By Team IntuitEcon
IntuitEcon will be posting weekly updates on our subscribers only page every week until the Brain Trust gets into a rhythm of Synthesized Learning. We will move these to our public blog after one month. Let us know what you think!
The CPI in June topped estimates rising 0.9% and 5.4% year over year. Much of the rise is not attributable to more volatile food and energy prices as core CPI rose 4.5% from June 2020. This was the largest advance since November 1991 and is putting some pressure on the Fed to address growing inflation concerns. Inflation has well known direct consequences for consumers through erosion of purchasing power, but may also have important implications for banks and financial institutions. A rise in inflation could create more volatility from uncertainty in discount rates used to price financial assets generally … as we discuss in our weekly market focus.
Unemployment benefit applications continued to decline last week to 360,000. The continued decline suggest a continued recovery, but may also be driven by a reduction in enhanced pandemic programs. Despite higher than expected inflation and and a strong recovery … treasury yields remain near their lows of 1.3% since peaking in late March at 1.72%. Gold appears to have benefited from this rally in bonds. Interest on bonds is viewed by some analysts as the "opportunity cost" of holding precious metals which some view as a useful hedge against inflation. Ten year breakeven inflation expectations rose the past week 2.22% to about 2.35% yesterday. That's above the Fed long term traditional target of 2%, but well below the 2.54% high in May.
We did a little tax loss harvesting this week...selling some Organovo $ONVO and buying some silver mining companies $SILJ. The reasons for picking ONVO had more to do with it falling further than some of our other holding than anything about the company itself. This was more of a tax play than anything and we wanted to buy more silver to increase our hedge against the potential for a shift in correlation regimes and the fundamentals reasons we expressed on Twitter last year (link).
The correlation between S&P 500 stocks and 10 year treasury bonds increased rapidly in 2021. From mid-2020 to the end of May the 65 day rolling correlation jumped from around negative 0.5 to positive 0.4. That high level of positive correlation just barely surpassed priors high since 2000. The average yearlong correlation since 2008 has been around negative 0.2 to negative 0.65. Taking a longer view, the correlation between stocks and bonds over the past century has been much higher than the past decade. From 1926 to 1945 the ten year forward correlation was around a positive 0.2 … fell to a then record low of negative 0.2 in 1956 … then rose to around a positive 0.35 to 0.5 from 1960 to 1990 before falling to what have been unprecedentedly low levels.
While we don’t have many decades of data to evaluate … there do appear to be correlation regimes that relate stocks and bonds. Some of our internal research suggests that these regimes extend to risky vs non-risky assets more broadly such as corporate bonds. One theory to explain the driving force behind these correlation regimes is the impact of inflation. All cash generating financial assets can be valued by discounting future cash flows. It is customary to do this by adding a risk premium to benchmark rates (i.e. sovereign bond yields). During periods of low and stable inflation the volatility in these benchmark rates is muted and so price movements in financial assets are largely determined by their own unique fundamentals. Stocks are driven by earning s. Corporate bonds are driven by credit factors. But all financial assets are tied to benchmark rates, so when these rates become less predictable then correlations between financial assets rise.
Regardless of the cause of higher correlation regimes…a reversion to the historical mean should be considered. Financial institutions rely heavily on correlation assumptions when managing their portfolios. Banks with significant broker dealer operations can exposed to hedge funds, pension funds, and insurance companies that rely on the same types of assumptions. Capital rules embed assumptions about correlation benefits. Some of these are calibrated to the current regime of lower negative correlations. We may remain in an exceedingly low correlation regime for years to come, but it’s worth considering the implications of higher correlations because of the implications for banks, and similarities between today and prior periods of regime change.
So what to do?
Correlation regimes are slow to play out. The last time markets went through something like that was in 1965 ... and it took a few years before the rise in inflation led to a broad fall in asset prices. Our short term outlook hasn't changed. Our main thesis is the #2ndTechBubble and that isn't likely to be disrupted by a correlation regime change that will likely take years to impact market psychology. Disruptive innovation stocks were crushed this year out of an interest rates narrative that has very little impact on securities with such high risk premiums. If anything we see companies like 3D Printing, Genomics and the Education Revolution stocks in our portfolio as a safe haven against these broader macro risks.
But if we are headed for a Correlation Regime change, as we very well could be, having Silver and Gold in the portfolio provide valuable diversification. Especially Silver ... and that is why we bought more of it. That and it is one of the most positive skew bets one can make on electrification as we explain here (link).
Bernard and Team IntuitEcon
We will publish our first Machine Learning Weekly tomorrow, and discussing it along with our market update on Sunday. If you are a subscriber, don't forget to submit questions and join the conversation! Zoom link will be sent out at 6pm EST. Recording starts promptly at 7pm.
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