Explaining Past Volatility

Explaining past volatility

Maple Leaf
Originally published in the April 2005 issue

In the case of money, it also seeps toward a new home, though perhaps not as quickly. We might be thankful it poured into hedge funds, without a doubt. It also surged into long term bonds, since their yields were (and still are) higher than shorter term instruments. It found its way into emerging markets, corporate bonds (both high grade and investment grade), commodities, and collectibles. Let's not forget CDO's, private equity, LBO's, ABS, MBS, income trusts and almost any other financial instrument youcould devise that targets the famous 'Libor plus' returns. It also mercifully found its way onto corporate balance sheets, which were diligently repaired, which ignited a chain of lower default rates, tighter credit spreads, and higher equity prices.

Most importantly, negative real rates propelled US home equity prices as Pimco's Bill Gross astutely observed (April 2005, Pimco.com). The catapult in residential valuations in the US 'created' 3 trillion dollars of wealth, three times the amount created in the tech bubble of 1999-2000. Economists often mention the 'wealth effect', and how the tech melt up made people so comfortable with the financial position in their brokerage account they spent money heartily in those days. With three times as much wealth added over their heads in this cycle and extra incentive to spend via reduced deposit rates, not to mention 0% 5 year loans for durable goods, they're likely to spend a little. Actually, they're likely to spend a lot. In hindsight, it isn't hard to explain the unsustainably low level of US savings, and consequently the US trade deficit. Effectively, money flowed into consumer spending and retail cash registers in an enormous way. The following is a graph of the US current account balance and savings rate courtesy Bloomberg.

All of the above has led to significantly reduced volatility, in the form of trending markets. As stocks rallied in 2003, there was always a seller ready to take profit if prices rose quickly, and always a buyer waiting for a dip to get into the chase for better returns. Emerging markets had only a couple swoons for the same reason. Any effort by credit spreads to back up was swiftly met by CDO issuance gobbled up by yield hungry fixed income portfolios. Even the dollar had the same two-way pressures – most speculators were short, and 'take-profit' bids were always present. Similarly if the dollar tried to rally there were many late to the game thankful for a new chance to underweight. In short, we've witnessed several slow grind, non-volatile one-way bets.

Admittedly this is described with the benefit of hindsight, but after that quick recap of recent history, I need only point out that liquidity is now being drained from the system. This phenomenon is true not only is the US, but also in most other major markets. In fact, there are scarcely any countries globally (of liquidity importance) with an inverted yield curve and expectation that rates will fall. Brazil is one exception, after having hiked rates 350 bp in the last 9 months. There are a few roughly flat curves, all of which started raising rates quite some time ago and by a meaningful amount including Australia (3 years, 125bp), UK (18 months, 125bp), and Mexico (2 years, 500bp). More importantly, yield curves are upward sloping in the US, Canada, Europe, Scandinavia, Switzerland, South Africa, India, Japan, and every Southeast Asian country. For completeness, it's worth noting China is also amongst those making efforts to slow growth, although hiking interest rates is not their method.

While everyone knows these facts, most cling to the 'rosy scenario' forecast of the future. Maybe for some it's too painful to consider other paths. Maybe many believe FED Chairman maestro Greenspan can engineer a slow unwind. Perhaps, but the probability of error is rising. Of course he wouldn't intend to cause pain with unexpected harsh rate hikes. Thus, the FED warned in the December 2004 minutes of excess leverage, added a statement of concern about inflation in March 2005, and does anyone remember Greenspan's words November 19, 2004 – "Rising interest rates have been advertised for so long and in so many places that anyone who has not appropriately hedged his position by now, obviously, is desirous of losing money". 10 year US rates were 4.13 when he made this comment, and they are 4.33 today. A 20 basis backup in 5 months ? The market is ignoring warnings from the guru they are counting on to smooth the process. I printed and glued these words to my computer screen, lest we forget.

While we're looking backwards at economic history, one need not look too far back to see what experience the market might go through in a more unpredictable rising rate environment. After all, it was this same FED Chairman that hiked rates aggressively in 1994 after 'falling behind the curve'. Most speculators buckled down for a rough ride last June when the first hike came, but then quickly went back to chasing carry. What was Greenspan referring to by "appropriately hedged"? A risqué suggestion, but might he have meant sell EM, equities, real estate, collectibles, credit, CDO's, LBO's, ABS, MBS, and not just straight bonds? Most hope it was just a gentle nudge to raise the back end of the yield curve. I'm starting to wonder.

Spraying water onto the lawn is far easier than retrieving it. People who look back at the realized volatility of the past two years (average market memory of a trader) and extrapolate forward are failing to analyse the causes. Banks use 2 years of data in their Value-at-Risk calculations, and taker bigger and bigger positions as the 'old era' of volatile markets falls out of the model's realm of possibility. Some point to a new era of stability in economic figures. Why? The only argument I hear is because they have been stable recently. Again unquestioning linear extrapolation. Certainly not because global imbalances have been corrected. Certainly not because cheap and abundant Chinese labour is changing the way business is done globally. Judging from trade deficits/surpluses, government budget deficits/surpluses, and hugely asynchronous consumer savings rates, it's far easier to argue the world is in disarray and financial stresses are more likely than ever – That is, if there isn't a massive pool of liquidity looking to seep into every crack. Markets have been non-volatile because they have been trending. If they continue to trend, they will continue to be non-volatile. Simple. Is the existence of a trend in the past indicative of propensity to trend in future? Given those trends were fuelled by the provision of liquidity, and that stimulus is now being removed, the probability of increased volatility is rising. I think investment products should carry a warning – "Past volatility is not necessarily indicative of future precariousness."

How will things unfold this time? In the past they unravelled after corporations over borrowed in the good times and were then squeezed by higher interest payments. Defaults rose, credit spreads widened, jobs were lost, and spending slowed. This time, with the debt burden in the hands of the consumer, reduced spending might lead to reduced profits, lower share prices, wider credit spreads, and higher default. Or perhaps high commodity prices, particularly oil, will squeeze too much out of middle America's wallet and start the ball rolling. In any case, the risks are rising week-by-week and month-bymonth. The following chart (courtesy Morgan Stanley) is interesting, as they argue rates will rise until a disaster occurs, not until the much debated and magical 'neutral' rate is achieved.

Why hasn't something happened already? 10 months and 7 rate hikes have passed, and the world is still a pretty nice place. The S&P is just 4% from it's high this cycle, Eurostoxx is 2% shy, the Nikkei 4%. Credit spreads, autos aside, have backed up only marginally relative to their gains of the past 2 years. The global economy is very robust, earnings growth is reasonable, and inflation is modest.

The key here has to be that real rates only became positive in the past few months, meaning the watering hose was still on for the second half of 2004, but at a weakening pace. Second, growth in China and consequently all of Asia-ex-Japan will power on for a while after their customer stops spending, as a pegged currency, and sticky interest rates and government policy mean adjustments will not be efficient or swift. These countries have 46% of their GDP comprised of exports (36% in China), with tremendous growth driven by exports to the US. It is likely linear thinking is a global phenomenon, and they are building infrastructure expecting this trend to continue. Third, it will take some time for people to change their habits. With rates at 1%, the consumer could afford a lot. 2%, quite a bit. 3%, starting to bite. 4%, time to reduce credit card debt, no more 0% financing offers, why do we own 3 cars and 6 televisions? 5%, let's start selling on EBAY, put savings in a bank account, and themonthly floating mortgage payment is WHAT??

Auto investors are taking notice. Ford (-31% ytd) and GM (-28% ytd) are not anomalies. They have lowered 2005 forecasts, and are the most obvious candidates to be squeezed from the factors described above. But they are not alone Investors seem unwilling to extrapolate from their troubles, and very willing to compartmentalize that situation. Again referring to a study by the smart folks at Morgan Stanley, they point out that despite the rise in US home prices over the past 5 years relative to incomes (+46.3% versus +12.8%), homes have become more affordable. Odd? Magic accounting? No, simply due to the shift in mortgages to floating and interest-only, actually payments have decreased. In other words, if you play the carry game like everyone else and borrow short term floating to fund a long term fixed asset that you can't afford to lose, and don't make any principal payments to try to genuinely own your home, you too can still participate. Is this lunacy? The difference is that speculators playing the carry game will stop out of their trade when it starts losing, and are watching the position actively. Residential homeowners "stop loss" will be when they default and land in the street.

We read a lot about equity valuations being very modest, much better value than before past sell offs and turbulence. The most common argument is that earnings and dividend yields are attractive relative to bond yields. Just playing with the equation, three outcomes would correct that opportunity – first, equity prices could rise, most people's preferred scenario. Second, earnings could slow as spending slows. Isn't that inevitable given the US savings rate and government deficits? Third, bonds could move lower. Isn't that what Mr. Greenspan warned about? It's always worth a bit of cynicism when an argument that something is to be bought is based on its cheapness relative to something else. Stocks are cheap relative to bonds. Bonds are cheap relative to cash. And cash is just plain cheap! That's changing.

It's worth mentioning the China Currency Bill proposal in the US senate to impose 27.5% tax on all Chinese goods sold in the US. It is very unlikely this action goes forward, and it has been withdrawn pending Finance Committee review, and a vote in the summer. Drastic protectionist measures are a long shot, but public debate is inevitable, growing, and will lead to something. We see this as a wildcard volatility catalyst, and add it to the mental pile of unexpected potential shocks including SARS, Avian Flu, terrorism, and North Korea/Taiwan/ Iraq/Iran military situations.

Another key pillar of support for a continuation of the steady state, and low bond yields, is a story that sounds like this – US rates can't rise very much or else they'll burst the bubble in housing and paralyse the bloated grossly indebted consumer. US housing inventory hit an all time high in January, and US auto inventories hit a 22 year high in February. Who will buy these goods if rates rise? If rates go up, things will slow so fast they'll come right back down, so buy any dip in bonds. The fallacy in this argument is that it recognizes a structural problem with the global engine of growth, US consumer spending, but still paints a positive picture. It may be fair to bullish on bonds based on this scenario, in which case one must also be bearish corporate outlook as far as credit, profit, and valuation, bullish volatility, and nervous about systemic leverage. If global volatility picks up, all the carry trades, including curve trades, high yield, EM, MBS, ABS, etc are in question. Not a pleasant picture at all.

Next, if one believes rates can't rise or the consumer will choke, then effectively the FED has lost interest rates as a policy tool. If commodities keep going higher, or oil continues to surge, then what? So far longterm inflation expectations are benign, but this could change. There will be a choice to make between controlling inflation and crushing the economy, or continuing to pump the economy and watching inflation run. I hope they would choose the former, but in either case the markets will be sloppy.

In summary, we see the headwinds to global steadiness increasing from all directions. Real rates in the US are finally positive, rising, and mirrored globally. Cracks in the foundations are already appearing, as EM and high yield performed poorly in March, and equity markets were slightly soft. US auto stocks have been crushed. World financial markets are becoming increasingly more interesting as liquidity is drained and bubbles must be unwound. Many participants are backward looking, and even then only at recent history. Cheap money found its way into many things and must now find its way back home.