Dear Friends,
We are kicking the year off with significant volatility across the markets. It feels like there is a considerable amount of capital moving across markets creating initial volatility. Year-to-date we’ve seen over 4 bln in outflows in the HYG ETF, the NASDQ is down over 7%, 19 days into the year, and the 30-year TIP is 17 points off its top (price) set in late 2021. These are interesting times.
I wanted to share with you the conversations I’ve had with my team this week. My goal is to continue our commitment to open communication and our desire to bring you closer to our investment process. I hope you find this helpful.
Please reach out if you are interested in talking about any of these thoughts or themes.
With great appreciation,
Gibson
I continue to believe that we are headed into a stronger, longer, and more durable recovery and the normalization process is going to bring much greater volatility. With this could be one of the more difficult, if not the most difficult, years of my 31-year career. I see too many elements of the recovery hitting inflection points in a period of time that has little historical reference.
What makes this year different (than most) is that the volatility, usually triggered by negative events, could be triggered by things going really right as well. The consensus is firmly anchored around a view that both inflation and growth will aggressively turn over and normalize at levels slightly higher than pre-covid levels. This strongly held consensus view is validated by the 7% YoY headline CPI print and the 9.7% YoY headline PPI print last week, along with the long bond sitting around 2.14% – did you think the words ‘7% or 9% inflation’ would ever come out of your mouth?
Many believe we could see a material rally in rates and a flattening of the yield curve this year. I can also see the exact opposite happening – yields moving significantly higher and the yield curve steepening. The hard part of this discussion is assigning probabilities to these ‘wing’ outcomes. Again, there are too many issues within the economy, politics, and markets coming to inflections points to forecast with any accuracy. And anyone telling you that they have it figured out should get into the entertainment business or politics and out of the financial markets. I say that with humor, but the truth is nobody knows how this is going to play out. The reality is we could see a significant rally in long rates followed by a major sell-off in a short period of time – we have been here before. Amplifying the problem here is that the return outcomes (for fixed income) are substantial on both bullish and bearish outcomes (significant positives or negatives) – durations are long, and coupons are low.
Saying this with recognition of my strong bias toward how we manage money, as we progress through the next 12 months, we are going to get a lot of new information and will have to adjust our portfolios’ risk positions and duration positioning around the information as it drives changes in consensus and creates a new direction in the market. In my opinion, we will experience periods of longer duration and a reduction of risk positioning in our portfolios followed by periods of being short duration and taking on new risks in credit and mortgage-backed securities throughout the year. If my view on volatility comes to fruition, our core process and our size/scale could allow us the luxury of making these changes with limited friction.
Similar to 2021, with yields low and durations long, large portfolio mistakes or errors around risk cannot be cushioned by the yield/coupon. Note the graphic below that highlights the return outcome on the 30-year US Treasury. A 75-basis point move up or down produces expected returns in the +20% to -14% range. While long duration securities always present wide bands of return outcomes, one can see the limited impact of the coupons in helping to feed that total return.
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30-yr U.S. Treasury Total Return Analysis
Source: Smith Capital Investors, Bloomberg, 1/13/2022
Keeping the long duration and low coupon environment in mind, I want to share one additional consideration that sits at the forefront of my mind these days – many fixed income managers produced index beating performance over the last two decades by being long duration and having higher carry, (out yielding) the indices that they were measured against. This process (maybe philosophy) served them well. While there were periods of significant short-term underperformance for those employing this strategy, the bull market in bonds and the hyper-market sensitive Federal Reserve bailed the significant risk-taker out. The higher carry not only facilitated index beating results but also covered up significant mistakes made in the portfolio management process (we all make mistakes!).
But this is not the case today. Big mistakes and aggressive risk taking are much more transparent in performance outcomes and could result in the bond portion of an asset allocation model producing results that are inconsistent with the overall investment objective. I am probably stating the obvious here when I say that there could be implications around higher volatility associated with process breakdown or significant change as we progress through very volatile markets. In many ways, I am concerned volatility feeds more volatility as managers realize the scale of adjustments that must be made to their investment process to deal with this environment. Something to consider.
I leave you with one last consideration.
There are many people comparing inflation today to that of the late ‘70s. This is an easy conclusion after the strong CPI and PPI prints this week. I found it really helpful to go back in time and look at the duration of time with heightened inflation concerns, the magnitude of the inflation move, and how the long bond (30-year US Treasury) reacted. See the graphic below.
Previous Periods of High Inflation
Start Duration Change in Inflation
12/76 ~ 4 years ~ 10% change
12/86 ~ 4 years ~ 5% change
10/06 ~ 2 years ~ 4% change
07/09 ~ 2 years ~ 6% change
05/20 We are 6 months in ~ 7% change
Source: Smith Capital Investors, Bloomberg, 1/13/2022
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I don’t want to draw too many conclusions from historical references as each environment had a unique set of risks that brought about different outcomes, but the context is helpful.
Also, note that the Volker move resulted in a ~12% reduction in inflation over an approximate 6-year period of time – during which the long bond went from 15% to 7%. Additionally, it’s important to bear in mind that the reductions in rising inflation in the last three decades have been far shorter in duration.
An aggressive, inflation fighting Federal Reserve has proven that they can get inflation under control in short order. But do they have the fortitude (or tools) to truly fight deflation? Will it be different this time? Most definitely. Worth considering? I believe so.
30-yr U.S. Treasury (blue) vs. Consumer Price Index YoY (white)
Source: Smith Capital Investors, Bloomberg, 1/13/2022
I hope this quick note helps you think about the markets a little differently. I am confident I am not leaving you with a strong opinion around where rates are headed (except that they will be volatile). My base thesis today is that the recovery shows foundations of being stronger, longer, and more durable than the consensus believes, but I ask for grace in changing my mind on this thesis as time passes.
I believe inflation will be stickier due to wage adjustments and post-covid resets, but respect that the four-headed horseman of disinflation is still with us – demographics (cannot argue with this), globalization (better said, our addiction to cheap goods and labor), technology implementation (disruption) and now debt overhang. Also, 7% and 9%+ inflation are not at all sustainable, in my opinion, and therefore believe the consensus is largely correct that inflation will turn over this year.
The big question is – where will it settle out?
The biggest wild card I see on the horizon is the markets not fully comprehending what the Fed officials are socializing today – a more aggressive use of their balance sheet as a policy tool going forward over traditional manipulation of short-term interest rates. The implications of this require us to think differently around many things ‘fixed income’ and how these coming adjustments will feed into our core thesis around a very volatile year.
Thank you for allowing me the opportunity to share my thoughts. And to our investors, thank you for the confidence you have in me and my team in navigating these challenging markets.
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