Crescat Capital Fanning the Flames of Inflation
Since 2009, tremendous central bank inflationary monetary policies on a global scale have been met with deflationary inflation expectations in what some refer to as a Keynesian liquidity trap. The result is the largest global financial asset bubble of our lifetime. This is in fact a bubble as defined by the combined record valuation of US household and non-profits holding stocks, bonds, and cash relative to these same entities’ underlying income. It is also a global debt to GDP bubble of historic proportions. The bubble did already peak last year with the oil price collapse and the stock market melt-up and melt-down in China, followed by a small yuan devaluation. We strongly believe that we have only seen the tip of the iceberg in terms of the erosion of the real value of financial assets and the rise of interest rates, and even more inflation, which is necessary to reconcile the global debt to GDP bubble. China is the lynchpin: the credit and currency bubble that has caught the world off guard. China is leading the selling off of developed market sovereign bonds to cushion its inevitable currency crisis. Most investors still don’t get it.
The inevitable reconciliation of the record global debt-to-GDP through inflation will negatively impact the valuation of fiat currencies (cash), bonds, and stocks by definition. By owning the right inflation hedge securities and by being short most overvalued financial assets, active, hedge-fund style investors have the chance to preserve and increase wealth for their clients in a rising interest rate and rising inflationary environment that is undeniably in front of us. Equity index fund investors and those holding large savings in cash and fixed income securities in our view may see nominal gains over the next three to five years, but will suffer negative returns in real terms necessary to transfer wealth from creditors to debtors.
We are in the early stages of a new financial asset crisis. Many investors do not realize it yet, but after the convulsive market melt-up that we just had, they have been quick to exit their long-term underperforming hedge funds. This massive shift is the type of capitulation that could be one of the hallmarks of this financial asset bubble market-top: masses abandoning hedge funds and active managers in a passive vehicle buying frenzy because of their underperformance compared to equity index funds over the last seven years.
Beating the market substantially over time is indeed possible, and Crescat has proven that in all three of our products since inception. To beat the market over time with Crescat, investors need to invest when we see that the time is right (right now!), believe in us and our process, and then stick with it. This means that clients need to invest during and stay with us during our inevitable shorter-term periods of drawdowns and underperformance. If clients invest after a drawdowns or a period of underperformance, we are confident that the long-term results they seek will come to fruition. Here are some statistics that will help illustrate this point:
Joel Greenblatt, a Columbia finance professor and money manager summed it up well in a recent Barron’s interview. He talked about a study that showed how many investors fail to time active managers properly. The study shows that the best performing hedge fund from 2000 to 2010 was up an average 18% per year during the same time the overall market was up less than 1% annualized. The problem was that the average investor went in and out of the fund at the wrong times on a dollar-weighted basis to lose 11% per year. He goes on to cite statistics for top-quartile managers for the entire decade of the 2000s that were similarly instructive. 97% of those managers spent at least three of those years in the bottom half of performance, 79% spent at least three years in the bottom quartile, and 47% spent at least three years in the bottom decile.
At Crescat, we have delivered top quartile, long-term net performance in all three of our products on a risk-adjusted basis. Yet, we have seen clients shaken out during our periodic drawdowns to not receive our long term market beating net returns. Our drawdowns have been no greater than market-sized drawdowns on average. Sometimes, particularly in our hedge funds, the drawdowns can come in up markets. We strive for low correlation to the markets in our hedge funds, particularly at times when the overwhelming preponderance of signals from of our macro themes and valuation models are bearish.
To be a top performing manager over time means having a sound discipline and taking prudent risks. Every good manager will face speed bumps from time to time. The ones that perform the best over long periods of time have sound fundamental-based and repeatable investment processes and prudent risk controls. In our case, we combine our disciplined, fundamentally-driven equity valuation model with macro models and themes to navigate boom and bust market cycles across three Crescat products. We also use a Conditional Value at Risk model to limit our risk exposure and diversify it across various longer-term macro and shorter-term opportunistic themes. We have one firm-wide investment discipline that we express through three client products: Long-Only Large Cap, Long-Short Equity, and our multi-asset class Global Macro strategy.
We have been facing some crosscurrents in the markets that have hurt our short-term performance, but we are staying grounded in our discipline that has worked to produce some of the best long-term returns in our industry. Our process has only become more refined, disciplined, and we believe better over time and experience. Many of our short positions in our hedge funds had been working against us since the mid-February stock market melt-up. But our short positions have started performing better recently. We strongly believe this melt-up is unsustainable and that we are near the end of a cycle of broad hedge fund underperformance and broad index versus active manager outperformance.
A recent drop in precious metals longs, and in our Twitter equity long equity position have also hurt us recently across all strategies, but gold and silver and related equities have started to perform well again in recent days affirming our views. We incorporate both long and short positions in or hedge funds. Our hedge funds are not speculation funds but are funds that truly attempt to hedge. We believe that our short positions in our hedge funds will be critical as we enter the next phase of the financial asset bubble devaluation that will coincide by definition with rising interest rates and rising inflation globally.
Our Global Fiat Debasement theme that houses our gold and silver long exposure has been our best performing macro theme across all Crescat products year to date. We expect this trend to continue. Gold remains historically cheap relative to the global fiat monetary base and global central banks are net buyers of gold. We want to be on their side.
We strongly believe that we have only seen the tip of the iceberg on the China yuan currency devaluation and that China is headed for a currency crisis that will have broad contagion effects on global financial markets.
The Fed and other developed market global central banks are newly determined to stoke inflation expectations under the traditional Keynesian idea that inflation is a good thing for an economy that is operating below its full potential. Inflation is already on the rise and so are interest rates globally. The problem is that rising inflation expectations and rising interest rates, while they are good for nominal economic growth, can also ignite animal spirits that move financial flows out of financial assets and into inflation hedge assets that can cause unruly corrections in financial asset prices. This is where central banks are between a rock and a hard place.
The Fed has been running a hot monetary policy for more than seven years where they have been in both a negative real interest rate environment and one with real rates below the Fed’s theoretical natural (real) rate of interest, the latter being the rate keeping inflation stable. By running below the natural rate for the last seven years, the Fed along with other global central banks have already been creating substantial pent up inflationary pressure that, to date, has only succeeded in creating financial asset bubbles. After years of failing to surface materially, signs of inflation are starting to appear. Both wages and rents are on the rise, as well as inflation expectations. The rise in inflation expectations as of late, although only just starting after many years of declining money velocity, is the critical timing variable.
Ideally, economic policy makers want to see increased economic transactions and true productivity increases, not just increases in wages and prices through inflation. Productivity growth has been elusive under an aging demographic despite many exciting technological advances particularly in computing and biosciences. Wage and price inflation will indeed boost nominal GDP and help to devalue debt. So, here we are. The Fed is now deliberately trying to increase inflation expectations and is now willing to let the economy run hotter than the 2% inflation target. They are finally succeeding in turning up expectations.
In our Global Macro Fund, we have new theme that we call Peak Deflation and we are short a variety of long duration low interest sovereign bonds as the worlds developed market central bankers are now deliberately bursting the financial asset price bubbles they have created.
The bottom line is that the current global financial asset bubble has already started to unwind. It will continue to unwind as all bubbles do. It will unwind with rising inflation in wages and prices and hopefully some productivity gains too. Absent a miracle productivity surge, the one thing we can count on is rising inflation, rising interest rates, and declining real values of financial assets.
Below you will find October mid-month and YTD net estimates for all three strategies:
Crescat Global Macro: -2.3%
Crescat Long/Short: -4.5%
Crescat Large Cap: -4.0%
S&P 500: -1.8%
2016 YTD Net Estimates (through 10/17/16)
Crescat Global Macro: -7.8%
Crescat Equity Long/Short: -7.4%
Crescat Large Cap: +7.5%
S&P 500: +5.9%