This note was originally published at 8am on July 24, 2013 for Hedgeye subscribers.
“Fragility is the quality of things that are vulnerable to volatility.”
We have quoted Nassim Taleb a number of times at the start of the Early Look and, admittedly, I didn’t check to see if this was a recycled quoted. Nonetheless, it is a very apropos quote for the topic of today’s Early Look and for contemplating risks in markets generally.
The title for today’s note comes from a story, which is referenced in Taleb’s most recent book “Antifragile”, that emanates from rabbinical literature (Midrash Tehillim) and is about a king that is angry at his son. In fact, the king is so angry at his mischievous son that he explodes one day and tells his son he will crush him with a large stone.
Herein lies the dilemma according to the story: a king who breaks his oath is considered unfit to rule. The king is now faced with the decision to either crush his son, or to give up his throne. Luckily before the poor prince was crushed, an advisor (the Hedgeye of the era perhaps?) came up with a solution. The king should cut the stone into very small pebbles and pelt his son with these pieces.
Taleb’s point in this analogy is to explain how fragility stems from non-linear effects. That is, if you double the dose, you get more than twice the effect. By way of a practical illustration, if you have five shots of Jack Daniels, you have a buzz. But if you have ten shots of Jack Daniels, your wife (or husband) makes the couch up for you to sleep on that night.
Back to the global macro grind . . .
As it relates to non-linear impacts on the global markets as of late, interest rates have certainly had the most critical impact. In the Chart of the Day, we highlight a slide from our most recent Q3 Theme Presentation that looks at quarter-over-quarter moves in interest rates. As the slide shows, the move in interest rates in the last quarter was the largest percentage increase in fifty years. (Yes, the last time this happened Sandy Koufax was pitching for the L.A. Dodgers.)
We were on the road in Europe talking to clients last week and not surprisingly interest rates were a key topic of discussion. Many of the more astute investors actually narrowed in on this precise point of interest rate volatility. Our view is that volatility of rate increases will be more benign moving forward, which, as we’ve been stating, should be positive for the U.S. dollar, domestic economic activity and U.S. stocks.
To the extent that volatility picks up, the effects of interest rate increases will be non-linear. In reality, a move from 1.63% on the 10-year treasury to 2.63%, or an increase of 100 basis points, shouldn’t have a meaningful impact on asset classes or the economy. The markets become fragile, though, when this 63% back up in rates occurs in a very compressed time period, as it did in May – June. In pushing the interest rate ball under water, the global central banks have created a set up in which interest rates are very fragile (to use Taleb’s definition).
In addition to the risk of rates increasing at a rate that is highly volatile, the other key focus area of investors in Europe on our visit related to the impact of #RatesRising to housing. This is certainly a legitimate question as the wealth impact from home price increases is a key reason we are bullish on U.S. consumption. Specifically, as a consumer’s balance sheet improves via an increasing home price, so too does their confidence, ability to borrow and subsequently spend.
Based on our long run analysis of housing, the recent accelerated move in rates has not altered the fact that the affordability of purchasing a home remains at historic lows. On the basis of median mortgage payment as a % of median income, the housing market is at 22% and well below the twenty-five year median of 28%. On the basis of median mortgage payment to median rent, the housing market is at 99%, which is also well below the long run average of 131%.
This is not to say, of course, that housing won’t be impacted by a volatile move in rates, but the housing market is still so depressed based on historical levels it should have the ability to manage through #RatesRising. June data from the NAR seems to support this as existing home sales were up 15.2% year-over-year and the national median home price in June was up 13.5%. So yes, housing can do well if rates continue to rise.
Switching to infomercial mode for second, I want to highlight that we will be expanding our U.S. financials research coverage and are launching on U.S. asset management stocks on Monday July 29th at 11am. Jonathan Castelyn has joined Josh Steiner’s team in a senior role and will be initiating on these names. As always, we will be actionable and Jonathan will have 2 short ideas and 2 long ideas. Please email firstname.lastname@example.org for access.
Our immediate-term Risk Ranges are now:
UST 10yr 2.47-2.71%
Keep your head up and head on the ice,
Daryl G. Jones
Director of Research