House on Fire
5 minute read
The new Omicron variant could further complicate our world's economic activity and increase the chaos on supply chain breakdowns - from semiconductor delays to worker shortages. "It certainly increases the uncertainty for inflation," quipped Jerome Powell a few days ago. More Fedspeak that market observers continue to interpret for the benefit of their balance sheets. More recently, Fedspeak has finally fessed up that inflation is not temporary. A significant breakthrough in truth is telling – especially when you're testifying before the Senate. (Note that experts opine that Omicron is unlikely to make the current vaccines irrelevant, but maybe less effective, and in fact, BioNtech's founder said that vaccinated people would likely remain protected.)
We believe Almost Daily Grant's captured the real issue perfectly, saying, "… growing price sensitivity to changes in interest rates stands as a more pressing concern for corporate creditors. Measured duration now stands at a near record high of 8.6 years, Bloomberg noted last week, up from just over 7 years in mid-2019 and just over 6 years in 2007…a relatively modest interest rate increase could result in market value losses far exceeding credit losses in even a severe default scenario." Long duration is the elephant in the room most wealth managers are ignoring. (https://www.grantspub.com/resources/commentary.cfm)
Suppose the Atlanta Fed’s fourth-quarter 8 percent annualized growth rate estimate is correct? In that case, Bill Gross' warning that: "Investors are living in a "dreamland" brought on by global central banks' decision to continue pumping up the world economy even as it has rebounded sharply from the pandemic" is a bit late in coming.
Almost every category of goods manifests an excess of demand relative to supply from rental cars to washing machines, plane tickets, and furniture that has to fill panic-bought homes. The 10-year US Treasury real rates as of yesterday are minus 4.6%, a level historically associated with far-reaching inflation, depression, and may explain the hyper moves in crypto, commodities, US stocks, and record price being fetched for lesser-known works of art. We believe Deutsche Bank's chief executive Christian Sewing put it perfectly: "The supposed cure-all of the past years — low-interest rates with seemingly stable prices — has lost its effect, now we are struggling with the side effects. Monetary policy must counteract this — and sooner rather than later”.
Bank of America’s Flow Show (part of BofA Global Research Reports) reports that we have had $32t of global policy stimulus, $840 million per hour central bank asset purchases, international stock market cap up to $60 trillion in 18 months, GDP approaching an annualized 10% year over year, CPI>5% over the last several quarters, house prices >20% over the last year, and the lowest interest rates in 5000 years. Can we sustain this without our economic house burning down?
Congress just passed $1tn of legislation to repair, upgrade and create a new infrastructure bill to fix inland waterways, crumbling bridges, passenger rail, high-speed internet for all. No doubt we needed this legislation to make us more competitive globally and create higher-paying jobs. Still, it may further exasperate inflation unless the Federal Reserve ceases to be politicized. It is no longer March 2020.
According to BofA's recent Manager Survey, 35% of investors believe inflation is now permanent, vs. 61% who believe it to be transitory. Is transitory six months, or is it six years? That depends on the Federal Reserve, but given recent actions and statements, I profess it could be the latter, even if the Fed begins a serious tightening program by year-end. Of course, the Fed will ultimately raise rates, as they are already behind the curve, and some shock moves are a real possibility. The Fed seems to have accepted the truth on inflation; they know they have to protect our economy; and no longer are they defending their "transitory" punchline. Investors and consumers alike need a responsible Federal Reserve that can use all the weapons they have on hand to protect this country against the ravages of inflation. So, they should not care about pleasing any political constituencies and use the weapons they have at the ready.
This country and economy can and should manage to thrive with a 2% Fed Funds rate and 5-6% mortgages on homes that are not "panic buying priced." I would rather pay $500,000 for a home with a 5% mortgage than a 3% mortgage on the same house for over a million dollars, knowing that in five or even ten years, I might very well have to sell it at a loss as new construction will reach record highs. Raising interest rates helps the working family to invest rather than speculate on their most significant asset. Ray Dalio summarizes: "Some people make the mistake of thinking that they are getting richer because they are seeing their assets go up in price - without seeing how their buying power is being eroded." https://markets.businessinsider.com/news/stocks/ray-dalio-billionaire-investor-us-cpiinflation-surge-real-value-2021-11
No doubt, Mr. Dalio is correct. American hourly pay was up 4.6% in the year ending September 2021, while CPI rose 5.4% during that same period. Here's the wage-price spiral in action - the working family sees the grocery bill go higher, which means they will demand higher wages in expectations of future rises of that grocery bill or used car.
Finally, a couple of weeks back, Vice Chairman of the Federal Reserve Board Clarida reiterated his view that he sees "upside risk" to inflation and expects robust growth in the fourth quarter of 2021. Will there be a rate rise sooner than expected? We think so. According to data provider Leveraged Commentary & Data, the forcing of low rates sparked a record number of bond market issuances, with 149 US companies tapping the junk bond market for the first time this year ( https://www.ft.com/content/b76e2d6f-5e40-479a-bcf9-1e27181a9d67) . As a result, the face value of outstanding debt in the high-yield bond market has vaulted above $1.5tn.(https://www.ft.com/content/50e1c3c1-8922-40d2-9c95-737fb5bb8ad0)
Fears of rising prices and interest rates have ignited increased interest in Treasury inflation-protected securities - TIPS- to hedge against inflation. We believe the issue is duration. The face value of a TIPS bond is adjusted according to the official consumer price index - CPI. The higher the CPI, the higher the face value for TIPS. Given this scenario, we believe TIPS will only perform better than Treasury bonds if the stated CPI is higher than what the market anticipates. The ETF "RISR" seeks to provide more correlated mitigation against rising interest rates by delivering current income and negative duration. So, RISR aims to provide upside risk mitigation as interest rates rise when bond portfolios suffer declines in value. TIPS may mitigate against increasing inflationary expectations, but rising interest rates will hurt TIPS unless a concomitant increase in break-even inflation rate more than offsets the duration impact.
Investors have also been buying commodity-centric equities to hedge inflation. What happens with a 10% drop in the S&P 500? Are they correlated? A broad equity markets selloff is likely to have a lasting negative impact on all types of equities. So, while the beta of commodity-centric equities may be below in a typical market environment, there is some risk is that this beta may increase in a significant market correction given they carry a higher standard deviation than most other equity investments. (Commodities: The Portfolio Hedge, by Caroline Banton/Investopedia).
Finally, shorting the Treasury market or using puts on longer-term treasuries is a highly leveraged strategy compounded by negative carry.
RISR is projected to earn low to mid-single digits in a stable rate environment.
To potentially hedge your fixed income portfolios, FolioBeyond's approach to managing the risk of higher rates with its RISR ETF is aimed to:
1. More direct.
2. Generates positive current income.
3. Contains less basis risk.
4. Is a diversifier with low equity beta.
5. Designed to profit, even if rates only rise modestly.
The Fed seems to have accepted the truth on inflation; they know they have to protect our economy, and no longer are they defending their "transitory" political punchline. Investors and consumers alike need a responsible Federal Reserve that should not care about pleasing any political constituency and use the weapons they have at the ready.
Sadly, they have a lot of ground to cover.
For investors who want to add an allocation of MBS IOs and USTs to their portfolio, there's the FolioBeyond Rising Rates ETF ("RISR"). You can find the prospectus here. RISR is an active ETF that seeks to protect against rising rates while generating current income when rates remain stable. RISR does this by holding MBS IOs, which it does in combination with USTs, to achieve an overall target duration for the fund of negative 10 years.
George Lucaci
Global Head of Distribution
FolioBeyond
www.foliobeyond.com
glucaci@foliobeyond.com
908-723-3372
Important Information
Investors should consider the investment objectives, risks, charges and expenses carefully before investing. For a prospectus or summary prospectus with this and other information about the Fund, please call (866) 497-4963 or visit our website at www.etfs.foliobeyond.com. Read the prospectus or summary prospectus carefully before investing.
Investments involve risk. Principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. The fund is new and has limited operating history to judge.
Fund Risks - The value of MBS IOs is more volatile than other types of mortgage-related securities. They are very sensitive not only to declining interest rates, but also to the rate of prepayments. MBS IOs involve the risk that borrowers may default on their mortgage obligations or the guarantees underlying the mortgage-backed securities will default or otherwise fail and that, during periods of falling interest rates, mortgage-backed securities will be called or prepaid, which may result in the Fund having to reinvest proceeds in other investments at a lower interest rate. The Fund’s derivative investments have risks, including the imperfect correlation between the value of such instruments and the underlying assets or index; the loss of principal, including the potential loss of amounts greater than the initial amount invested in the derivative instrument. The value of the Fund’s investments in fixed income securities (not including MBS IOs) will fluctuate with changes in interest rates. Typically, a rise in interest rates causes a decline in the value of fixed income securities owned indirectly by the Fund.
Please see the prospectus for a complete description of principal risks.
Definitions
Basis Point: Basis points, otherwise known as bps or "bips," are a unit of measure used in finance to describe the percentage change in the value of financial instruments or the rate change in an index or other benchmark.
Beta: Beta is a measure of a stock's volatility in relation to the overall market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market.
CPI: The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living.
Duration: Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
Negative Carry: Negative carry is a condition in which the cost of holding an investment or security exceeds the income earned while holding it.
Put: A put is an options contract that gives the owner the right, but not the obligation, to sell a certain amount of the underlying asset, at a set price within a specific time. The buyer of a put option believes that the underlying stock will drop below the exercise price before the expiration date. The exercise price is the price that the underlying asset must reach for the put option contract to hold value.
Short selling: Short selling is an investment or trading strategy that speculates on the decline in a stock or other security's price. It is an advanced strategy that should only be undertaken by experienced traders and investors.
Standard Deviation: Measures historical volatility. Higher standard deviation implies greater volatility
S&P 500 : The S&P 500 Index is the Standard & Poor’s composite index of 500 stocks, a widely recognized, unmanaged index of common stock prices.
TIPS: Treasury inflation-protected securities (TIPS) are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value.
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