larger than GDP (a downward trend), and with it you can see that was in tandem with a recession.
Chart of the Federal Deficit as a Percent of GDP. Circles shows the relationship of a declining ratio and a recession.
In the most recent years, however, we find ourselves in a position of supposed economic growth, yet for the first time in a long time, the deficit is growing faster than GDP (see the red circle to the right). And according to the past, this is a clear indicator of a potential recession ahead. So this is definitely something to keep a look out for. Invest with extra caution, and when possible, a hedge isn't a bad idea to consider.
The Debt Problem
With a growing deficit and pile up of debt, we need to acknowledge that this is becoming a more dominate issue. It's incredible to think that as the US debt grew over the years, the interest payments to service the debt remained he same (they should've increased with the amount of debt) - the reason why they've stayed the same points to a decreasing interest rate environment.
Chart of the Federal Debt more than doubling in a decreasing interest rate environment.
Chart of the Federal Interest Expense staying range bound between approx. $190 Billion and $260 Billion for over a decade,
The results of doubling the debt was great, it led to a growing economy through great QE (Quantitative Easing) stimulus; guiding financial assets to all time highs and it was cheap to do that since rates were dropping.
We are now entering a new interest rate environment where rates are on the rise - and the implications can be astounding. First, the debt, everything comes back to US debt - if interest rates double, going from 1.5% to 3%, then US debt service expense will double - which is generally funded by government tax revenues. Unfortunately, tax revenues will likely decrease with President Trump's new tax policies to lower tax rates, thereby putting the US in a tight situation and making it more difficult to pay the interest expense on the debt - and in looking at the chart above, the last time debt service expense reached our current levels, it didn't end so well (see 2008 not the chart).
Now what's a potential solution to this growing debt problem? Inflation. Or perhaps deflation. But it's still to early to tell which way the rope will swing.
In a weak economy, central banks can step in with more ease and justification. However, we're in what people are calling strong economic conditions, which suggests that there isn't much the FED can do. But the question for us isn't about a weak or strong economy, it becomes whether or not it's a healthy economy. Since 2009, we've experienced nothing but a decreasing interest rate environment, which has led us to a wonderful bull market. But now with an increase in rates, we begin the true test. The weak hands will undoubtedly be shaken out, and through this time, volatility is likely here to stay. It's becoming a world of bottom-up stock picking; choose your investments with diligence.
Thanks for reading.
Your Financial & Investment Advisor,