This note was originally published at 8am on November 12, 2013 for Hedgeye subscribers.
“Ignorance more frequently begets confidence than does knowledge; it is those who know little, not those who know much, who so positively assert that this or that…”
Having fun out there yet?
If like us, your conviction on what an appropriate gross and/or net exposure should be has wavered in recent weeks, Darwin’s quote probably resonates with you. With respect to financial markets, I, for one, don’t understand how anyone could’ve had enough conviction to positively assert anything beyond a simple “I don’t know” in recent weeks, but that’s just me. What do I know?
Without speculating on the level of ignorance (or lack thereof) implied by the views of any market participant(s), we continue to tip our hat to the “QE is effective; see, I nailed it all along” community – if for nothing other than their unwavering confidence.
Does QE actually “work”, however? Moreover, how does one go about determining its effectiveness? This debate really centers on the question we asked in the video we published earlier last week:
“Does the price of money determine the pace of economic activity or does the pace of economic activity determine the price of money?”
Without getting all philosophical before breakfast, our answer to that question was simply, “It’s reflexive.”
Considering, it would seem that trying to determine the causality behind the demonstrable acceleration in economic growth we’ve witnessed in the YTD is little more than a fool’s errand. Was QE responsible for producing economic growth or were expectations of QE’s eventual demise the stimulus the economy needed?
Sourcing the data, the reflexive relationship between the US dollar, US interest rates and the slope & magnitude of real GDP growth is almost impossible to disregard without being completely subjective or grossly qualitative. Whether you’re looking at the current economic cycle or the past three decades of economic cycles, the data speaks for itself:
- 2013: In calculating monthly averages for the DXY and UST 10Y Yields, we see that the USD and US rates were most strong (on a YTD percentile basis) in the JUL/AUG/SEP periods. Coincidentally, that’s precisely when the ISM Non-Manufacturing and Manufacturing surveys, Conference Board Conference Board Consumer Confidence Index readings and the NFIB Small Business Confidence Index readings were also recording their strongest levels in the YTD (on a percentile basis). Moreover, the slope of the DXY and UST 10Y has tracked the slope of the aforementioned high-frequency growth data nearly perfectly in the YTD.
- 1983-2013 (trailing 30Y): In calculating quarterly averages for the DXY and UST 10Y Yields, we see that concomitant QoQ appreciations in both indicators are closely associated with both relatively rapid economic growth and periods of #GrowthAccelerating. Specifically, Real GDP growth has averaged +4.2% on a QoQ SAAR basis in #StrongDollar + #RatesRising periods; that compares to +2.4% for #WeakDollar + #RatesFalling periods. From a 2nd derivative perspective, GDP growth tends to accelerate +23bps on average in the former environment and decelerate -23bps on average in the latter environment.
To our knowledge, qualitative assertions have yet to trump basic arithmetic in any debate.
The more we reflect and debate internally as a team, the more we find ourselves squarely in the camp of: “Who cares about causality anyway?” As investors, all we really want to do is isolate the signals – be they quantitative or fundamental – that give us the best probability of being right on the slope of growth, inflation and/or policy.
From there, we can begin to speculate in financial markets using reasonably accurate assumptions for what we believe to be the three most important factors in determining asset prices.
With respect to financial markets, what matters most is what everyone thinks everyone else thinks about QE and the only way to record any consistency or accuracy in attempts to measure that is to set aside our own dogmas.
In short, we do not think it is helpful to engage in the debate surrounding the causal impact of QE upon the economy. In our view, it is impossible to determine causality without being qualitative or subjective because we don’t have accurate data about the expectations and intentions of all the agents that make up an economy.
As such, all we can really do as investors is interpret the signals as they come and play the ball as it lies. Focusing our attention on anything else is a clear deviation from the task at hand (i.e. making money).
Regarding the task at hand, we do know that QE and its associated expectations are causal to the prices of many assets globally. As such, the name of the game remains isolating the signals that give us the best forward-looking read on growth, inflation and/or policy – or the eventual tapering of said policy:
- Quantitative: Solid comeback for the US Dollar Index right to our TREND line of 81.39 resistance this morning; will it hold? US Treasury rates (10Y Yields) – which are now trading demonstrably above their 2.63% TREND line – are suggesting a DXY breakout has become an increasingly probable event.
- Fundamental: Analyzing economic data like a Fed Head would imply tapering is a spring of 2014 event at the earliest. Moreover, the lack of liquidity in the bond market should take a mid-to-late-DEC tapering squarely off of the table: primary dealer inventory is -73% off its 2007 highs and equivalent to a mere 0.8% of outstanding US corporate credit vs. a peak of ~4% in 2007. Please note our emphasis on the word “should”, as what we think the Fed should do and what the Fed does are quite often two very different things.
- Correlation Risk: While three days does not a trend make, very immediate term correlations are signaling what may be a return to the pro-growth trade of #StrongDollar + #RatesRising = positive US equity beta amid decidedly negative EM beta that has: A) dominated much of the past year; and B) was interrupted by a return to the post-crisis playbook of “QE = short US dollars; buy everything else” in the weeks since SEP 18 (i.e. the day of the Fed’s “no taper” surprise). See the Chart of the Day for more details.
So what do investors do with all of these convoluted signals? In a phrase: #GetActive. If you’re not yet familiar with our call for active mangers to outperform over the both the intermediate term and long term, please ping us for a review of our 4Q13 Macro Themes.
Indeed, it would seem that stock-picking will become increasingly important as we start to move away from what has been an elongated period of minimal return dispersion at the sector level – likely due to the strong performance of typically low-beta, high-yielding sectors in an era of institutionalized yield chasing.
For those of you who are keen to add new techniques to your analytical toolkit, we’ve built a model that backtests exceptionally well in screening for prospective alpha at the single security level. For more on that, please CLICK HERE for the data and CLICK HERE for the accompanying manual. Email us if this is something you’d like to discuss further.
Our immediate-term Risk Ranges are now:
UST 10Y Yield 2.64-2.79% (bullish)
SPX 1748-1778 (bullish)
VIX 12.29-14.55 (bearish)
USD 80.93-81.53 (neutral)
Pound 1.58-1.60 (bullish)
Gold 1271-1312 (bearish)
Keep your head on a swivel,
Associate: Macro Team