Friday 27 May 2016

Corp profit margins getting squeezed from here

Due to the political dynamics in the US (i.e. against recessions, asset market crises, pro growth, pro full employment etc.), although it appears to me the Fed wants to get rates to about 1%, I think the pace is slow and they will be very reluctant to go much beyond that for fear of triggering a recession.

In my opinion Trump will engage in infrastructure projects to inject some demand into the blue collar labour markets. If wages outpace nominal GDP by even 50bps a year you have a progressive compression in economy wide profit margins in favour of labour, reversing what has happened in the last 20 years due to a combination of outsourcing and debt supported aggregate demand. US corp profits have to fall about 40% before this rebalancing is done.

Many listed companies wont have this pricing power, by definition, and profit margin compression is likely to cause an ongoing de-rating of the equity market - there are overall headwinds to investing in US shares, while Draghi is still at the stage of inflating the asset prices.

You can see here the top is in already for US corp margins:

From here this rebalancing towards labour and away from the financial system and capital is more or less unavoidable whether its inflation or a recession delivering it and most of the actors are strongly biased towards inflation. 

Thursday 26 May 2016

Minimum wage luddites?

When I was a child I heard about the Luddites. The were a group of angry workers who smashed machines because machines 'destroyed jobs'. How ridiculous, machines increase productivity. Yet today as machines replace min wage workers, these same complaints are raised, even on the likes of zerohedge.

Its certainly true that other jobs will need to be created for these people to find work, which comes back to my Trumponomics infrastructure call.

I once asked a Finnish friend how Finnish companies worked with the high labour costs. His simple answer was you need high value businesses and high productivity. Ie pushing up a minimum wage forces up productivity and forces businesses to invest in value adding investments.

Max Keiser used to talk about the 'gulag debt serfdom' of workers in the current economic model. Pushing up min wages to the point where you can live off them is a key driver of my view that from here we have inflation and that from an economic sectoral balance perspective the cycle tilts in favour of labour and away from capital and financial instruments.

Monday 23 May 2016

What are machine learning hedge fund strategies?

There is a lot of resources being poured into machine learning strategies in the hedge fund industry. So what are machine learning based strategies?

Put simply AI/ neutral networks/ pattern recognition/ machine learning are all part of the same group of quantitative research processes. They are one part of the research process that leads to the actual trading strategy.

Most active investment strategies are based around a formal strategy, which aims to identify mispriced securities or to out trade other traders. The problem is how do you know you have the best strategy? I how do you know you have specified the strategy best?

Older quant strategies often started with a thesis, such as trading around directors dealings or earnings. The quant would research it on a semi quant/ semi discretionary basis, and if they believed they had an inefficiency that was exploitable, build a model to capture it.

The problem is, how do you know you have built the best model?

Simple, ask a computer to run as many combinations of the parameters that could describe the situation as possible and come up with clusters of similar situations/ trades and then build models around those optimal trades. This often leads to thousands of discrete models across multiple trading strategies. Take Directors dealing for example, some Directors may have a better track record than others, buying vs selling may offer different information, preceding earnings/ share price behaviour may have information in it, the job title of the director may have different information. Once you ask the computer to look down as far as the contextual track record of individual directors across thousands of stocks over 20 years of history, apart from the huge computing power need, you end up with thousands or tens of thousands of individual computer models.

These individual models aim to better capture the inefficiencies than one or a few models that are applied across all stocks and time frames. Ie you are going from a blunt one size sits all series of quant models to many discrete, tailored models. The ultimate objective being to capture the inefficiencies better than the next guy, whether he is a quant or not.

Trumponomics - what might it look like?

With Americans likely facing a Trump/ Hillary election and Americans having an almost perfect track record of electing the personable, charismatic candidate over the awkward, DC insider, Ivy leaguers, looks to me like Trump will be in the White House in January.

What might the economic/ market impact of his presidency be?

These are just my musings.

The US is in a debt trap with debt growing ~3x faster than GDP. To effect even greater negative real rates Trump needs inflation. For inflation you need labour demand. Ipso facto Trump will monetise a 'people's QE' focused on infrastructure. This could be as simple as directing the Fed to exchange Treasuries for new infrastructure loans without increasing the size of the Fed's balance sheet.

With negative real rates rising due to wages outpacing GDP growth, corporate profit margins will be squeezed to below long run averages, which means maybe a 40% fall in economy wide margins from here. This will see domestic stocks which lack pricing power trading near book value while within the indices the money will go into real assets and growth names.

The US 10yr Treasury has got to have a chance to seeing over a 3% yield by year end and higher later assuming this tightening doesn't trigger a recession.

The Dow went sideways for 16 years from the late '60s to the early '80s, when Volker killed inflation. Over this time span inflation eroded 90% of the USD's purchasing power. I think we are in the process of entering a 10-20 year inflation cycle after a three decade credit expansion.

Gold was pushed up by commodity index demand into 2011 and pushed down on the subsequent unwind, despite not being an industrial commodity. Gold also had a 45% price correction in the middle of the 1970's bull market. I think $2000 plus gold is a near term target and $10k medium term.

Emerging markets are going through a rebalancing process with weaker FX, terms of trade shock, commodities bottoming and political changes in many countries as reformists are elected. Emerging Markets should begin a new investment and reform-led credit cycle this year. But not all EM's are equal and there is no long run direct connection between equity returns and GDP growth.

Like with any new cycle the winners of the new cycle are unlikely to be the same winners as from the last cycle. As such; smart phones, FANG's, biotech etc look stretched and anything related to EM, commodity, real assets might end up looking cheap at these levels.