Concerns About Stagflation - Are These Concerns Legitimate?

We have been through a protracted period of stagnant growth - particularly in the developed world - driven largely by the aging of the "baby boom" generation.  Social benefits / entitlements in the U.S. are crowding out gross domestic savings - the primary source for funding investment - dollar for dollar.  Output per hour has been growing at approximately half percent annually in the U.S. and other developed countries over the past five years, compared to earlier growth rates closer to two percent over longer periods. This is a considerable difference.  As productivity slows down, the entire economic system slows down, which has provoked rise in economic and nationalistic populism indicated by phenomena such as Brexit and Trump.


At the same time, the risk of inflation is beginning to rise in the U.S.  Inflation may finally be getting back on track to reach the Federal Reserve’s goal, as the U.S. cost of living accelerated following a weak stretch of readings, Labor Department data showed two weeks ago. The 0.2 percent rise in the core gauge Energy prices rose by the most since January.

The official unemployment rate is firmly below 5% which might put upward pressure on wages and unit costs in general. Demand is picking up, as manifested by the recent broad increase of the money supply, slowly igniting inflationary pressures. It is also worth noting that home prices are rapidly rising above median incomes, which is not supportive of continued economic growth, and is comparable to some degree to the situation in 2007.  

Where there are expectations of rising inflation, in combination with slow economic growth, the discussion turns to stagflation.  To date wage increases have largely been absorbed by employers, yet if costs are moving up, prices ultimately must follow. If you impose inflation on stagnation, you get stagflation.

Despite the widespread optimism in the stock market, much could go wrong in the next 12 months. The first and rather obvious problem is that increasing inflation expectations could be wrong. Just as the pundits and pollsters who made such miscalculations with Donald’s Trump chances at winning the election. If inflation rises and job numbers and wages don’t increase in turn, stagflation might become that “black swan” lurking and hiding behind the golden clouds of our universe. Caveat Emptor!

September 16, 2017
- Vidak Radonjic
The Beryl Consulting Group LLC

Commentary: The great QE unwind is coming

After ending quantitative easing in 2014, the Federal Reserve now plans to begin shrinking its balance sheet over the next several years by tapering the reinvestment of its Treasury and mortgage-backed security holdings. During the same period, U.S. deficits are projected to grow substantially — notwithstanding the possible enactment of any of President Donald Trump's major proposed legislative initiatives, which would likely cause deficits to swell even further.

Increasing U.S. deficits will require the Treasury to ramp up bond issuance. As a greater risk premium will be required to attract new buyers to absorb both the U.S. primary deficit and the Fed's reduction in its holdings, the U.S. yield curve is likely to steepen. Price concessions into Treasury auctions will likely increase as well.

The European Central Bank, for its part, is increasingly expected to begin winding down its QE program in 2018. This is likely to bring steeper European yield curves, putting additional pressure on the U.S. curve to steepen further.

By communicating the end of QE in advance and increasing the rate of reduction gradually, the Fed hopes to avoid the "taper tantrum" that roiled markets from 2013 until early 2016, when U.S. equities, and global assets more generally, were subject to periodic risk-off episodes.

The aim of QE was to push flows into more productive investments — not just financial assets. Unfortunately, evidence for increased economic activity from QE is relatively weak.

Yet QE did have an impact. It artificially flattened yield curves, weakened the country's currency, allowed poorly performing companies to roll over debt and inflated asset prices.

By depressing yields on government securities, QE encouraged yield-seeking behavior. Many analysts note that the growth of central bank balance sheets has been eerily correlated with the increased value of global risk assets and U.S. equities.

In June, the Federal Open Market Committee raised interest rates by 25 basis points for the third consecutive quarter. The Fed did so, based on internal Phillips curve models, which predict that low levels of unemployment lead to increasing inflation. As the Fed starts to implement its balance sheet runoff, it may find it increasingly difficult to maintain its rate hiking cycle.

Balance sheet reduction is likely to commence in the fourth quarter for both U.S. Treasury holdings and mortgage-backed securities. The combined maximum rate of reduction is $10 billion a month but rising incrementally to a maximum $50 billion a month by the fourth quarter of 2018.

While the Fed has previously tapered its purchases, and in fact ended purchases for brief periods twice, neither it nor any other major central bank that has engaged in QE has actually tried to shrink its balance sheet thereafter. What's odd is that the Fed and other central banks have made claims about the efficacy of QE, but when the policy goes into reverse, they seem to think there won't be any meaningful effect.

The Fed says it hopes the process will "run quietly in the background" and not amount to policy tightening. We shall see. I believe that Fed balance sheet shrinkage could have substantially greater effects on both bond markets and financial markets, generally, than conventional interest rate increases.

Since QE purchases ended, the Fed has continued to reinvest the coupon and principal payments of both Treasuries and MBS holdings. Starting in October, the Fed will likely reduce reinvestments of purchases of Treasuries by $6 billion a month, while reducing MBS reinvestments by $4 billion a month.

In 2018 the Fed will allow up to $180 billion of Treasuries and up to $120 billion of MBS to run off. Thereafter, it will allow up to $360 billion of Treasuries and up to $240 billion of MBS runoff.

This is likely to come against a backdrop of a rising U.S. deficit, which is projected to rise to more than $1 trillion by 2022 (vs. $500 billion in 2015). These projections, moreover, do not include the possible enactment of any of President Trump's likely deficit-raising policies on fiscal spending, defense increases, infrastructure spending or tax cuts.

In the Treasury market, increased supply at auctions will grow steadily throughout 2018, which will likely result in significant yield curve steepening. Rather than being used as a liquidity point for investors to buy large quantities of bonds, Treasury auctions will be more difficult to digest.

It is therefore likely that as net new issuance increases (accounting for the reduction in Fed purchases), we will see significant stress and concessions into Treasury auctions. This will coincide with the Congressional Budget Office forecasts of net funding needs approaching, or even exceeding, the levels that existed in 2009 and 2010.

After years of financial repression, with yields at historic lows and financial institutions on much firmer footing, and with an upturn in global synchronized growth, appetite for government securities is waning. Hence, we expect to see a steeper yield curve and wider MBS spreads.

More importantly we expect to see substantially more difficulty for the U.S. and European governments to issue debt at auctions and syndications. We might even see bond market vigilantes start to impose fiscal discipline on the U.S. government.

Pensions & Investments
By Said N. Haidar · August 24, 2017 11:00 am

Said N. Haidar is founder and chief investment officer of Haidar Capital Management, New York. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.

Gold's Rally Against Oil Is Just Beginning

  • Precious metal rallies amid tensions to near $1,300 level

  • Slump in oil indicates start of three-year gold rally

Even as some analysts decry that gold is looking expensive, the rally may be just getting going.

In the midst of a tumultuous month in U.S. politics and global security, traders have pushed gold futures to near a nine-month high. But if the history of gold’s relationship with oil is any guide, that surge may last longer than the flare-up in geopolitical tension.

The precious metal has rallied 11 percent in 2017 to trade at $1,294.40, compared to a 10 percent slump in crude. That divergence in price may still be going, meaning gold should continue to outperform oil before the 34-month cycle ends, according to a study of past trading patterns for the two assets.

“Gold has rallied during the recent market setback and is now testing its key resistance level of $1,300,” Matt Maley, an equity strategist at Miller Tabak & Co., wrote in a note to clients. “That is the level that stopped rallies in both April and June, so if it can finally break above the level in any significant way, it’s going to be very positive for the yellow metal.”

Whether driven by technical factors or the threat of derailed U.S. economic growth, money managers are flocking to gold. Net-bullish bets on the metal are the highest since October, according to Commodity Futures Trading Commission data.


Meanwhile, investors added $321 million to the SPDR Gold Shares exchange-traded fund so far this month, while pulling $540 million from the SPDR Energy Select Sector fund, according to data compiled by Bloomberg.


Dani Burger and Guido Riolo

    $12 BILLION HEDGE FUND: The stock market has changed, and we're going to have to do things differently

    Spencer Platt/Getty Images

    Spencer Platt/Getty Images

    The stock market has changed, and investors are going to have to sharpen their wits.

    That's according to Dmitry Balyasny, the managing partner at the billion-dollar hedge fund Balyasny Asset Management. The firm managed $12.6 billion in hedge-fund assets at the start of the year, according to the Hedge Fund Intelligence Billion Dollar Club ranking.

    Balyasny wrote in a letter to investors that the rise of passive investing and quant funds and a surge in hedge-fund assets had made the stock market more efficient, leaving fewer easy money-making opportunities.

    It's certainly been true that as exchange-traded funds have increased their share of the stock market, they've been blamed for suppressing fluctuations and pushing a measure of volatility to near-record lows.

    And while it's difficult to attribute the low-volatility environment to just one driver, ETFs, which allow for the easy purchase of huge swaths of stocks, may have made the market more monolithic and sapped it of price swings.

    "We think the challenges, consolidation, and changes in the industry are due to one main factor: There isn't enough alpha to make everyone happy," Balyasny said in the letter, which was reviewed by Business Insider. Balyasny declined to comment.

    He identified three key questions for equity long/short funds, or those that bet on and against stocks.

    Can long/short strategies work in an ETF and index-flow-led market?

    ETFs, which simply track an index, have hoovered up assets at a high rate over the past decade. US-listed ETFs saw $283 billion in net inflows during 2016, taking aggregate assets under management to $2.5 trillion, according to Citigroup.

    Balyasny notes that passive investors now own more than one-third of the US stock market and fundamental stock investors make up only a small fraction of total trading each day.

    This has a few implications, according to Balyasny - in particular, an increase in the relative importance of stock-price catalysts, such as earnings releases. From the letter:

    "Day-to-day action is very ETF-driven. While this action won't change the ultimate valuation of individual companies, it will increase short-term correlations. Portfolio construction needs to be tight and tilts need to be very well managed to navigate these powerful flows. This makes catalysts, earnings, and other events extremely important to play - and play correctly - because that is when dispersion is most likely to occur."

    Balyasny cites Japan as an example of what happens to markets with high levels of passive ownership. More than 70% of Japanese stocks are passively owned, according to the letter, given the Bank of Japan's stock-buying program, "yet liquidity in Japan is fine, and the fundamental stock selection opportunities remain robust," he said.

    In other words, passive investing doesn't kill stock-picking. It just puts an emphasis on calling the big catalysts for stock moves right.

    Can long/short investing work in a crowded field?

    Another common complaint among investors: Everyone is chasing the same trades.

    "While crowding has been reduced from last year's peak, most verticals are still pretty crowded," Balyasny said. "A correct, fundamentally variant view is hard to come by, and the alpha is short-lived as others catch on."

    Still, it's possible to find unique ideas and deliver alpha, according to the letter.

    "The market is just very competitive," he said. "While the business is tough in the short run, it is ultimately good for survivors."

    Can long/short work in markets dominated by computers?

    Quant funds have become popular with investors and are hoovering up assets. According to a recent Credit Suisse survey, about 60% of global institutional investors said they were likely to increase allocations to incorporate some quantitative analysis over the next three to five years, with pensions showing the most interest.

    According to Balyasny, it isn't a case of fundamental investing versus quant investing; the two need to combine. From the letter:

    "Some of our worst trades are caused by an over-reliance on data without a variant fundamental view (e.g., a short position in a fundamentally challenged business with deteriorating current data where results come in close enough in light of low expectations to cause a big squeeze).
    "On the flip side, some of our best trades have been when our teams identify some fundamental inflection in a business that has not been picked up yet in the data. Each approach can be successful on its own if practiced by a top team, but combining the two will lead to the best results."

    The letter said Balyasny's Atlas Global fund was basically flat for the year to date, while the Atlas Enhanced fund was up 0.78%.

    "We believe that as we continue to scale up deployment and enter summer earnings season, returns should improve back to our target range," Balyasny said.

    Business Insider
    Matt Turner and Rachael Levy