In Brief

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Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

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Today, I’m writing about Howard Marks’ most recent memo, which you can find here: Oaktree Capital – Something of Value.

Major bonus: I sent my note to Mr. Marks as a courtesy in case he had any feedback (because he is a legend and I’m scared of authority figures). He was kind enough to get back to me. He didn’t just reply with a one-line email, he gave me almost an hour of his time. So herein, I combine the original piece I wrote with my notes from a 60-minute phone call with Howard Marks. Enjoy!

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Howard Marks has been a great investor and one of the best finance writers in the business for decades. He has been writing must-read investor letters since I was in high school. His latest memo “Something of Value” contains much insight, particularly about why traditional value investing is likely permanently impaired as a strategy and why Growth vs. Value is a false dichotomy.

The Marks letter spans 18 pages so my piece today will scratch the surface. If you have time, go read the memo from Howard Marks first, then come back.

Here is my quick review + summary + partial rebuttal + phone interview excerpts. Just so it’s clear: the indented quotes are from the memo and the left justified, larger font quotes are from our phone call.

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Howard Marks on value and efficient markets

With unlimited computing power widely available to most investors in the world, stocks that are cheap on simple metrics like price/earnings etc. are probably cheap for a reason. Unlike pre-internet, when you had to scour annual reports in a library to find company metrics, everyone now has access to detailed company financials. If you want to be a value investor, more imagination is required than simply running a P/E or P/S screener on Yahoo! and buying whatever pops out.

In ye olden days, it was hard to get timely and accurate corporate information and so simply buying cheap things worked because not everyone knew what was cheap. There is no reason to think that should work going forward.

Here is the key quote from Marks’ note:

In the past, bargains could be available for the picking, based on readily observable data and basic analysis. Today it seems foolish to think that such things could be found with any level of frequency. If something about a company can be easily read in an annual report, or readily discovered by a mathematically competent analyst or computer, it stands to reason that, in most cases, this should already be appreciated by the marketplace and incorporated in the prices of the company’s securities. That’s the essence of the Efficient Markets Hypothesis.

Thus, in the world we live in today, investing on the basis of rote formulas and readily available fundamental, quantitative metrics should not be particularly profitable. (This is not necessarily true during market downturns and panics, when selling pressure can cause prices to decouple from fundamentals).

That last sentence is the key—and it should also be stated in reverse. That is: growth can also outperform value during manias and bubbles as buying pressure can cause prices to decouple from fundamentals.

Essentially what this all comes down to is that markets are mostly efficient but efficiency breaks down at times due to behavioral factors. Markets defy EMH and decouple most aggressively from fundamentals during manias and crashes. Despite the wide availability of home computers and financial data, for example, value still outperformed from 2000 to 2007 as the NASDAQ bubble unwound and mean reversion following the dotcom mania (and crash) eventually brought things back into balance.

Value and growth cycle back and forth… Each time value underperforms (like now), prognosticators find a new explanation for why that might be permanent, not cyclical. If anything, though, what stands out to me is that the ratio of the growth and value indices looks to oscillate fairly consistently around 1.00.

I initially read the memo as a bit of an assertion that “value is dead”, but that’s not right. Marks explained to me on the phone that that is not what he meant.

“Market inefficiency is mostly cyclical now. In the past it was structural.”

What he meant was that structural inefficiencies that once existed are gone and will never come back. Pre-internet, there was alpha sitting around all over the place. Anyone with a calculator, a basic understanding of DCF, and a strong work ethic could scoop up that alpha because markets were structurally inefficient. Now, markets are structurally efficient and veer into inefficiency only during cyclical periods of extreme emotion. You either need to use a behavioral approach, or you need to understand the companies, industries, and technologies way better than anyone else. That level of understanding requires a much deeper knowledge than one can glean by scrolling through publicly-available data.

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Howard Marks on growth

The memo avoids declaring a new paradigm to justify current record-high valuations … but it definitely feels like it wants to declare a new paradigm! For example:

It’s also worth noting with regard to truly dominant companies that are able to achieve rapid, durable and highly profitable growth that it is very, very hard to overprice them based on near-term multiples. The basic equations of finance were not built to handle high-double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter.

The last line is definitely debatable and the entire paragraph is kinda debatable, but not quite the language you see from #truebelievers in presentations for various NEWECONOMYDISRUPTORS™ ETFs. “The shares of frictionless businesses are reasonable to own at any price, multiple, or valuation because super long duration assets have nearly infinite cash flows!”  While this sort of 1999ish statement has now made its way into the mainstream narrative, Mr. Marks stops just short of making it.

The idea that some companies have infinite cash flows discounted at a near-zero interest rate means valuation no longer matters for some companies is the same numerator mistake everyone made in 2000 (near-infinite growth of the World Wide Web… For, like, ever!). To be clear, a) the denominator story now is different from 1999 and b) Mr. Marks never says valuation doesn’t matter, but he gives more than a passing nod in that direction as he suggests there may be a few companies out there right now where almost any valuation could be seen as reasonable. One other note: just because US government yields are at 1.5% or companies can borrow at low rates, that doesn’t mean company WACCs are 1.5%. Take a look at the WACC for a few of your favorite companies. It’s not zero and it’s not even close!

Anyway, I found Marks’ arguments against value more compelling than his arguments in favor of growth, but the whole memo got me thinking.

One big message I took from the memo is that investors should not get married to one style. Trade and invest flexibly using the logic of what style makes sense at any given moment in the regime you find yourself. That does not mean you have to chase the current fashion, it just means you should think for yourself and be flexible. Don’t rigidly declare yourself a value investor or a growth person.

Another takeaway for me is that even the smartest people in the world (like Howard Marks) risk overweighting recent information. This is not a criticism of Mr. Marks, just a hard-to-avoid fact for all human beings. Recent news, information and performance are easier to remember than prior (or future!) performance. I could also be wrong and there is something truly new and different about today’s crop of tech companies. I’m open to that possibility, but I also doubt it. There have always been companies perceived to be dominant and expected to achieve rapid, durable growth as far as the eye can see. As Marks says:

John Templeton warned about the risk that’s created when people say, “It’s different this time,” but he also allowed that 20 percent of the time they’re right. Given the rising impact of technology in the 21^st century, I’d bet that percentage is a lot higher today.

Personally, my guess is that the number is still well below 50%. On the phone, I tried to press Mr. Marks on this topic because it’s the most interesting aspect of the letter. When a “value guy” who correctly identified 1999 as a bubble in real time and sidestepped it nods to the idea it might be different this time … that’s interesting!

When I pressed him on the phone he said:

“Yes, you could say I’m struggling with a partial conversion.”

“Drill down and be open-minded.”

His defense of a more open-minded position on “highly-valued” tech is rooted in the idea that you cannot make blanket statements about entire industries without having an intimate knowledge of the firms themselves. The quip he used was:

“All generalizations are flawed, except this one.”

So his feeling is that now, given the enormous growth rates and very low interest rate environment, you need to keep an open mind and understand each individual company, industry and technology. This clearly doesn’t square with the 1999 experience. Even the very best companies in 1999 were terrible investments. For example, if you bought Amazon in 1999 or 2000, you were underwater for 10+ years!

“Sure it’s like 1999, but it’s not 1999, it’s 2021“

Mr. Marks says we are experiencing something similar to the Internet Bubble in some ways but 2021 is vastly different in other ways. Rates are low and the Fed is not hiking. Some assets are overvalued and in a bubble, but some are not. To make blanket statements like: “stocks are too high” or “tech is overvalued” is not the right approach. He believes you need to drill down and make more granular assessments, whether it’s crypto, tech or old economy stocks.

He did make it abundantly clear that he still believes that valuation always matters. He spent about 10 minutes emphasizing and reiterating that he does not currently believe and will never, ever believe that valuation does not matter.

“Value vs. growth is a false dichotomy.”

Marks said his grandmother used to joke: “What do you like better: summer or the country?” Value vs. growth is not a spectrum, it’s two sides of the same coin.

“It’s not what you buy, it’s what you paid.”

He said: “I’m going to sell you my car, do you want to buy it?” I mumbled for a second and he clarified: “The question makes no sense.” Every asset you buy is a combination of the intrinsic worth of the asset and the price you pay. Looking at one or the other in isolation is dumb. People define “value” as cheap, but they are often talking about price, not worth.

… “carrying low valuation parameters” is far from synonymous with “underpriced” ….

Traditional capital-V Value Investing is all about numbers: ratios, book value, cash flow, price-to-earnings, etc… Meanwhile, Growth Investing is all about the company: Tell me the story, what a great product, DISRUPTION!, huge moat, revenue growth, innovators!, viral founder, and so on. Again, this is a false dichotomy. Good investors should be looking at both, not one set of variables in isolation from the other.

I don’t believe the famous value investors who so influenced the field intended for there to be such a sharp delineation between value investing, with its focus on the present day, low price and predictability, and growth investing, with its emphasis on rapidly growing companies, even when selling at high valuations.  Nor is the distinction essential, natural or helpful, especially in the complex world in which we find ourselves today.  

“A high P/E stock can still be cheap.”

Real value investing is not about buying cheap things. It’s about buying assets for less than they are worth and waiting for the market to agree with your judgment. This might mean buying a stock at 70X earnings when it’s worth 250X earnings. Or it might mean a stock at 0.8X earnings is expensive because it’s going bankrupt. Good investors understand and study the relationship between price and intrinsic value and do not buy assets based on value metrics or growth stories in isolation.

Even famous so-called value investors like Ben Graham and Warren Buffett made as much or more money in growth as they did in value. I did not know that! Super interesting.

Graham went on to achieve enviable investment performance although, funnily enough, he would later admit that he earned more on one long-term investment in a growth company, GEICO, than in all his other investments combined.

Buffett, the patron saint of value investors, also practiced cigar butt investing with great success in the first decades of his career, until his partner, Charlie Munger, convinced him to broaden his definition of “value” and shift his focus to “great businesses at fair prices,” in particular because doing so would enable him to deploy much more capital at high returns.

This led Buffett to invest in growing companies – such as Coca-Cola, GEICO and the Washington Post – that he could purchase at valuations that were not particularly low in the absolute, but that he found attractive given his understanding of their competitive advantages and future earnings potential.  While Buffett has long understood that a company’s prospects are an enormous component of its value, his general avoidance of technology stocks throughout his career may have unintentionally caused most value investors to boycott those stocks.  Intriguingly, Buffett allows that his recent investment in Apple has been one of his most successful.

“Don’t place arbitrary or artificial constraints on your portfolio. It’s not about being best at a particular game, it’s about choosing the game you can win.”

Unless you are forced by mandate, don’t corner yourself into a particular style. Just like in trading I say it’s best not to be a breakout trader or a mean reversion guy or anything similar… In investing, it’s best not to pigeon-hole yourself as a value guy or a growth woman etc. Intellectual flexibility and adaptation lead to long-term outperformance, not the expert application of a single investing style.

This is relevant right now with regard to the bullish ESG story. ESG investing might be the best thing to do ethically, but from an investment point of view it’s hard to imagine the thing that everyone in the upper echelons of finance loves (and is actively and publicly signaling it loves) will outperform the things that everyone thinks are icky. I mean, Philip Morris is one of the best-performing stocks of all time, and a big part of this is because for much of its existence, people would not touch it.

 “No asset is so good that it can’t be overpriced.”

Marks started at Citicorp in 1968, in the midst of the Nifty Fifty bubble ^[1] and that experience (like my 1999 experience) puts him always on alert for bubbles. Here’s a quick excerpt from a 2018 Wharton piece:

Marks recalled that when he took a summer job in Citibank’s investment research department in 1968, investors were crazy for the “Nifty Fifty” — 50 large-cap, blue-chip growth stocks in America that included IBM, Xerox and Coca-Cola. He said they were selling for “astronomical” prices of 80 to 90 times earnings. That compares with the average price-to-earnings (P/E) ratio for the S&P 500 in the post-war period of about 16 times earnings.

Enthusiasm for “growth stock investing” carried investors to the ridiculous conclusion that for the stocks of the fastest-growing companies, no price is too high. That was just before the “nifty-fifty” stocks of America’s best companies lost up to 90% of their value in 1973-74.

Formative experiences shape behavior for decades. Everyone forms strong bonds to salient early-life experiences, whether those experiences involve investing or life outside finance. If you grew up in the Great Depression, you reuse aluminum foil. If you grew up in the 70s, you scrimp on gas.^[2] If you came of age in 1999, you might find the smell of highly-valued tech particularly pungent. As a general rule, these sorts of bias are bad.

Marks noted in our conversation that this predilection for bubble detection can be both a blessing and a curse. While it might save you from going all-in levered long at the most egregious moments of euphoric overvaluation, it can also lead you to be too cynical. It can lead to gigantic missed opportunities.

While the idea that some companies can be good investments at what appear to be sky-high valuations didn’t resonate much with me because I feel the same thing was said in 1999, it did resonate with me big time when Marks said his partial conversion on the 2020 disruption economy is in some measure motivated by this realization:

“I was too skeptical in the past. Skepticism can lead to knee-jerk dismissiveness.”

When he said those words, my brain lit up a bit because I have suffered from the same bias of excess dismissiveness many times. Healthy skepticism is great. Reflexive cynicism and dismissiveness is bad. Marks’ comment hit home for me and the conversation may have influenced my less skeptical view of NFTs a few weeks later (see AM/FX: The metaverse contains infinite Pop-Tart^® cats). If I was wrong about the iPhone and I was wrong about bitcoin (and Twitter… Who’s ever going to use that???)… Maybe next time I should be more open minded? And perhaps less wrong?

The risk, of course, is you end up on the other end of the spectrum—that’s not good either!

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Reflexive cynic

Highly skeptical

Healthy skeptic

Rational optimist

Unrealistically optimistic / gullible

Pollyanna

I have been too far left on this spectrum, and so has Howard Marks

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While I want to be less knee-jerk dismissive overall, my observation right now is that there is a large swath of the investment community wearing the Growth Investor blinkers and that has put them too far to the right on the spectrum from cynic to unrealistic optimism and beyond.

Easier said than done in the stock market, obviously, but I think it’s a good framework.

In ten years, I bet we will look back at many of the outsized investment winners of 2020 and see them as flukes. Separating skill from luck is notoriously difficult in finance. Evaluating the performance of any strategy or fund manager by how it, he or she performed in 2020 could be the epitome of Taleb’s fooled by randomness. I think “persistent investing skill” and “performance in 2020” are more likely to be inversely than positively correlated.

Many fund managers who delivered stellar performance in 2008 left investors disappointed in 2009. It is the aggregate performance of managers and strategies over multiple years that matters, not 2020 outcomes.

Anyway, a lot to chew on here. I thank Howard Marks for the memo and for being so generous with his thoughts and his time. There is no reason he needed to spend an hour talking to me on the phone, and I sincerely appreciate that he did.

Finally, Mr. Marks suggested I check out this 1962 Warren Buffett interview, just for fun. It is fun!

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[1] A year or so before man landed on the moon and 18 months before the letters “LO” were transmitted over the ARPANET in what is widely viewed as the birth of the internet.

[2]> See: Malmendier and Shen, Scarred consumption (2021) https://voxeu.org/article/scarred-consumption and Severen and Benthem, Formative Experiences and the Price of Gasoline (2019) https://www.nber.org/papers/w26091

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Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

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The best way to rob a bank is to own a bank.

I think that the collapse over the past week of Greensill Capital has a lot of systemic risk embedded within it, particularly as the fraudulent deals between Greensill and its major sponsors – Softbank and Credit Suisse – come to light. And that’s not even considering Greensill’s second tier of sponsors – entities like General Atlantic and the UK government – all of whom are up to their eyeballs in really dicey arrangements.

Yeah, that’s Lex Greensill at Buckingham Palace in 2019, receiving a CBE (Commander of the Order of the British Empire) from Prince Charles for … wait for it … “services to the British economy”. LOL.

And yeah, that’s former UK prime minister David Cameron, positively beaming in this photo that his publicist chose for the 2018 announcement that he would be joining his good friend Lex Greensill as a “special adviser” to the company, keen to assist with the company’s mission to “democratize” supply-chain finance and “transform construction finance with Big Data and AI”. I mean, that’s what the white paper says, so it’s gotta be true.

Today, David Cameron is waking up to headlines like this in the UK press:

Hope all those free rides on Lex’s personal fleet of four private jets (all bought by Greensill Capital’s German banking subsidiary and leased back to Lex, btw) were worth it, David.

Is this a Madoff Moment for the unicorn market? Honestly, if you had asked me a few weeks ago, I would have told you that a Madoff Moment was impossible in our narrative-consumed, speak-no-evil market world of 2021. Now I’m not sure. We’ll see, but I think this has legs.

By all rights, Greensill – the eponymously named investment bank started by former Citigroup and Morgan Stanley banker Lex Greensill in 2011 – should have been shot between the eyes in 2019. That’s when their “supply-chain finance” loans, in this case to the steel and energy companies of the UK’s “Savior of Steel”, Sanjeev Gupta, blew up Swiss asset manager GAM’s $11 billion flagship fund, the Absolute Return Bond Fund (ARBF).

It’s a story as old as capital markets … Greensill lent Gupta a lot of money, Greensill wined and dined and private jetted ARBF portfolio manager Tim Haywood, and so naturally Haywood bought as much of the Greensill-originated loans as humanly possible, topping out at 12% of ARBF NAV. LOL. The loans, of course, were not as they seem, Gupta’s companies were nowhere near as solid as they were represented, and GAM ended up firing Haywood and seeing their stock price crater. Lots of people lost lots of money … end of the road for Greensill, right? Nope.

Enter Masayoshi Son, CEO of Softbank, who ended up putting $1.5 billion into Greensill in 2019 through Softbank and then another $1.5 billion into Greensill through the Vision Fund, becoming Greensill’s largest investor and diluting the prior largest investor – General Atlantic – from a 15% to a 7% position. And then the fun begins.

Since that 2019 rescue, Greensill has lent billions of dollars to Softbank and General Atlantic affiliates (mostly Softbank, but GA looks plenty stinky here), loans that were then bought by Credit Suisse funds and laundered by Greensill’s German bank subsidiary. Now when I say ‘laundered’, I don’t mean that metaphorically. The German banking and markets regulator, BaFin, has suspended Greensill’s banking license and referred the case for criminal prosecution.

Here’s an example of how the scam worked. Again, it’s a story as old as capital markets. In early 2020, Greensill lent Softbank portfolio company Katerra $435 million. The company ran into … errr … operational difficulties, and Softbank ponied up $200 million in additional capital last December. For its part, Greensill wrote off the $435 million loan in exchange for … again, wait for it … 5% of common equity. LOL. The $9 billion valuation for Katerra (I am not making this up) was determined by Softbank, of course, and so the Greensill German bank subsidiary reported on its balance sheet that all was well. A $435 million senior loan, secured by trade receivables, was exchanged for a 5% equity position in a bankrupt company, with no loss reported. Seems fair!

As always, the best way to rob a bank is to own a bank.

Second best way is to find a really big bank to buy up all the crap loans you originate, and that’s where Credit Suisse comes in. After the GAM debacle in early 2019, there was zero question that the loans Greensill had been selling to Credit Suisse for years were just as stinky as the loans they had sold to GAM. And yet Credit Suisse did … nothing. Actually, that’s not fair. They purchased MORE of the securitized loans from Greensill than ever before. They marketed their funds HARDER than ever before.

I’m sure it’s just a coincidence that Softbank put $500 million into the Credit Suisse funds after their 2019 Greensill investment.

I’m sure it’s just a coincidence that Credit Suisse was the lead advisor to Greensill when they raised hundreds of millions in new capital at a valuation of $7 billion all of … [checks notes] … four months ago.

I’m sure it’s just a coincidence that Credit Suisse and Greensill found a Japanese friend-of-Softbank insurer, Tokio Marine, willing to put a wrapper around the Greensill loans so that Credit Suisse could market these Greensill lending facilities as … one more time, wait for it … a safe-as-houses money-market fund.

Money quote from an investor in this $10 billion Credit Suisse fund family, per the FT:

“You thought you were in an arm’s length arrangement where all your fellow investors had a pure financial interest,” he said. “Imagine you then found that, in fact, some of your co-investors were funding themselves.”

Yep, imagine that. Like I say, it’s a story as old as capital markets. Here’s a fun fact. Did you know that Credit Suisse has paid more than $9 billion since 2009 in legal penalties and settlements?

But then the house of cards came tumbling down. Something spooked Tokio Marine (they’re now putting the blame on a “rogue underwriter”), and once the insurance wrapper came off, Credit Suisse professed shock … shock, I tell you! … as they suspended redemptions from the funds (LOL) and announced a hard-hitting internal investigation into how it was possible that this could have happened. I’m sure they’ll find a “rogue portfolio manager”. And then Credit Suisse dropped a dime to the German bank regulators, BaFin, who after the Wirecard debacle were apparently only too eager to show that they weren’t totally corrupt and incompetent.

So here we are. The ECB is now asking whether or not the situation is “contained”.

Will it be contained? Will all this be swept under the rug? Probably. Apollo is apparently going to buy the shell of the Greensill trading platform for less than $100 million (down from $7 billion a few months ago), and bury this as deep into the bowels of the Earth as it is possible to be buried. Pretty much all of the Greensill directors have resigned and claimed the Sgt. Schultz / Hogan’s Heroes defense (“I see nothing! I know nothing!”), including Lex’s brother (I guess Elon is not the only one who likes to keep board seats in the family). So I am certain that we will hear this week from the ECB and other bank regulators that the situation IS, in fact, contained.

And I’m also certain we’ll be treated to another barf bag Softbank earnings deck this quarter, where Masayoshi Son waves his hands with extra vigor to explain away the Greensill “investment”. Here are some of my personal faves from last year’s virtuoso performance in narrative construction after the Wework debacle. Again, I am not making this up.

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Then again … maybe Lex Greensill is feeling a wee bit abandoned by his erstwhile friends at Softbank or General Atlantic or the UK government. Maybe Gupta’s GFG steel business or some of these Softbank/Vision Fund companies can’t find short-term financing to replace their sweetheart deals at Greensill, and lots of people lose their jobs. Maybe there’s a bad email at Credit Suisse. There’s always a bad email.

So maybe this won’t be swept under the rug after all. And if it’s not …

This is the first Big Fraud I’ve seen in 13 years with the sheer heft and star power to ripple through markets in a systemic way. Not since Madoff.

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A quick but important note: We don’t have a dog in this fight. But we are conflicted. We have subscribers at almost all of the firms being mentioned. Our principals have done business with many of them. We’ve been clients of some, too. We like most of them. On both sides. We also don’t really care what any of them think. Make of it what you will, but clear eyes, even with us.

THOR: How did you…

KORG: Yeah, no. This whole thing is a circle. But not a real circle, more like a freaky circle.

THOR: This doesn’t make any sense.

KORG: No, nothing makes sense here.

Thor: Ragnarok (2017)

The whole of Thor: Ragnarok is pretty outstanding, as far as action-comedy films go. But the prison scene is almost certainly my favorite.

The premise is absurd. Thor – the guy in the picture above who isn’t a walking rock, if superhero movies aren’t your thing – is trying to escape a room that is plainly a circular hallway by dashing forward. It is a silly thing to do in the first place. Most circles boast that pesky feature whereby moving forward in one direction always brings you back to where you started. This room, however, is further designed so that running in one direction on the circle apparently doesn’t permit you to run all the way around the circle. You are, perhaps randomly or perhaps predictably (the audience never learns, exactly), transported back to where you began.

Why go through the trouble of creating a freaky circle whose magical affectation simply recreates the most basic identifying feature of a garden-variety circle, that is, that trying to go forward will only bring you back to where you started? As Korg and Thor both observe, the whole gag doesn’t make any sense.

All of which is why it’s perfect. And why it’s a perfect meta-joke. The freaky circle makes sense neither as a prison element nor a plot element. Making it both, however, makes it work for both. You, the audience, now feel a bit of the “Wait, what? Why?” confusion that Thor felt. Brilliant. Absurd.

But for all its absurdity, doesn’t it also feel a little bit familiar?

After all, the usual shenanigans of our financial world bear the same garden variety features that they ever did: too-big-to-fail gain privatization and illiquidity/loss socialization. A half dozen institutions discovering how to leach value via transactions and flow on every novel method to “democratize investments“. The rest of the nominal agents of the investment and corporate world leveraging the prudent man rule to capture as much value from principals as possible before the music stops, all under the guise of “yay, alignment.”

Nothing new under the sun and all that.

And yet somehow the ways in which each of these garden variety features manifest has been made so impenetrable, so arcane, so purposefully complex that we’re left to wonder why they even bothered with the layers of artifice in the first place.

In other words, it’s freaky circles as far as the eye can see.

But I think that you, Korg, Thor and I got something wrong. It does make sense if we think less about what it means for us and more about what it means for the designer of the room. And there is only one possible reason why the designer of the circular prison – or, say, the construction finance lender who was transforming their industry using AI and Big Data – would create a Rube Goldberg device that caused us to end up in exactly the same place we were going to end up anyway.

They do it because it is helpful to them that it doesn’t make any sense to us.

We wrote about it briefly before – but I just keep coming back to this Dyal – Owl Rock SPAC tie-up.

I’m still not sure what to make of it.

As we explained in that prior piece, Dyal is a private equity manager that, through funds it raises from the capital of big institutional asset pools (think pensions and university endowments), buys stakes in the management companies and general partners of other asset managers. It has a particular expertise buying stakes in private equity and credit shops.

Here’s what we wrote about the “Blue Owl” deal in December:

The TLDR is this: one of Dyal’s funds bought a minority stake in one of the biggest private credit shops in 2018. Their funds bought a minority stake in a big direct lending / BDC sponsor firm earlier this year. The latter (HPS) formed the sponsor to a SPAC (Altimar) that has made a proposal that would merge the former (Owl Rock) with Dyal (the GP), its minority private equity investor.

Russian Nesting Deals, Epsilon Theory, December 3, 2020

This was weird enough on its own. But if there’s a strong signal for “you’re on to something” here at Epsilon Theory, it is when publishing something brings a paucity of attention in our comment section and social media – but a lot of direct attention from people in the industry. And this one did exactly that.

Sure enough, within a matter of weeks, we read of not one but two lawsuits from portfolio companies the Dyal funds had bought stakes in – Sixth Street Partners and Golub Capital – seeking injunctions against the proposed merger/IPO with the SPAC sponsored by the Dyal affiliate.

If this is not your world, know that these are not tiny shops. This isn’t a single-store franchise in Des Moines standing up to corporate. Once upon a time, Sixth Street may have been your usual spin-out-half-of-a-Goldman-desk-in-2009-and-see-what-happens story, but the erstwhile special sits team that formed this company has built something really big and really successful. Different backstory for the Golub team, but same end-game. This is a huge private credit shop.

While we’re at it, you could say the same thing for Dyal. Their ideas for how to exploit the underserved market need for liquidity for the owners of asset manager GPs germinated well after those of Petershill (Goldman) and roughly around the same time as those of Blackstone. Who are Goldman and Blackstone? Yeah, in this niche, that’s the universal Jeopardy question to the answer, “The two firms you absolutely would not want to compete against if building a new investment industry-focused private equity business from scratch.” Even so, Dyal still built a leadership-level position. Theirs is a ridiculous achievement. They’re absolutely enormous. Good for them.

Same for Owl Rock. The placard on this particular door hasn’t been around very long, but anyone who doesn’t know Doug Ostrover doesn’t know anything about this corner of our industry.

And so, because these are all legitimate Big Boys, and because these firms in question are already in partnerships with one another that must work, the internecine lawsuits themselves are a Big Deal.

The basic contention of both Sixth Street and Golub is that (1) they have a consent right to the transfer of ownership in their companies and (2) there are demonstrable breaches and/or reasons to believe that breaches of confidential information would be inevitable and endemic to the contemplated post-merger business model of Blue Owl – the contemplated Dyal/Owl Rock entity. In other words, Sixth Street and Golub think they get to vote on the deal, and they think there’s no way that Dyal, their financial sponsor – which as Blue Owl will now be a direct competitor in the credit space – can credibly say they can or will abide by confidentiality requirements about their activities.

I have no idea if the former claim is true.

Most private equity investments take place through a series of limited partnership vehicles. It is certainly quite common for a private equity partnership to require consent to transfer an interest from one limited partner (LP) to another. The same is true for most direct private equity investments in companies. Likewise, a change in control of the management company with an advisory agreement with a fund will usually trigger a consent or proxy process among the fund’s limited partners. Securities laws governing investment advisers require it, in fact, although since the client is technically the fund and not its limited partners, there IS an aggressive posture a private equity manager might take that runs an end-around on LPs. They rarely do so, and usually proceed with the usual LP consents. After all, if the purpose of the change in control is to create equity value for the private equity manager, there’s no quicker way for a company reliant on raising new funds to destroy that value than to piss off their big LPs. In this case, the LPs are being asked to consent, so that’s not really the question.

The question is whether a change in control of the management company to your usual private equity limited partnership would trigger an affirmative consent right for the underlying investments of that partnership. That would be really unusual. Then again, what Dyal is doing involves a level of partnership that is really unusual in private equity, and they are, in a sense, potentially in the same business as the companies they acquire. It is entirely reasonable that the purchase or operating agreements might contemplate such a consent right, and entirely reasonable that they might not, but without reading the actual, unredacted documents it is impossible to know.

As to the second claim? Look, you do a deal like this because you want a public market for your interests. Maybe because you want more independence and upside that currently belongs to your parent. Maybe because you know that when it comes to scale in this industry, more is almost always better. The reason you have to tell limited partners in the funds you manage that you are doing a deal (since one does not really tell one’s clients “duh, because I want cash for my super-illiquid equity interest some day, you dummy”) is because of “resources” and “access to deal flow.” All of which makes it sort of awkward when you also have to say to portfolio companies and courts, “We will prevent any sharing of information that would constitute competition with our own portfolio companies.”

Sort of like telling your clients “We will never use flour” and then issuing a press release that says, “We are excited to launch our new bread-making business.” They aren’t literally contradictory, but I mean, c’mon. Some lawyers are gonna make the tiresome expression “robust controls” do a hell of a lot of work in the next few months.

So maybe they get some kind of injunction and maybe they don’t. In any case, no matter how strongly you might feel about it, my gut feeling is that no one’s gonna stop a deal over the latter claim. Courts and regulators have created such a powerful narrative around “yay, robust controls!” that even if one party is literally telling their own LPs that doing things the controls would make really, really hard is the justification for doing the deal, our collective willingness to believe that information will not be shared in Bad Ways knows no bounds.

As for the former claim – which, again, may or may not have merit – Dyal has made their position abundantly clear:

Sixth Street is attempting to assert the existence of a consent right that we believe simply does not exist. We appreciate the broad support from investors, partner managers, and other key stakeholders. The strategic combination is tracking towards a close in the first half of this year.

Statement by David Wells, Outside PR for Blue Owl, as quoted in Institutional Investor

That may be true, too! The funny thing about it, though, is that at least some of this “broad support” appears to be a wee bit engineered. I know it would have been better to make a “manufactured consent” reference, but if you’re jonesing for Chomsky, you’re reading the wrong Epsilon Theory co-founder.

What do I mean by “a wee bit engineered?”

Well, the parties that the PR guy is presumably referring to (other than other portfolio companies) are, namely, the limited partners of the various Dyal and Owl Rock funds, the voting shareholders of the Altimar SPAC and the shareholders of the various Owl Rock-sponsored BDCs. In other words, a lot the people who do get to vote on the deal. OK, the people who get to vote on advisory contracts that are conditions to close the deal. Same difference.

Thing is, a number of the largest limited partners in the Dyal and Owl Rock funds and a couple of the largest shareholders in the Owl Rock-sponsored BDCs who have the effective right to consent to the transaction are also companies who own a piece of an Owl Rock management company holding entity. Little perk of being willing to seed private BDCs with a 9-digit wire transfer. In other words, there appear to be a range of institutions who may not necessarily be aligned with other LPs and shareholders.

In most cases, those institutions probably have an unencumbered right to vote, but even if they decided because of affiliation concerns or conflicts not to do so or to do so at a capped level, a non-abstention non-vote (i.e. where you just sit on the ballot) is still helpful to one leg of the 1940 Act’s proxy rules. And if even that weren’t true, it remains true that narratives of “unfairness” or “imprudence” begin with the big, credible institutions – or they do not begin at all. Because the fiduciary rule is built around this concept, the implied consent of the largest, most credible institutional players not only removes the risk of assent, but may even create risk to dissent.

Who are those institutions? For the most part, really sharp, well-run places with good folks running them. Like the State of New Jersey.

And Rhode Island.

And maybe Oregon. Truth be told, I’m not sure if Oregon took Owl Rock up on the management company stake or not, although it seems to me they certainly would have been eligible for it at a $150 million commitment to ORCC III. Fun fact: they announced that commitment at the same time they announced a $125 million allocation to a Sixth Street European specialty lending fund. Small world.

Probably South Carolina, too, although if so, perhaps they’ve made the decision to merge that management company interest into the line item reporting their LP commitment on CAFRs. There are plenty of sharp allocators down there, so it seems like a reasonable assumption.

In short, Asset Manager A is merging with Asset Manager B, into whose equity securities Asset Manager A has already caused its own clients to invest, and to whom Asset Manager A has caused others of its own clients to lend money to, and is doing so through the acquisition by a SPAC sponsored by Asset Manager C, into whose equity securities Asset Manager A has also caused its own clients to invest, meaning that clients of Asset Manager A who had intended for their capital to be deployed on an arms-length basis are now effectively becoming both creditors and equity owners of Asset Manager A by merits of their enlistment of them as a vendor, and effectively both paying and receiving transaction fees and expenses to and from Asset Manager C, respectively. And this is able to happen, at least in small part, because Asset Manager B has granted equity ownership that would gain value in a transaction involving Asset Manager B to very large investors in their products who accordingly have a significant say in the outcome of a vote involving a transaction involving Asset Manager B.

Or, in the immortal words of Ray Stevens:

Alternatively, if you are a small LP or BDC investor who is wondering what is going on here, and you weren’t large or important enough to merit getting a seed deal, let me translate the message to you:

But here’s the real conundrum:

I’m pretty sure there’s not anything illegal going on here.

Unless there’s a real cause embedded in the agreements among these parties, I’m not sure there’s anything tortious going on here.

Hell, I’m not even sure there’s anything wrong going on here.

When Owl Rock gave all those big pensions and endowments effective GP ownership for their seed investments, what they were doing wasn’t unusual. It certainly wasn’t illegal. It was an entirely rational response to the power of a large block of capital with an appetite for risk. It is a power (because of my seat, not relatively unimportant me) I have some experience wielding. In my prior life, we squeezed external manager fees into oblivion because we could and because we felt that we should. We bought a stake in Bridgewater for Texas Teachers, an opportunity that came to us because we were a huge, strategic, long-term limited partner. An opportunity you probably didn’t get to see.

We got to negotiate better structures than the deals you probably got, not because we were smarter or more charming, but because we were representatives of a $100 billion+ pool of assets. We also selected a hedge fund seeding / incubation partner whose offering included potentially getting us GP stakes in various funds in the same way all these big pools of capital did. I’m a big fan of the guys at Reservoir we ended up hiring to do exactly that.

There is nothing inherently nefarious about offering those deals. And nothing inherently nefarious about accepting them. Maybe you disagree. Fine, in which case I am nefarious, because I not only accepted these deals, I demanded them as a representative of an asset owner.

Nor is there anything inherently nefarious about the big institutions who will participate in the Altimar PIPEs that will grease the gears of this whole construction, or whatever benefits were offered to them in exchange for their support. Yes, even though it’s Koch and whatever other bogeyman some might be tempted to summon to make all this seem blatantly evil, which it isn’t.

Still, if you are a smaller institutional limited partner in some of these funds wondering why you’re being jawboned about why “this is going to give us access to so much more in-house expertise!” and why “these lawsuits are no big deal!” and why “this isn’t a distraction, we are still aligned with you!”, so vote vote vote, I hear you.

And if you were a retail investor in the public BDC because you liked the yield and felt like your interests were served by the mutual self-interest of other equity owners, but then discovered that maybe some owners were more equal than others, and that maybe the goal of the adviser affiliate hired by the BDC wasn’t just to maximize the returns of the BDC but of the adviser, and that maybe you’d like to express that with your vote, and that maybe you’d like to join with other BDC investors in doing that since clearly they’re in the same shoes with you and…oh.

I hear you, too.

If I were a ‘partner manager’ with business overlaps, I would probably be hopping mad, and that’s without even being party to any of the ‘partnership’ discussions. And yet, if I were a limited partner in one of the funds managed by the advisors in question, I would probably still vote yes on my proxy for the new advisory contract. First, because the GPs in question are really good at what they do and, in some cases, just about the only game in town. A no vote isn’t going to get me those cheap co-investment rights on the next fund, and that probably matters more to my stakeholders than whether some not insignificant conflicts are being appropriately managed – or even that it is possible to manage them. Second, because the problem here, at least in my opinion, isn’t that the people here are bad or that they’re doing extremely bad things for investors.

The problem is that investors in 2021 are sold on a meme of markets in which equity owners and limited partners are “protected” by the mutual self-interest of other equity owners and limited partners (and boards, LOL) without taking into account that nested ownership structures allow powerful institutions to create incentive structures which manufacture…er…compliance for enough of the “important” participants to eliminate the effective agency of small institutions and individuals.

The problem is that we have decided to vest immense power into narratives about “incentives” and “alignment” and the ability to have “robust controls”, when we know that each of those things is fragile to any change in assumptions about the underlying aims of the principals and agents involved. Here’s a rule of thumb for you: they want a clear path to liquidity, and everything else is just pretty words.

The place this game leads us toward is a circular prison. Those who were sold on the “democratizing power” of vehicles like BDCs and SPACs that give “access to asset classes previously only open to big institutions” will realize that, as with every other investment, the sponsors will take their cut, and the big asset pools will take their cut, and the GPs that end up having lent money to themselves with their clients’ money will take their cut, and at the end of the day, what you get is whatever they couldn’t claim.

Same as it ever was.

The only difference is that the artifice through which all of this is achieved is far more obtuse, far more engineered, far more designed for the purpose of allowing those parties to do those things without opposition. I’m not saying that the Blue Owl transaction is unique. Quite the contrary. I am saying it is par for the course in outcome, except that its very structure is designed to distract or abstract from the manifold conflicts embedded in it to make that outcome more likely. It is a freaky circle, a thing which ends up at the same place but accelerates and ensures its outcome.

And makes us wonder what the hell is actually going on.

I DON’T know what that outcome will be for Dyal limited partners. I DON’T know what it will be for Owl Rock limited partners or shareholders in its various BDCs. I DON’T know what it will be for Dyal portfolio companies. These are really good investment firms with really smart people. If anyone can make a weird-ass, convoluted deal work, it’s them.

What I DO know is that everything we are telling limited partners and shareholders about the democratization and alignment of their interests across markets, not just for this particular deal, is complete nonsense.

If you know how to parse those two truths, please let me know.

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This piece is written by a third party because we think highly of the author and their perspective. It may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

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Overview

Last November in Blue Wave I wrote:

“The coming stimulus isn’t a panacea! It means massive deficits will persist. They will require higher taxes and incredible amounts of US Treasury issuance. Higher TAXES and rising LONG-YIELDS (all else equal) are the price for stimulus. The former drags on growth and earnings while the latter will require a Fed response that occupies its balance sheet. If the Fed does not act, higher yields will derail risk assets, just as they did at the end of 2018.”

For months, I’ve written that equity market participants have been ignoring the possible tradeoffs that come with massive stimulus: higher taxes and higher yields. I have strongly suggested that stimulus won’t place the economy back on some exceptional pre-pandemic growth trajectory. Sustainable growth comes from innovation and productivity gains – not from stimulus checks. Moreover, I have argued that the Fed’s ability to stimulate (asset prices or the economy) has been limited because rates and yields are already so close to zero. For some time, I have reasoned the risk of a rise in yields has been asymmetrically high.^[1] Now that I believe the risk of non-transitory inflation is elevated without the durable and sustainable growth to justify it (a change in view), the Fed is confronted with an even thornier problem. In stark contrast to my view, the popular meme has suggested fiscal policy wouldn’t have any negative impacts, and equities would continue to rise on the multiple expansion that low rates would assure.^[2]

Yesterday, as the 10-year yield hit 1.6%, equities sold off. How much higher might yields go? Something as seemingly straightforward as the impact of inflation on bond yields is the subject of debate in academic circles. Thank goodness I’m not an academic; I care about what makes sense rather than about defending any particular school of thought. The first order effect of inflation on yields (‘reflation’) has merit, but it has its limits. Based upon Fisher’s real rate of interest framework, and despite the obvious shortcomings of his Quantity Theory of Money (QTM), this idea is generally accepted.^[3] However, one must consider other factors. Ultimately, the analysis of yields must center on market participants’ expectations for the Fed’s reaction to both inflation and Treasury supply. Said differently, term premia depend largely on uncertainty around the future path of rate policy. For now at least, it appears the current pace of Fed purchases isn’t keeping yields in check. Under current circumstances, inflation is the Fed’s kryptonite.

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Discussion

Let’s discuss three forces that may move Treasury yields; they are interdependent. First, there’s inflation. Next, there’s Treasury supply. Third, there’s the Fed reaction function, which ultimately plays the most crucial role. What about the idea taught in college neoclassical economics class that the interest rate is the clearing price for money at which savings equals investment?^[4] This kind of market determined interest rate equilibrium exists only in a reserve constrained regime (i.e. –gold standard), in which the monetary policy authority does not set the price (i.e. – interest rate). Today, the Fed serves as a monopolistic price setter of interest rates. By deciding how it conducts OMOs (open market operations; i.e. – the scope and duration of Treasury purchases), the Fed influences bond prices and sets interest rates. Quantitative easing is a form of OMO that acts directly on long yields, whereas traditional OMOs (in a system with fewer reserves) acted on short-duration Treasuries.^[5] Consider this: theoretically, if there were no Treasury issuance, the Fed could simply create reserves and use those reverses to directly fund Treasury deficits.^[6] It could do so without Treasury issuance and without creating reserves to buy those Treasuries. However, Treasury issuance and the Fed’s operations around it are the principle determinant of yields across the curve. QE was a game changer.^[7]

Inflation is the only wildcard that might interfere with its game plan. As I discussed in my most recent paper Inflation Perspiration, I’m now concerned about inflation for the first time since the GFC ended. Fed communications that it intends to tolerate inflation above target under its new average inflation targeting framework will only go so far. It’s rarely had to deal with fiscal policy stimulus well in excess of what is necessary to close the output gap. Exacerbating this dynamic are still challenged supply chains. We are seeing this in semiconductors. Commodities, too, are screaming inflation, as the fiscal stimulus and supply chain disruptions are global in scope. The Fed might want to have a conversation with the executive branch to indicate that a policy mistake could lead to inflation that forces a hike or leads to higher market yields about which the Fed decides to do nothing. Markets do that: they correct for interventions by acting in unforeseen ways. In this case, the reflexivity is occurring in yields. In coming days, it will be interesting to see whether or not the belly of the curve begins to flatten. The belly tends to move first, and if 5-year yields begin to pick up relative to 10s, then it may indicate that expectations about the probability of a hike are increasing. If 5-10 continues to steepen, it could indicate that the rise in 10-year yields is more about fears about supply.^[8] Either way, long-duration yields and term premia reflect uncertainty around the path of future rate policy.

Bond Yields: Inflation

Let’s first consider inflation and how it might work to impact Treasury yields by first order effect through inflation (Fisher). Consider this identity:

i = r* + E(π) where i = nominal rate, r* = the real rate, and E(π) = expected inflation.

One needn’t accept QTM, for this framework to be useful. By this definition, an inflation expectation is built into nominal yields, but it’s important to recognize that this expectation may be adopted over time as inflation becomes self-reinforcing. Arguably, yields represent the opportunity cost associated with 1) choosing saving versus consuming or 2) choosing one form of savings versus another.^[9] What is the market mechanism by which yields adjust to inflation? When some economic actors perceive durable or storable goods as being more expensive in the future, their preference may shift from saving (in the form of Treasuries) to buying those goods now. That is to say, the fixed income from the Treasuries will buy less of the same refrigerator later. For this reason, they might sell Treasuries, convert them to cash, and use the cash to buy a fridge. As these expectations are adopted, more market participants sell their Treasuries, this will result in successively lower prices for Treasuries (higher yields) until the yield is eventually high enough that it meets the market expectation for inflation. A new market consensus about future inflation brings yields to a new equilibrium (all else equal and with no government intervention).^[10] This is but one dynamic.

The owner of Treasuries foreseeing inflation may also decide, rather than change his/her preference to consume rather than save, to change the form of savings. Logically, s/he may wish to own an asset whose stream of cash flows (unlike Treasury bond) changes with inflation. Perhaps commercial real estate with short term leases or LIBOR based loans might fit that bill. Even when reframed as Keynes might, the reason for this change in ‘liquidity preference’ is because that person wants to transform the Treasury into cash and (quickly) redeploy the cash into an asset that benefits from inflation. No matter how it’s cast, it seems plausible that yields may rise with inflation because the cash flow from Treasury ownership is less valuable in real terms.^[11] In this way, inflation, disinflation and deflation may still exert some power over yields. In turn, as yields rise as part of this dynamic, this may tighten financial conditions enough to reflexively control demand-driven inflation without Fed intervention.^[12] Perhaps, the Fed will allow that now.

Bond Yields: Reaction Functions

There’s a second order effect of inflation: it causes the Fed to react – creating uncertainty around the future path of rates and yields. It’s likely even more important than inflation’s first order impact, as the Fed has an arsenal of tools designed to manage rates and yields (including unlimited reserve creation as part of QE). Thus, what rising long-yields and greater term premia are saying is that the bond market expects inflation to prompt the Fed to raise rates. Mathematically, yields over ‘n’-periods are given by the geometric average of the short rates that prevailed in each period. Thus, if the expectation is for persistently low short-rates, long-yields should be anchored to that expectation.

There’s another way to think about this through bond market dynamics. If bond investors are confident the Fed won’t hike, they will buy the long-end and sell short the short-end to fund the purchase. In turn, this carry trade arb knocks down long yields towards funds. The more certain market participants are that Fed funds in anchored, the less term premium remains after the arb occurs. The risk to the carry trade always comes from a change in the cost of funding (short rates). This arbitrage is a form of duration transformation, and so is QE. When the Fed ‘quantitatively eases,’ it takes the following steps: 1) it creates excess reserves (i.e. – issues FRNs or cash); 2) it creates a reserve liability on its balance sheet; and 3) it buys Treasuries with the excess reserves. All of this effectively funds short (issues FRNs) to buy long and transforms the duration of longer-duration Treasuries into that of cash (i.e. – none). The Fed’s willingness to do this ‘arb’ is only constrained by its own expectations about inflation!

For this reason and others, the Treasury yield curve likely does not steepen as much as we’ve seen it historically. We usually see 3-month 10-year spread above 300 basis points at its widest. We’ll be lucky to see it above 200 basis points this cycle. It certainly can’t bull steepen anymore with funds at zero. The bear steepening will be self-moderating because the market and economy can’t take a move much above 2% on the 10-year, as the regression in Figure 1 shows. Lastly, were the steepening to persist for too long on persistent inflation, the Fed might be forced to hike, but it would be more likely that higher long-yields would do the Fed’s work for it. Bond volatility hit its low last September and again in March. Exhibit 2 of the Appendix may provide some context for just how much bond volatility the Fed is willing to tolerate. It seems like the MOVE index could go back to the 90, which is the regression prediction.

Bond Yields: Taper Tantrums

The Fed reaction function is also important when it comes to absorbing Treasury supply.^[13] ‘Taper tantrums’ are yet another way to characterize what happens when there’s uncertainty about the path for future policy. This is what market participants generally talk about when they speak of the ‘taper tantrums’ during periods like 2013 and 2018.^[14] In 2018, yields rose to 3.25% at the end of the year. It wasn’t Fed policy in reaction to inflation that did it, it was the Fed’s attempt to normalize its balance sheet. It perceived inflation was persistent enough for it to begin selling its Treasuries just prior to maturity. PCE had been above 2% since July 2018, so the Fed maintained its confidence about taper in its December meeting. A taper tantrum followed this stubborn communication around the trajectory of policy. Equities sold off, and yields reflexively fell in response to this risk off. This led to an early 2019 inversion of the U.S Treasury yield curve. Because financial markets and the banking system, upon which the economy relies, don’t function well with an inverted curve, the Fed does not tolerate it for long.

Figure 1 shows the downtrend in 10-year yields since 1994 (RH; orange). That downtrend is banded by a regression at 1SD (yellow) and 2SD (red). The regression suggests that about a month to 6-months after an extreme (2SDs) in yields, equity market corrections occur.  We observed this in early 2000, mid-2007 and 2018. In turn, a yield curve inversion often follows, and the Fed is often forced to cut. That cut normally results in a bull steepening. It’s also interesting to observe that yields typically fall after the initial and extreme move above trend only to rebound to just above the trend prediction (blue dotted), just as they did in 2001 and 2008. Yields appear to be doing something similar now. In those instances, equity selloffs persisted. Here’s where the reflexivity comes in again: if equities sell off further, they may do some of the Fed’s work for it. Capital may flow back into Treasuries from equities and may drive 10-year yieldsdown – perhaps, even enough that the Fed does not need to increase the pace of bond purchases. The difference now is that yields are already so close to zero in the ZIRP (zero interest rate policy) world.

Convexity hedging is another reaction function, which is often discussed when yields begin to rise quickly. This one is market based. At times it’s overblown, but in light of how active the mortgage market has been at such low rates, it’s worth discussion here. Unlike most bonds, mortgages demonstrate negative convexity. Convexity is the rate of change in duration when prices change. When rates fall, mortgages tend to be prepaid and refinanced. This shortens portfolio duration (negative convexity). As rates rise, and holders of mortgage securities see the duration of their portfolios increase, they sell Treasuries to shorten the duration of their portfolios. Exacerbating the dynamic now are low bond yields; convexity is higher when interest rates are lower. Thus, smaller moves in yields mean a bigger change in portfolio durations and require more Treasury sales. At times, this activity may exacerbate moves in the Treasury market. The Fed plays a role here, too, as it owns ~35% of the MBS market and it does not hedge.

Bond Yields: Equities

I have often rebutted the argument that low rates and yields mean higher P/Es as a matter of logic. They don’t, and higher yields because of inflation without durable growth are unwelcome in equity markets. First, low yields do not drive multiples higher. Only lower yields can do that. Near the S&P’s recent high, the 10-year yield was at 61bps. Last I check ed, Fed funds have been near zero for quite some time. Second, P/Es (once converted to equity yield) can’t be compared to Treasury yields until after adjusting for inflation. Only when real yield moves lower is inflation good for equities relative to Treasuries. Currently, real yields are creeping higher. Third, an assessment of P/Es requires not just a comparison to real rates, it also depends on what market participants require as an equity risk premium (ERP), which moves with expectations for earnings.^[15] Surprisingly, required real ERP for equity investors has been increasing since 1990. As it has since July, Exhibit 1 of the Appendix shows that ERP (red) looks quite expensive. It is currently about 1.5SD rich to the regression prediction line (lower ERP indicates less premium and, thus, more expensive).

Not all equities will be impacted alike if inflation presents more persistently than most believe. Mature large, cap technology companies whose revenues streams from the cloud and subscription software services and whose cash flows are more like bonds than equities may be impacted more than growth technology names. Likewise CRE REITs whose portfolios have sticker, long-term leases and utilities won’t fair as well in an inflationary environment. Cyclical commodity and energy companies could benefit, albeit, eventually inflation makes life difficult if costs can’t be passed through to customers. Small caps, in particular, remain recklessly overvalued as retail flows have inflated their values.

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Conclusion

The economy and markets are highly sensitive to interest rates and yields. The equity market’s reaction to 10-year yields at just over 3% in 2018 seems to provide some anecdotal evidence of this. The Fed will try to avoid persistently higher yields at all cost; normally QE would enable the Fed to fund short to buy long and keep bond yields under control. However, inflation complicates its motives. Profligate fiscal policy, unlike monetary policy, can be quite effective at prompting an inflationary overheat if the stimulus significantly enough exceeds the amount of the output gap. The first two rounds of stimulus have largely filled that gap. With annualized fourth quarter 2019 GDP at $21.75 trillion versus annualized fourth quarter 2020 GDP at $21.49 trillion, down 1.2% year-over-year, there is a good chance that another $1.9 trillion in fiscal spending will put year-over year GDP growth up between 6% and 7%. Moreover, the release of 50% of pent up savings (currently 13% of disposable income) could release another $250 billion into the economy.

Inflation caused by demolition of the output gap could be exacerbated by supply chains that are just now starting to heal from a supply-side shock. In semiconductors, the cause of the current shortage is a mixture of factors: demand spikes for consumer electronic products like laptops due to the pandemic-driven WFH trend, slowdowns in chip production also caused by the pandemic, bottlenecks due to an outsource of chip production to firms like Taiwan Semiconductor Manufacturing Company (TSMC), and lingering effects from the trade war. These shortages alongside a rally in commodity prices (supported by global stimulus especially in China), could make inflation more persistent as supply chains take time to heal. The Fed is in a tough spot. Where’s Lois Lane when you need her?

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Appendix

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Disclaimer

AlphaOmega Advisors, LLC (AOA) does not conduct “investment research” as defined in the FCA Conduct of Business Sourcebook (COBS) section 12 nor does AOA provide “advice about securities” as defined in the Regulation of Investment Advisors by the U.S. SEC. AOA is not regulated by the SEC or by the FCA or by any other regulatory body. Nothing in this email or any attachment to it shall be deemed to constitute financial or other professional advice, and under no circumstances shall AOA be liable for any direct or indirect losses, costs or expenses that results from the content of this email or any attachment to it. AOA has an internal policy designed to minimize the risk of receiving or misusing confidential or potentially material non-public information. The views and conclusions expressed here may be changed without notice. AOA, its partners and employees make no representation about the completeness or accuracy of the data, calculations, information or opinions included in or attached to this email, is based on information received or developed by AOA as of the date hereof, and AOA shall be under no obligation to provide any notice if such data, calculations, information or opinions expressed in this email or any attachment to it changes. Any such research may not be copied, redistributed, or reproduced in part or whole without AOA’s express written permission. The prices of securities referred to in any research is based on pricing as of the date the research was conducted, may rise or fall at any time thereafter, and past performance and forecasts should not be treated as a reliable indicator of future performance or results. This email and any attachment to it is not directed to you if AOA is barred from doing so in your jurisdiction. This email and any attachment to it is for informational purposes only and does not constitute an offer or solicitation to buy or sell securities or to enter into any investment transaction or use any investment service. AOA is not affiliated with any U.S. or foreign broker dealer. AOA or its principals may own securities discussed herein.

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Notes

[1] Please see Check In: To Infinity and Beyond, August 17^th, 2020 and see Exhibit 2 of the Appendix.

[2] I have continuously asserted that low rates alone do not lead to multiple expansion; only lower rates can do that and only assuming that risk premia stay constant. So close to the zero bound, traditional policy is stuck.

[3] As Eric Tymoigne of the Levy Institute argues: “Changes in interest rates do not reflect changes in the opportunity cost induced by inflation in the present/future consumption arbitrage, they reflect changes in uncertainty that affect the stock equilibrium between liquid and illiquid assets.” As it turns out, this statement is far less profound than it first appears because, as he later states, “[the] condition of indifference [due to expectations for changes in interact rates] may include the concerns about inflation via the introduction of an inflation premium in nominal rates, but these concerns are included in the broader concerns of liquidity and solvency.”

[4] This identity holds in a closed economy.

[5] The plethora of system reserves necessitated a shift to the use of IOER as the Fed’s principal tool to manage to the funds target rate.

[6] Of course, this isn’t the way the system works!

[7] QE also helps the Fed signal its commitment to its policy to keep rates anchored.

[8] The two are not mutually exclusive as long-yields are the geometric average of short-yields.

[9] Keynesians disagree on what I take to be a technicality.

[10] This of course, assumes that different market participants have different expectations for inflation. I don’t see this as a fallacy of composition, as this is often the way markets work as they move in and out of equilibria, which are something of an academic fiction and if they do exist are usually short-lived, as George Soros argues in his Alchemy of Finance.

[11] As I will point out, it is the comparison of real 10-year yield to earnings yield that may make equities less attractive relative to bonds as inflation rises – but only if real yields are rising, too. There are also other factors to consider.

[12] On the other hand, some believe that most inflation comes from supply shortages that tighter financial conditions will only exacerbate by constraining supply further (i.e. – limiting the availability of loans that might be used to increase capacity). This is the flip side of the argument I’ve been making that low rates create overcapacity that keeps inflation low.

[13] This could also be looked at as constraining the supply to non-Fed buyers.

[14] Risk-asset markets rallied significantly because the Fed was focused on lowering yields on MBS, and that QE program purchased mostly MBS securities. This program had palpable economic impact through lower borrowing costs for homes. Recall that this program was announced in September 2012, and while focused on MBS, it also helped keep longer-dated yields down – that is, until the Fed announced a taper in June 2013. The 10-year yield rose quickly in expectation of taper and the Fed was ultimately forced (in September 2013) announce no taper would occur and the 10-year yield fell again throughout 2014.

[15] ERP_f =E/P_f – (Y – E(π)) where E/P_f is the forward earnings yield, Y is the nominal yield, and E(π) is expected inflation.

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For most of the last 40 years – at least since Tip O’Neill or one of his aides coined the term – the third rail of US politics has been Social Security.

It is strange to think about. We are all MMTers now, after all, and what’re a few trillion dollars among friends? In 2021, entitlement reform is a third rail in the same way that a high-voltage power line is a third rail. Sure, it will electrocute you, but who is going to go through the trouble of getting to it? We didn’t stop talking about entitlement reform because people were too afraid of it. We stopped talking about entitlement reform because neither of the two parties has even the faintest interest in it.

Yet even during its heyday, I would argue that Social Security was never really America’s third rail. Politicians talked about it all the time, even if half of their conversations consisted of calling it a third rail. A true third rail would be an issue or policy that everyone was too afraid to even bring up in that context. It would be a topic we were too afraid to discuss at all.

I think there are a handful of these topics. Teacher unions are one of them.

And that third rail status might be changing, if only for a short while.

The California GOP held its spring convention over the last few days. Now, hope springs eternal for the GOP in California in the same way (if far less credibly) that it does for Democrats in Texas. In a big state, there is always some narrative to spin about a huge population group that can be turned – or turned out – to shift historical voting behaviors. That is especially true if you’ve got at least one well-known hotbed of traditional opposition (e.g. anything north of Chico, or the People’s Republic of Austin, respectively) in the state.

In his address to the convention, Karl Rove expressed a typical flavor of this optimism. He argued that a diverse working class could be brought into the Republican fold in California. It was not too dissimilar from the arguments Donald Trump himself relied on in 2016. But this time, Rove and other speakers were light on mentions of former President Trump as a mechanism for achieving this electoral flip. Instead, they suggested the promotion of narratives around the various misdeeds and missteps of the San Francisco School Board, teacher unions and Thomas Keller superfan Gavin Newsom.

Politico covered some of this in an article over the weekend.

CAGOP: Putting TRUMP in rearview mirror? [Politico]

…The convention was largely devoid of any mention of the single biggest influence and driver of enthusiasm in the party’s grassroots over the last four years. Republican strategist Karl Rove failed to even mention Trump’s recent tenure in the White House — and suggested that the San Francisco School Board may be more on voters’ minds this year.

Now, I don’t know if Rove is correct. Speaking personally, I suspect that avoiding the mention of Trump in either a favorable or unfavorable light probably reflects more of a Roveian keep-your-options-open strategy than any kind of well-considered view on Rove’s part about what is going to matter to voters in any coming elections. At any rate, you don’t need me to develop your own opinion on the reality of how state GOP conventions are grappling with the World After Trump.

What I DO know is that in Narrative World, Rove isn’t entirely wrong. School boards spending time renaming Abraham Lincoln Middle School or something while many teacher unions oppose safe school re-openings and make fun of parents who ‘want their babysitters back’ absolutely makes for a powerful narrative. Is that narrative powerful enough to move teacher unions out of third rail status?

It is early, and the switches on this rail are very hard to throw.

On the one hand, the generally public sector union-friendly Democratic party has a decent control on power at the federal legislative level and in many states. On the other hand, you could observe that many of the same things are true about national media – and the narrative structure of teacher unions present in national media has changed over the last several months.

A lot.

To establish a baseline, we can take a look at just five years ago, in 2016. At that time, our analysis of linguistic centrality indicates that there were three distinct narratives about teacher unions: (1) unions in our area are fighting for a fair contract, (2) unions are joining the fight against testing obsession and (3) teachers and students alike are harmed by the underfunding of schools. While coverage obviously includes op-eds and editorials that were not always supportive, in general these were sympathetic, linguistically distinct, regionally cohesive narratives.

To visualize this in part, take a look at the network maps below, each of which roughly approximates our analysis of these narratives using the software from our friends at Quid. Nodes are individual articles about teacher unions in 2016. Bold-faced nodes generally represent those we have identified as being about a particular narrative, framing or topic. As usual, similarly colored clusters are very linguistically similar. Closeness and connecting lines also indicate dimensions of linguistic similarity. North, south, east and west have no meaning outside of distance and connectivity. The short of it is the same as above: these were generally central, distinct, internally cohesive narratives about teacher unions. When outlets wrote about each of these topics, they tended to use the same language, talking points and phraseology.

Through 2020, on the other hand, while there were distinct articles about each of these topics, in our judgment they had no influence on the narrative structure of teacher unions. In 2020 there was one narrative: “districts are discussing how and when to re-open schools.” That the nodes are nearly all in bold (i.e. that they are part of this framing) is not an accident. The topic permeated practically every discussion about teacher unions in 2020.

For the first 5-6 months of the pandemic, I would describe most of the coverage as sympathetic. By September, we think it can be observed anecdotally and subjectively that a meaningful change had taken place. We also think the data bear it out. Why do we think that?

Because there was no topic that became more about the role of teacher unions in American society than coverage of the resistance to re-opening put forward by the unions serving the Fairfax County Public Schools in northern Virginia.

Because that topic, local as it was, became among the most central, most interconnected clusters of the coverage of teacher unions in 2020.

It is a small cluster, to be sure – after all, this is only one among thousands of school districts in the United States. But we think this debate framed how the narrative of teacher unions in the pandemic would shift in late 2020 into 2021. In short, by Q4 of 2020, we think the narrative began to transition from “districts are discussing how and when to re-open schools” to “why are teacher unions opposing re-opening?”

In YTD 2021, this framing – no longer mostly confined to Fairfax County – had spread, as narratives do, to all corners of coverage. The threat of strikes in Chicago. Debates over teacher vaccination policy nationwide. Varying opinions of President Biden’s One-Day-A-Week plan. And yes, the same raging debates in California.

Readers’ opinions may differ on the reality of school openings. I’m guessing they probably changed a bit over time, too.

In my own town, I was supportive of closures in March. By July, I felt confident enough in the data to support elementary school openings but was suspicious enough of high schools that I considered them a legitimate superspreader risk. By mid-September I’d generally come to the conclusion with more data that my view was wrong – too conservative. By then I believed that high schools with appropriate precautions outside of raging hotspots could – and in my area where my opinion matters, should – re-open. Today, I have some concerns about high schools in emerging B.1.1.7 areas, but none that rise to the level of changing my mind.

Maybe your path was similar. Maybe you felt more comfortable with broad re-openings sooner. Maybe it took you some time. Maybe you’re not there yet.

No matter what you believe about the reality of school re-openings or the role teacher unions have played in school re-opening policy, and no matter how that belief changed over time, in narrative world the switch on this third rail has been flipped.

For better or worse, for the first time in a very long time, everybody knows that everybody knows it is now possible to openly discuss and debate the social role of teacher unions. That doesn’t mean that anything about the relationship schools have with these unions will change. It means that it can change.

I remain concerned that this is a conversation that can and will be easily co-opted by those with a political interest in creating conflict between groups that have every reason to be aligned. Still, we are where we are. In the same way that narrative shaped a conversation about the role of police going forward in 2020, this narrative can shape a conversation about the role of teacher unions and public sector unions more broadly. My money is still on the status quo.

But I’ve been wrong before.

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The dirty little secret of every riot and protest and looting that ever existed in the history of mankind … IT’S FUN.

Lucifer’s Hammer on Epsilon Theory, August 31, 2020

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During the summer of 2020, as widespread non-violent protests for racial justice gave way to steadily creeping violence and property destruction, we published our concerns on these pages that there was practically zero political will – and zero political incentive – by either party to do what was necessary to reduce that violence.

Republicans and Donald Trump believed that the violence at a number of BLM-related events would be framed alongside deeply unpopular “defund the police” narratives as long as they continued. They believed, I think, that this framing would be electorally helpful. However perverse, from a purely electoral perspective I believe they were right on both counts. They did not win the presidency, of course, but on most ballots the GOP outperformed very low expectations. I think antipathy toward the events of the summer played a significant role.

Still, if he wished to do so, Donald Trump possessed and did not exercise meaningful power to de-escalate and reduce this violence at multiple points.

Democratic leaders at state and local levels had even more power, I would argue. They also largely elected not to exercise that power, if for very different reasons. In their case, I think there was genuine concern that calling in resources like the National Guard to maintain order would be seen as a betrayal of the very arguments about the nature of state power deployed against black communities being made by those protesting. More practically, I think they believed that this action would have the effect of increasing voter apathy for an already moderate-looking slate. More perversely, I think they felt some confidence that generally sympathetic national media would be very unlikely to pay very close attention to what was happening at some of these rallies, lest doing so unduly influence the electorate to make a Wrong Decision. I think the Democrats were right about each of these things.

No, they weren’t right. They were correct. They – and the GOP – were correct in their evaluation of optimal electoral strategy under the conditions of a competition game. But there was nothing right about allowing the destructive LARPing that took place in the late summer by activists and counter-activists alike to continue unabated.

Bad things happen when the equilibrium state of national politics is to be nearly always correct and nearly never right.

Or, in the words we published in August:

They are both sowing the wind.

And they will both reap the whirlwind.

Neither the Democratic party nor the Republican party survives a defeat this November in anything close to their current form. I think several people are starting to think about that.

But here’s what’s also true:

Neither the Democratic party nor the Republican party survives a victory this November.

And no one is thinking about that.

Luficer’s Hammer on Epsilon Theory, August 31, 2020

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The GOP is reaping the whirlwind today.

The sowing of militaristic language and existential Flight 93 Election rhetoric by the political right led directly to one of the most embarrassing days in the history of our Republic. No, I don’t think those Clown Putsch buffoons attempted to stage a coup. But a crowd of 330 million just watched a crowd of 330 million watch thousands of pastors, pipefitters, engineers, Q activists and business owners together wrap themselves in Trump flags and parade through the halls of the US Capitol. They watched them charge into the chambers with plastic cuffs and Tazers. They heard the “hang Mike Pence” chants. They saw a mob with thin blue line flags literally try to beat Capitol Police officers with them.

And then those 330 million saw lockstep claims by some half of sitting GOP representatives and most of their favored news anchors that these were the actions of Antifa. Without evidence. And without apology.

If you think the media purposefully made less of the violence this summer than an institution less transparently politically invested in the defeat of Donald Trump might have done, I think you are correct. If you think that what happened on 1/6 will ever be seen by a country that watched last week’s images in real time in the same category as the events of the summer, I think you are insane.

As Ben wrote before, the Republican party probably does not survive this in anything close to its previous form.

But make no mistake about it: The sowing of affinity for The Right Kind of Violence we saw in the summer and affinity for The Right Kind of Concentrated Power that we are seeing manifest today on the political left will have lasting results, too. The collective and collusive de-platforming of individuals and app developers happening over the last few days is, by any reasonable account, entirely within the legal rights afforded to Twitter, Facebook, Apple, Google, Amazon and scores of associated service providers under current law. In the very short run (i.e. over the period of a week), I think it is very likely that these actions could reduce the potential for violence.

In the long run?

Friends, the political forces that galvanized support for Trumpism were built on the foundations of a belief that conservatives are not given a fair shake in media, a belief that Big Tech firms run by wealthy, liberal, elites seek to control the lives of hard-working American families, and a belief that a coordinated political-technological infrastructure has led directly to their political marginalization. You can think they are incorrect. You can even think that they are wrong. But if you think that these actions will reduce the influence of Trumpism, political division, polarization and willingness to do violence, so are you.

There is substantial territory that exists between flaccid permissiveness toward the people who committed, sought to commit or directly incited violence to influence the outcome of an election on the one hand, and gleefully instituting widespread political purges that will exacerbate the long-term consequences in exchange for warm justice fuzzies today on the other.

There is a brief window where I think we have the opportunity to commit to building a common national identity together. Seizing this opportunity will mean a lot of us demonstrating corporate humility for actions we may not have taken ourselves, actions of which we bristle at being called guilty, but which in our heart of hearts we know we could have spoken up or taken more action to help prevent. Seizing this opportunity will mean a lot of us leaving a wellspring of anger we will feel is entirely justified at the door.

Not seizing it, I fear, will mean that we all reap the whirlwind.