For all of the “fire and fury” rhetoric between Kim Jong-un, the leader of the Democratic People’s Republic of Korea* and President Trump, domestic equity markets fell all of 1.4% last week. Based on the breathless coverage by media pundits, you would have thought the market was in an unequivocal freefall. Perhaps, after nine years of a bull market, that as of late has also been characterized by historically low volatility, a large swath of the investing public has grown “soft”. That is, market action out of sync with investors recent experience (though mild by historical standards) causes a disproportionate level of alarm. While risky assets declined in response to the geopolitical tensions, safe haven assets received a bid as the yield on 10-year Treasury bond retreated to 2.19% and gold jumped 2.4% for the week. The price of crude seemed more in tune with fundamental production and storage levels than politics, falling 1.5% to $48.82 per barrel. The VIX Index jumped 54.6% for the week, which seems like a lot, but it currently stands at 15.5, several points below its long-term average level. The substantial increase in the VIX Index (relative to the small move in equity markets) likely resulted from investor positioning well-ahead of this week’s geopolitical fireworks and is discussed further in the “Short Volatility” section at the end of this piece.
For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.
Inflation Stagnation – Recent metrics are running counter to the Fed’s message that weak inflation is transitory and additional interest rate hikes are warranted. Intelligent people can disagree on the length of time specified by the term “transitory”. The dictionary definition is “not permanent”. By that definition everything is transitory with the exception of God and the passage of time. Unfortunately, members of the Fed (and mere mortals like the rest of us) don’t have the luxury of operating within an open-ended timeframe in which transitory could mean one month or 100 years. The Fed’s timeline is closer to the former as they attempt to normalize interest rates without pushing a slow-growth economy into recession. As such, the meaning of transitory takes on greater significance.
On that note, Producer Price Index (PPI) and Consumer Price Index (CPI) data for July revealed a continued absence of inflationary pressures. As such, the duration of weak inflation data is beginning to stretch the logical, if not practical, bounds of what transitory means (or should mean) to the Fed.
In July, PPI declined by 0.1%. PPI measures prices at the wholesale or producer level (i.e. the cost of goods and services further up the value chain from the consumer). This reading was consistent for both the headline PPI and Core PPI, which were expected to rise 0.1% and 0.2%, respectively. On a year-over-year basis, PPI peaked at 2.5% in April, but has now declined to 1.9% – its lowest level since January. PPI is often viewed as a leading indicator for CPI as higher prices at the producer level often get pushed down to consumers as businesses attempt to maintain profit margins.
Similar to PPI, June readings for CPI were also below expectations of economists (and some members of the Fed) that continue to believe a pick-up inflation is imminent. To be fair, the headline CPI increased by 0.1% to 1.7% on a year-over-year basis (vs. expectations of a 0.2% bump), however Core CPI (ex-food and energy) remained at 1.7% year-over-year (note: if not for rounding to one decimal place, Core CPI actually decreased slightly year-over-year).
The chart below shows the respective levels of PPI (blue shading) and Core CPI (gray line) since 2011.
Sources: Bloomberg and Covenant Investment Research
The good news is inflation isn’t dead, it’s dormant and a sustained trend of slowly rising inflation will emerge if the economy continues to expand. Even at 2%-2.5% annualized growth, inflation will eventually reach the Fed’s target of 2%.
However even slowly rising inflation could be in jeopardy if the Fed tries to fine-tune monetary policy such that inflation lands perfectly at 2%. In fact, they will almost assuredly fail to reach their target. In other words, should the Fed treat the 2% target as a ceiling rather than an average level around which inflation can fluctuate (below and above) by continuing to raise interest rates in the face of data that suggests otherwise, the economy is likely to slow further and inflation to fall short of their target. As FTN’s Chief Economist, Chris Low, quipped “The Fed should be wise to follow the advice of its young maverick Kashkari [Federal Reserve Bank of Minneapolis President]: Be patient and acknowledge what is in the data. It is the path to ultimate credibility.”
Dallas Fed President Rob Kaplan seems to be lining up behind Kashkari as well, stating last Friday that the Fed should be patient for further evidence that inflation will rise before tightening policy again. Keep in mind that the Fed’s current plan for interest rates (i.e. their “dot plot”) includes raising rates one more time this year and three times in 2018. At the same time the Fed intends to reverse Quantitative Easing later this year which is also a form of monetary policy tightening. The combination may prove to be too much tightening for an economy expanding at a sub-3% annual growth rate, causing the Fed to reassess planned rate hikes for 2018.
Short Volatility – One area generating legitimate concern amongst sophisticated investors, but has received little media coverage, is the growth of short volatility (aka “short vol” investment products. Over the last several years Wall Street has sought to capitalize on the prevalence of low volatility by promoting short vol ETFs and ETNs (exchange traded notes) also known as “inverse VIX” products (e.g. XIV, SVXY, ZIV, etc.) and other strategies that incorporate the sale of volatility such as covered call writing and “return enhancement overlays”. These products sell volatility to the market and are consistently profitable so long as volatility remains at current levels or moves lower. Vol selling strategies are analogous to an insurance company that sells earthquake insurance – it is a very profitable line of business, until a large earthquake strikes and the insurance company is obligated to make good on the policies they sold. The performance of naïve vol selling strategies typically look something like this – long periods of small, but consistent gains, followed by large losses.
In early August, the number of short VIX futures positions hit an all-time high as investors gravitated to the gold rush of easy money. In turn, last Thursday’s selloff resulted in record trading of VIX options and futures (the underlying instruments for VIX-related products) with the highest ever-single day volume in VIX options and the 3rd largest VIX futures rebalance (Source: Macro Risk Advisors). Keep in mind this occurred after only a 1.4% selloff in the S&P 500. The bigger concern is that a larger selloff sparks a positive feedback mechanism in which selling feeds on itself generating outsized losses for the holders of short-volatility products and equity markets in general.
*The Democratic People’s Republic of Korea was formed in 1948 and has had exactly three leaders: Kim Il-sung, his son Kim Jong-il, and his grandson (and current leader) Kim Jong-un. I looked, but could not find a definition of “democratic” that includes a political system comprised of a lineage of ruthless dictators.