Monday Macro – it’s definitely choppy out there but the Vix is slumbering

A short note for the bank holiday weekend. Why at some stage UK 10 year bonds might be attractive. Plus, Big Government might meet its maker if rates stay too high.

Programming note – there won’t be the usual investment ideas note this coming Wednesday but there will be some weekend reading links on Friday. Next week – from Monday 5^th June – I’m off for a week in sunny Croatia, with no letters or notes.

Given our fortunate sunny weather, I plan to keep today’s Macro note short by focusing on the question of uncertainty. Put simply, we’re living in peculiar times with a surfeit of big-picture developments, regime changes, and macro uncertainty yet US stock markets – as measured by the Vix index - are currently experiencing almost classic average volatility compared to the medium-term average.

The average level for the Vix over the last 20 years is around 19.27 and the last time I looked that index was trading at 19.14. The chart below shows the Vix index since before the pandemic, with the blue line the 200-day moving average and the red line the 20-day moving average. I think the message here is “nothing to look at” i.e all very normal.

Yet, I don’t know about you, but it doesn’t feel normal out there in the real world of macroeconomics. We are very clearly mid-way through some big regime changes – which I have talked about before – yet equity investors seem to be shrugging this all off.

On this point, it’s worth taking note of Howard Silverblatt, chief analyst at S&P Dow Jones who last week collated some US market stats, with the headline that come Thursday May 25^th, the  S&P 500 total return year-to-date was up 7.91%.

“However, ex the top 8 contributing issues (7 companies) it is down -0.29%, and ex Information Technology and Communication Services it is down -0.40%”. As for breadth year to date (price only) “231 issues [were] up with 109 up at least 10% and 46 up at least 20%” while “271 issues [were] down with 132 down at least 10% and 43 down at least 20%”.

One might at this point accuse me of overestimating the uncertainty out there – as we’ve clearly shown week after week, corporate earnings are surprising us on the upside, and at the end of the day what really counts for investors are those profits.

But I think we can empirically argue that there is real uncertainty out there and one point of evidence comes from a paper by US fund management group AQR in a paper by Jordan Brooks HERE.  It makes the entirely reasonable point that macro uncertainty is indeed elevated, even when measured quantitatively.

AQR points to research by Kyle Jurado, Sydney Ludvigson, and Serena Ng (JLN, 2015) which uses a large set of economic releases [one-month-ahead forecasts of 132 macroeconomic series] to build a comprehensive monthly “macro uncertainty index.” The index is freely available at the academic’s website HERE.

The chart below shows this JLN index from 1960-2022.

As the AQR paper observes,

“Macro uncertainty has indeed been exceptionally elevated throughout the 2020s. It peaked in the first half of 2020 and is currently at levels not seen since the 1980s, save for during the global financial crisis.

“The recent period stands in contrast to the 2010s. a decade during which macro uncertainty was consistently, and often meaningfully, below average.3 Elevated macro uncertainty is associated with both high equity market volatility and negative equity market performance. During months in which the JLN index exceeds one, average annualized excess returns for U.S. equities is -16 percent and average annualized realized volatility is 21 percent, versus +6 percent average excess returns and 12 percent average realized volatility in all other months”.

If we agree with this analysis – and I do – what are the investment implications? Unsurprisingly the AQR report suggests investing in trend-following strategies, one of their long-term favourite ideas. Personally, I think the best ideas are probably the simplest – diversify your risk assets, geographically (don’t bet the farm only on US equities), by style (mix some value stuff in there with growth stocks), and by geography (probably some emerging markets and some Japanese equities).

You could also just play safe and sit tight in cash which is becoming ever more attractive, especially in the UK – where interest rates look like they might now peak at 5.25% or even 5.5% - as well as the US. I’m also becoming drawn to the rather contrarian idea that government bonds might start to become more attractive at some point in the not-too-distant future.

Quant strategist – and fund manager Charles Ekins, of Ekins Guinness, reminds us that UK 10-year gilt rates are now nearly back to Truss levels. This has pushed the trusty 10-year into oversold territory based on their measures, although not extremely oversold levels.

Ekins isn’t quite bullish yet on gilts but he’s beginning to spy a tactical opportunity:

“Our model has been cautious of Bond markets including Gilts for some time – they remain in a clear downtrend, and it is a similar downtrend for US Treasuries. The Oversold situation in Gilts does not change anything immediately. However, our model will now look for a tactical recovery which, if it occurs, would be worth allocating to. Otherwise, if the short term recovery does not materialise, we will instead wait until Gilts either become extremely oversold (which may or may not happen) or the medium/long term trend picks up (which will take a while).”

My own sense is that once UK 10-year gilts push past 4.5%, and then 5%, we’re entering much more interesting terrain. My core view is that most developed world nations are now dominated by Big Government i.e massive fiscal spending to lower risk for their citizens via handouts, welfare states and health services. Whether you agree with this set of policies, or not, is rather beside the point as the spending taps have been turned on by governments of all complexions. I would suggest they’ve done that because macro uncertainty is perceived by most citizens to be very high. The flip side of this is that this era of Big Government makes a Higher for Longer rates regime painful for government interest payments. I can absolutely see interest rates staying above 5% for a year or two but beyond that governments will be keen to get rates – both interest and inflation – back in the box at a range of between 2.5% to 5%. In these circumstances, a 10-year gilt yield of over 5% would represent a very real opportunity.

There is though a risk with this argument – that inflation is not brought under control and rates stay higher much longer i.e the rest of the decade. In that case, the chart below should serve as a warning for both government bond investors and the Treasury. It shows UK 10-year gilt rates for the last 50 years and reminds us that for many decades, 6% yields on long-duration government bonds were extremely common. For much of the 80s and 90s, investors expected 10-year yields to be well in excess of 6% per annum, which implies a huge increase in government debt payments.

If that does happen, then Big Government make at some stage meets its maker as electorates rebel against high inflation and high tax rates.

Somehow governments need to find a way to make their economies grow faster.