Incrementum Advisory Board Meeting Q4 2017 –Special Guest Ben Hunt, Author and Editor of Epsilon Theory

The quarterly meeting of the Incrementum Fund’s Advisory Board took place on October 10 and we had the great pleasure to be joined by special guest Ben Hunt this time, who is probably known to many of our readers as the main author and editor of Epsilon Theory. He is also chief risk officer at investment management firm Salient Partners. As always, a transcript of the discussion is available for download below.

Ben Hunt, author of Epsilon Theory and chief risk officer of Salient Partners

As usual, we will add a few words here to expand a little on the discussion. A wide range of issues relevant to the markets was debated at the conference call, but we want to focus on just one particular point here that we only briefly mentioned in the discussion. In fact, as you will see we are about to go off on quite a tangent(note: Part II will be posted shortly as well).

Among the things Ben Hunt specializes in are the narratives accompanying economic and financial trends, and not to forget, economic and monetary policy, which inform the “Common Knowledge Game” (in his introductory remarks, Ronald Stoeferle provides this brief definition: “It’s not what the crowd believes that’s important; it’s what the crowd believes that the crowd believes”). This reminded us of something George Soros first mentioned in a speech he delivered in the early 1990s:

Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.

This is undoubtedly a great insight and great advice for traders and investors. Long-time readers may recall that we have occasionally mentioned in these pages that Ludwig von Mises described successful speculators as akin to “historians of the future”. Soros appears to have a very similar view of speculators.*

We believe that being au fait with sound economic theory to some extent can be helpful for people investing in financial markets, but a good grasp of economic history seems even more important. The process speculators employ to arrive at their decisions has certainly more in common with what Mises called the understanding of the historian than with economic theorizing. Knowledge of theory can improve and refine said understanding though, and help constrain forecasts.

Soros coined the term “reflexivity”, which describes something very similar – as he put it, it sets up a feedback loop between market valuations and the fundamentals that are being valued. This is something we can nowadays e.g. observe among junk bond buyers and their odd beliefs about future default rates.

The reflexivity consists of the fact that these default rates depend to a substantial extent on their own willingness to refinance junk-rated companies, many of which would perish if they stopped doing so. In other words, the state of their own confidence contributes decisively to “fundamentals” that are highly important in determining the solvency of the borrowers they continually evaluate. It doesn’t get more reflexive – and as we mentioned, when buyers of euro area junk bonds are paying yields as low as those on US treasuries, it is pretty certain that this confidence is somewhat misguided.

The Inflation Narrative

To come back to Ben Hunt’s observations about narratives: once a powerful market trend has been underway for some time, countless rationalizations are usually offered to justify prevailing valuations. As a rule these aim to convey the idea that one should expect the trend to continue, regardless of how outrageously distorted or extended it seems to be in terms of traditional metrics. Policymakers feel compelled to provide narratives rationalizing their decisions as well, which are subsequently incessantly echoed in the media (this is how they become “common knowledge”).

Ben Hunt mentioned a specific narrative that has accompanied quantitative easing for almost a decade now (even longer, if we take Japan into account). At first glance it appeared reasonable enough: central bankers argued that QE would help increase “inflation”. This is of course unequivocally true in terms of monetary inflation, but they referred to consumer price inflation. Alas, both CPI and inflation expectations obviously failed to respond appreciably to their ministrations. Ben posits that this narrative may be set to falter in a rather unexpected manner, by continuing to defy widespread expectations.

US CPI y/y and three major changes in Fed policy – the beginning and end of active money printing operations and the beginning of the rate hike cycle. QE has done all sorts of things, but CPI has essentially gone nowhere, particularly while QE was still underway (QE 3 ended in October 2014)

In short, the idea is that the end of QE, or rather its upcoming unwinding (“quantitative tightening”), may be accompanied by an unexpected increase in consumer price inflation. One cannot help but be sympathetic to this idea simply based on how contrarian it is. Meaningful consumer price inflation is pretty much the last thing anyoneexpects. We actually briefly discussed this aspect in these pages back in March in “Price Inflation – the Ultimate Contrarian Bet”.