With markets in turmoil, inflation all but non-existent, and global GDP growth stalling, the FED’s next significant move will be to follow many other central banks and ease. As interest rates have only moved up by a quarter percentage it is likely quantitative easing or negative interest rates are coming. Most major market participants are now aware of this, opinions on whether it is a good idea are divided. At Davos, some attendees were calling for global central banks to stop easy money policies and let economies correct. In this note we explain why this is unlikely and how we will take advantage of the FED’s next move.
Household net worth, debt, business spending, and QE
One of the main purposes of quantitative easing was to inflate asset prices. The idea is: when asset prices increase consumers feel confident and start spending, businesses hire and invest, inflation rises, and the economy normalizes. Our analysis shows only moderate correlation between household net worth and future consumer spending (Chart 1). The correlation between net worth and consumer spending peaks out at ~0.60, with consumption lagging net worth by two months. One of the reasons for the moderate, not strong, relationship this is that financial assets comprise an ever increasing share of net worth. As most financial instruments are marked to market daily, changes in market price cause wild swings in consumer and business sentiment (Chart 1 and Chart 2).
Chart 1: Change in net worth and household spending
Chart 2: Composition of net worth
As we’ve pointed out in a previous note, many American consumers have been left behind by an economy with global supply chains, knowledge sector growth, and the rise of low wage and temporary work. Instead of the intended purpose, easy money policies have artificially inflated asset prices. Haunted by the great recession and left behind by the economy, consumers have focused on deleveraging and saving instead of spending, which is one of the reasons why inflation has not taken off. As consumers deleverage businesses have taken on debt, and instead of using the debt to invest in the future they have used it to artificially inflate earnings per share through share buy-backs (Chart 3). Large share buy backs mask the fact that earnings and sales in S&P 500 firms have declined throughout 2015, pointing to weakness in the global economy. Some market participants are beginning to tire of the financial engineering and beginning to push for change - one reason why short term focused activist funds are starting to fall out of favour.
Chart 3: S&P 500 share buy backs
Internationally, corporate and government debt binges have fuelled over capacity in China which is now experiencing slowing growth as a result. As China was the main driver of global GDP growth out of the great recession (Chart 4), and a large consumer of commodities (Chart 5a and 5b), we can expect the global economy to slow.
Chart 4: World and China GDP
Chart 5a and 5b: World and China Imports/Exports
In short: today’s macro economic climate does not support current asset valuations. Investors are irrationally buying assets at high valuations because they believe that easy money policies support high asset prices and/or the macro economic climate will eventually catch up to the market. Central banks are easing monetary policy in an attempt to push economies to catch up with asset valuations and keep asset valuations high. Since consumers are deleveraging, monetary easing is having a limited impact on the real economy.
What happens next
At Vital Data Science, we analyze the global economy and asset prices several ways. One process we go through is to collect hundreds of thousands economic indicators, reduce and extract features, then summarize the global economy in a three dimensional visualization (Figure 1). While this tool over-simplifies the complexities and interactions in the global economy, it is useful for spotting long term trends. Our representation shows the economy peaked early 2015 and has been in decline since. We extracted features from this representation and built a model using the features as variables. We found markets lag our bull/bear indicators by 12-18 months. Back testing showed the model was ~70% accurate in predicting market swings. This model is currently predicting a bear market.
Figure 1: Three dimensional representation of the the global economy
Another approach we take is to run an algorithm through the macro economic statistics we collect and develop indexes representing areas of interest in the global economy. We train a model on the indexes and forecast market movements. Our model, when back tested 20 years, is 87% accurate in predicting major market swings. This model is also predicting a bear market.
We believe that current distortions in the global economy have deviated from historical patterns in two key ways:
- Increased interdependence in global economies through global supply chains; and
- worldwide acceptance of unorthodox central bank policies like quantitative easing and negative interest rates.
Models based on historical information cannot accurately reflect these new dynamics without a significant adjustment of forecasted results. Taking all of this into account, our current base case global macro economic scenario is:
- The US is not immune to the global slow down and the heat experienced at the tail end of 2015 will cool by the end of the first half of 2016.
- The Greenspan put is coming. You can call it the Yellen put. The FED will not raise interest rates, it will lower them, and then return to quantitive easing or negative interest rates by 2017.
- US equity markets will swing wildly but trend flat to negative in 2016, before the end of the year a bear market will be evident.
- Consumers will continue to deleverage and save through 2017. Normal spending growth will return when debt burden returns to normal levels. Then the next cycle will begin.
- Investors and corporate management teams will begin to adjust to the deflationary deleveraging phase in the global economy and financial engineering will peak in 2016, then begin decreasing in 2017.
The world is becoming increasingly turbulent: conflicts in the Middle East, tension between Russian and the West, and tension between China, its neighbours, and the United States all have economic implications. Global political turbulence perpetuates the monetary policy race to zero and below, and increases the time required to work through global economic imbalances (i.e. oil supply/demand). In our view, this is the largest risk in the global economy over the long term.
Our belief that current global economic distortions cannot be accurately reflected by existing economic models, which are trained using historical data, without significant adjustment of forecasted results, was the driver of our earlier market neutral strategy idea. Currently, we see success coming from beginning to move away from market neutral and into a net market short position. We see the buffering impact of global central banks policies having a decreasing effect in supporting asset prices going forward and believe that it will take a number of years for the real economy to catch-up to current asset valuations.
In our note in December 2015, we highlighted three pair trade ideas. We continue to believe that these positions will yield success. To take advantage of our global macro view, we also highlight other ideas below. Table 1 summarizes our position ideas and results to date. To date, our position has yielded a small loss, in the same period the S&P 500 dropped 7.5%.
Table 1: Update on existing positions
To take advantage of our global macro view, we believe positions in US treasuries, and a net short position on the S&P 500 will yield success going forward. An example portfolio is shown in Table 2. We will optimize this portfolio as the direction of the global economy becomes more clear, in future notes. The next important check point for us is the FED’s March meeting.
Table 2: Vital Data Science Inc. example portfolio
A note on benchmarking
As we have developed enough positions to build a very concentrated long/short portfolio, we are establishing a benchmark to validate our ideas. Our benchmark will be 70% US equities represented by SPY, and 30% US Treasuries represented by GOVT. We believe that such a ‘do nothing’ portfolio presents most investors a reasonable alternative to active trading and balancing. It is easily replicated, realistic, and presents reasonable risk/reward balance.
On a go forward basis we will measure results relative to this benchmark. If our positions expand to include global assets or alternative investments, we will adjust the benchmark.
Any material provided in this blog is for general information use only. You should not act based solely upon the materials provided herein. Vital Data Science Inc. advises you to obtain professional advice before making investment decisions. Your use of these materials is entirely at your own risk. In no event shall Vital Data Science Inc, its officers, directors or employees be liable for any loss, costs or damages whatsoever.