Had the Cayman Alternative Investment Summit taken place in early January instead of February, all the talk about investment risks and threats to the economy would have been about geopolitics. Following the market corrections in early 2018, the debates instead centered on inflation and the potential for interest rate rises.
For KPMG chief economist Constance Hunter, the low interest rate environment with low inflation, near-full employment, good GDP growth in the U.S., tailwinds from fiscal stimulus and synchronized global growth, for the first time since 2007, constitutes a “snowflake economy.”
“It is perfect and beautiful but somewhat fragile,” she said.
The first indication that it cannot last came with the market turmoil, which saw the stock market spooked by the latest payroll statistics from the U.S., which many investors interpreted as inflationary.
“The thing to get right in 2018 is what is happening with inflation,” Hunter said in a panel that discussed investing in a world of uncertainty.
The question of whether higher wages will translate into higher inflation, and thus additional interest rate rises by the Federal Reserve, cannot be answered by looking at the headline figures alone. By drilling down further into the statistics, Hunter noted a pay disparity between wages at large, highly productive and high-paying firms, which make up 7 percent of the labor force, and all other companies.
In addition, almost all of the gains shown in the February payroll data went to supervisory workers who represent 20 percent of the labor force. Only if the data showed pay increases for non-supervisory workers in the U.S., the effect may, in fact, be inflationary, she argued.
The stock market fear of inflation is built into the current market structure. To generate returns of 5 or 7 percent in a low or zero interest rate environment required excessive leverage, said Ben Melkman, CEO and CIO of Light Sky Macro LP, who believes the stock market corrections were just the tip of the iceberg, with some investors unwinding their short volatility strategies used to achieve their yield targets.
“It is a warning signal of how much financial engineering there has been in a financial environment,” he said. Over the next two years as inflation calls for central banks to take liquidity out of the market, the excessive financial engineering will become unmasked, Melkman added.
Jim McCaughan, CEO of Principal Global Investors, noted that the markets are experiencing a period of heightened tail risk, a term for low probability risks that have a potentially high impact.
This was the result of populist and nationalist policies in the U.S. and the rest of the world as well as the increase of leverage, he said.
However, McCaughan thinks the fear of a hawkish Fed, which could raise interest rates four times in 2018, is “an overheated fantasy.” The idea nevertheless took hold of the markets, with the implication that this could bring forward the recession and make it more difficult to hold equities in a world of competing yields.
That on its own would have led to a 3 or 4 percent set-back in equities, he said. “The problem is there are a lot of procyclical strategies that when that 3 or 4 percent drop in equities happened, the algorithms behind the strategies basically forced selling.”
In particular, short volatility, target volatility and risk parity strategies have the potential to cause a serious set-back.
In addition, leveraged and short ETFs, which have grown significantly, are procyclical products that can lead to a self-feeding market decline, McCaughan said.
Melkman added that as investors have embraced passive investing, liquidity mismatches across all ETFs will also make them difficult to unwind.
Credit ETFs, for instance, represent even on a non-leveraged basis many hundreds and thousands of times the liquidity of the underlying product, he said, which means when the market tries to sell that ETF “it has no bid to hit.”
He argued that the market had become too worried about the inflationary mindset and this has caused a policy setting that is completely inappropriate for the state of the economy.
Quantitative easing and zero interest rate policies, which are still prevalent in Europe and Japan, were fine when there was excess capacity and no inflationary pressure. But Melkman sees the markets at an inflection point with every major economy running at full capacity, global demand running above trend and the beginnings of a more inflationary environment.
“What we are going to see through 2018 and going forward, there is no way to satisfy the above trend growth that we are seeing all across the world, except for high prices.”
McCaughan disagreed, arguing that this view underestimated the impact of technology on behavior and the economy. The effect of e-commerce on retail trade has made products up to 30 to 40 percent cheaper but this was not reflected in the inflation numbers. “I think that on its own is probably why inflation is overstated already in the economic numbers,” he said.
The deflationary effect of technology is also one of the reasons rates stayed so low, McCaughan noted.
He considered announcement of higher wages by companies like WalMart, which gave out large bonuses and increased their minimum wage, amounted to mere “political grandstanding,” because the next day the retailer closed 65 large stores, which in itself is deflationary.
At the same time the labor participation rate among the youngest and oldest Americans is rising, which is going to take the pressure off wage hikes, added Hunter.
She advised investors to watch real wage increases to non-supervisory workers in the U.S. and any reduction in purchases by the European Central Bank and the Bank of Japan throughout 2018.
Melkman said investors should be extremely cautious and book the profits after an “amazing” ten-year run.
“As we normalize the interest rate and liquidity setting, have some dry powder, don’t be overextended in some of the risky assets and don’t be overexposed to low-yield interest rates or leveraged credit,” he said. “Keep leverage low and have the dry powder to buy when other investors are having difficulties.”