Bootlegging & Banking

This note was originally published at 8am on November 03, 2014 for Hedgeye subscribers.

“I don’t mind going back to daylight saving time.  With inflation, the hour will be the only thing I’ve saved all year.”

-Victor Borge

During daylight savings time, in the fall and winter months, the U.S. Virgin Islands are one hour ahead of East Coast time. 

Instead of getting up at 4am everyday, I could get up at 5am…and, you know…..be on an island. 

Keith’s in Cali this week.  When he gets back, I’ll try to leverage the jet-lag + daylight savings  brain fog combo and float the “Hedgeye Caribbean” proposal, again….

“you miss 100% of the shots you don’t take”

Bootlegging & Banking - st1

Back to the Global Macro Grind...

In our 4Q Macro Investment themes call we profiled a series of bubbles which, among others, included:

  • Complacency Bubble: Daily moves of >1% vs. Average VIX level (by year)
  • Inequality Bubble: Labors Share of National Income vs. Congressional Disapproval vs. Gini Coefficient
  • Hedge Fund Correlation To Beta Bubble:  Hedge fund trailing correlation to the SPX vs. Average Relative Monthly Performance
  • Leverage Performance Chase Bubble:  Margin Debt (inflation Adjusted), % of SPX Mkt Cap
  • Expensive Small Cap Illiquidity Bubble:  Russell 2000 Trailing PE vs Average Market Cap Traded (by year)
  • Basement Dwelling Bubble: Real Median Household Income vs. 18-34YOA Homeownership Rate vs. Housing Expense as % of Median Income
  • Spread Risk Bubble:  IG & High Yield Spreads over Treasuries vs. Bond Volatility vs. Total Corporate Debt Outstanding

Our timing on the complacency bubble proved particularly prescient (substitute “lucky” if you’d like).  Prior to our themes call, the VIX was trading at its lowest average level in a decade and just 11% of trading days saw moves in excess of 1% in either direction.  Subsequent to our call, the VIX has been higher by ~33% on average and the SPX has had daily moves greater than +/- 1% over 50% of the time.    

We expect the Dramamine ride to continue. 

Taking a broader view, each of the aforementioned bubbles are, in some magnitude, outcroppings of the larger bubble that is Central Banking. 

With the explicit goal of QE initiatives being financial asset price inflation - and the hope for the ultimate trickle down and around effect - asymmetries and inequalities have become more pronounced in recent years.  Such policy manifestations, however, are more an extension of secular trends than neoteric phenomenon. 

The financial sector and those tied to it have benefited disproportionately since the turn of the interest rate cycle circa 1980.  From 1980 to its peak in 2006,  the finance industry grew from less than 5% of the economy to ~8.3%, taking share at a rate of ~13bps per annum while the financial sector weight in the S&P500 rose from less than 10% to greater than 20% over the same period. 

Industry and activity chase price/profit and the broader reality of the great moderation – which, instead of promoting natural economic cycling, effectively propagated the accumulation of latent risk – is that 30+ years of lower highs and lower lows in interest rates supported a multi-decade run in financial asset price appreciation - a phenomenon exaggerated further by the twin peaks in both demographics and household & corporate leverage. 

Alongside that financialization, the gini coefficient in the U.S. increased almost a full decile and the share of total income earned by the top 1% of families more than doubled from less than 10% to greater than 20%.

The minority with financial assets and those tasked with managing them - which, coincidentally, became increasingly less mutually exclusive - benefited as bond prices had a historic bull run while the ongoing, incremental lowering of discount rates provided for a perma-juicing of asset values via the Present Value effect.  

Q: How much would the median home be worth today if rates were at 10% instead of 4%?

A:  About -45%, or -$110K, less. 

Quasi-relatedly, the policy perpetuated asset bubble rotation into housing destroyed a perfectly predictive housing model. 

Over the pre-1995 historical period, New Home Sales could be modeled as an almost perfect periodic function.  For the aspirant, part-time quants like myself, who would like to plot the function, here’s what I got on a 1st pass…..

f(x) = 241*sin(2Pi/82*x-20.5)+614   ….#CoolButUseless

Perhaps as the last of the cumulative displacement from trend burns off in the next few years we can return to a similarly predictable oscillation in new housing demand.     

Anyhow, a couple weeks back, Janet Yellen expressed concern over the ongoing rise in inequality that team FOMC itself helped perpetuate. 

Janet failed to explicitly address the role of central bank policy in that burgeoning divide but the Fed does hold an appreciation for the lag between Wall Street’s discounting of policy via prices and actual Main Street effects.  And with the normal policy transmission channel left mostly prostrate by the zero bound in rates,  the less potent and longer lagged trickle through of Wall Street wealth to the real Main Street economy has become the hoped for transmission channel detour route. 

Ironically, or unfortunately, the problem with that ideology is that the prescription for ineffectual QE becomes more dovishness in the belief that it’s the bottlenecked transmission of policy and not the policy itself that’s core to the problem.  From that perspective, more and/or longer ‘easiness’ remains the most favorable conduit for the (eventual) leak through of policy to the populace.   

“You keep going until you can’t turn back. That’s where there isn’t any choice. You don’t know where that is. You don’t know until you pass it. And then it’s too late.”

Nucky Thompson epitaphed the bubble in 1920’s Prohibition barbarism and capped the series finale of Boardwalk Empire with that quote.  

I suspect there’s some transferable insight in that Boardwalk epiphany. 

Our immediate-term Global Macro Risk Ranges are now:

UST 10yr Yield 2.16-2.35%

SPX 1967-2023

VIX 13.31-17.79

USD 84.99-87.11

Yen 108.99-112.98

WTIC Oil 79.47-81.43 

To Bootlegging, Central Banking….and kindred spirits...

Christian B. Drake

U.S. Macro Analyst

Bootlegging & Banking - Inequality EL