A Race Against Time. October Commentary part 2 of 3

November 16, 2022

Click here to download pdf version: Oct 2022 Part 2 – A race against time

TL;DR

Inflation, Debasement, and Tails oh my

In Part 1, What a Difference a Month Makes, I covered how our strategies performed in October including what the main drivers were. Here, I’ll be covering some of my thoughts on what everyone needs in their portfolio but no one is thinking about right now.

What now?

As I write this, two important and highly-anticipated events have occurred in November. The Federal Reserve announcement and Press Conference gave Chairman Jerome Powell a chance to reiterate his firm resolve to raise rates higher and for longer than markets had anticipated. And yet, the November 10th milder than expected US CPI reading and resulting +5% equity market explosion seem to portend a Fed Pivot sooner rather than later.

I recently recorded a webinar with the brilliant and incisive Michelle Makori, Editor-in-Chief of Kitco News (replay link here) and I wanted to share two charts from it that are particularly relevant:

*Source: Zerohedge

The chart above shows the difficulty European Central Bankers had in predicting the rising inflation rate over the last year, and how their predictions of moderating inflation have so far been singularly incorrect. My takeaway: Even for the smartest Macro forecasters out there, whatever we think we know, we don’t know it quite as much as we think we do, and it’s hard to make predictions.

A Race Against Time

The chart below shows the prior tightening cycles of the Federal Reserve and the terminal Fed Funds Rate, compared to the Inflation Rate. Notice that the current Terminal Rate expectation (orange triangle) is far below the Inflation Rate (green line).

*Source: Zerohedge

In my view, the issue for the Federal Reserve is that they are in a race against time. They have to stop inflation before the funding costs on our $30 trillion National Debt become so high that we reach a death spiral. If we hit 5-6% short term interest rates for an extended period of time, the interest payments on the National Debt eventually consume huge fractions of Federal Tax Revenue. The problem is that unlike many corporations, which sold 100-year bonds for negative interest rates at the bottom of the market, the US Government did not extend its borrowing duration, which is currently averaging about four years. So, that’s about how long they have to get rates back down. Notice in the chart above how long it took for the Fed Funds Rate to drop in each prior inflationary cycle.

However, the Fed can’t raise rates too quickly, or they’ll break something, as almost happened in the UK with leveraged Pension Funds, or as Zerohedge.com often points out, may be happening in the Treasury markets with off the run Treasuries (see here).

Even if we stop inflation, what about the next recession?

It does appear from Powell’s most recent remarks on November 2 that he is dead serious about stopping inflation. But what if this causes a recession? The Global Financial Crisis of 2007-08 required $30 Trillion of Central Bank Balance Sheet expansion, just a tiny fraction of which has now been reduced. What about the next recession, which may already be here? How much printing will that require? And will this be the final straw that tips us into fiat currency debasement? It’s worth pointing out that not a single fiat issuing government since Roman times has failed to debase its currency eventually. From a historical perspective it’s only a matter of time.

Protecting against the great debasement of the 2030s?

It’s for this reason that I’ve been talking a bit less about left-tail/downside protection lately, and  more about two-sided left and right-tail protection in both fixed income and equities.

If a base currency starts to drop in value as it is over-printed, even if equities do nothing in real terms, they’ll still rise in nominal terms and it’s absolutely critical to keep up. Now, to be clear – I’m not predicting currency debasement or hyperinflation as a most likely outcome. I’m merely suggesting that this particular risk – a catastrophic one – is on the playing field in a way that it has not been before, because the Central Banks are no longer able to control the nonlinear dynamic system of the Global Economy in the way they have done so for the last 50 years. Unlike equity bear markets, which might drop 50-75%, and eventually recover over 2-10 years, moderate to hyper-inflation can destroy 95-99.99% of value with no hope of recovery, unless one keeps up.

Consider how a typical long-short equity hedge fund with a typical +0.3 Beta to equities would have done in 1920s Austria. Without a 1.0 or higher Beta to equities, performance would soon turn into a 100% loss, merely by not keeping up with the stock market’s nominal appreciation. To me, an inflationary world requires two-sided convexity. And it doesn’t even take hyperinflation to pose big upside risks. Remember that in 18 months starting in late 1975, the S&P rallied 90%!

Smart Alpha’s two-sided protection improves return while reducing risk

We have worked to build inflation protection into our Smart Alpha Program, which is explicitly designed to provide “Two-Sided Tail Risk Protection.” Because it is -0.2 correlated to the S&P 500, without adding any additional risk, it results in a remarkably large increased return to an equity portfolio. As you can see in the chart below, depending on the tracking error one is willing to allow, various combinations exist.

The same substantial portfolio improvement occurs when the Smart Alpha Program is added to a 60/40 (or 50/50) Balanced Portfolio. Because the Smart Alpha Program is negatively correlated to Stocks and Bonds and provides two-sided tail-risk protection, it dramatically improves the return of 60/40 Balanced Portfolios without increasing the risk. While tripling return, it reduces overall risk and drawdown size (at a 51% allocation).

New version of our Flagship: RG Niederhoffer Macro Diversified Fund

Reflecting the +32%, +19% and +86% performance of our flagship fund over the last three years and the increasing possibility of currency debasement and massive asset price inflation in coming years, we are going to launch a modified version of our Diversified Program in a fund format early in 2023 called the R. G Niederhoffer Macro Diversified Program.

This program will maintain the features that made it the #2 fund in the October HSBC Flash Report – absolute return, long realized volatility, short-duration systematic trading of all four asset classes – but will also add the upside convexity and an ability to ride out strong up years in equities that we feel are an even greater possibility now than ever before.

Adding the upside convexity will also address some of the challenges the original Diversified Program has faced over its 30-year history, where we have perhaps erred on the side of providing a bit too much equity downside protection for our clients. With our historical -0.4 Beta to the S&P since 2000, we suffered more than many funds during the years in which Central Bank liquidity crushed volatility and boosted equities to huge gains. While we don’t see this happening anytime soon due to the inflation risk, it’s still worth considering as a potential outcome.

Stay tuned for our last installment of this month’s commentary coming tomorrow. Part 3: The Notorious SBF (and other acrimonious acronyms such as FTX, BTC and ETH).

Warm regards,

Roy Niederhoffer

President

PS Lisa Ferrero and I will be in Europe from December 5-9. If you’d like to set up an in-person meeting to discuss our Smart Alpha, Diversified Macro or Emerald Programs, or have a conversation about your thoughts on 2023, it would be my pleasure. Alternatively, we’d love to catch up on Zoom before year-end.

 

IMPORTANT DISCLAIMERS

 

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Roy G. Niederhoffer Diversified Program (“Diversified Program”) data reflects the performance of Roy G. Niederhoffer Diversified Fund (Offshore) Ltd. (“DFO”) Class N (an offering with monthly liquidity), net of fees, expenses, and the reinvestment of dividends (during periods when individual stocks were traded), as follows: (i) January 2020 to March 2020, pro forma returns based on actual trading of a representative managed account trading the Diversified Program, adjusted for the leverage of DFO Class N, but having lower fees than DFO Class N; and (ii) beginning April 2020, returns of a representative managed account trading the Diversified Program that has the same leverage as DFO Class N, but lower fees than DFO Class N.

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The hypothetical performance of Smart Alpha Program through November 15, 2018 can also be described as extracted performance, because it is based on a subset of the actual trading of the Diversified Program. You should have already received actual returns for the Diversified Program. If you have not received such returns, please contact Lisa@Niederhoffer in Investor Relations.

Sources: Source: RGNCM; S&P 500 – Total Return; Hedge Funds – HFRXGL; CTAs – SG CTA Index. Comparison to indices is for demonstrative purposes only. No representation is made that results will track or otherwise reflect any particular index.

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