In his piece today, Dylan Grice returns to his favorite topic: hedging tail risk. That said, he also compares one Ben Shalom Bernanke to Rudolf von Havenstein who singlehandedly increased the German money supply by a few hundred million percent in a few weeks. Yet that is not Grice's focal topic (for those who wish to read Grice's extended thoughts on the von Havenstein-Bernanke comparison, click here), and instead the SocGen strategist goes a few steps ahead and looks at the possibility that if indeed there is a massive bubble being blown, nowhere is it more obvious than in the Emerging Market world. And taking that idea, Dylan, who lately has been very much on a tail risk hedging wave, provides one idea of how to protect against cheap inflation risk originating in the Emerging Markets (or where-ever).
But first, as it certainly deserves a mention, here is today's stab at Rudy von H:
My latest notion concerns the bizarre but true tale of the hapless von Havenstein who was trying to reassure a desperate German populace in August 1923 at the height of the hyperinflation. Upon hearing complaints from good citizens that by the time they’d visited the bank to withdraw wages, filled up their wheelbarrows with the proceeds and struggled down to the local shop to buy a week’s worth of groceries, they could barely afford a potato, von Havenstein paused, thought and then added two plus two, to arrive at about … oooh … sixteen million, the hyperinflation rate then prevailing.
Noting that currency bestows purchasing power and observing the troubling lack thereof across the country, he diagnosed the problem as being a lack of currency, and concluded that more printing would solve the problem. Thus he boasted on 17 August 1923:
“The Reichsbank today issues 20,000 milliard marks of new money daily … In the next week the bank will have increased this to 46,000 milliards … The total issue at present amounts to 63,000 milliards. In a few days we shall therefore be able to issue in one day two-thirds of the total circulation.”
So where is the prevailing bubble today? In the emerging markets (to skeptics of course), where believes, like Von H see nothing but unlimited growth and green pastures
Bubbles always start with a compelling story. In the mid-1990s, the hype said that technology in general and the internet in particular were going to change the way we lived, the way we did business and the way we interacted with one another. And, as it happened, subsequent vents justified the hype. They just didn’t justify the nosebleed valuations tech stocks attracted before the crash of 2000.
Today, emerging markets are the compelling story du jour: their demographics are broadly favourable, their people work hard, they’re starting from a low base and their governments are solvent. But it’s better than that, the stock markets don’t look richly valued either. The following charts shows Shiller-type real Cyclically Adjusted Price Earnings ratios for the BRIC markets (i.e. real CAPE ratios, with a seven-year cyclical adjustment).
So EMs should be a slam dunk here for true believers, whose problem of knowing when to exit is something they can worry about later. But what about the sceptics? What about those who worry that China poses a potentially bigger deflationary shock than the Great Crash of 2008, or who are already nervous of the “this time is different” feel that emerging market discussions are increasingly taking? What to do for those who worry that India is overheating, or who think it is too risky to be aggressively betting on a world in which the biggest governments are also the least solvent?
Grice suggests buying some cheap (hyper)inflation insurance. In fact, Grice's presentation from two weeks ago on the topic of tail hedges should be required reading for all asset managers, especially those who never have an original idea and like blind, stupid and retarded lemmings follow everyone else as the last hot potato buyer of bubble stocks such as Amazon, Netflix and pretty much everything else.
A few weeks ago I ran through five ‘tail-hedges’ and concluded that the deflation tails were generally too expensive. But the flipside is that inflation hedges are relatively cheap, and what is a nascent EM bubble if not a near-term inflationary risk? The following chart shows that two-year skew – the difference between the implied volatility of puts relative to calls – is incredibly rich, reflecting the strong revealed preference to protect the downside relative to the upside. Central bankers don’t know much; but they do know how to blow bubbles, and the equity options market is currently offering relative value on precisely that scenario.
This is just the tip of the Iceberg. Below we include Grice's full notes from SocGen's terrific conference, and suggest that anyone concerned about the idiots in the Eccles building blowing up the world, should get in touch with Dylan direct about self-flagellation suggestions, and hedge ideas.