wknd
notes


                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               An Interesting Life

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The Case for Quantum Change

The Case for Quantum Change
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wknd
notes

Each Sunday morning for over a decade, One River’s CIO, Eric Peters, has published “Wknd Notes.” It is an unorthodox take on markets, politics, and policy that’s widely read across our industry and within global policy/political circles. Eric has written for as long as he has traded and the discipline is part of his investment process. Drawing on wide-ranging, multi-disciplinary research, historical study, and discussions with interesting characters throughout the world, Eric collects those things he finds most thought-provoking each week and distills them into a concise letter. At times the ideas and views are consistent with his own, but just as often, they challenge his positions and it is this openness to opposing views that helps him maintain a flexible mind in the search for emerging opportunities and risks. His writing is a reflection of how he thinks, and as such it is as focused on identifying the right questions to ask as it is on seeking answers. The publication of this work is Eric’s way of exchanging ideas/information and developing dialogue with a network grown over his thirty-one-year career.

wknd note: An Interesting Life

“When you and I grew up, half the world was covered in communism,” said the CIO. “Global markets and international business provided the keys to liberate the human potential stifled by that system,” he continued. “When we started in the business, there weren’t vast pools of human capital moving piles of paper. But those days are done.” Too much of society has become financialized, optimized. Such a structure leads to corrupt incumbents, fragility, instability. “Markets and economics are no longer the answer to the world’s problems. And that’s not to say communism is the solution. It’s not. But it appears clear we’re entering the type of decade you see a couple times a century where politics dominate.”

Overall: “Virtual currency-related business activities are illegal financial activities,” declared the People’s Bank of China, increasingly desperate to ensure the successful rollout of their centralized digital yuan. “The government will resolutely clamp down on virtual currency speculation, related financial activities and misbehavior in order to safeguard people’s properties and maintain economic, financial and social order.” Beijing stopped short of outlawing the ownership of such digital assets. They prefer centrally controlled coercion, slow suffocation. One risk to outlawing the ownership of virtual currencies is that citizens who forfeit them are forever resentful. And states that turn their citizens into criminals at scale do so at great peril. Soviet communists turned such transformation into an art form. These are the stakes at play. China’s central bank digital yuan will provide Beijing with unparalleled transactional insight and financial control. It further intends to export this system as an alternative to the US dollar, directing business in China through its new international payments system. But the free market has already created parallel systems that lay outside of Beijing’s dominion. Bitcoin is one. Ethereum another. So are stablecoin. Such systems are built to meet market demand for digital versions of an existing fiat currency, such as the US dollar. More than 98% of the $128bln of global stablecoin is linked to the US dollar. Even more impressive, the annual transaction turnover of US dollar stablecoin is over $100trln. It is an astonishing success of blockchain technology applied by the private sector at scale. There is no such demand for the digital yuan – the largest private CNY stablecoin is less than $5mm. China and the US are, thus, confronting very different positions. China success in the digital currency arena hinges on control – the digital yuan will be used by decree. US success depends on regulators integrating US dollar stablecoin into the mainstream. They will. And when they do, these technologies will come under conventional oversight, unlocking exponential growth. Benefits will accrue to the nation with the currency that the market selects. That remains, unambiguously, the US.

Week-in-Review (expressed in YoY terms): Mon: Multiple Asia countries closed for holidays, fears of Evergrande collapse surge as interest payments loom, PM Trudeau remains Canadian PM but falls short of majority as hoped, Yellen reiterates need for debt ceiling relief as deadline approaches, Biden allows vaccinated to come to the US, Pfizer says their vaccine is safe for kids 5-11, German PPI 12% (11.1%e), HK CPI 1.6% (1.7%), Canada home px index 18.4% (17.8%p), US housing mkt index 76 (74e), S&P -1.7%; Tue: Riksbank unch as exp, RBA mins show desire to unwind bond purchase program ASAP, RBNZ’s Hawksby suggested 25bps increments are appropriate in times of uncertainty (market had begun to expect 50bp move at next meeting), CB of Indonesia unch as exp, Hungary CB hikes 15bps (25bps exp), OECD stated near term inflation risks are to the upside and gathering momentum, Biden gives first address to UN summit, China pledged to stop financing coal-fired power plants, UK issues first environmental focused govt bond – “green gilt’ – to record to demand, Texas doctor that admitted to performing abortion is sued under new law, UK PSNB 19.8b (14.6b exp), Sweden unemp 8.8% (8.4%p), US housing starts 3.9% MoM (1%e), S&P -0.1%; Wed: Fed unch as exp – slightly hawkish / Powell hints at taper beginning in Nov and being done by mid-2022 (faster than exp), PBOC injected 90b via OMO, US House of Rep voted to suspend the debt limit to maintain funding – bill could fail in Senate causing govt to shut down 10/1, BoJ unch as exp, France to return ambassadors to US after AUKUS fallout, Russia PPI 28.6% (28.4%e), S&P +1.0%; Thur: Evergrande headline ping pong: “China tells Evergrande to avoid USD bond default” / “China asks local gov’ts to prepare for downfall of Evergrande” / “USD bond holders haven’t received int payment”, CBRT cut 100bps (unch exp), BOE unch (as exp), BCB hiked 100bps as exp, Norges bank hiked 25bps as exp (first hike), SARB unch as exp, SNB unch as exp, Australia PMI mfg 57.3 (52p), France mfg PMI 55.2 (57e), German mfg PMI 58.5 (61.4e), EU mfg PMI 58.7 (60.3e), UK mfg PMI 56.3 (59e), US init claims 351k (320k exp), US mfg PMI 60.5 (61e), US leading index 0.9% (0.7%e), S&P +1.2%; Fri: PBOC announces that all cryptocurrency related transactions are now illegal and must be banned, Evergrande bond holders still waiting for interest payment (30d grace period has begun), China released Canadian prisoners after Canada released Huawei executive Meng Wanzhou, S. Korea PPI 7.3% (7.1%p), Sweden PPI 15.8% (13.5%p), Brazil IPCA 10.05% (9.94%e), S&P +0.2%.

Weekly Close: S&P 500 +0.5% and VIX -3.06 at +17.75. Nikkei -0.8%, Shanghai -0.0%, Euro Stoxx +0.3%, Bovespa +1.7%, MSCI World +0.2%, and MSCI Emerging -1.1%. USD rose +19.4% vs Ethereum, +12.0% vs Bitcoin, +2.8% vs Turkey, +1.6% vs South Africa, +1.1% vs Chile, +0.9% vs Brazil, +0.7% vs Yen, +0.5% vs Sterling, +0.3% vs India, +0.2% vs Indonesia, +0.2% vs Mexico, flat vs Euro, flat vs Australia, and flat vs China. USD fell -0.9% vs Canada, -0.4% vs Sweden, and -0.1% vs Russia. Gold -0.2%, Silver +0.2%, Oil +3.0%, Copper +1.0%, Iron Ore +3.2%, Corn -0.4%. 5y5y inflation swaps (EU flat at 1.74%, US flat at 2.38%, JP -1bp at 0.23%, and UK +5bps at 3.82%). 2yr Notes +5bps at 0.27% and 10yr Notes +9bps at 1.45%.

YTD Equity Indexes (high-to-low): UAE +55.1% priced in US dollars (+55.1% priced in dirham), Saudi Arabia +29.7% priced in US dollars (+29.7% in riyal), India +26.4% in dollars (+27.7% in rupee), Russia +25.8% (+22.8%), Czech Republic +25.2% (+27.3%), Austria +24.9% (+31%), Argentina +23.6% (+44.8%), Netherlands +21.4% (+26.7%), Israel +19.6% (+19%), Hungary +19.3% (+22.4%), Norway +19.2% (+19.3%), Venezuela +18.8% (+328.2%), Taiwan +18.8% (+17.2%), S&P 500 +18.6%, Canada +18% (+17%), Denmark +17.2% (+22.9%), Sweden +16.9% (+23.4%), NASDAQ +16.8%, Poland +16.6% (+23%), MSCI World +15.4% (+15.4%), Mexico +15.3% (+16%), France +14.6% (+19.6%), Russell +13.8%, Ireland +13.8% (+18.7%), Euro Stoxx 50 +12.2% (+17.1%), Finland +11.6% (+17%), Italy +11.4% (+16.8%), Belgium +9.5% (+14.3%), UK +9.4% (+9.1%), Germany +7.9% (+13.2%), South Africa +5.5% (+6%), Switzerland +5.4% (+10.4%), Spain +5.3% (+9.9%), Australia +5.2% (+11.5%), Singapore +5.1% (+7.6%), China +5% (+4%), Greece +3.4% (+7.9%), Japan +2.8% (+10.2%), Portugal +2.4% (+6.8%), Thailand +1% (+12.5%), Indonesia +1% (+2.8%), Korea +0.3% (+8.8%), New Zealand -1.1% (+1.3%), Chile -5.9% (+4.8%), Brazil -7.8% (-4.8%), Philippines -8% (-2.6%), Malaysia -9.6% (-5.8%), HK -11.5% (-11.2%), Colombia -18.8% (-8.9%), and Turkey -21.3% (-6.2%).

Regime Change: After decades, you recognize patterns. The biggest winners and losers in each cycle tend to be younger. Unburdened by the past, open to change, they often lack fear. Older folks who remain standing are either lucky or attained some wisdom, acquired at great cost. Pain. The most honest of those live in the fear that they have gotten lucky, and it will run out. Having recognized the impossibility of knowing the future, and knowing each cycle contains some new surprise, they surround themselves with younger people, blending the strengths of young and old.

Chase Muller and Patrick Kazley on our team co-authored a whitepaper titled: Regime Change Resilience - Rebooting Risk Mitigation with Structural Correlation. Here are some excerpts:

Regime Change II: Beginning in 1962 when the daily bond time series is available and going through today, the correlation between stocks and bonds is slightly negative (-0.1 correlation). The t-statistic, or level of reliability of that full sample observation, is highly statistically significant with a -7 t-stat, where a t-statistic of approximately +/- 2.5 or larger is typically considered statistically significant. The t-stat being much larger than that makes it very unlikely to be a spurious finding over the sample period.

Regime Change III: However, if you divide this timeframe into different periods, the apparent consistency and reliability of this observation changes drastically. From 1962-1981, when US interest rates went from historic norms to record highs, the correlation between bonds and equities inverts and is positive (+0.2 correlation). Thus, in Oct 1981 when interest rates reached their secular peak, if you had used a backward-looking risk model to estimate cross-asset correlations or build a risk mitigation portfolio, you would have assumed equities and bonds were positively correlated, and indeed the significance of that relationship would have been entirely supported through a statistical lens (+13 t-stat).

Regime Change IV: Naturally, you might be tempted to look at these results and conclude the relationship between equities and fixed income is indeed reliable, as long as you control for the rising or falling rate environment. However, the relationship and changes to it are not as easily predicted by a single factor such as the general drift of interest rates over time. To illustrate this, from Oct 1981 – Oct 1998 when rates collapsed from highs, the relationship between stocks and bonds was also positive with a higher level of consistency (+0.2 correlation, with a +16 t-stat).

Regime Change V: Lastly, the 1998-present period resulted in a -0.4 correlation between stocks and bonds, with a highly significant -30 t-stat. What we have not explored here, but is also worth highlighting at least in passing, is the potentially undesirable conditional correlation that can accompany transitory relationships. Even an assumed relationship that holds on average over longer time frames can break down in extreme risk-off events and lead to deeper drawdowns and more short-term pain. March 2020 was a such a case of risk assets concurrently declining and transitory correlations breaking down when they were needed most.

Regime Change VI: Using backward-looking returns to justify cross-asset correlation expectations might yield convincing statistics, but ultimately this approach has not proven to be a fully reliable method of sourcing correlation estimates essential for proper risk mitigation and diversification. Indeed, without properly matching a statistical observation with an intuitive linkage, you run the risk of relying on ephemeral relationships for stability. This raises a question: If forward-looking allocation models based on historical returns are only valid in a world of relatively static cross-asset relationships, how does an allocator find reliable sources of diversification in the face of regime changes?

The answer is rooted in finding and adding sources of structural correlation that are resilient to such impacts. See the attached PDF to read the full whitepaper that examines the topic: Regime Change Resilience - Rebooting Risk Mitigation with Structural Correlation

Anecdote: “I’m stressed Dad,” said Jackson, nearly twenty-years-old, preparing for mid-terms. I smiled, hearing in his voice the story of my life. “Stress is okay, drowning isn’t. Which is it?” I asked. “Let me put it this way, my easiest classes are Calc 3 and Physics.” I laughed, couldn’t help it. “What’s your favorite class?” I asked. “Matrix Theory for sure. My professor is awesome.” Jackson and I discussed Matrix Theory this summer -- back when I knew more about quantum mechanics than he – I explained how happy I was he’d earned the opportunity to study something so enigmatic. There’s nothing as gratifying as seeing our children surpass us. And I’d glimpsed the leading edge. “It’s wild the way he teaches, he’s young, unusual, incredible. He just told us the exam will be 80% what we’ve studied, and 20% things neither he nor we have ever seen.” I nodded. Young minds are sublime. The greatest teachers unleash them. Werner Heisenberg made his miraculous breakthrough at twenty-three, after a period of total isolation and fevered contemplation on Helgoland, a desolate island in the North Sea. Heisenberg’s uncertainty principle opened the field of quantum mechanics. “Our whole class was like, you’re kidding right? Of course, he wasn’t. But I get it, he’s training us to think for ourselves under pressure, to see what ideas form, to stretch us. Maybe himself too.” Stress is the prerequisite for growth, the key ingredient for an interesting life. I explained to Jackson I’ve spent a career over my skis, getting myself naked short, scrambling to cover, over and over. That’s how you build a business, or anything for that matter. It is what produces the pressure to perform. In time you come to see stress as a gift, a lever. “Your professor is exactly the kind of person you need to fill your life with, that’s something I wish I’d learned at your age,” I said. “I hear you Dad,” Jackson said, laughing, “but at this exact moment, I’m just kind of wishing I’d chosen an easier major.”

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.

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