Macro and Credit - The Ultimatum game

"Never accept ultimatums, conventional wisdom, or absolutes." -  Christopher Reeve, American actor

Looking at the United Kingdom under the guidance of Prime Minister Theresa May moving towards "hard BREXIT", we decided this time around, when it comes to selecting our title analogy to go for the "Ultimatum game", which is a game in economic experiments. In this game, the first player (the proposer) receives a sum of money and proposes how to divide the sum between the proposer and the other player. The second player (the responder) chooses to either accept or reject this proposal. If the second player accepts, the money is split according to the proposal. If the second player rejects, neither player receives any money. The game is typically played only once so that reciprocation is not an issue.  Given our fondness for behavioral economic and psychological accounts, our title analogy and the aforementioned experiment suggest that second players who reject offers less than 50% of the amount at stake do so for one of two reasons. An altruistic punishment account suggests that rejections occur out of altruism: people reject unfair offers to teach the first player a lesson and thereby reduce the likelihood that the player will make an unfair offer in the future. Thus, rejections are made to benefit the second player in the future, or other people in the future. By contrast, a self-control account suggests that rejections constitute a failure to inhibit a desire to punish the first player for making an unfair offer. The ultimatum game is important from a sociological perspective, because it illustrates the human unwillingness to accept injustice. The tendency to refuse small offers may also be seen as relevant to the concept of honour. The extent to which people are willing to tolerate different distributions of the reward from "cooperative" ventures results in inequality that is, measurably, exponential across the strata of management within large corporations. Some see the implications of the ultimatum game as profoundly relevant to the relationship between society and the free market, with Prof. P.J. Hill, (Wheaton College, Illinois) saying:

"I see the [ultimatum] game as simply providing counter evidence to the general presumption that participation in a market economy (capitalism) makes a person more selfish."

Given the rise in inequality in conjunction with populism, there is a rising drift between the have and the have not, which is leading for some politicians to somewhat embrace or envisage rebalancing Wall Street towards Main Street in order to avoid capitalism's own demise. As of late we find of interest that, as we posited in our previous musing, the cozy relationship between politicians and central bankers is waning as illustrated by rising criticism coming out from German leaders and directed towards the ECB. But, moving back to "Brexit" and the "Ultimatum game" currently being set in motion, as we posited in our conversation "Optimism bias" from June 2016 from a game theory perspective we indicated at the time:

"For our take on "Brexit, we will keep it simple for our readers: From a game theory perspective and prisoner's dilemma, the only possible Nash equilibrium is to always defect. The United Kingdom "defecting" could mean, we think, taking business (and profits) from other European Union members in the long run. First mover advantage? Maybe..." - source Macronomics, June 2016

While having correctly guessed in 2016 both Brexit and the US election (which earned us some nice bottles of wine from "optimistic" friends), given the English common law system is UK's best export (Singapore, Hong Kong, etc.) as well as its best business friendly feature, we do think that the United Kingdom benefit from first mover's advantage to that respect. Why so?

"Common law as a foundation for commercial economies

The reliance on judicial opinion is a strength of common law systems, and is a significant contributor to the robust commercial systems in the United Kingdom and United States. Because there is reasonably precise guidance on almost every issue, parties (especially commercial parties) can predict whether a proposed course of action is likely to be lawful or unlawful, and have some assurance of consistency. As Justice Brandeis famously expressed it, "in most matters it is more important that the applicable rule of law be settled than that it be settled right." This ability to predict gives more freedom to come close to the boundaries of the law. For example, many commercial contracts are more economically efficient, and create greater wealth, because the parties know ahead of time that the proposed arrangement, though perhaps close to the line, is almost certainly legal. Newspapers, taxpayer-funded entities with some religious affiliation, and political parties can obtain fairly clear guidance on the boundaries within which their freedom of expression rights apply." - source Wikipedia

 "Assurance of consistency" - try to have this in France. It is totally the opposite. As per our previous conversation: 

"The only point you should take into account is that the advantage of explicit guarantees is that markets tend to "function" better under them." - source Macronomics, January 2017

Hence our long term more favorable view for the United Kingdom and the Common Law premia that needs to be taken into account when it comes to assessing the prospect for the country and its currency we think. 

Furthermore, the Ultimatum game is clearly being played out by president elected Donald Trump with US corporations in his quest to "make America great again". Again, the ultimatum game is profoundly relevant to the relationship between society and the free market economy. As we posited in our conversation "The Great Wall of China hoax", global rise in populism, came hand in hand with lowering the living standards of the average American, and hearing the inaugural speech from president elected Trump on the 20 of January makes it clear to us, that this will have a significant impact on allocations as the Ultimatum game will be starting in earnest:

Sir Jimmy Goldsmith wrote a lengthy but great thoughtful reply called "The Response": 

"Hindley would prefer to reduce earnings substantially rather than 'block trade'. In other words, he would prefer to sacrifice the well-being of the nation rather than his free-trade ideology. He has forgotten that the purpose of the economy is to serve society, not the other way round. A successful economy increases wages, employment and social stability. Reducing wages is a sign of failure. There is no glory in competing in a worldwide race to lower the standard of living of one's own nation. " Sir Jimmy Goldsmith 

So you already might be asking yourself where we are going with all this, well, we have long argued the following as per our conversation "The Grapes of Wrath" back in October 2016:

"In terms of validating the "recovery mantra", we believe that meaningful wage inflation is a necessary condition. When it comes to inflation expectations, demographics and additional components in different parts of the world such as Japan, the United States and Europe have to be assessed differently.

For instance, in the United States, the recent decline in apartment rents in some big cities points towards near term "inflation headwinds" for the stagflationary camp.

As a reminder, rising rents have been an important factor in keeping US inflation expectations alive given the importance of the shelter component in US CPI calculations which represents one third of headline CPI and 42% of core CPI. When it comes to assessing some of the drivers of inflation, labor demographics are a key driver of real long-term fed funds. Also the question of productivity growth is paramount we think, particular when one looks at the quality of the jobs created since the onset of the Great Financial Crisis (GFC)., mostly of low quality.

Whereas the United States have yet to experience a significant rise in labor participation and has seen as well a significant fall in its productivity, the Japanese economy has overall achieved productivity growth with continuous deleveraging and hefty corporate cash balances and a tight labor market thanks to poor demographics and rising women participation rate in the labor market. As we posited in June this year in our conversation "Road to Nowhere":

"When it comes to Japanese efficiency and productivity, no doubt that Japanese companies have become more "lean" and more profitable than ever. The issue of course is that at the Zero Lower Bound (ZLB) and since the 29th of January, below the ZLB with Negative Interest Rate Policy (NIRP), no matter how the Bank of Japan would like to "spin" it, the available tools at the disposal of the Governor appears to be limited.

While the Japanese government has been successful in boosting the labor participation rate thanks to more women joining the labor market, the improved corporate margins of Japanese companies have not lead to either wage growth, incomes and consumption despite the repeated calls from the government. The big winners once again have been the shareholders through increased returns in the form of higher dividends. In similar fashion to the Fed and the ECB, the money has been flowing "uphill", rather than "downhill" to the real economy due to the lack of "wage growth". This is clearly illustrated in rising on the Return Of Invested Capital (ROIC) " - source Macronomics, June 2016

We concluded at the time:

"If indeed Japan fails to encourage "wage growth" in what seems to be a "tighter labor" market, given the demographic headwinds the country faces, we think Japan might indeed be on the "Road to Nowhere. Unless the Japanese government "tries harder" in stimulating "wage growth", no matter how nice it is for Japan to reach "full-employment", the "deflationary" forces the country faces thanks to its very weak demographic prospects could become rapidly "insurmountable". - source Macronomics, June 2016

Either you focus on labor or on capital, end of the day, Japan has to decide whether it wants to favor "wall street" or "main street"." - source Macronomics, October 2016.

While the inaugural speech of the newly elected President Trump did focus on bringing jobs back to America and making America first, on that subject we read with great interest our former esteemed colleague David Goldman's take in his latest column published in Asia Times entitled "Donald Trump, American hero" and his take on "productivity":

"The problem is how to protect Americans. The global supply chain is so closely integrated that it is hard to discourage some imports without doing real damage to American industries. The border tax proposed by House Republicans would prevent corporations from deducting imported inputs as costs for tax purposes. For industries like oil refining, that would create enormous distortions, while providing windfalls elsewhere. My own preference would be to use selected tariffs for products that benefit from government subsidies overseas, which is entirely permissible under World Trade Organization rules.
Ultimately, no government can protect American workers unless productivity growth resumes. American productivity growth has fallen to zero for the first time since the stagflation of the 1970s. Without productivity growth, American living standards will fall, irrespective of whether the government pursues protection or free trade. I have argued elsewhere in this publication that reviving military and aerospace R&D is the key to productivity growth." - source David Goldman, Asia Times,  20th of January 2017

There lies the crux of the problem, to make "America great" again, you need CAPEX growth and more importantly, "productivity" growth.

In this week's conversation, we will look at jobs, wages and the difference between Japan and the United States, in relation to the "reflation" story or "Trumpflation".

Synopsis:

• Macro and Credit - The wage / productivity paradox
• Final chart - International trade and Nash equilibrium

• Macro and Credit - The wage / productivity paradox

While we recently used Japan as a base case when assessing the negative impact low rates have had on real estate assets, leading some becoming nonperforming in our recent conversation  "The Great Wall of China hoax", what has been plaguing Japan since they have reached effectively full employment is indeed the outlook for wages. Without wage rising, there is no way Japan can truly break its deflationary spiral and the Bank of Japan create sufficient inflation. This is clearly indicative of the malaise of the Japanese economy. On that subject we read with interest Nomura's take in their Japan Economic Weekly note from the 13th of January 2017 entitled "Outlook for wage rises remains bleak":

"Employers and employees deaf to government's calls for wage rises

No sign of a pickup in the rate of wage rises from New Year events

Prime Minister Shinzo Abe has taken the opportunity provided by New Year events such as those organized by Japan's economic associations to reiterate his calls for companies to raise wages. However, we see no sign from the response of either employers (and their associations) or employees (and their trade union representatives) of any pickup in the rate of wage rises at this year's spring wage negotiations. Any discussion of what is happening to the Japanese economy, inflation, or market factors such as interest rates will have to assume for the time being that there will be no marked increase in wage rises.

Deep-seated reluctance of employers to increase fixed costs

While Japanese business leaders share Abe's positive attitude towards wage rises in general terms, they appear to be slightly less enthusiastic when it comes to putting this into practice. A good example of this is the frequent inclusion by Sadayuki Sakakibara, Keidanren chairman, of the provisos "companies that enjoyed earnings growth last year" and "on an annual pay basis" when expressing his desire for wage rises. We see this as reflecting a deep-seated reluctance by business leaders to increase fixed costs. With companies facing increasing uncertainty, they may well be more reluctant to increase the base pay of their regular employees as this would amount to an increase in fixed costs.

The unions are also cautious about demanding wage rises

A certain reluctance of some trade unions to demand wage rises also appears to be an impediment to a pickup in the rate of wage rises. We think that the cautious attitude of the trade unions probably reflects the less optimistic view that companies now have of their growth prospects as well as the increasing uncertainty they face and that workers and their trade union representatives may tacitly prefer the stability of a job for life to a bigger increase in base pay (see our 21 October 2016 Global Research report Why is wage inflation so low despite a shortage of labor? - The ''base pay wall'' facing the Japanese economy).

Limits to how far working practices can be reformed without freeing up the market for regular employees

In view of the attitude of employers and employees, the only way to overcome obstacles to speeding up the rate of wage rises would be to free up the market for regular employees to make the cost of employing full-time employees a variable cost. Similarly, safety nets such as vocational training and greater provision of unemployment benefits would be needed to overcome the concerns of workers and trade unions about freeing up the labor market for full-time employees. It seems that, as freeing up the market for full-time employees touches on the system of lifetime employment that forms the cornerstone of Japanese employment and working practices, it is off limits for those seeking to reform working practices such as the present government." - source Nomura

Indeed, the cornerstone of the Japanese employment system has long been lifetime employment and a clear impediment in freeing up the market. There is no way the Bank of Japan on its own can fill its inflation mandate without the government stepping in and playing out the "Ultimatum game" with Japanese business leaders. When it comes to the "Ultimatum game" and reflationary policies in the United States, we think that the recent raft of corporations folding under the pressure exercised by Donald Trump is clearly a sign that the new US administration is clearly being serious on its willingness to focus on America and Americans. Obviously this will have significant implications in terms of allocations. Put it simply as displayed by our friend Cyril Castelli from Rcube, rising wage pressures imply lower profit margins:

- source Rcube

End of the day, earnings revisions matter, as they are according to our friend, the best leading indicator for expected cash flows momentum. Negative earnings revisions always imply weakening cash flows and inversely. Also, "Mack the Knife" aka King Dollar + positive real US interest rates is tightening financial conditions globally. Cheap dollar funding has been exported to many Corporate Emerging Markets as highlighted in recent studies completed by the Bank for International Settlements (BIS). 

When it comes to Japan, clearly as indicated by Nomura, the Japanese wage paradox is weighing heavily on inflation, when the country is getting close to full employment (which is not the case in the US regardless of the much vaunted 4.7% unemployment rate put forward by the Fed).  Japan has been a productivity laggard for many years. Japan's labor market is a two-tiered market. There is one group of Japanese workers, called "seishain" which has retained its privileged, old-style jobs comprising job security, benefits and regular raises while the other group is made up of low-security, low-pay, low-benefit, dead-end jobs. These individuals have very little chance of ever jumping up to the "seishain" track. In similar fashion, if someone digs deep into the BLS, one can argue that the US employment market has been facing similar issues since the Great Financial Crisis (GFC). 

On the Japanese conundrum, we read with interest Bank of America Merrill Lynch's take from their Japanese Economics Viewpoint note from the 19th of January entitled "Jobs, wages and the BoJ":

"The biggest medium-term macro surprise?

We believe that the re-acceleration of wage growth could provide one of the biggest macro surprises for Japan in 2017. Investors appear to be increasingly coming around to our view that the Japanese economy is due for a solid, 1.5% pick-up in 2017, up from 1.0% in 2016. However, skepticism around the potential for higher wage growth—the key to Japan’s reflation efforts—runs deep.

Tackling Japan’s wage paradox

The doubts may be warranted, given that wage growth has remained stagnant over the past few years despite the unemployment rate plunging post-bubble lows and business surveys pointing to record tightness in the labor markets. We think the relative weakness of the wage indicators reflects both cyclical and structural factors. On the demand side, the slowdown in the economic recovery after the 2014 tax hike reduced wage pressures. On the supply side, the reserve of lower-paid, part-time and “non-regular” workers meant that there was still some “invisible” slack in the labor sector.

Approaching full employment

However, 2017 could mark an important inflection point as both demand-side and supply-side factors drive the economy towards full employment. We forecast the unemployment rate to drop to 2.9% by the end of 2017, and 2.7% by the end of 2018, from 3.1% today. There is already evidence that remaining labor market slack is quickly diminishing. Moreover, demographic headwinds will begin blowing much harder in the coming years, resulting in tighter labor supply.

Wages growth to double in FY17, reach 2% in FY18 

The FY2017 Shunto spring wage negotiations are unlikely to result in significant base pay increases. But we still see the combination of tight labor supply and stronger demand lifting nominal per worker wages to around 1.4% in FY2017, and close to 2% in FY2018, up from the 0-0.5% pace of the past three years. Adjusting for job growth, we see nominal employee compensation holding steady between 2-2.5% and real employee compensation of around 1.2% over the next two years. This should support consumption.

But patient BoJ to keep rates on hold

Our optimism on the outlook for labor markets and wage growth underpins our above consensus inflation forecasts. We see Japan-style core inflation rising 1.2% in FY17 (0.9% on a CY basis), and 1.5% in FY18 (1.4% on a CY basis). If our forecasts are correct, the risks of early BoJ policy normalization, including rate hikes, may become an important theme in the markets in the second half of this year.

However, we remain of the view that the timing of BoJ “lift-off” remains far away and that the central bank will keep its rates targets under its Yield Curve Control (YCC) framework unchanged through FY2018. Running a “high pressure” economy is the best shot the BoJ has at re-anchoring inflation expectations and reducing future deflation risks." - source Bank of America Merrill Lynch

Re-anchoring inflation expectations can only come from increasing wage growth and some significant labor market reforms in Japan. Not only wage growth is still eluding the Japanese economy, but, productivity has been yet another sign of "mis-allocation" of resources which has therefore entrenched the deflationary spell of Japan in recent years.

As put forward by Bank of America Merrill Lynch's note, there is a disconnect between job growth and wages in Japan:

"Disconnect between job growth and wages

Investors are often perplexed by the disconnect between Japan’s headline wage data and the relative strength of its labor market indicators. As of November 2016, Japan’s unemployment rate stood at 3.1%, down from 4.1% at the beginning of the Abenomics recovery phase (November 2012). Meanwhile, the job-offers-to applicant ratio has been climbing steadily, reaching the highest level since 1991 (Chart 2). 

Various business surveys also point to record labor market tightness. The employment conditions indices in the Bank of Japan Tankan reflect deep labor shortages, especially among non-manufacturing SMEs (Chart 3).

Despite robust job growth, total cash earnings data in the Ministry of Health, Labour and Welfare’s Monthly Labour Statistics (MLS) have been disappointingly weak. This measure, which tracks nominal wages on a per worker basis—picked up in the initial phase of the Abenomics recovery but has recently weakened and is stuck at around 0.4%, while hourly wage growth is tracking around 1% (Chart 4).

Digging into wage growth by component, the slowdown in 2015-16 was in part due to a collapse in bonuses (which is linked closely with corporate profits) (Chart 5).

But more importantly, the combination of aggressive fiscal tightening, coupled with a downturn in the global export cycle caused Japan’s economic recovery to stall, reducing cyclical wage pressures.

That being said, structural factors may be in play as well. Over the years, wage growth— in both per worker and per hour terms--has become less responsive to changes in the unemployment rate. In other words, the slope of the Japan’s Phillips curve has flattened, with the break coinciding with the onset of deflation in the late 1990s.

Part of this reflects a trend rise in lower paid, “non-regular” workers, which include various forms of part-time and temporary employment (Chart 8).

The main split in Japan’s dual labor market is defined by job status. “Regular” workers generally work full time, are directly hired by the employer, and receive bonuses along with a wide range of employee benefits.1 While regular workers enjoy an upward sloping wage curve, reflecting regular, seniority-based pay promotions, the wage curve for non-regular workers is virtually flat, resulting in a huge pay gap—average lifetime income for non-regular workers is about 60% of “regular” workers’ levels (Chart 9).

Please note that due to differences in classification of workers between the MHLW Monthly Labor Statistics and the Ministry of Internal Affairs’ (MIA) monthly Labor Force Survey (which does not cover wage data), from here on out we focus on employment and wage developments of part-time workers, which are a decent proxy for the broader “non-regular” category.

Based on MLS data, the part-time employment doubled from around 15% in March 1990 to about 30% today (Chart 8). The good news is that the pace of increase in the part-timers’ employment share has been slowing, with the rise limited to a relatively modest 1.6ppt between Q3 CY2012 and Q3 CY2016. But even such a small drag represents a powerful drag on headline per worker wages since part-timers receive lower pay and work fewer hours by definition (Chart 10).

On average, the continued shift towards part-time employment has subtracted about 0.5ppt from growth in total cash earnings per worker (Chart 11).

Had the part-time share stayed neutral, per worker wages would be tracking closer to 0.8%YoY—about double the headline figure.

Reasons for optimism

The popular view in Japan seems to be that the Phillips curve is dead and that the weakness in wage growth will remain entrenched. There is also a strong belief that the secular shift in non-regular/part-time employment is unlikely to be reversed any time soon, keeping wage pressures contained. We disagree, and believe that growth in total cash earnings per worker will pick-up from around 0.5% in FY16, to around 1.4% in FY17, before rising to around 2% in FY18." - source Bank of America Merrill Lynch

The reason we have to disagree with Bank of America Merrill Lynch and their reason for optimism comes from our discussion from June 2013 in our post "Lucas critique":

"Robert Lucas argued that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data. In essence the Lucas critique is a negative result given that it tells economists, primarily how not to do economic analysis:

"One important application of the critique (independent of proposed microfoundations) is its implication that the historical negative correlation between inflation and unemployment, known as the Phillips Curve, could break down if the monetary authorities attempted to exploit it. Permanently raising inflation in hopes that this would permanently lower unemployment would eventually cause firms' inflation forecasts to rise, altering their employment decisions. Said another way, just because high inflation was associated with low unemployment under early-twentieth-century monetary policy does not mean we should expect high inflation to lead to low unemployment under all alternative monetary policy regimes.

For an especially simple example, note that Fort Knox has never been robbed. However, this does not mean the guards can safely be eliminated, since the incentive not to rob Fort Knox depends on the presence of the guards. In other words, with the heavy security that exists at the fort today, criminals are unlikely to attempt a robbery because they know they are unlikely to succeed. But a change in security policy, such as eliminating the guards for example, would lead criminals to reappraise the costs and benefits of robbing the fort. So just because there are no robberies under the current policy does not mean this should be expected to continue under all possible policies." - source Wikipedia

So, as one can infer from the point made above and in continuation to the points made in our conversation "Goodhart's law", Ben Bernanke's policy of driving unemployment rate lower is likely to fail, because monetary authorities have no doubt, attempted to exploit the Phillips Curve.  

In the 1970s, new theories came forward to rebuke Keynesian theories behind the Phillips Curve by monetarists such as Milton Friedman,  such as rational expectations and the NAIRU (non-accelerating inflation rate of unemployment) arose to explain how stagflation could occur:

"Since the short-run curve shifts outward due to the attempt to reduce unemployment, the expansionary policy ultimately worsens the exploitable tradeoff between unemployment and inflation. That is, it results in more inflation at each short-run unemployment rate. The name "NAIRU" arises because with actual unemployment below it, inflation accelerates, while with unemployment above it, inflation decelerates. With the actual rate equal to it, inflation is stable, neither accelerating nor decelerating. One practical use of this model was to provide an explanation for stagflation, which confounded the traditional Phillips curve." - source Wikipedia

In similar fashion to what we posited in our conversation "Zemblanity", both Keynesians and Monetarists are wrong, because they have not grasped the importance of the velocity of money. QE is not the issue ZIRP is as we recently discussed.

The issue with NAIRU:"The NAIRU analysis is especially problematic if the Phillips curve displays hysteresis, that is, if episodes of high unemployment raise the NAIRU. This could happen, for example, if unemployed workers lose skills so that employers prefer to bid up of the wages of existing workers when demand increases, rather than hiring the unemployed." - source Wikipedia 

As we posited at the time, when unemployment becomes a target for the Fed, it ceases to be a good measure. Don't blame it on Goodhart's law but on Okun's law which renders NAIRU, the Phillips Curve "naive" in true Lucas critique fashion.

On this occasion, we think's Bank of America Merrill Lynch's optimism is indeed leaning towards naivety because the older a country's population gets, the lower its inflation rate. While economics textbook would like to tell us that a slowdown in population growth should put upward pressure on wages and therefore induce inflation as labor supply shrinks à la Japan, as discussed in our June 2013 conversation Singapore-based economist Andrew Cates from UBS macro team indicated that demographics influence demand for durable goods and property. As per our conversation "The Great Wall of China hoax" like in Japan, at some point low-yield assets such as real estate become nonperforming.

Therefore we agree with Andrew Cates as reported by Simon Kennedy and Shamin Aman in their Bloomberg article from the 7th of June entitled "Aging Nations Like Low Prices Over High Income":

"He cited a Federal Reserve Bank of St. Louis study that says because the young initially don’t have many assets, wages are their main source of income. The young are therefore comfortable with relatively high wages and the resulting inflation.
By contrast, because older generations work less and prefer higher rates of returns on their savings, they are averse to inflation eating away at their assets.

“Whichever group predominates in any economy will therefore have more ability to control policy and more ability to control economic outcomes,” said Cates." - source Bloomberg

So if the "old" like in Japan still predominates the economy, we have a hard time believing the Bank of Japan will be able to control economic outcomes and it appears clear to us that their monetary policies have truly become ineffective.

In similar fashion and as highlighted above in our quote from David Goldman, the United States need to resolve the lag in its productivity growth. It isn't only a wage issues to make "America great again". But if Japan is a good illustration for what needs to be done in the United States and therefore avoiding the same pitfalls, then again, it is not the "quantity of jobs" that mattes in the United States and as shown in Japan and its fall in productivity, but, the quality of the jobs created. If indeed the new Trump administration wants to make America great again, as we have recently said, they need to ensure Americans are great again.

Finally for our final point and given our chosen title, we would like to look at a simplistic international game.

• Final chart - International trade and Nash equilibrium

Given we started our conversation mentioning a game relating mostly to BREXIT, we thought we would end this conversation by looking at the known unknown of what the new US Trump administration stance will be when it comes to international trade. To that effect, our final chart or diagram, comes from Bank of America Merrill Lynch's Credit Market Strategist note from the 20th of January and entitled "The times they are changin' "and looks at international trade from a game theory perspective:

"International Trade game

Consider the following simplistic game of International Trade. Suppose there are two countries that can each choose between the two policies “Free Trade” and “Protectionism”. Because international trade in most circumstances boosts global growth it follows that protectionism is growth negative. Put differently, while in isolation a country can boost economic growth by playing the “Protectionism” card, the associated costs to the other country outweigh these gains. There are four possible outcomes (Figure 2). 

One equilibrium is that both countries agree to play “Free trade” (NW corner of figure), where we say that both have GDP of 10 (arbitrary units). Suppose now that Country 1 unilaterally plays “Protectionism”, in which case the outcome in the short term is the SW corner of the chart where this country boosts GDP by 2 to 12 at the expense of Country 2 that sees a 3 decline in GDP to 7. Note that world GDP declined by 1 as protectionism is distortive and thus creates inefficiencies.

However, the SW corner is not a sustainable equilibrium as Country 2 stands to benefit from playing the “Protection” card as well – i.e., retaliate – as they can increase GDP by 2 at the expense of country 1. That moves us to the SE corner – the “Trade Warfare” outcome - where each country has GDP of 9, a loss of 1 from the “Free Trade” equilibrium. Hence there are only two sustainable equilibria in this international trade game – “Free trade” in the NW corner, if both countries agree and commit, or trade warfare in the SE corner if they do not.

What this means is that the new administration’s intentions to restrict international trade are almost certainly negative for US economic growth in the longer run. Of course what prompted the coming US pushback against imports is that, even though trade boosts the economy, there are winners and losers. Thus we are unable to say unambiguously that the country is better off in utility terms just because that is the case in dollar terms." - source Bank of America Merrill Lynch

If the second country rejects protectionism, like in our case of the Ultimatum game, then neither countries receives any money, and this dear friends means to us lower global trade which is indeed bullish gold, in the end (hence our  recent positive stance), but we ramble again...

"The philosophy of protectionism is a philosophy of war." -  Ludwig von Mises

Stay tuned!

Macro and Credit - The Society of the Friends of Truth

"Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth." - Marcus Aurelius

Looking at the surging demand for insurance to protect cash aka "hoarding" taking place in Switzerland courtesy of NIRP, given this exactly what we discussed in our previous conversation "The Law of the Maximum", we decided again this week to pick yet another analogy in our chosen title towards the French Revolution given our "pre-revolutionary" mindset. The Society of the Friends of Truth (Amis de la Vérité) also known as the Social Club, was a French revolutionary organization founded in October 1790 and formulated political theories on democratic government, more equitable distribution of wealth and was the first revolutionary group to identify itself as cosmopolitan and made appeals to scholars worldwide. The Club's political orientation was liberal and promoted the ideal of a society composed of small and medium economic producers such as craftsmen, farmers, merchants and entrepreneurs. Given the rising critics relative to the "wealth effect", a strategy openly supported by the members of "The Cult of the Supreme Beings" aka central bankers, we wonder if we should not recreate through our musings "The Society of the Friends of Truth" hence our title. After all we have been hammering for a while the on-going "japanification" process of the European banking system and the unresolved issues of some banking system such as the Italian one in supporting economic growth through the "credit impulse" given their balance sheets "constraints". 

In this week's conversation we would like to revisit the threat of rising positive correlations thanks to the "The Cult of the Supreme Beings" and what it entails for diversification strategies, risk parity strategies as well as "hedging" for credit and more. After all, we do not think there is a better way to rekindle "The Society of the Friends of Truth" than discussing again the subject of "tail risks" and non-linearity events.

Synopsis:

• Macro and Credit - Watch out for rising positive correlations
• Macro and Credit  - Is inflation back into play?
• Final chart: The downward trend in bond yields has limited insurers' hedging budgets

• Macro and Credit - Watch out for rising positive correlations

While we mused on twitter at the end of August the following: 

"Piece of advice for Central Bankers, rising cross-asset positive correlations and risk parity strategies do not mix well..." - source Macronomics, twitter feed.

It is time we think for the members of the Society of the Friends of Truth to reacquaint themselves with our wise words from our February conversation "The disappearance of MS München" in which at the time we said we were writing for posterity and tackling in depth various aspects of risk including the inadequacy of VaR (Value at Risk) as a risk measurement tool. You might already be wondering where we are going from there but as a gentle reminder, in our book, rising correlations reduces the benefit from diversification, in the end hitting fund's equity directly. Whereas we have mostly disregarded "diversification" this year we opted to avoid the diversification risk in a NIRP world (putting in jeopardy "balanced funds" with reduced downside protection of the bond buffer component thanks to lower yields) for a much simpler "barbell strategy". Therefore we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that is there was a huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up and apart from the most recent "jittery" Fed induced hiking or not hiking moves, for us this strategy worked out fairly well in 2016.

This is what we wrote in our February long conversation:

"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:

"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing. The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016

In our Society of the Friends of Truth, rising positive correlations are a warning sign and also clearly indicative of central bankers meddling with asset prices. This can be clearly seen in the below CITI chart displaying rising cross-asset correlation and the VIX index:

- source CITI, H/T Steen Jakobsen

This also a subject we discussed in our May 2015 conversation "Cushing's syndrome". We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:

In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out

We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 

"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets

Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment.

Furthermore, there are some more indications of some other strategies being directly threatened by central banks intervention and rising positive correlations which could lead to some nasty non-linear price movements and VaR shocks we think.

This clearly the case for Volatility Control Products as indicated by Deutsche Bank in their Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions":

"One year later, vol control funds continue to draw focus in severe selloffs

One year ago today, on August 24, 2015, severe volatility drove S&P 500 futures to be halted in pre-market trading, listed SPX option markets to go black, and other equity market dislocations to arise. That moment was one of the most severe shifts in SPX volatility, switching from a relatively low volatility period to extremely high volatility (11% selloff in a week) almost instantaneously. Vol control funds, multi-asset investment portfolios with a dynamic asset allocation determined by market volatility, were important contributors to the severity of that selloff. In this piece, we provide background on vol control funds and guidance on how investors can monitor them going forward.

Vol up, sell stocks: a market feedback loop

Vol control products sell equities when volatility is rising and buy equities when volatility is falling, creating a market feedback loop. Product growth has slowed - but rebalancing impact has grown in illiquid, risk-averse markets. This has been, and continues to be a driver, of the repeated pattern of sharp selloffs followed by consistent rebounds seen in the last 2Y, and contributes to high skew and vol-of-vol in derivative markets. Several fund features - most importantly lags in trading following a volatility spike - keep the products from becoming a systemic risk. Vol control products are not the only large market feedback loop structure (risk parity, leveraged/inverse ETPs, and CPPI are other important ones) - but we believe they are the most important feedback loop given their size and responsiveness to market shifts.

 Sharp transitions from low vol to high vol are becoming increasingly common

The most important trading implication of a large vol control market is the funds' impact on sharp selloffs. We have had almost as many transitions from very low vol to much higher vol in the last 6Y as we have had in the prior two decades.

DB Vol Control Composite tracks current positioning

Through fund-by-fund research of $200bln of vol control funds, we have categorized the funds into four categories, and created a DB Vol Control Composite model based on systematic strategies that we believe captures the essence of these products' equity allocation patterns. We estimate that a sudden 4% global equity selloff today would drive $20bln of selling by vol control funds - less than earlier this year - as realized vol is now below many funds' thresholds.

Last August, around $50bln of equities were sold by vol control funds

We estimate that in the aftermath of the Aug-15 selloff, vol control funds sold around $50bln of global equities, and in the aftermath of the Brexit vote sold around $25bln. These numbers are large in absolute terms - and stand out when they're coming from an investment type that does minimal asset allocation rebalancing on a typical day-to-day basis.

Arguably rising positive correlations and repressed volatility are we think, recipe for large trouble ahead thanks to central banks meddling. A clear illustration of the impact of "Brexit" was discussed in our conversation "Optimism bias" back in June, which clearly caught "off-guard" many pundits. This "Brexit" sucker punch or Blue Monday" price action was clearly illustrated in Deutsche Bank 's very interesting report:

"Brexit: what matters is how big a surprise the vote was

In the aftermath of the UK's referendum to exit the EU, vol control funds likely sold around $25bln of global equities due to the sudden pickup in volatility. This would have been different had polls been more accurate: had market-implied Brexit likelihood drifted toward a Leave result over several days rather than shocking market participants in the middle of the night, markets may have ended at the same prices - but in a gradual path. Unlike what actually happened, this slow-motion drift toward Brexit would have left vol control products fully invested. It's not the outcome of the Brexit vote that drove selling by these investors - it's the path markets took to get there.

In the figure below, we compare the number of SPX shares held by a $10bln investment in a hypothetical fund linked to the S&P 500 Managed Risk Index - Moderate (a representative index of some vol control funds that we describe later in the note) under two scenarios: what actually happened, and a hypothetical slow-motion Brexit in which the market hypothetically realizes that Leave will win over the course of the vote week. The shock nature of the Brexit vote caused 900,000 shares of the SPX to be sold by this strategy than it would have had just four trading days' prices been replaced with a gradual descent toward the post- Brexit low.

Vol control products aim to achieve a fixed realized vol

Volatility control products are funds that promise their investors a specific realized volatility – either by aiming to achieve an exact number (e.g. 10% realized vol), a specific range (e.g 8-12% realized vol), or a limit (no more than 12% realized vol). The volatility objective is a constraint on the otherwise return-maximizing goal of the portfolio.

We define vol control funds as products having these characteristics:

■ Dynamic asset allocation. The percentage of assets invested in equites varies, at least partially systematically, over time based on market conditions.

■ Asset allocation is a function of volatility levels. The product's allocation to equities is primarily a function of how high either equity volatility or cross-asset volatility is, whether measured through implied, realized, or subjective metrics. We do not include products whose asset allocation is a function of asset classes' relative volatility to each other.

Typical vol control funds are global, multi-asset portfolios

Even though vol control funds are largely a US-based investment option, most vol control funds are managed as global asset allocation portfolios, including equities and fixed income, from both US and international markets. They typically hold almost-static allocations to either security-level or fund-level investments, and then manage the overall expected volatility of the portfolio by trading futures
contracts on global equity indices in response to changes in market volatility. The charts below show the asset allocation of the long and short sides of a typical vol control fund. The fund holds a diversified, multi-asset long portfolio, and then reduces its equity exposure by 17% of AUM via several short futures positions:

In similar fashion to CPPI strategies, these funds must decrease leverage to protect principal hence the dangerous feed-back loop for these strategies increasingly at risk from rising cross-asset correlations with reduced buffer from the bond allocations in some case such as the much vaunted stars of the last decade aka "balanced funds".

As we have pointed out, positive cross-asset correlations are on the rise and should be monitored and of great concern. As we pointed out in our short August conversation "Positive correlations and large Standard Deviation moves", indicates growing systemic risk we think. As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger...That simple.

The below chart made on Bloomberg by Adnan Chian (through our twitter feed), represents an illustration of the risk for "balanced funds" getting "unbalanced" as mentioned above:

- source Bloomberg / H/T Adnan Chian - Twitter - 30th of August 2016

In addition to this, we read with interest Bloomberg's take on rising correlations from their article from the 31st of August entitled "Stocks and Treasuries haven't moved together like this since China's Yuan devaluation":

"The last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan, with strategists heralding the onset of "quantitative tightening."

In stark contrast to the recent experience, modern portfolio construction has typically been predicated on a negative correlation between stocks and bonds, lowering the overall volatility of the portfolio and producing better risk-adjusted returns.
"The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield but that shift from negatively correlated to positively correlated will play havoc for portfolio level risk management (and risk parity)," writes Peter Tchir, head of macro strategy at Brean Capital LLC.
The risk parity strategy, which, in very basic terms consists of a levered long position in Treasuries and a long position in stocks, has been on fire in 2016. Bank of America Merrill Lynch Head of Global Rates and Currencies Research David Woo has warned that tough times could be in store for this strategy if investors heading into the U.S. presidential election begin to price in the possibility of fiscal easing in the U.S., anticipating a clean sweep at the polls by either party." - source Bloomberg

While we have touched on "Vol Control Products", "balanced funds" and CPPI, no doubt to us that very successful "Risk Parity Strategies" could as well be impacted by the rising trend as put simply by Bloomberg in their article:

"The diversification benefits of a traditional 60/40 (stocks/bonds) portfolio would disappear in such an environment, causing portfolio managers to scramble and search for a new hedge." - source Bloomberg

In our Society of the Friends of Truth, which you hereby are a member by now, in our "investing book", these strategies are indeed directly threatened by the rise of "positive correlations". On the subject of "Risk Parity Strategies" we would like to redirect you dear member to the guest post from our Rcube friends  which we published on the 14 August 2013 entitled "Is Risk Parity a Scam":

"Because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a big rotation that would bring 10-year yields back to a theoretical long-term equilibrium value.

According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…
From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself."

Conclusion

Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance based arguments that are often put forward by the proponents of risk parity.
From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:
1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategy's performance under different scenarios.
2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.
3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.
4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.
5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.
For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).
There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's numerous flaws.

However, we have little doubt that when the next "black swan" terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage one's life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.-"Is Risk Parity a Scam", August 2013

We could not agree more with our friends.  In addition to this, dear member of "The Society of the Friends of Truth", is that when it comes to Risk Parity and "Risk" we reminded ourselves Bank of America Merrill Lynch US Equity Derivatives Research note from the 30th of August 2015 entitled "Risk parity is not the risk, vol control is, but how big is it really?":

"Risk parity is not the risk, vol control is
Much has been made recently of the threat of forced selling by risk parity funds during market shocks as volatility spikes. However, the risk in our view lies not in the basic construct of a risk parity fund, but rather in the risk-management mechanism often overlaid onto risk parity funds (as well as other funds) which aims to manage an investment such that it has constant volatility. This “target volatility” risk overlay is a dynamic portfolio rebalancing mechanism that can induce rapid shifts in a portfolio’s allocation, particularly when volatility spikes from a low base level, which is when these funds apply maximum leverage.

The perverse side effects of vol of vol tail events

Our core thesis for volatility in 2015 was that we would witness a greater number of “local tail events” or contained but violent shocks in markets including volatility due to bank deleveraging, waning liquidity and the growth in high frequency trading. The recent market events appear to be yet another example of these risks playing out. A byproduct of these violent shocks, which erupt from a calm, low vol market, is true tail events in the volatility of volatility – the VIX recorded its largest 2-day percentage rise in history last week. This is also a toxic mix for strategies that aim for constant volatility exposure as the amount of leverage they employ is directly linked to their volatility.

Vol control applied to risk parity can further exacerbate risks

Because risk parity funds are inherently low volatility strategies (the recent volatility of an unlevered fund is less than 5%), they are often levered to achieve higher volatility (and higher returns), and in many cases a volatility control is also overlaid to maintain a more constant risk exposure through time. Risk parity derives its low volatility from the diversification benefits of holding both stocks and bonds in equal risk weighting. However, if a spike in volatility occurs at the same time that bond/equity correlation breaks down, this will lead to even larger spikes in risk parity volatility and therefore greater de-leveraging. In theory if these funds were large enough, their rapid liquidation of both bonds and stocks could lead to heightened correlation thus further exacerbating their rise in volatility and demanding further deleveraging.

From theory to reality, near term risks are much reduced

Volatility control is a dynamic risk-management strategy that has been applied widely in
recent years, not only to risk parity funds. If we assume $400bn in risk parity funds, half of which use vol control, we estimate recent events could have generated $30-$80bn in selling pressure on equities and $50-150bn on bonds. Estimated selling pressure from risk-control funds applied to non-risk parity portfolios could equate to an additional $25bn- $50bn in equity selling, which together is less than 10% of the $1.7tn of S&P 500 e-mini futures traded last week. Interestingly, we also see almost no evidence of impact on the Treasury futures market despite estimated liquidity demands from risk parity rebalancing being even greater. This selling pressure also assumes funds all operate mechanically. Many funds can exercise discretion to smooth out their rebalancing. Importantly, for those funds that operate mechanically, they likely have already de-levered, and with volatility now elevated, further shocks will be much less impactful." - source Bank of America Merrill Lynch.

By now you probably understand our "nervousness" in these strategies given that if correlations break down, and they are by the way, then no doubt that there is a heightened risk of "fast and furious" deleveraging at play.

All these strategies suffer from not only "optimism bias" but from a "herd mentality", meaning everyone is playing the same way, this for us reinforce somewhat this "doom-loop" or negative feedback loop which would entail much steeper drawdowns for these strategies than anticipated. All in all, these strategies we discussed are very sensitive to a spike in volatility, and what matters therefore as shown by the "Brexit" episode is not the news outcome but the "velocity" of the news to have an impact on the forced deleveraging prospects for these investment strategies mentioned. After all asset allocation strategies allocate capital on the basis of volatility. When "The Cult of the Supreme Beings" aka central bankers mess with the signal (VIX index), we wonder how "Vol control" is going to operate if indeed we get very large volatility moves going forward as put it bluntly by Bank of America Merrill Lynch in their 2015 report:

"It is really the combination of a sudden, violent drawdown following an extended period of calm that is most toxic for target volatility funds and generates the largest potential rebalancing needs" - source Bank of America Merrill Lynch

So what to do in this kind of "environment", we think that "diversification" is being threatened by rising positive correlations, therefore, increasing cash levels, cash being a strategy is therefore paramount in the case of violent intraday drawdowns and sudden spike in volatility.

When it comes to Fixed Income, what would really drive a sell-off in the asset class, would be a return of inflationary pressures. When it comes to our views, us being members of the Society of the Friends of Truth, we are in the "lower for longer" camp and until we see a clear manifestation of wages pressure in the US we will sit tightly in the deflationary camp. This brings us to our second point about "inflation" and "flows".

• Macro and Credit  - Is inflation back into play?

While back in March 2016 in our conversation "Unobtainium" we discussed the possibility of a rise in inflation hence the current perceived heightened risk of a rate hike in September by the Fed. Back in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:

"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015

Obviously has indicated by Markit, our case for UK linkers in August clearly blew away our preference given the performance of UK linkers over US linkers with a very significant performance overall:

- source Markit, H/T Simon Colvin

But, given our "deflationary" incline and the embedded deflation floor of US linkers, from a diversification perspective we continue to like the asset class, particularly given as of late of the significant inflows through ETF as indicated by Société Générale in their ETF Market Signals note from the 5th of September entitled "Record creations on inflation-linked bonds":

"Inflation-linked bonds came back to net creations after net outflows in July and posted all-time-high $600m monthly inflows, mainly thanks to USD denominated benchmarks (see chart 6).

- source Société Générale

 
 Now, as per our October 2015 conversation, inflation-linkers, even in a rising cross-asset correlation world bring diversification benefits, although they have not been immune to the rising trend in cross-asset correlations. However their embedded deflationary floors at least for US linkers make them, we think particularly attractive. What is of interest is that unlike US TIPS, Gilt linkers do not benefit from this "deflation" floor. In a growing NIRP world with now some European Investment Grade companies (Henkel, Sanofi), US linkers have the advantage that both the principal face value and the coupon payment can never decline below the value at issuance. How that for a financially repressed world we dare to ask dear members of the Society of the Friends of Truth?

If we are indeed, in a prolonged period of deflation, such as the one we think we are currently experiencing, the embedded "deflation floor" both applied to the stated coupon as well as to the face value of the bonds. These are indeed very interesting features that should not be neglected when selecting an exposure to the index-linked sovereign bond markets. This is particularly true for believers like us that, the US economy is weaker than what every pundits think and that, going forward, US growth is likely to disappoint (see recent PMI for services for example...).

As we asked ourselves back in October 2015, could the  the Fed really hike when US breakevens are falling , which could be clearly indicative of deflationary forces at play? This also another reason why the embedded "deflation floor" in US TIPS is so enticing:

- graph source Thomson Reuters Datastream - H/T Warburg on Twitter

But, there is a caveat, with the on-going discussions surrounding "fiscal stimulus", especially in the US as both presidential candidates are pushing for it. As well at play, we think there is, in similar fashion to "Brexit", markets it seems are falling once more for an easy victory for Hillary Clinton it seems. 

We know how that played out for "risky assets" once the news hit the screens. On that subject we read with interest Bank of America Merrill Lynch's Cause and Effect note from the 26th of August entitled "Pricing a perfect gridlock":

"Gridlock = Goldilocks

Our analysis suggests the market is pricing an easy victory for Hillary Clinton but a split Congress in the November elections. In other words, the market is pricing a high probability of continued gridlock in Washington. We believe this is the reason why the market is long risk parity trades and short volatility right now.

Risk-off ahead of November 8

Risk parity portfolios have not done well when uncertainty and volatility go up. History tells us to expect Clinton’s lead to narrow and volatility to rise in the final stretch of the elections. We recommend buying a 3-month AUD/USD digital put to position for a possible unwinding of risk parity trades that can become self-fulfilling once it starts.

Clean sweep = higher USD and higher US rates

We cannot remember the last time the FX and the rates markets have so much at stake in a US election. While gridlock probably means lower rates and a weaker USD, a clean sweep would likely lead to both higher USD and higher rates over the medium-term, in our view. We believe the volatility market is underpricing the bi-modal nature of the outcome of the election for US fiscal policy outlook." source Bank of America Merrill Lynch

From our perspective, as members of The Society of the Friends of Truth and given our long lasting contrarian stance, we would tend to fade the "easy victory" for Hillary Clinton and as, we posited in our first bullet point, we would rather go short risk parity trades and long volatility right now, no offense to Bank of America Merrill Lynch. We do not want to suffer from "Optimism bias" but we are not yet falling for the "pessimism bias", we tend to sit nicely in the "realistic bias" camp. Overall, the big issue for risk parity trades comes when both volatility and correlation of the underlying components rise together. This we think is going forward a very important factor to keep in mind. Furthermore, we think that option markets are too complacent and pricing too little of a potential move. With risk parity still remaining levered at elevated levels, this we think could turn out to be a "bad recipe" for asset prices and significantly "boost" the "velocity" in the surge of "volatility".

When it comes to our inflation expectations, we continue to believe that wages acceleration hold the key to the "recovery story", so far, we are not buying it, and we will continue to fade it hence our attraction for the embedded deflation floor of US linkers.

For our final chart, we would like to point out to our fellow members of the Society of the Friends of Truth, that the unintended consequences of the "The Cult of the Supreme Beings" aka central bankers has had an impact on hedging budgets (particularly because both duration risk and credit risk have risen).

• Final chart: The downward trend in bond yields has limited insurers' hedging budgets

Our final chart comes from Deutsche Bank' s Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions". It shows that the unintended consequences of the trend in low bond yields has limited insurance companies' hedging budgets:

"Low interest rates, high vol-of-vol, and volatility aversion have driven growth

Three financial market trends have been catalysts for growth of vol control
products:

■ High vol-of-vol. Volatility itself has been volatile for the past few years, and as a result insurers' hedging costs have been changing quickly. In this environment, vol control funds' more stable volatility profile is particularly valuable to issuers.
■ Low interest rates. Interest on invested funds can be another source of hedging funds for insurers. With US interest rates repeatedly hitting new lows, insurance companies have little margin for error. Stabilizing hedging costs is one way to reduce the need for this cushion.
■ Post-financial crisis worries. Investors continue to be haunted by the ghost of 2008: recency bias has driven heightened worry about another 2008-like event. This volatility aversion has made volatility control attractive to investors (as a peace-of-mind feature) - even in products that do not have the technical hedging needs that drive much of the growth." - source Deutsche Bank

Furthermore, there is a well a clear warning in Deutsche Bank's note for the pundits such as pension funds that keeps picking up pennies in front of a steamroller namely selling volatility:

"Tail protection for short vol strategies increasingly timely at low vol levels

The growth of vol control products has, at least at the margins, the potential to re-frame how volatility sellers manage their positions. Conventional wisdom has typically been that selling vol is more dangerous at very high vol levels than it is at low levels despite the seemingly more attractive entry points. However, the potential for market feedback loops like vol control funds to intensify selloffs that start at low vol levels makes short vol strategies riskier at low starting vol levels - increasing the need for tail protection as an overlay." - source Deutsche Bank

 As a member of the Society of the Friends of Truth, we could not agree more. Any good trader will tell you that being short gamma is a very poor risk/return proposal....particularly pension funds with fiduciary duties we think...

"In a time of universal deceit - telling the truth is a revolutionary act." -  George Orwell

Stay tuned!