Friday, April 21, 2017

Be Very Afraid of These Markets?

Katherine Burton and Katia Porzecanski of Bloomberg report, Paul Tudor Jones Says U.S. Stocks Should ‘Terrify’ Janet Yellen:
Billionaire investor Paul Tudor Jones has a message for Janet Yellen and investors: Be very afraid.

The legendary macro trader says that years of low interest rates have bloated stock valuations to a level not seen since 2000, right before the Nasdaq tumbled 75 percent over two-plus years. That measure -- the value of the stock market relative to the size of the economy -- should be “terrifying” to a central banker, Jones said earlier this month at a closed-door Goldman Sachs Asset Management conference, according to people who heard him.


Jones is voicing what many hedge fund and other money managers are privately warning investors: Stocks are trading at unsustainable levels. A few traders are more explicit, predicting a sizable market tumble by the end of the year.

Last week, Guggenheim Partner’s Scott Minerd said he expected a "significant correction" this summer or early fall. Philip Yang, a macro manager who has run Willowbridge Associates since 1988, sees a stock plunge of between 20 and 40 percent, according to people familiar with his thinking.

Even Larry Fink, whose BlackRock Inc. oversees $5.4 trillion mostly betting on rising markets, acknowledged this week that stocks could fall between 5 and 10 percent if corporate earnings disappoint.

Caution Flags

Their views aren’t widespread. They’ve seen the carnage suffered by a few money managers who have been waving caution flags for awhile now, as the eight-year equity rally marched on.

But the nervousness feels a bit more urgent now. U.S. stocks sit about 2 percent below the all-time high set on March 1. The S&P 500 index is trading at about 22 times earnings, the highest multiple in almost a decade, goosed by a post-election surge.

Managers expecting the worst each have a pet harbinger of doom. Seth Klarman, who runs the $30 billion Baupost Group, told investors in a letter last week that corporate insiders have been heavy sellers of their company shares. To him, that’s “a sign that those who know their companies the best believe valuations have become full or excessive."

He also noted that margin debt -- the money clients borrow from their brokers to purchase shares -- hit a record $528 billion in February, a signal to some that enthusiasm for stocks may be overheating. Baupost was a small net seller in the first quarter, according to the letter.

Another multi-billion-dollar hedge fund manager, who asked not to be named, said that rising interest rates in the U.S. mean fewer companies will be able to borrow money to pay dividends and buy back shares. About 30 percent of the jump in the S&P 500 between the third quarter of 2009 and the end of last year was fueled by buybacks, according to data compiled by Bloomberg. The manager says he has been shorting the market, expecting as much as a 10 percent correction in U.S. equities this year.

China Slowdown

Other worried investors, like Guggenheim’s Minerd, cite as potential triggers President Donald Trump’s struggle to enact policies, including a tax overhaul, as well as geopolitical risks.

Yang’s prediction of a dive rests on things like a severe slowdown in China or a greater-than-expected rise in inflation that could lead to bigger rate hikes, people said. Yang didn’t return calls and emails seeking a comment.

Even billionaire Leon Cooperman -- long a stock bull -- wrote to investors in his Omega Advisors that he thinks U.S. shares might stand still until August or September, in part because of flagging confidence in the so-called Trump reflation trade. But he said that they will eventually resume their climb and end the year moderately higher.

Likely Culprit

While Jones, who runs the $10 billion Tudor Investment hedge fund, is spooked, he says it’s not quite time to short. He predicts that the Nasdaq, which has already rallied almost 10 percent this year, could edge higher if nationalist candidate Marine Le Pen loses France’s presidential election next month as expected. Jones tripled his money in 1987 in large part by correctly calling that October’s market crash.

While the billionaire didn’t say when a market turn might come, or what the magnitude of the fall might be, he did pinpoint a likely culprit.

Just as portfolio insurance caused the 1987 rout, he says, the new danger zone is the half-trillion dollars in risk parity funds. These funds aim to systematically spread risk equally across different asset classes by putting more money in lower volatility securities and less in those whose prices move more dramatically.

Because risk-parity funds have been scooping up equities of late as volatility hit historic lows, some market participants, Jones included, believe they’ll be forced to dump them quickly in a stock tumble, exacerbating any decline.

“Risk parity,” Jones told the Goldman audience, “will be the hammer on the downside.”
Is Tudor Jones right to worry about risk parity strategies? First, for those of you who don't know about risk parity, I draw your attention to this CME paper authored by people working at the Clifton Group, Understanding Risk Parity.

It states the following:
In its simplest form, risk parity seeks to balance the contribution to total portfolio risk from each asset class that composes a diversified portfolio. A traditional 60% equity / 40% fixed income portfolio, which is the base of many investors’ portfolios, is not diversified. Approximately 90% of the risk in this traditional portfolio is concentrated in equities, due to the fact that historically equities have been three times more volatile than fixed income securities. Risk parity seeks to avoid this concentration of risk through the construction of a more diverse, risk balanced portfolio.
The authors then go on to highlight common criticisms of risk parity:
Like all investment strategies, risk parity has its detractors. One common criticism is that this strategy requires leveraging low-risk assets, primarily bonds. Risk parity allocations create an overweight to bonds in order to equalize the contribution to risk from all asset classes. Levered bond strategies performed well over the last several years as interest rates declined sharply since the onset of the financial crises in 2007. Risk parity critics note that given today’s interest rate environment, investors should have tempered expectations for the performance of their bond holdings in the future.

These critics may miss the objective of a risk parity approach, which is to have equal contributions to risk from all asset classes in the portfolio. The purpose of seeking equal contributions to risk from varied asset classes is to limit the potential economic impact to any one asset class in the portfolio. By equally weighting risk across a broad array of other asset classes such as equity, real estate, credit spreads, commodities, and inflation bonds, risk parity is not dependent solely on bonds as the source of diversification or return. It is important to note that a rise in interest rates would impact a risk parity strategy in different ways, depending on why interest rates were rising.

A gradual rise in interest rates as a result of a period of economic stability and prosperity would be positive for a risk parity approach. Although bonds may underperform in this environment, growth assets such as equities, real estate, and credit spreads would likely exhibit above average performance. If interest rates rise in response to increases in inflation expectations, a risk parity approach should benefit from exposure to inflation sensitive asset classes such as commodities and inflation linked bonds. In summary, because diversification is central to a risk parity strategy, there will likely always be some asset classes in the portfolio performing below expectations. However, at the same time other asset classes may well be performing above average.

The goal of the strategy is to allow the investor to collect the average risk premium across all asset classes over time in the most efficient manner possible and thus realize a superior risk-adjusted return.

Another criticism leveled at risk parity is that it often employs leverage. Risk parity strategies target a total level of portfolio volatility commensurate with an investor’s risk and return objective. To achieve this objective, a risk parity strategy may employ economic leverage in the form of futures contracts and financial leverage in the form of repurchase agreements and over-the-counter swaps. At a 10% risk target, it is not uncommon for a risk parity manager to have 200% cumulative exposure. This amount of leverage is required to equalize the risk contribution from low-risk assets like nominal and inflation linked bonds.

Leverage by itself is not a problem. Anyone who has used a mortgage to finance the purchase of a home has been exposed to leverage. What is critical is how that leverage is managed. It is here that the diversification prevalent within the portfolio and the operational and implementation experience of the manager are important. Diversification must be considered not only at the total portfolio level, but also among the various asset classes that are levered within the portfolio and therefore may require daily liquidity. Proven operational experience in managing leverage is key to risk parity managers. This experience should include having systems in place to monitor leverage levels on a real-time basis and developed plans for managing the strategy through challenging market environments. Assuming the diversification and experience criteria are met, the amount of leverage employed in a risk parity strategy should not create excessive risk to the investor.
Now, risk parity strategies have become very popular as rates plunge to historic lows and equities reach high valuations. In Canada, two of the best pensions -- HOOPP and OTPP -- do their own risk parity strategy internally instead of farming it out to an external manager. In order to do this properly, they too have invested heavily in systems and their portfolio managers are very experienced in managing leverage across asset classes (also, unlike other Canadian funds, their investment policy allows them to take on the leverage required to do this strategy internally).

But most pensions and large investors aren't able to do risk parity internally so they farm it out to big hedge funds like Bridgewater or AQR, two well-known risk parity titans.

How do risk parity strategies perform? Let's have a look at the Salient Risk Parity Index which is a quantitatively driven global asset allocation index that seeks to weight risk equally across four asset classes — equities, rates, commodities and credit. The Index is calculated daily, rebalanced monthly, and targets a 10% volatility level.

Below, you can see the annual returns which can be found here along with monthly and weekly returns (click on image):


As you can see, it's not always smooth sailing for risk parity strategies. In 2008, this index was down 17%, which was a lot better than what stocks did that year, but in 2015 it was down 12%, considerably underpeforming the stock market.

Incidentally, risk parity woes contributed to Bridgewater's lackluster performance in 2015, but last year risk parity performed well and so did Ray Dalio's behemoth fund, earning $4.9 billion for its clients, all due to its All-Weather (risk parity) portfolio which outperformed its flagship Pure Alpha portfolio.

But if you listen to Paul Tudor Jones's warning, you'd think risk parity strategies are doomed and they can heavily influence all risk assets, especially stocks.

Here is where I tune off. Why? Because he over-exaggerates their effects on the market, which is why the quants are firing back at his claims:
For AQR Capital Management LLC, a giant in the risk parity field, the concerns are overblown, with any selling forced by the strategy having an “utterly trivial” impact on the $23 trillion U.S. equity market.

“There are scenarios in which risk parity funds sell equities, but the possible magnitude of that is very small,” said Michael Mendelson, a risk-parity portfolio manager at AQR.“Some reports have grossly exaggerated the potential impact.”

Jones, who oversees $10 billion in his Greenwich, Connecticut-based Tudor Investment hedge fund, is the latest active asset manager to whip up fears surrounding the automated strategies that were a favorite target of bank researchers during the selloffs in August 2015 and early 2016. The strategy has less than $150 billion invested in it, according to data provider eVestment, most of at AQR and Bridgewater Associates’ All Weather Fund.

That’s significantly lower than the roughly $500 billion Jones estimated. And of that total, only around a third is investing in equities, Mendelson said. That compares to the nearly $2 trillion in market value that evaporated from U.S. equities during the last stock market correction.

“Even on a sharp move in the stock market, the positioning changes would be utterly trivial and would have about zero impact,” Mendelson said.

Cash Fleeing

Risk parity bases its allocations to different asset classes on risk rather than capital, as in the typical 60-40 stock-bond fund. So, for example, U.S. Treasures and international government bonds often play a larger role in risk parity funds than in other asset pools, while stocks usually take up a smaller slice.

In addition, money has fled risk parity funds in seven of the past nine quarters, for net outflows of more than $16 billion among funds tracked by eVestment.

But even in the scenario that Jones lays out, the funds wouldn’t dump their stock holdings for a variety of reasons, according to Edward Qian, who’s credited with coining the term risk parity. Because of the safer asset concentration, the strategy performs relatively better when stocks tumble and wouldn’t need to sell as much as a traditional 60-40 portfolio, Qian said.

“They’re always focused on the equity portion of risk parity, saying that equities might have a terrible time and other scary fear mongering things,” Qian said. “Even if someone has a stop loss or equity reduction program, it can’t be a significant player in those time periods.”
In short, while risk parity strategies are intellectually appealing, they really aren't as popular as people think. A lot of pensions aren't sold on the idea of risk parity and a lot of them cannot undertake this strategy, at least not in-house which is why they farm it out to big shops.

In order to draw inference on risk parity strategies, you need to see total assets under management of these strategies as a percentage of total stock and bond market capitalization, which is still peanuts.

Sure, at the margin, when risk parity strategies get whacked it can cause problems in markets for a brief period, but I'm not sold on the idea that "risk parity will be the hammer on the downside."

This is pure nonsense from a "legendary investor" who has been underperforming and cutting fees to keep investors onboard.

Is Janet Yellen afraid of Paul Tudor Jones and risk parity? Of course not, the Fed can crush macro gods like Tudor Jones, Ray Dalio and George Soros like little bugs, and it has a lot more arsenal in its war chest than what most investors think.

Are there reasons to be afraid of these markets? You bet. My chief concern -- and that of the Fed -- remains global deflation. This is why I'm highly skeptical of the reflation trade everyone is buying hook line and sinker, especially now that the next economic shoe is dropping and the Fed is considering to shrink its balance sheet, which ironically will only exacerbate global deflation.

Large investors are also preparing for the next downturn by rushing into alternative assets but investing in these strategies has been mixed and if deflation does strike, it's safe to assume there's nowhere to hide except good old US long bonds (TLT) which from a risk-reward perspective, remains my top recommendation this year and probably next year too (click on image):


But things move very quickly in these high frequency, Twitter infested schizoid markets. We shall see what happens after the French elections this weekend and if the Trump Administration is able to pass tax cuts and its infrastructure spending program (if so, US long bonds could get hit again but I would use that pullback to buy more).

All this to say stop listening to the dire warnings of legendary investors. Unless you're privy to their trading books, you have no idea how they're positioned and performing and whether they want to send out false signals to scare people off.

My rule of thumb is to look at what they're actually buying and selling every quarter but don't base any investment decision on what top fund managers are buying or warning of. More often than not, you'll get badly burned.

These markets are ruthless, unrelenting and just brutal.  Everyone from top traders to lowly retail investors is finding it hard to make money. But one thing is for sure, there is a major beta bubble going on in public markets and you need to be well diversified to mitigate against downside risks.

In the meantime, everyone is dancing to the music worried about what happens when the music stops. This is why I hate these markets and why I'm an ardent defender of large, well-governed defined-benefit plans which ensure people can retire in dignity and security (read Mauldin's latest, Angst in America, Part 4: Disappearing Pensions and my recent comment on America's growing retirement angst).

One final note, my recent comment on Canada's real estate mania has proven to be extremely popular.  I'm increasingly concerned about Canada's $1.1 trillion shadow banking system which is now half as large as banks, and you can see the dominoes are beginning to fall as Home Capital (HMC.TO) melted down yesterday on the stock market the same day Ontario was trying to hammer housing (read Garth Turner's latest, Cold Comfort).

Still, Home Capital's stock is bouncing up today (wouldn't touch it with a ten-foot pole!) and I was surprised to see the Royal Bank is the latest Canadian firm to explore a sale of bonds backed by uninsured residential mortgages after that bank's CEO warned of a frothy Canadian housing market.

To my former BCA Research colleague Steve Poloz who is now the Governor of the Bank of Canada, all I have to say is "be very afraid of Canada's housing bubble."

On that note, where are the contributions to this blog? I work very hard every single day to provide all of you with great insights on pensions, markets and the economy and I'm getting tired of asking for handouts. Be polite, please take the time to donate or subscribe to this blog on the top right-hand side to show your support. I thank every single one of you, especially those on a fixed income, who support my efforts.

Below, Guggenheim Partner’s Scott Minerd says he expects a "significant correction" this summer or early fall. Highly likely but who knows if "sell in May and go away" proves to be right this year? Stay tuned, quant hedge funds might ramp this market up even more before they pull the plug.

Update: One astute global macro trader told me "it's more vol control strategies that de-lever quickly as vol rises." In particular, he sees more risk from vol targeting annuities, not risk parity strategies and thinks that US equities have further upside as positioning and sentiment is too cautious. Like I said, stay tuned, we'll see what happens next week and in the second half of the year.

Thursday, April 20, 2017

Investors Rushing Into Alternatives?

A couple of weeks ago, Leslie Picker of CNBC reported, Private equity is breaking records left and right as funds rake in money:
Private equity is taking off, and breaking records along the way.

In some ways, private equity's gain comes at the expense of hedge funds' losses. In others, it is simply emblematic of the tremendous amount of capital sloshing around the world, with few other places to invest after almost a decade of low interest rates.

North American funds secured their highest first-quarter fundraising total ever, raising $62 billion, according to data compiled by Preqin, an alternative assets research firm. Worldwide, 253 private capital funds ended their fundraising process in the quarter, hauling in $156 billion, the data showed, which was the best first quarter since right before the financial crisis.

The momentum is likely to continue into the second quarter, with more than 3,000 funds currently marketing to investors, according to Preqin.

Apollo Global Management hopes to raise more than $23 billion in a fund that it is currently marketing to investors, according to three people with knowledge of the matter. That would be the largest private-equity fund ever, surpassing the nearly $22 billion fund raised by Blackstone in 2007. The closing could come as soon as next month, one of the people said.

Apollo declined to comment. Bloomberg reported last month that Apollo was fundraising.

For most investors in private equity, it all comes down to performance, at least in the long run. In the year 2016 through September, a Cambridge Associates index of private equity returns posted gains of 8.5 percent, which was about half that of any public stock index.

But in the long run — and for those investors expecting some sort of a decline in the public markets, it's all about the long run — private equity continues to outperform most equity benchmarks, with almost 11 percent returns over 10 years, according to Cambridge Associates.

Tough days for hedge funds

Compare those private-equity inflows with hedge funds, which saw investors pull out $106 billion last year, the most since 2009, after posting returns about half that of the S&P 500. Private equity's 8.5 percent gain net of fees surpasses hedge funds' 4.95 percent gain based on HFR's index over the same period.

Ironically, hedge funds also see value in the upswing in private equity. This week, fund manager Tiger Global bumped its passive stake in Apollo to 12.5 percent from a previously disclosed 7 percent, according to a filing.
M&A upswing? Not quite yet

Despite having plenty of capital to put to work, private equity firms have been muted when it comes to making acquisitions. Buyout activity fell in the first quarter to only 970 transactions, representing $53 billion, which was down from the 1,058 deals worth $89 billion during the previous quarter, according to Preqin data.

In some ways, this represents the double-edged sword of having so much capital in private equity. Plenty of managers are ready to deploy it, but as they chase assets, it can drive up prices, making them more expensive. Moreover, valuations in the public markets continue their upward climb.

As interest rates rise, however, private equity executives are hoping that the valuations will compress and they'll be able to become buyers again.
It was less than a year ago when Joe Baratta, Blackstone Group's top private equity dealmaker came out to publicly warn us that these are treacherous times for private equity.

Treacherous times for private equity? Sure doesn't look like it when you look at all the money these PE kingpins are raising in their new funds.  No wonder their publicly traded stocks have been on a tear in the last few months (click on image):


The truth is private equity funds have more money than they know what to do with. This isn't a bad thing (for them) as private equity firms typically charge a management fee on committed capital (the size of the entire fund) rather than called capital (the portion of the fund that has been "called" or collected from LPs by the GPs.

Typically fees are based on committed capital on the first 4-5 years. Once the investment period ends, they are calculated on invested capital.

You might think this is ludicrous but as Roberto Medri notes here, fees are computed on committed capital in the interest of aligning GP/LP incentives:
  • If fees were to be computed on called capital, GPs would have an incentive to invest too early at the expense of potential better deals later in the life of the fund
  • If on net invested capital (cost basis), GPs would have an incentive to invest early and exit late
  • If on committed capital, the fees are certain and don't depend on the timing of investments, which is clearly the best setup to focus on getting good deals. Committed capital is certainly the largest number to compute fees from, but you can just lower the fees percentage or come up with a declining fee structure, still independent from the timing of investments.
So why are big investors pumping billions into private equity at this time? I've already discussed some reasons. There is a major beta bubble going on in public markets and now that the next economic shoe is dropping and the Fed is considering to shrink its balance sheet, pensions, sovereign wealth funds, endowments, insurance companies and other large investors are all looking to prepare for the next downturn.

The article above states that as interest rates rise, private equity executives are hoping that the valuations will compress and they'll be able to become buyers again.

But what if rates don't rise? What if we have yet to see the secular lows on interest rates? What if a big deflationary tsunami strikes the global economy? Then what?

Well, if that happens, it will be a challenging time for all asset managers in public, private and hedge fund markets. If you're investing in private equity because you think rates are headed higher, you might be sorely disappointed.

But you can make a case that public market valuations are frothy and that there are better deals to be had in private markets. Still, the good old days where private equity offered a big fat juicy premium over public markets are over and no matter what happens next, you need to prepare for lower returns in all asset classes, public and private.

What about hedge funds? Jeff Cox of CNBC reports they saw their biggest inflows in 20 months in March even after badly trailing the market:
After flocking from hedge funds in 2016, investors are beginning to find their way back.

In fact, March saw money came back into the $3.1 trillion industry at the fastest pace since August 2015 — a 20-month span that saw fund managers adjust fees and make other concessions as clients fled.

The month saw inflows of a healthy $15.7 billion, capping off a first quarter in which a fresh $21.9 billion in cash came in, according to industry tracker eVestment.

That follows a dismal year that saw $106 billion in outflows, the worst since the financial crisis, according to eVestment's count.

The interest this year has come despite a period that was nothing special return-wise. The funds that eVestment track saw a 2.63 percent gain, well below the S&P 500's 6.1 percent move for the first quarter. March's jump in cash accompanied returns of just 0.33 percent.

Moreover, investors have been putting their money in the wrong places so far.

More than half this year's inflow — $11.46 billion — has gone to macro-based funds, which have rewarded clients with a measly 0.77 percent return so far. Managed futures have been the biggest laggard class, down 0.3 percent, while still attracting a healthy $6.47 trillion in new cash.

Equity has been the best strategy, with a return just shy of 4 percent, and has attracted $5.64 billion.

Analysts at eVestment figure that clients are going to macro strategies in anticipation of "market turbulence" ahead. The category actually saw net outflows of $9.8 billion in 2016 and just $1.3 billion in inflows for 2015.

During January and February, more than 70 percent of funds produced positive returns; in March the number dropped to 60 percent, but both figures were above the two-year average of 56 percent.

Over the past several years, large funds have performed best, though this year funds with less than $250 million in assets have led, gaining 2.76 percent.
Make no mistake, despite the inflows in March, these are still brutal times for hedge funds. John Burbank's $2.5 billion Passport Capital is shutting its long-short equity fund, which managed about $833 million. According to people familiar with the matter, assets at the firm have been shrinking on the back of underperformance and investor redemptions.

ValueAct's Jeff Ubben, one of the most-respected activist hedge fund managers out there, is returning $1.25 billion to his investors because he is concerned about the stock market's high valuation.

Yesterday, a friend of mine sent me a Bloomberg story that Guard Capital was shuttering its $885 million macro hedge fund. The fund run by former Goldman Sachs trader Leland Lim lost 5.1 percent in 2016, even after recovering from steep declines early in the year.

While equity hedge funds are posting their best start of the year since 2013, macro funds have been struggling and this includes hot new funds run by top traders. Rokos Capital Management, one of last year’s best-performing macro hedge funds, lost 4.7 percent in the first quarter as macro funds struggled.

Again, none of this surprises me as I mentioned earlier this week that even Goldman Sachs's trading revenues took a hit last quarter in these brutal markets.

Does it mean that macro hedge funds are screwed and equity hedge funds will continue to outperform? Not necessarily, a prolonged bear market could hammer equity hedge funds that have a lot of beta embedded in their portfolio.

Anyway, faced with high public market valuations, investors are concerned about the next downtrun and they are voting with their asset mix, shifting ever more assets to private equity and hedge funds.

I understand the reasons behind this move but given the high fees and lackluster performance, I'm skeptical if this will help them weather the storm ahead. The evidence at US state pensions investing in alternative strategies has been mixed so I would proceed with caution.

But judging by the inflows into private equity and even hedge funds, it seems like large investors are going to continue plowing billions into these alternative strategies, which tells me that returns going forward will necessarily come down and there will be more attrition and closures in the future.

Below,  Matei Zatreanu, System2 CEO, discusses how hedge funds are using big data investing, as well as potential challenges. More evidence of quant funds taking over the world.

Wednesday, April 19, 2017

Are State Pensions Failing to Deliver?

Rupert Hargreaves of ValueWalk reports, State Pension Funds Take On More Risk, Higher Fees For Worse Returns:
State and locally run retirement systems are increasingly turning to alternative and complex investments to help boost returns but these decisions may not be the best for all stakeholders involved, that’s according to a new report from The Pew Charitable Trusts.

The report, which is the latest in a series of reports from Pew on the topic, uses data from the 73 largest state-sponsored pension funds, which collectively have assets under management of over $2.8 trillion (about 95 percent of all state pension fund investments).

The use of alternative investment by pension funds varies widely across the industry. The use of alternative investments for the 73 largest public funds analyzed by Pew within its report varies from 0 to over 50% of fund portfolios. There are also vast differences in returns and returns reporting.

State Pension Funds Take On More Risk, Higher Fees For Worse Returns

For the 41 largest state funds that can be clearly compared against target returns—those reporting performance after accounting for management fees and on a fiscal year basis— the average annual target return in 2015 was 7.7 %. Actual annualized returns over ten years, however, averaged 6.6 % and ranged from 4.7 % to 8.1 % a year. Only one of the 41 (and two of all 73 funds) exceeded their target return in 2015.

At the same time, the majority of funds report on the basis of a fiscal year ending June 30 and include 10-year performance returns minus the fees paid to investment managers, although 12 funds report on a different period and more than a third provide ten year returns only “gross of fees.”

States also vary in whether they include performance-based fees for certain investments, known as carried interest, for private equity. States that disclose the cost of carried interest report higher fees than states that do not.

Over the past three decades, public pension funds have increasingly relied on more complex investments to reduce volatility and improve returns. A difference of just one percentage point in annual returns on the $3.6 trillion managed by the US pension industry equates to a $36 billion impact on pension assets.

However, while asset managers have been diversifying into assets such as real estate, hedge funds, and infrastructure in an attempt to reduce volatility and improve returns, Pew’s research shows US public pension plans’ exposure to financial market uncertainty has increased dramatically over the past 25 years. Between 1992 and 2015 the expected equity risk premium for public funds increased from less than 1% to more than 4%, as bond yields declined in the assumed rates of return remained relatively stable. What’s more, research shows that the asset allocation required to yield target returns today has more than twice as volatile as the allocations used 20 years ago as measured by the standard deviation of returns.

Given the fact that the majority of pension funds target a long-term return rate of 7% to 8%, with three only falling outside the range and given the current depressed interest rates available on fixed income securities, is easy to see why funds are investing in more complex instruments in an attempt to improve returns.

Indeed, Pew notes public pension funds more than doubled allocations to alternative investments between 2006 and 2014 with the average allocation rising from 11% of assets to 25% on assets. The higher expected return on these assets has allowed pension funds to keep return assumptions relatively constant.

But while managers have diversified in an attempt to improve returns, it seems exactly the opposite is happening. The shift to alternatives has coincided with a substantial increase in fees as well as uncertainty about future realized returns. State pension funds reported investment fees equal to approximately 0.34% of assets in 2014, up from an estimated 0.26% in 2006, which may seem like a small increase but in dollar terms, it equates to over $2 billion.

Pennsylvania’s state public pension funds are some of the highest fee payers in the industry with reported annual fees coming in at more than 0.8% of assets, or 0.9% when unreported carried interest for private equity is included. The dollar cost is $700 million per annum.

In total, the US state pension system paid $10 billion in fees during 2014 this figure includes unreported fees, such as unreported carried interest for private equity. Pew’s analysts estimate that these unreported fees could total over $4 billion annually on the $255 billion private equity assets held by state retirement systems.

Unfortunately, for all the additional risk being taken on, and fees being paid out, alternative investments and not helping state pension funds hit their return targets. 10-year total investment returns for the 41 funds Pew looked at reporting net of fees as of June 30, 2015, ranged from 4.7% to 8.1%, with an average yield of 6.6%. The average return target for these plans was 7.7%. Only one plan met or exceeded investment return targets over the ten-year period ending 2015.
You can click on the images below that accompanied this article:






Let me first thank Ken Akoundi of Investor DNA for bringing this report to my attention. For those of you who like keeping abreast on industry trends, I highly recommend you subscribe to Ken's daily emails with links to investment and pension news. All you need to do is register here.

You can go over the overview of The Pew Charitable Trusts report here and read the entire report here.

Take the time to read this report, it's excellent and very detailed in its analysis of state funds, highlighting key differences and interesting points on unreported fees and the success of shifting ever more assets into alternative investments like private equity, real estate and hedge funds.

A few things that struck me. First, it's clear that state pensions are paying billions in hidden fees and something needs to change in terms of reporting these fees:
Comprehensive fee disclosure in annual financial reports is still uncommon, but a few other states have also adopted the practice. The South Carolina Retirement System (SCRS) collects detailed information on portfolio company fees, other fund-level fees, and accrued carried interest in addition to details provided by external managers’ standard invoices. Likewise, the Missouri State Employees’ Retirement System (MOSERS) is particularly thorough in collecting and reporting these fees, not only by asset class but also for each external manager. Both states reported performance fees of over 2 percent of private equity assets for fiscal 2014 in addition to about 1 percent in invoiced management fees.

If the relative size of traditionally unreported investment costs demonstrated by CalPERS, MOSERS, and the SCRS holds true for public pension plans generally, unreported fees could total over $4 billion annually on the $255 billion in private equity assets held by state retirement systems. That’s more than 40 percent over currently reported total investment expenses, which topped $10 billion in 2014. Policymakers, stakeholders, and the public need full disclosure on investment performance and fees to ensure that risks, returns, and costs are balanced to meet funds’ policy goals. Such assessments are unlikely when billions of dollars in fees are not reported.
I totally agree with that last part, we need a lot more fee transparency on all fees paid by asset class and each external manager. In fact, there should be a detailed breakdown of fees paid to brokers, advisors, lawyers, and pretty much all service providers at any public pension plan.

Moreover, it's completely ridiculous that more than a third of state pensions only provide ten-year returns "gross of fees". All public pensions should report all their returns net of all fees and costs because that represents the true cost of managing these assets.

Worse still, if you look at the state pensions that do report their ten-year returns gross of fees, you will see some well-known US pensions like CalSTRS and Mass PRIM (click on image):


It makes you wonder whether they have the appropriate systems to monitor all fees and costs or they are deliberately withholding this information because net of fees, the returns are a lot less over a ten-year period.

The Pew report also highlights mixed results among state pensions in terms of returns following a shift to alternative investment strategies:
Although no clear relationship exists between the use of alternatives and total fund performance, there are examples of top-performing funds with long-standing alternative investment programs. Conversely, funds with recent and rapid entries into alternative markets—including significant allocations to hedge funds—were among those with the weakest 10-year yields.
Among the funds with successful long-standing alternative investment programs, the report cites the Washington Department of Retirement Systems (WDRS):
For example, the Washington Department of Retirement Systems (WDRS) is among the highest-performing public funds and has had a private equities program since 1981, making it one of the earliest adopters of alternative investments. In 2014, the WDRS had 36.3 percent of total investments in alternative asset classes, including 22.3 percent in private equity, 12.4 percent in real estate, and 1.6 percent in other alternatives. Hedge funds were notably absent from the mix. The fund’s long-term experience with the complexities of alternatives is reflected in its performance metrics: The WDRS has one of the highest 10-year returns of plans examined here, at 7.6 percent in 2015, buoyed in large part by the performance of its private equity and real estate holdings.
Now, a few points here. Notice that almost all of the alternative investments at WDRS are in private equity (22.3%) and real estate (12.4%) and more importantly, they were early adopters of such investments and have relationships that go back decades? This means they really know their funds well and likely also do a lot of co-investments with their GPs (general partners or funds they invest in) to lower their overall fees.

Another success in shifting into alternatives was South Dakota's Retirement System:
Similarly, the South Dakota Retirement System began its private equity and real estate programs in the mid-1990s and realized 10-year returns of over 8 percent in 2015. The fund held nearly 25 percent of assets in alternative investments in 2014, but lowered this to less than 20 percent in 2015, comparable to the 18.3 percent held in alternatives in 2006. The 2015 allocation includes over 10 percent in real estate, 8 percent in private equity, and 1 percent in hedge funds. The fund reports net since inception internal rates of return of 9 percent for private equity and 21.4 percent for real estate, in comparison to the S&P 500 index of 5.8 percent for the same period.
But most state plans have struggled shifting assets into alternatives:
Conversely, plans with more recent shifts into alternatives—especially those with significant investment in hedge funds—are among those that exhibit the lowest returns. For example, the three funds with the weakest 10-year performance among net fiscal year reporters—the Indiana Public Retirement System, the South Carolina Retirement System, and the Arizona Public Safety Personnel Retirement System—are also among the half dozen funds with the largest recent shifts to alternative investments. All three have increased their allocations to alternatives by more than 30 percentage points since 2006. Significantly, these funds also have hedge fund allocations above the median fund, and all three rank in the top quartile for reported fees.

For example, in contrast with the WDRS and South Dakota’s early diversification, South Carolina shifted into alternatives precipitously in 2007 when the state enacted legislation to establish a new retirement system investment commission and provide the needed statutory authority to invest in high-yield, diversified nontraditional assets. Within a year, over 31 percent of plan assets were invested in alternatives, and by 2014 those assets made up nearly 40 percent of the fund’s total.

As detailed in an independent audit, rapid diversification into alternative investments proved difficult for a newly founded, under-resourced investment commission: The South Carolina Retirement System’s 10-year return of only 5 percent in 2015 is among the lowest of the plans studied. Given the long-term, illiquid nature of these investments, correcting misjudgments or realigning investments made quickly during the commission’s first years may prove challenging.
Ah yes, I remember when South Carolina was going to throw in the towel on alts. Instead, it kept on going, praying for an alternatives miracle just like North Carolina.

But there are no miracles in alternative assets, just more complexity and higher fees and if not done properly, it's a total disaster for the plan and its stakeholders.

The report also notes that many states have consistently achieved relatively high returns without a heavy reliance on alternatives:
The Oklahoma Teachers Retirement System (OTRS) stands out in terms of performance among state-sponsored pension funds. It ranked near the top percentile of all public funds in the United States with a 10-year return of 8.3 percent gross of fees in 2015. The OTRS holds 17 percent of its assets in alternatives—below the fund average of 25 percent—with the bulk of its investments in public equities (62 percent) and fixed income (20 percent). Diversifying within the equity portfolio, employing low-fee strategies, and cutting operating costs are explicitly part of the fund’s overall strategy.

The Oklahoma Public Employees Retirement System (OPERS) takes this approach even further, with 70.2 percent of its investments in equity and 29.5 percent in fixed income. The fund holds no alternative investments. OPERS’ investment philosophy is guided by the belief that a pension fund has the longest of investment horizons and, therefore, focuses on factors that affect long-term results. These factors include diversification within and across asset classes as the most effective tool for controlling risk, as well as the use of passive investment management. Still, the fund does employ active investment strategies in less efficient markets (click on image).


The report also highlighted the need for greater standardized reporting to increase transparency:
Public retirement systems’ financial reports are guided by GASB standards, in addition to those of the Government Finance Officers Association (GFOA) and the CFA Institute. Collectively, these guidelines are widely recognized as the minimum standards for responsible accounting and financial reporting practices. For example, both GASB and the CFA Institute require a minimum of 10 years of annual performance reporting; the CFA suggests that plans present more than 10 years of data. The GFOA recommends reporting annualized returns for the preceding 3- and 5-year periods as well.

However, funds apply these standards differently. And because the performance and costs of managing pension investments can significantly affect the long-term costs of providing retirement benefits to public workers, boosting transparency is essential.

In a recent brief on state pension investment reporting, Pew reviewed the disclosure practices of plans across the 50 states and highlighted the need for greater and more consistent transparency on alternative investments. State funds paid more than $10 billion in fees and investment expenses in 2014, their largest expenditure and one that has increased by about 30 percent over the past decade as allocation to alternatives has grown.

However, over one-third of the funds in the study report 10-year performance results before deducting the cost of investment management—referred to as “gross of fees reporting.”
But the biggest problem of all at most US state pensions is they're delusional, stubbornly clinging on to their pension rate-of-return fantasy which will never materialize. They do this to keep contributions low to make their members and state governments happy but sooner or later, the chicken will come home to roost, and that's when we all need to worry.

The other problem and I keep referring to this on my blog, is lack of proper governance, which effectively means there is way too much political interference at state pensions, making it extremely hard for them to attract and retain qualified candidates that can manage public, private and hedge fund assets internally, significantly lowering costs of running these state pensions (basically the much touted Canadian pension model).

There are powerful vested interests (ie. extremely wealthy, politically connected private equity and hedge fund managers) who want to maintain the status quo primarily because they are the main beneficiaries of this US pension model which increasingly relies on external managers to attain an unattainable bogey.

But after reading this report, you need to ask some hard questions as to whether this shift into alternatives, especially hedge funds, has benefitted US state pensions net of all the billions in fees being doled out.

"Ok Leo, but what's the alternative? You yourself have pointed out there is a major beta bubble going on in markets and now that the next economic shoe is dropping and the Fed is considering to shrink its balance sheet, what are these state pensions suppose to do?"

Good question. First, every investor needs a reality check and to prepare for lower returns ahead. Second, if deflation is coming, it will decimate all pensions, especially chronically underfunded pensions. They need to mitigate downside risks as much as possible and in a deflationary environment, the truth is only good old US long bonds (TLT) are the ultimate diversifier.

But bond yields are low and headed lower, which effectively means pensions need to diversify and take intelligent risks to make their required rate-of-return. Here is where it gets tricky. There are intelligent ways to take on more risk while reducing overall volatility of your funded status (think HOOPP, Ontario Teachers' and other large Canadian public pensions) and dumb ways to increase your risk which will only make your general partners very wealthy but not benefit your plan's funded status in a significant and positive way (think of most US state pensions).

My only gripe with The Pew Charitable Trusts report is it doesn't focus on funded status to tie in all other information they present in the report. Pensions are all about managing assets and liabilities and it would have made the report a lot better if they focused first and foremost on funded status of each state pension, not just returns and fees.

Still, take the time to read the entire report and you have to only hope that one day Pew will do the same report for Canada's large public pensions and compare the results to their US counterparts.

Below, Chris Retzler, Needham Growth Fund, explains why he thinks we are still in a bull market as the market growth trajectory not over. And CNBC's Bob Pisani takes a closer look at the market's malaise.

We shall see if "sell in May and go away" applies this year but one thing is for sure, challenging markets and lower yields suggest a lot of chronically underfunded US pensions are in for a very tough time ahead. Now more than ever, we need to really understand what's going on at these state pensions.


Tuesday, April 18, 2017

Beware of QE Sheep?

Gerard MacDonell of the Beinn Bhiorach blog posted a nice comment, Fed Vice Chair Fischer on QE (added emphasis is mine):
He says that balance sheet contraction will be no big deal. QE itself was a big deal (very stimulative), but it's going away will be pretty much irrelevant. It is asymmetrical that way, as magical things are. And we all know QE works mostly through magic. Bernanke covers his tracks, just like our lord and savior does.

Fischer is particularly clear that the balance sheet contraction will not be so bad as the taper tantrum, which is pretty hilarious. During the tantrum, the forward stock of assets on the Fed’s balance sheet was actually rising, because Fed signaling was reducing the expected pace of ultimate asset sales to greater effect than it was dragging forward the date of the slowdown of purchases Hardly anybody mentions this because it wrecks the whole QE / tantrum story, which is aloof from any need for — you know — evidence.

But Ben Bernanke alluded obliquely to this when he said, correctly, that the taper tantrum was not about the size of the balance sheet. It was instead about the Fed being clear that it had turned hawkish and markets drawing an inference for the path of RATES. Not that things are so because Bernanke says they are, but I find it piquant that a big advocate for QE, like Bernanke, would so readily surrender such an important pro-QE argument. Good for him! Objective, if only safely in hindsight.

Again, this is not something mentioned in polite company. And now here comes Fischer to assure us that the tantrum will not happen again. The balance sheet contracting will have much less effect than its forward size slowing its rate of assent.

How could that possibly be? Umm, because the balance sheet never mattered much. But the willingness of academia, Wall Street and the media to swallow uncritically anything the Fed says is a sight to behold. I betcha few will even note any logical inconsistency in what Fischer says, although I would bet his most recent assertion is the right one.

That some of this crew would also believe in the supposed heroic skepticism and independent thinking of the so-called bond vigilante is richer still. Not so much mounted gun slingers as sheep. Baaaah Baaaah.
Apart from a few typos, this is a great comment. When Gerard focuses on macro and less on Trump, I love reading his views.

Is Stanley Fischer right about the balance sheet contraction? Of course not. Go utter such nonsense to Ray Dalio or George Soros and they will either laugh at you or rip you apart.

Balance sheet contraction at a time when the next economic shoe is dropping isn't exactly bullish for risk assets.

This is a tough environment to make money. Very tough. Just just ask Goldman Sachs:
In a statement, Goldman Sachs Chairman and CEO Lloyd Blankfein called the quarter "mixed" and that client activity was "challenged."

Unlike its competitors, Goldman's trading desks struggled in the first quarter. The bank's trading division had net revenue of $3.36 billion in the first quarter, down 2 percent from a year earlier and down 7 percent from the fourth quarter. Trading revenues in bonds, currencies and commodities was effectively flat in quarter while trading revenues for stocks were down 6 percent from a year earlier.

The hit to Goldman's trading in the first quarter is a rare misstep for a bank known to have some of the best traders on Wall Street. JPMorgan Chase, Citigroup and Bank of America's trading divisions all reported increases in trading last quarter.
Oh well, the good news is that the Fed's balance sheet contraction won't be a big deal.

Yeah right, if you believe that nonsense, you deserve to have your head handed to you.

As I stated in my last comment on the next economic shoe dropping,:
[...] early in the second quarter, high beta stocks are losing momentum and selling off. It's too early to tell whether we are in the early stages of a Risk-Off market but I still maintain that if you want to sleep well, buy US long bonds (TLT) and thank me later this year. In this deflationary environment, bonds remain the ultimate diversifier.
As far as QE sheep telling you that the Fed's balance sheet contraction is benign, ignore them and while you're at it, ignore all those bond bears and inflationistas telling you that rates are going to skyrocket. The reflation trade is doomed and those that think otherwise will get crushed.

Below, Federal Reserve Vice Chairman Stanley Fischer said he doesn’t see a replay of the so-called taper tantrum of 2013 as the central bank rolls out its plan for reducing its big balance sheet.

Remember the golden rule from my old friend, the combative economist at McGill: "Don’t believe anything until it’s officially denied." I would keep it even simpler, question everything, period.

Monday, April 17, 2017

Is The Next Economic Shoe Dropping?

Martin Crutsinger of the Associated Press reports, Consumer prices down 0.3 percent in March:
Consumer prices fell in March by the largest amount in more than two years, pushed lower by another sharp decline in the price of gasoline and other energy products.

Consumer prices dropped 0.3 percent in March following a tiny 0.1 percent rise in February, the Labor Department reported Friday. It was the first monthly decline in 13 months and the biggest drop since prices fell 0.6 percent in January 2015. In addition to a big 6.2 percent fall in gasoline prices, the cost of cell phone plans, new and used cars and clothing were all lower last month.

Core inflation, which excludes volatile food and energy, dropped 0.1 percent last month. Over the past 12 months, inflation is up a moderate 2.4 percent while core prices have risen 2 percent.

The Federal Reserve seeks to manage the economy to produce annual increases in inflation around 2 percent. But since the 2007-2009 recession, the worst downturn in seven decades, inflation for a number of years lagged below the 2 percent level, raising concerns that the economy could be in danger of toppling into a destabilizing period of falling prices, something not seen in America since the 1930s.

However, with steady gains in employment and a jobless rate now down to 4.5 percent, the lowest in nearly a decade, and energy prices rebounding, inflation is beginning to rise. The Fed last month boosted a key interest rate for the second time in three months and has projected two more rate hikes this year. Three rate hikes this year compare to single rate hikes in each of the past two years. The Fed uses higher interest rates to keep inflation under control.

Ian Shepherdson, chief economist at Pantheon Macroeconomics, said that the drop in prices in March could have been influenced by problems the government had in adjusting for Easter sales. He said if there were more of a slowdown in inflation in April that could force the Fed to change its plans for future rate hikes.

"Another month like March and a June rate hike will become less likely," he said in a research note.

For March, energy prices dropped 3.2 percent, led by the big 6.2 percent plunge in gasoline prices. Even with the decline, gasoline prices are 19.9 percent higher than a year ago.

Food costs edged up 0.3 percent last month but remain only 0.5 percent higher than a year ago.

Outside of energy and food, the prices of car insurance, medical care and airline fares were all up in March.
Friday was a big day for US economic data. Zero Hedge did a decent job covering a lot of the releases. First, it noted, "Reflation" Is Officially Dead: Core CPI Tumbles For The First Time In Over Seven Years, going over some charts and noting this:
The biggest driver for the headline plunge was energy, which declined 3.2%, with the gasoline index falling 6.2%, and other major energy component indexes decreasing as well. The food index rose 0.3 percent, with the index for food at home increasing 0.5% its largest increase since May 2014.

But the real story was in the core number because CPI ex-food and energy dropped -0.1%, another huge miss to the +0.2% rise expected, and also the first - and worst - decline since January 2010 (click on image):

Among the core components, the shelter index rose 0.1 percent, and the indexes for motor vehicle insurance, medical care, tobacco, airline fares, and alcoholic beverages also increased in March. These increases were offset by declines in several indexes, including those for wireless telephone services, used cars and trucks, new vehicles, and apparel.

More details from the report that will likely assure that Yellen will not be hiking rates for a long time:
The index for all items less food and energy declined 0.1 percent in March. The index for communication fell 3.5 percent as the index for wireless telephone services decreased 7.0 percent, the largest 1-month decline in the history of the index. The index for used cars and trucks continued to fall, declining 0.9 percent in March, and the new vehicles index decreased 0.3 percent. The apparel index declined 0.7 percent in March after rising 0.6 percent in February.

The shelter index rose 0.1 percent in March, its smallest increase since June 2014. The rent index rose 0.3 percent and the index for owners' equivalent rent advanced 0.2 percent, but the index for lodging away from home fell 2.4 percent. The medical care index increased 0.1 percent in March, as the index for hospital services rose 0.4 percent, the index for prescription drugs was unchanged, and the physicians' services index declined 0.3 percent.

The index for motor vehicle insurance continued to rise, increasing 1.2 percent in March. The index for tobacco rose 0.5 percent, the airline fares index increased 0.4 percent, and the index for alcoholic beverages rose 0.2 percent. The indexes for recreation, for education, and for household furnishings and operations were unchanged in March.
Even Shelter inflation is now rolling over (click on image):

What else was released on Friday? Again Zero Hedge reports, retail sales declined for a second straight month as real earnings declined:
For the second month in a row, retail sales declined in March as 'hard' data fails to live up to 'soft' data's hype. This is the biggest 2-month tumble in retail sales in over 2 years (click on image).


The full breakdown shows the biggest declines in building materials and motor vehicles (click on image).


This drop in sales should not be a total surprise as real average weekly earnings have now failed to rise for 3 straight months (click on image).

Two more 'hard' data series to add to the list that dismiss the hope embedded in all the soft survey data... but we are sure stocks know better.
Indeed, as shown in the chart below, there is a disconnect between soft survey data and real economic data (click  on image):


What else happened on Friday? Again, from Zero Hedge, the Atlanta Fed slashed its Q1 GDP forecast to 0.5%, the lowest in three years:
Just over two months ago, the Atlanta Fed "calculated" that Q1 GDP was going to be a pleasant 3.4%, confirming that the Fed had made the correct decision by hiking not only in December, but also last month. Since then, the Fed's own GDP estimate has crashed in almost linear fashion, and as of this morning - after the latest disappointing retail sales report - it had plunged to just 0.5%, which if accurate would make Q1 the weakest quarter going back three years to Q1 2014 (click on image).

From the regional Fed:
The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2017 is 0.5 percent on April 14, down from 0.6 percent on April 7. The forecast for first-quarter real consumer spending growth fell from 0.6 percent to 0.3 percent after this morning's retail sales report from the U.S. Census Bureau and the Consumer Price Index release from the U.S. Bureau of Labor Statistics.
Putting the Atlanta Fed's forecast in context, a 0.5% GDP would mark the weakest quarter in 37 years, or going back to 1980, in which the Fed hiked rates. Then again, considering today's abysmal CPI and retail sales data, the narrative to focus on next is not so much hiking, or balance sheet normalization, but when the Fed will resume easing, cut rates (as per Donald Trump's recent suggestion) and/or launch QE4.
No doubt, all this talk of the Fed hiking rates aggressively following the election of Donald Trump was premature. The Fed is data dependent and in my opinion, its number one concern remains global deflation spilling over into the United States.

Go back to read my comment on why the reflation trade is doomed where I give you a global snapshot of why deflation remains a serious concern for monetary authorities.

Not surprisingly, after dismal economic data putting in question whether the Fed will continue hiking rates, the US dollar took a tumble, especially relative to the yen where it stands at a 5-month low:
More indications that the US economy is not doing anything like as well as the soft survey data would suggest has sparked a fresh round of selling in USDJPY...(click on image):


Sending the yen to its strongest since just after the Trump election (click on image)

Against a basket of broader currencies, the US Dollar Index (DXY) has been losing steam since the beginning of the year (click on image):


Of course, every time there is weak US economic data making it less likely the Fed will hike rates, the US dollar declines and the dollar bears come out to growl. But as I explained in my comment on the greenback back in March, most of the recent decline in the US dollar can be explained by lopsided positioning as speculators were massively long the dollar following the election of Donald Trump.

From a macro perspective, the decline in the US dollar eases US financial conditions and acts like a cut in rates. The same goes for any country, a rise in its currency acts like a rate hike, a decline like a decline in rates.

What else? A decline in the currency raises import prices and stokes inflation expectations higher but conversely, an appreciating currency lowers import prices and pipeline inflation pressures. For small open economies, the effects are much larger.

Why am I sharing all this with you? It's critically important to understand currency dynamics in a deflationary world where rates are near record lows. This is where global inflation and deflation pressures play out and I would be very careful interpreting short-term trends in the US dollar here.

Why? Because as I keep telling you, the US economy leads the global economy by six months. So, even if in the short-term, the US dollar takes a hit, as currencies appreciate relative to the dollar, it tightens financial conditions in countries outside the US, many of which export to the US.

In other words, I don't buy the story that the greenback is set for a major decline. I would be using this selloff in the first half of the year to add to US dollar positions and keep in mind that as US data rolls over, global data will roll over too and real rate differentials will once again favor the US dollar. And if a crisis occurs later this year, global investors will run to the safety of US Treasuries and the US dollar.

If you look at the weekly chart of the US dollar ETF (UUP), you'll see despite the recent selloff, the greenback's ETF is still up since July 2015 and it will be interesting to see if it dips below its 50-week moving average and moves back up or bounces off it (click on image):


If the US dollar rebounds in the second half of the year, we can get that dollar crisis I warned of late last year, but it seems like the Trump Administration is well aware of this risk and trying to limit the odds of this outcome, talking down the dollar lately.

We shall see how it plays out but be careful reading too much into the US dollar's recent selloff, in my opinion, it's a temporary move due to bullish speculative positioning at the start of the year.

As far as stocks are concerned, given my views on the reflation trade being doomed, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE)  and Financial (XLF) shares on any strength here (book your profits while you still can). The only sector I trade, and it's very volatile, is biotech (XBI) but technology (XLK) is also doing well, for now.

Still, early in the second quarter, high beta stocks are losing momentum and selling off. It's too early to tell whether we are in the early stages of a Risk-Off market but I still maintain that if you want to sleep well, buy US long bonds (TLT) and thank me later this year. In this deflationary environment, bonds remain the ultimate diversifier.

Hope you enjoyed this comment and I remind all of you to kindly donate or subscribe to this blog on the top right-hand side under my picture.

Also, the point of my macro comments is to make you think critically of what's going on out there and support you in your investment decisions. I don't proclaim to have a monopoly of wisdom on markets and the global economy, but I want to educate people on how to understand the bigger picture and think a lot more critically when interpreting economic and financial data.

Below, CNBC's Steve Liesman takes a look at the disconnect between hard and soft economic data. And Rodrigo Catril, currency strategist at NAB, says markets are caught up in the US President's comments on lower interest rates.