Wait. Worry.

Oil at over 100 usd is bound to irritate the American SUV driver. When oil was at 147 usd in 2008, inflation was 5% and the world was a wonderful place. Yet we worry now when inflation is 1.6%. A high oil price is, however, a brake on economic growth.

There are complex relationships underlying the single number that characterizes inflation.

Demand outstripping supply is one way to stoke inflation.

Too much money for a given level of real demand chasing too little supply is another.

One cannot help but suspect that at least for the developed nations, who coincidentally form the bulk of the indebted nations, inflation is not such a bad thing. Central banks might conspire to ignite it or at least ignore it.

In emerging markets inflation has reared its head and central banks have been quick to raise interest rates in response.

The US Fed, however, seems content to hold down rates and to print money. Inflation there is a mere 1.6%, aided and abetted by falling house prices and costs of housing which account for over a quarter of the CPI basket. If housing stabilizes, it could place the Fed in a difficult position. For now, this phenomenon provides the Fed with latitude to print and to drive equity and credit markets higher. Until the Fed reverses its policy, equity markets, commodities and oil are likely to keep going higher.

Emerging markets’ fiscal rectitude and hawkish monetary policy have created a correction in their risky assets such as equities, but investors are likely to reward their responsibility once evidence that inflation is under control emerges. It is likely that this will only surface once the Fed starts tightening as well. This is the signal to rotate into emerging market equities.

As an asset class, equities are likely to continue their bull run. Global growth, at least the nominal variety seems supportive. Any pullbacks seem to be driven by responsible monetary policy and represent opportunities to buy. The outlook for bonds is less optimistic. Inflation is unfriendly to fixed income. Only short memories can argue for a the continuation of a 3 decade long bull run in fixed income. The 4 decades preceding Volcker’s inflation fighting crusade were very poor for fixed income.

The wildcard here is Middle East North Africa. The instability seems not to stem from religious or even political fracture but from social and economic pressures, notably along the lines of age on the one hand and orthogonally along the lines of income or wealth inequality.

The catalyst for the unrest is usually unpredictable, which has been the case. For the US the situation is dire. It risks not only energy security but strategic impairment in one of the most important regions in the world. Ironically, its ally and longtime Arab bugbear, Israel, has been reduced to a bewildered and quaking kibbitzer in this insane game.

There is the risk that the revolutions in Egypt and Tunisia spread to the rest of MENA. There is no good analogue. The fall of Communism in the late Eighties also left a clutch of countries irrevocably changed. The vacuum that Communism left behind was filled not with democracy or capitalism but chaos. MENA could go the same way. It is unclear what the Arab Street wants, although it is quite clear what it doesn’t want. Freedom and self determination are laudable ideals but not a sufficiently defined blueprint for nation building. Nature abhors a vacuum and tends to fill it with anarchy and chaos. The risk of more failed states arising is high.

Long term instability in MENA may encourage hoarding and further drive up the prices of commodities. A chronically high oil price while not catastrophic will act as a tax on global trade. The inflation rate associated with a given level of global output must rise.

It is hard to predict how the instability in MENA will unfold and it is futile to speculate on the repercussions to unpredictable events. One can only wait and see and react to the situation as it unfolds.

In the meantime we are nervously long the market with a tight stop and a tricky trigger finger.

Bernie Madoff alleged that JP Morgan “had to know” about his fraudulent scheme. Forget about JP Morgan.  Many of the victims of Madoff were just dishonest.

Madoff never hid the fact that his fund was self custodied and administered. He got investors to look the other way by suggesting that he was front running his own broker dealer operation.

Investors would have known that a simple split strike conversion trade could not achieve the results Madoff did except if he had an unfair advantage.

Not all of Madoff’s victims were dishonest. But the more sophisticated ones were. They knew he was ripping somebody off. They just never guessed it was them.

Inflation:

I had written about inflation in October 2010, cautioning that the output of the central bank’s printing presses would inevitable lead to rising prices.

Today, inflation is one of the main concerns in the global economy. Its not ideal but it is far from a catastrophe. Some inflation is healthy and the economy can sustain a higher level of inflation than it thinks it can.

US inflation

US CPI under-measures inflation due to a large weight (25.5%) in housing, owners’ equivalent rent.

Housing prices in the US are in a double dip, the Case Shiller 20 is -1.59% YOY for November 2010 (next reading Feb 22, 2011).

Discounting owners’ equivalent rent, all other items are rising at about 2.2% for the CPI number to equal the reported 1.3%.

If owners’ equivalent rent, which is correlated to house prices and mortgage rates starts rising, and there is evidence of recovery in the US(better GDP, manufacturing and employment numbers) as well as a pickup in mortgage rates, the impact on CPI could be significant. If housing simply flatlines, CPI will jump to 2.6%. If housing costs start to rise inflation will be higher.

Notably, inflation breakevens are around 2.95% so the market is not entirely mispricing inflation.

Is inflation a serious concern?

The source of the current inflation has been rising commodity prices from energy to industrial metals to agricultural products. Food is 13.7% of the CPI and of that 10% is likely raw foodstuffs. Fuel for transportation is 4.5%. In all commodities ex food and beverages is some 25% of CPI. In 2010 the CRB Index rose 16.60%.

Economic theory tells us that in the long run prices will rise to ration scarce resources. Also, sufficiently high prices will drive the search for alternatives.

Hyperinflation of the sort found in failed states tends to be a consequence of a failure of confidence and is discontinuous. This is not a systemic risk in the current inflationary environment. It can arise though if the situation in Egypt should spread into a wider paradigm shift akin to the fall of Communism in the early 1990s.

Wage price spirals tend to be persistent and self reinforcing. Theory does not account for political and social factors that render substitution away from labour infeasible. The current inflationary environment is not driven by wage inflation. In fact the labour market remains slack. US personal income growt peaked in 2006. While it has recovered robustly from the crash in 2009, it appears to have hit a ceiling again in late 2010.

Poorer economies such as China are at risk of wage price spirals. Food represents 34% of CPI in China. Wage growth in China is in the high teens and has been accelerating of late. Whereas India’s RBI has been proactive and hawkish on inflation, China’s PBOC is torn between maintaining some form of export competitiveness, upholding the value of its foreign reserves and tackling inflation.

The probability for runaway inflation to take hold in any of the major economies is non-trivial but the odds are low. The developed world has become accustomed to low inflation rates for too long. In fact a certain level of inflation is desirable, especially given the level of debt still on sovereign and household balance sheets. Higher interest rates too are not entirely undesirable as they represent a hurdle rate for investments and ensure a healthy respect for opportunity costs.

Longer term outlook for inflation:

The reason that developed world inflation has been so benign while interest rates were persistently low and economic growth was surprisingly robust is simple; even if central bankers were slow to realize it. As capacity utilization rates headed in to the 80% – 85% region in the US for example, developed countries began to outsource low value added services such as manufacturing, in effect, off-shoring capacity. This meant that the national, as opposed to domestic capacity limit was actually over 100%. There was slack in the system. The off-shoring of manufacturing also increased domestic productivity as developed economies became more heavily weighted in services.

The success of this strategy necessarily resulted in balance of trade, current and capital account imbalances.

The future will likely see developed economies attempt to rebalance their economies in favor of manufacturing and exports. The consequences are likely to be lower domestic productivity and a higher level of inflation associated with each given level of output growth, assuming that the technology of economy remains constant.

Higher commodity prices and food inflation appears to be fact of life. You can read about this elsewhere.

Higher fuel costs are expected to persist. Apart from the usual inflationary effects higher fuel costs act as a tax on trade. For countries where imports and exports are a significant portion of GDP, higher fuel costs can drive inflation indirectly.

While inflation is expected to be structurally higher going forward it is unlikely to be debilitating. As developing countries evolve towards better technology and innovation their productivity will rise to ease some of inflationary pressures. At higher frequencies, however, markets are driven by psychology and misunderstanding and a good deal of overshooting and cyclicality can be expected.

Artradis is basically a volatility fund which seeks to buy cheap convexity where it can find it. It is a structurally long volatility fund. And it has become tired of volatility falling steadily since the crisis of 2008.

Investors are selling FX vol, equity vol, commodity vol, credit vol, usually in the form of some structured product. So structured that they often don’t realize that they are in fact selling short vol, i.e. selling vol they don’t already own.

How much lower can vol go? Let’s look at the VIX index. Vols have a peculiar trading pattern. They tend to trend downwards over long periods and then spike up in times of stress. So shorting vol is a bit like playing the game of chicken. How long are you happy to career towards that oncoming car before you (or it) veer away? Too much courage ends in a blaze of glory.

The VIX spent the first half of the 1990s slowly receding to 10 before picking up in 1996 and spiking to 35 in 1997 on the back of the Asian crisis. It spiked again to 44 when LTCM imploded in a puff of leverage. It stayed elevated through the Dotcom bust, 9-11, peaking in 2002 at 40 amid accounting scandals and sagging equity markets. As the economy recovered from its wounds the VIX went into decay mode once again reaching a low of 10 in early 2007 before the US non-conforming mortgage market began to unravel. When global markets stared into the chasm in Sep 2008, the VIX hit a high of 60. It has spent the next 2 years receding to a level of 17 in Jan 2011.

With a global economy as unstable as it is today, granted in recovery mode, a strategy of shorting vol is simply risky. Shorting vol is equivalent to providing insurance. Premia are low. The compensation for providing insurance is therefore not commensurate with the risks. In such environments the safer trade is buying insurance, not selling it.

Its time to be long volatility. Unfortunately, for some habitually long volatility traders like Artradis, 2 years of receding vols have been too much to bear. And its usually when the 800 lb gorilla has left the room that the party begins.

The macro outlook is benign and it seems that the fiscal and monetary policies of the world have brought about some kind of normalcy and equilibrium.

There is consensus that equities should rise, government bonds will struggle, commodities and precious metals will appreciate, the USD will resume its weakness against the emerging market currencies and the Euro will decay or decompose.

In non-extreme states the consensus is usually a reliable guide and we are not at an extreme, except perhaps in sovereign debt.

US economic growth will likely trundle along at a healthy pace, abetted by the Fed’s funding of government largesse. Never underestimate the effectiveness of a blunt instrument as an all purpose tool. This is view is true for most economies.

Inflation is elevated almost everywhere except in the US where it is a paltry 1.1%. This is an area of potential risk.

Investors have tolerated money printing and low interest rates in the US because the labour market is loose, growth while positive is 2.6%, short of a 50 year trend rate of 3.3% and inflation is a paltry 1.1%. If inflation was to surprise on the upside, the reaction in the fixed income markets could be significant. Inflation is already under-measured due to the 25% weight of owner equivalent rent in the CPI and is closer to 3.5% than 1% assuming a double dip in housing is underway. Already the breakevens are saying 2.5%.

The implication for US equities is as significant. With economic growth as sluggish as it is, the spectre of inflation may suggest a higher structural NAIRU and a world where inflation is higher for each level of economic growth. This is the opposite of the 90’s Goldilocks economy where high growth coexisted with low inflation and low interest rates. The share of manufacturing in the economy is an explanatory factor. Almost everywhere manufacturing is driving the global recovery. Whatever the cause, high inflation and slow growth is not a desirable outcome.

Be that as it may, we now have a catalyst to look out for.

As long as governments are fabricating money, anything that cannot be extracted, manufactured or grown faster than the printing presses will appreciate.

Equities rarely track economic growth tightly or in phase. Equities are likely to be driven by macro factors for another year which means appreciation driven by fiat money debasement. Idiosyncratic risk is likely to continue to rise, albeit slowly. The recovery of idiosyncratic dispersion has been glacial since the crisis with performance dispersion being explained mainly by rotation through thematic macro and country factors. This is a difficult environment for the fundamental stock picking long short manager. A thematic trading manager will find easier pickings.

On other fronts, the number of M&A deals has steadily risen. Cash on balance sheet, successful refinancing of debt and low interest rates has brought a moribund market back to life. Even PE sponsored MBOs and LBOs have begun to resurface. The appreciation of acquirer prices is likely to embolden more CEOs fuelling more activity. Merger arbitrage funds are likely to see more opportunities going forward.

Governments’ pump priming has lead to wafer thin yields, increased debt issuance and desperate investors feeding a refinancing frenzy in 2010 so much so that default rates have dwindled as even the weak postponed their fate. The opportunities for distressed debt investors will definitely be less rich than last year. They are likely to get another chance. In the meantime, it pays to be extra discriminating when hiring a distressed debt manager.

Predicting the fortunes of macro funds is a tricky exercise, like riding a bicycle backwards. Macro will have ample opportunity to shine (or burn) given how macro driven markets have become. This is likely to persist at least until macro falls out of investors’ focus. The caveat is that the opportunity to get it wrong is quite great as well. Central banks telegraphing their intentions provide tailwinds to macro but particularly in the fixed income area.

Trend followers have done an average job. There have been a couple of reversals in the market but by and large markets have been well behaved enough for algos to take hold. Again fixed income has been easier for trend followers.

Convertible arbitrage has settled into its old cycle of rotation through gamma, vega and delta strategies as the market has unfolded. Issuance has recovered a little but no to pre crisis levels. Asia is the exception where issuance has been robust and arbs have been quick to take advantage.

Pure vol strategies have struggled, especially structurally long vol strategies. May provided a spike in vol but otherwise vol has trended down in a normal pattern. The trend has been so consistent since June that vol arbs should have been able to adjust. Many didn’t as they are chronically long vol or were unable to short vol and cover the tails.

For relative value and arbitrage, there is no new or old normal. As long as markets are liquid and the rules are known, these strategies will return to normal, and they have already. Moreover, the arbitrage opportunities have been sufficient for these funds to generate good returns at lower levels of leverage than prior to the crisis.

It’s a good time to be investing in arb and rel val.