2016: The Halftime Report - Purchasing Power & the Case for Active Management

“On one point only were economists agreed. Without exception those consulted say: ‘There is no sure hedge against inflation.’ ” - Hedging Against Inflation

2016’s midpoint is fast approaching. The following has occupied my mind for the first half :

INFLATION, DEFLATION, AND PURCHASING POWER

The “Inflation” vs “Deflation” trade(s) - January 1 through early February of this year was (largely) defined by the “deflation” trade(s)…indeed, if you examine the hedge fund performance figures through early February, you see that the best performing funds had high exposure to “deflation” trade(s). Since mid-February, the “inflation” trade(s) have been where capital has been (mostly) rewarded…that is, until the last 2-4 weeks.

At this juncture, the inflation bulls believe we are experiencing a pause/counter-trend before the inflation trade(s) resumeth. The deflationistas, on the other hand, appear to believe the February - April rally in the “inflation trade(s)” was largely driven by a pro-longed short squeeze coupled with explicit/implicit coordination between US and China (specifically as it relates to fx).

Either way, I see only one truly superior risk/reward trade (and the rest are terrible in comparison), with respect to the “inflation” and “deflation” trade(s). That is where I should and/or will devote most/all my energies/capital when it comes to the inflation/deflation framework.

This “truly superior risk/reward trade” I mention may prove to resemble going long the JPY in 2014.

Purchasing Power - In terms of trading/speculation, ‘inflation’ and ‘deflation’ hold concrete/actionable meaning for me. In terms of economics, I don’t know what ‘inflation’ nor ‘deflation’ mean anymore.  The economic measures of inflation/deflation don’t make sense to me.

For example, the medical care component of CPI only shows an aggregate increase of 15% since 2011…yet I know for a fact premiums have risen far more than that over the last 5 years (more like 10% CAGR over 5 years!).

On the other hand, ‘Purchasing power’, makes sense to me.

 

Purchasing power erosion

I know that the overall (domestic) purchasing power for most individuals/families in America is lower today versus 10 years ago, and 20 years ago. I know that the purchasing power of most residents in New York and San Francisco have dramatically eroded over the last 5 years.

Purchasing power accretion

I also know that most Americans’ purchasing power with respect to buying foreign goods/services have dramatically improved over the last 1-2 years (due to the strength of the $).

Technology has also improved purchasing power for us all, in some specific ways (e.g. smartphones). Yet the economists call this ‘deflationary’ (almost as if it’s a pejorative). I consider this ‘progress’.

I estimate that ‘purchasing power’ will matter in more obvious ways in coming years.

I believe that “they” want inflation… the “they” I’m referring to are government and central banking officials with fiscal and monetary policy responsibilities. The following lead me to believe that “they” want inflation:

• “They” know that debt is a problem.
• “They” know that history suggests that large (but not excessive) inflation is the least socially disruptive means to address the debt, so long as the inflation concurrently increases cost of living and wages in similar orders of magnitude.
• “They” probably would prefer relatively steady 5-15% true inflation, versus 2%-3% they claim as objectives, so long as the 5%-15% inflation doesn’t spiral upwards.
• “They” don’t mind eroding the balance sheets of savers and the wealthy, so long as they can preserve / minimize damage rendered to real wages.

The question remains whether “they” will succeed in “creating” inflation…I for one don’t know. Inflation is not inevitable, as “they” can elect (instead) to severely raise taxes, severely cut spending, debt jubilees, etc. No path is inevitable. Also, on a more optimistic note, further innovation/technology advances may improve productivity in coming decades, which would only help the real economy.

THE CASE FOR ENTREPRENEURIAL ACTIVE MANAGEMENT

 

I’m uber-bullish Active management…and concurrently bearish the current hedge fund paradigm - The sentiment towards active management, specifically (but not only) aimed at the 2/20 crowd, is (justifiably) very negative. Alternative investors have performed rather poorly over the last few years.

The incentive fee component does not seem the problem - it’s the management fee component. Perhaps limited partners should demand a refund for all the management fees paid for abysmal performance, a la a ‘clawback’.

Yet I see the seeds for future active management outperformance. The “risk/reward” in going “long” active management is skewed in favor of active management. A key driver (i.e. a necessary condition) for active management seems to be firmly in place.

Returning to Hedge Fund Entrepreneurial Roots

While I consider myself (uber)bullish active management, I doubt the extraordinary returns will originate from the well-known, worshipped, investment conference-frequenting, mult-billion $ aum hedge funds. Rather, they will hail from the:

“crazy ones. The misfits. The rebels. The troublemakers. The round pegs in the square holes. The ones who see things differently.”

My belief is not without precedent: recall that hedge funds were defined by the misfits, troublemakers, etc. until fairly recently (i.e. the last 10-15 years). For example:

• A sociologist turned diplomat turned journalist became the ‘father of hedge funds’ (Alfred Winslow Jones)
• English major turned taxi driver turned macro hf manager (Caxton)
• Academic/professor turned trader turned greatest investor (Rentech)
• Academic turned casino ‘gambler’ turned hf mgr (Thorp)
• A crew of high school + college dropouts turned alpha machines (Feshbach)
• Medical student dropout turned excellent/exceptional investor (Icahn)
• Medical resident dropout turned message board legend turned investor

The “institutionalization of hedge funds” have only served to place returns in institutional strait-jackets.  The institutionalization of hedge funds have castrated hedge funds of their very essence, replacing them with sterile qualities that bureaucrats would love, e.g.:

• Accreditation/pedigree vs aptitude
• Pro-cyclical behavior
• Mediocre / loser mentality, i.e. hug the indices and think like mutual funds…but get paid like hedge funds.
• Dis-incentivizing long-term decision-making, and true investment-oriented thinking and behavior.
• Dis-incentivize those with entrepreneurial leanings, incentivize those with bureaucratic leanings.

“I think you are like us. You are one of the pirates, and I’d like you to join my ship.” - Crispin Odey