The Macro Compass

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King Dollar Matters

Our monetary and credit system is USD-centric: the lion share of international debt, trade invoices, asset classes and FX volume is settled or denominated in US Dollars.

Funnily enough though, direct access to $ liquidity is only available to entities located in the United States but in a credit-based system the rest of the world also has an incentive to leverage in US Dollars to boost or enhance their global business models.That means European banks, Brazilian corporates or Japanese insurance companies which want to do global business will most likely get exposure to $-denominated assets and liabilities ($ debt) despite being domiciled outside the United States.

The required USD funding happens both on and off-balance sheet, and the FX derivatives market is an important part of the latter and the focus of the latest BIS report which is making the rounds.

In this article we will:

* Discuss the BIS paper, with a deep dive into the ‘‘hidden USD debt’’ story…but in plain English, and in a 15 minutes reading-time article;

* Present our conclusions and findings - spoiler: it’s much more nuanced than the clickbait-y media headlines floating around.

What’s This ‘‘Hidden Debt’’ All About?

Let’s first define some basis concepts first.

A Japanese insurance company which wants to purchase US Treasuries needs USD funding for this transaction, the same way a Brazilian corporate needs USD funding to boost their international activities.

USD bond issuance and repo funding are accounted on-balance sheet and hence transparent and easy to track: we know there is roughly $20-25 trillion of $-denominated funding sitting outside the United States. Big number.But there are also ways to get USD funding off-balance sheet.

FX derivatives (mostly FX swaps and cross-currency swaps) account for the lion share of off-balance sheet USD funding, or what the BIS called ‘‘hidden debt’’.It sounds complicated but it’s not.

A FX swap is an agreement in two steps:

* I sell JPY to buy USD spot (leg 1: spot exchange);

* I agree with the counterpart to sell back the USDs and buy back the JPYs at a pre-agreed price at a given date in the future (leg 2: forward agreement).

Notice how we exchange the full principal at maturity: in other words, this is loan secured by the FX amounts - a property not common to all derivatives, which makes this transaction also somehow similar to a funding deal.

Easy, right?A cross-currency swap is basically the same, but it’s done for longer tenors and it requires exchanges of cash-flows throughout the life of transaction.

Now, why does the BIS tag the USD FX derivatives funding as ‘‘hidden debt’’?Because accounting rules allow for it to be off-balance sheet.

FX swaps are reported on a net basis, while repo or bond issuance in US Dollars is reported on a gross basis and hence immediately visible on the balance sheet.

As per any derivatives, FX and cross-currency swaps require variation margin to be posted by the counterpart under water and hence their mark-to-market is continuously recorded but on average it accounts for 5-10% of the notional amount.So, how big are these notionals?

The BIS estimates off-balance sheet USD funding from entities outside the United States roughly in the $60 trillion ballpark, or ~3x the one recorded on balance sheet.

Massive number: is it all going to collapse?Hold your horses - it’s all much more nuanced than it seems.

Notional amount in derivatives generally matter very little: these contracts are often used to offset existing positions, and being mostly centrally cleared the Clearing House takes care that the continuous mark-to-market and margin posting exercise.

The main question is: who are the players involved, and are they really offsetting existing positions?

The BIS shows they are.The FX derivatives notionals (chart: red) sitting on corporates and banks’ balance sheet outside the United States show a positive relationship with the amount of world trade (chart: black).A $1 billion increase in quarterly global trade over a 6-month period is associated with a $660 million increase in corporates’ FX derivatives positions.

In other words, if a Brazilian corporate gets continuous access to $ cash flows because of its flourishing trade business, using FX swaps will actually be a risk-mitigating exercise as it will allow them to smoothen the USD/BRL FX risks ahead.

So, nothing to worry about at all?Again, it’s nuanced - which means there are material downsides too.

Where Is The Problem?

In short, there are two main problems:

* Plenty of USD funding needs for entities sitting outside the US means a continuous flow of fresh $ is necessary for this system to stay in equilibrium;

* There is a clear maturity mismatch between USD funding and assets, and hence rollover risk during stressed times: what if the lenders step away exactly when you need to rollover your USD funding as an entity outside the US?

The chart below depicts the problem 1. very well.It shows the YoY trend in Korean exports (blue, LHS) against the YoY performance of the DXY lagged by 9 months (orange, RHS, inverted).

As long as exports are growing, US Dollars are organically flowing to Korea and the USD doesn’t appreciate against other currencies - it actually often depreciates when global trade growth is strong.But if the trade growth music stops (blue line down), the USD often rapidly appreciates (orange line down, it’s inverted) a few quarters later.

Why does this happen?

Because a Korean exporter that has leveraged its balance sheet in US Dollars to enhance its business won’t have a problem in periods of strong growth, as $$$ organically flow and he can easily service its $-denominated liabilities.But when these USD cash flows dry up as the economy is weakening, all of a sudden servicing $ debt becomes hard.In a snowball mechanism, all foreign entities leveraged in US Dollars try to de-leverage…which means they bid up the spot USD itself, which in turn hits other foreign USD borrowers in a self-fulfilling prophecy.

The US Dollar wrecking ball in action.

The other problem with this sytem is that off-balance sheet USD funding in FX derivatives is often very short-dated: FX swaps generally mature within 1 year…...but assets are longer dated than that, and hence this funding must be renewed year after year.

Rollover risk is important.

Let’s take a Japanese insurance company - these guys were heavily involved in purchasing 10y+ US Treasuries and funding their need for $ in the FX swap market: they would sell JPY to buy USD spot, purchase the US Treasuries with it and agree to pay back USD for JPY in 1 year.

For long periods of time between 2010 and 2020 this was a very lucrative exercise.

The chart below shows the additional yield the Japanese insurer would get from purchasing 10y Treasuries and hedging the USD/JPY risk with a 1-year FX swap instead of just buying Japanese government bonds - this yield pickup was often in the 100+ bps area.Today the FX hedging costs are so high that this yield pickup has disappeared, similar to the 2005-2007 period.

Notice how the asset (US Treasury) tenor is 10 years while the funding (FX swap) tenor is 1 year - the Japanese insurance companies would need to roll-over their FX swap every year.

It works fine if there is little volatility and lenders of USDs in the FX swap market (e.g. US banks) are there - but what if they are not when you need them?

In September 2008 the FX swaps market froze: 1-year USD/xxx FX swaps suddendly became 100 bps more e…

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Hi all, and welcome back on The Macro Compass!

Quick reminder: from January 1st, getting access to this content (and much more!) will require a paid subscription.

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The Labor Market Holds The Key

Especially at turning points, looking beyond the main headlines in macro data can make the difference in understanding where do we really stand in the macro cycle.

The last US payroll report was tagged as very strong - but if you look deeper you realize the current state of the US labor market is far from ‘‘hot’’.

Job creation is clearly trending down, alternative real-time and forward-looking labor market indicators point to a sharp deterioration ahead and statistical inconsistencies are artificially boosting non-farm payrolls to the point the US government reached out to ask if I could help them look into it.

The labor market holds the key to the Fed reaction function in 2023, and hence it will be a crucial driver of asset classes performance - calling it right can make the difference for portfolios next year.

In this article, we will:

* Dissect the latest labor market report, starting from a deep look into the BLS official data and moving into alternative real-time and forward-looking job market indicators to grasp where do we really stand;

* Assess what that implies for the Fed policy and portfolios in early 2023.

The Devil Is In The Details

The labor market is much less hot than you think.

Let’s get one thing straight though: we are not in a recession yet.Job losses aren’t here, and nominal wages are still growing at a robust pace.But the labor market is clearly deteriorating fast: its current state is far from the ‘‘very tight’’ definitions we often hear, and looking forward it might get real ugly.

Let’s start from a thorough assessment of the official Bureau of Labor Statistics (BLS) latest data on the Non-Farm Payrolls (NFP) released on Friday.

#1: The NFP Report: Doing Okaysh, But…

Non-Farm Payrolls beat expectations, we had small net positive revisions and nominal wage growth surprised on the upside - it must be hot, right?

I can definitely agree that US wage growth remains way too strong to be achieve 2% inflation - right now, it’s rather consistent with 4.0-4.5% core CPI.But nominal wages are possibly the most lagging macro cycle indicator of them all.

For them to drop, you need: forward-looking growth down, activity down, companies cutting discretionary spending, consumption down, companies cutting capex and excess labor, activity down further, companies cutting core labor…and finally you’ll see nominal wages trending down as demand/supply in the job market rebalances.

And on top of it, one reason why nominal wages might remain strong is a stubbornly low participation rate: and while it’s true that less supply of labor coming back online means more wage bargaining power, it also means less people are actively contributing to economic growth.

Focusing on the momentum of job creation and where these jobs are actually created tends to be a more useful forward-looking macro exercise than focusing on wages.

The 3-month moving average of US NFPs is clearly trending down and in November the BLS reported most jobs were created in leisure&hospitality, education, healthcare and government.Accommodation and food services are still playing catch-up with the pandemic disruptions, and job creation in the government/education sectors are not necessarily a sign of strong economic activity.

The fact that economic-sensitive sectors like retail trade, transportation, manufacturing and some areas of housing-related jobs are all showing weakness is very telling - they move first, and they are clearly showing the direction ahead.

Now, the elephant in the room: there are some material methodological and statistical issues with the current BLS establishment survey, and hence the NFP numbers might well be…almost totally off.

Let’s see why.

#2: The Household Survey vs The BLS Establishment Report

A statistically significant survey requires a very large amount of respondents.

Well, the last NFP Establishment survey got the lowest response (49%) in 20 years.Luckily, we can benchmark the NFP survey with another regular job market gauge which is the Household survey.

There are three main differences between the two surveys:

* The NFP survey asks businesses and government agencies about job creation; the Household survey asks households;

* Multiple jobholders are counted for each (!) nonfarm payroll job in the NFP, while in the Household survey multiple jobholders are counted only once;

* The NFP surveys makes large use of statistical adjustments (e.g. net business birth/death adjustment) while the Household survey doesn’t.

According to the Household survey, literally almost zero net jobs have been created since March against the 2.7 million jobs reported by the NFP Establishment survey.

What?!

As said above, statistical adjustments abound in the Establishment NFP survey and they might have been very relevant in November given the low actual response rate.

The BLS estimates how many new business have been created on a net basis and adds the resulting estimated net new job creation to the NFP numbers every month.As recognized by the BLS itself, the pandemic has created major disruptions to their statistical methodologies which now keeps showing an amount of new net business creation roughly double (!) the pre-pandemic level.

This might be a strong artificial boost to NFP numbers, and explain a lot of the difference with the much weaker Household figures.

So, how do we get a cleaner reading of the real state of the US job market?

A good gauge for the current state of the US labor market is the pace of full-time hirings (excluding multiple jobholders).On a rolling 6-month % change basis, the momentum in US full-time hiring is basically flat and in line with the weakest prints (ex-pandemic) of the last 10 years.

Real-time alternative data can also be very helpful: for instance, LinkedIn collects data on its members (users and companies) adding new jobs to their profile and puts them into a hiring rate index.It shows the pace of US hiring is down 20%+ from last year.

By now, we have established that the US job market is not as hot as many people think.Actually, it’s weakening pretty fast.

The real question is what lies ahead for Q12023, and how to prepare portfolios for it?

Conclusions & Portfolio Implications

Robust forward-looking indicators are very useful in macro asset allocation because they tend to paint a good picture of what lies ahead for the main market drivers: growth, inflation and Central Banks.

Of the many we track at The Macro Compass, I chose the US Financial Conditions (orange line, inverted on the right-hand side) against the year-on-year NFPs (blue, left-hand side).Notice how rapid changes in US Financial Conditions lead job creation trends by 9 months: why?

Because once equity valuations and borrowing costs deteriorate - or in other words financial conditions tighten - companies first cut discretionary spending, then proceed towards hiring freezes and only later on they start cutting labor.It takes a few quarters for tighter financial conditions to hit the labor market.

Yet, right now it’s only a matter of when and not if.And my models are pointing to zero or negative job creation by late Q1 2023.

In other words:

If we should expect labor growth to gradually slow down to 0%, how do asset classes historically perform in this transition period towards a recession - which is my base case for Q2-2023?

Late 2000/Early 2001 is amongst the best historical parallels for the period ahead, followed by late 2007/early 2008.In both cases:

* Equity indexes dropped an additional ~10%, but defensive sectors

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Introduction

As my mentor always said: Alf, rule #1 as an investor is not to be stupid.And trust me, it’s not an easy rule to respect.

As a long-term or tactical macro investor, the emotion-driven biases threatening to kill our performance are countless: recency bias, being in love with a macro narrative even when invalidated by price action, mis-sizing positions and so on.

But over time I learnt the hard way that as a macro investor respecting 3 main principles is in most cases enough to avoid stupid mistakes.

In this short article, we will go through the most common mistakes and how to avoid them by respecting 3 simple principles.

Common Mistakes & How To Avoid Them

Now, picture this.

First month running money as a junior PM, and I want to pitch a trade idea to my senior colleagues.I really like it - and they go like ‘‘sure Alf, pitch it’’.

Adrenaline running high, I go through every piece of imaginable info and analysis necessary to back the trade. Finally, I have the pitch in writing. I send it over.

My to-be-mentor walks to my desk and here is how it goes:

Mentor: ‘‘Alf, don’t be stupid.’’Alf: ’’Oh, you don’t like the trade?’’Mentor: ’’That doesn’t matter - you sized it wrong and there is no stop loss. No trade.’’

This was my baptism to institutional macro investing, and my first lesson on how to avoid stupid mistakes (spoiler: I made many more in my career).

Now, let’s talk about the three most common mistakes in long-term and tactical macro portfolio management and how to avoid them.

#1: Don’Put All Eggs In One Macro Basket

We all know about the power of diversification.Many decades ago, Ray Dalio explained how the holy grail for every long-term investor should be to find return-additive, yet not highly correlated assets to add to her portfolio.

But in my experience, macro diversification is a nuanced subject.

To understand what I mean, let’s have a look at what the TMC Quadrant Asset Allocation model is pointing to today:

If you’d take it at face value, you’d be 100% in USD cash.This would classify as a ‘‘stupid macro mistake’’ - why?

Because however sophisticated your models might be, you can’t predict the future - macro investors instead have to assess future outcomes in a probabilistic way.

Say the Fed really pivots and cuts rates by 300 bps in 2023, and as a result we transition towards Quadrant 1.And to position for that you buy US and EU bonds, US tech and EU growth stocks.

That is not a macro-diversified portfolio. At all.You are assigning a 100% probability to a macro-base-case and getting no exposure to other macro factors (e.g. strong growth, persistent inflation) if you are wrong.

Don’t put all your eggs in one macro-base-case-scenario basket.Instead, think in probabilistic terms and try to add cheap positions that will deliver convex returns if your base case doesn’t realize.

#2: You Sure You’Re Running 5 Positions, Or Is It Just 1?

Around March this year, one of my top hedge fund clients reached out to discuss its portfolio ahead of Q2.

His book could be summarized by something along these lines:

* Long Brazilian Real vs US Dollar

* Long a basket of industrial commodities (Copper & Co.)

* Long Natural Gas futures

* Short 2y Treasuries

* Some exotic trade in equity derivatives

I told him he was basically running one trade - and that’s dangerous.

His macro narrative was that inflation was gonna massively surprise on the upside, that commodities were gonna contribute and benefit from it together with commodity exporters and that the Fed was gonna be forced to raise rates to 5%+ to fight inflation.

With hindsight today that was brilliantly prescient, wasn’t it?

But the problem was that as he was basically running 4 positions around that very same macro theme, he suffered a material drawdown in June/July and was brutally stopped out despite his main thesis proving to be correct in the end.

One way to avoid this mistake is to ask yourself: how much and to what macro risk factors is my aggregate book exposed to?If the answer is ‘‘all my trades make or lose money if xyz happens’’, maybe it’s time to re-assess your exposures.

I find Principal Component Analysis (PCA) very useful for that: it decomposes the data into principal components that try to explain as much variance as possible, hence eliminating a lot of noise and identifying the main macro risk factors to which my portfolio is exposed.

PCA will one of the many features available to Pro subscribers in the Portfolio Optimizer macro tool released in 2023.

#3: Do Not Proxy Trade

Let’s say you ran your macro models, and assessed probabilistic outcomes ahead.

You screened different asset classes and found good risk/reward investments that give you a nicely weighted exposure to different macro risk factors.

Now you are looking to implement positions, and in particular your analysis points to a short position in Crude Oil as part of your book.

You go ahead and put a short position on $XLE ($XLE ETF) as a very clear proxy expression of a short Oil view.And this happens.

In November, Crude Oil was down 8% while the XLE ETF was up 1%.

Your macro view was right, but you ended up getting exposure to your macro risk factor (short Crude Oil) via a proxy and as the 30-day rolling correlation broke down from its stable .75-.80 range you literally lost money on a good macro view.

Another great example of the dangers of proxy investing/trading is the pain many people who called the massive 2022 inflationary spike right had to suffer as they managed to get a big call right and still lose money.

If your macro call is for higher inflation, pay fixed inflation swaps.If you can’t, you are forced to look at proxies but be as close as possible to your macro risk factor.Sell your nominal bonds and buy TIPS.If you can’t, buy commodities with the tightest long-term correlation to inflation (gold is a real rates play, not an inflation play).

As my mentor used to say: don’t be stupid, Alf.Don’t proxy trade.

Conclusions

Macro investing is a tough cookie, and being successful over time is very complicated.But in my experience simply avoiding stupid mistakes sets you up on a pretty decent path already.

A) Don’t put all your eggs in one macro basket

The first thing to remember is that we can’t predict the future with 100% accuracy.Hence, while building portfolios and tactical trades around your macro-base-case-scenario makes sense you shouldn’t forget to get exposure to opposite macro risk factors too - in case you are wrong, you know.The best way to do this is to look for positions that will either benefit across macro scenarios or that will deliver asymmetrically positive returns if a low-probability scenario unfolds hence requiring only a small risk exposure in your portfolio.

B) Are you running 10 trades, or is it really 1 trade after all?

Having 10 positions in your book doesn’t guarantee proper macro diversification.It’s very important to ask yourself what are the macro risk factors behind each position, and whether your book has excessive concentration towards one of them.The best way to avoid this mistake is to do a PCA analysis, but if you can’t there is a much easier way: write down the top 3 macro drivers behind each position in your book, and check how many times you are exposed to the same driver.Hint: it shouldn’t be too many.

C) Do Not (!) proxy trade/in…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Hi all, and welcome back on The Macro Compass!

Quick reminder: from January 1st, getting access to this content (and much more!) will require a paid subscription.

As a loyal TMC reader, there is an exclusive offer for you: get in now and pay only 8 months instead of 12!The offer is time-limited: it runs for only 3 more days, and out of the 2,000 available spots only 145 are left (~20 for Pro subscribers).

Last round: check out which subscription tier suits you the most and take advantage of this exclusive offer before Nov 30!

All They Told You About Money Printing Is Really, Really Wrong

Without properly understanding money, it’s basically impossible to connect the countless dots of the global macro puzzle.

Yet, we assume we know all about money: universities and mainstream economic courses teach us that governments need money to fund their spending, Central Banks have the authority to print money we use, and commercial banks lend and multiply customers’ money in a fractional reserve banking system.

That’s literally all wrong.

Our monetary and credit system envisages two distinct tiers of money: real-economy money (potentially inflationary) and financial-sector money (potentially asset-price inflationary).

Governments and commercial banks have the ability to print real-economy money.Central Banks have the ability to only print financial-sector money.

In this article we will:

* Discuss the two main forms of money: real-economy and financial-sector money;

* Go through the basic mechanics of real-economy and financial-sector money printing, and debunk the most common ‘‘money printing’’ myths;

* Summarize the implications for markets ahead.

Real-Economy Money & Financial-Sector Money

Let’s first define the two main tiers of money, and why do we care about them from a global macro asset allocation point-of-view.

Real-economy money is the one used by non-financial private sector agents (e.g. households, corporates) to make transactions tha contribute to economic activity.The more real-economy money out there, ceteris paribus the more likely economic growth will be stronger.Also, a rapid increase in real-economy money at a time when the supply of goods and services can’t keep up will most likely generate strong inflationary pressures.

In other words, rapid changes in the amount of real-economy money anticipate rapid changes in economic growth and inflation - pretty relevant for asset allocation.

Financial-sector money is the one used by financial entities: mostly banks, but also pension funds, asset managers and so on.The more financial-sector money out there, the more likely financial agents will be over time to engage in riskier activities and to chase riskier assets in an attempt to generate better returns.

In other words, the level and rate of change of financial-sector money informs us about the attitude that financial institutions are likely to have towards taking risks.

Now, who prints what form of money and how does it work?

#1: Banks & Governments Print Real-Economy Money

Nowadays, given that in many jurisdictions cash transactions only account for < 5% of total we can state that real-economy money is mostly bank deposits held by the non-financial private sector (read: mostly held by us).

Every time commercial banks make a loan, new real-economy money is created.Banks don't lend reserves or existing deposits: as the Bank of England itself shows, when making new loans banks expand their balance sheet and literally credit your account out of nowhere.

By doing so, they create new deposits for the non-financial private sector (e.g. people).

Does this mean banks can just print as much money as they want?

Not really: banks are private capitalistic entities which need to maximize RoE for their shareholders and act within the tight boundaries of regulation.This means banks decide about their lending activity looking at these criteria:

* The creditworthiness of the borrowers

* The attractiveness of loan yields

* The required capital and balance sheet costs (i.e. regulatory constraints)

If there is a good trade-off amongst these 3 variables, they lend. Otherwise they don't.Did you notice how the amount of reserves they own is basically irrelevant in the decision-making process?QE ≠ real-economy money printing: we will come back to this later.

Now, the other real-economy money printer is the government: come again?

If the government spends more than it plans to collect taxes for (deficits), in most cases new real-economy money has been created. Government deficit spending increases the net worth of the private sector…without adding a liability to it!

Think about it: when the US government sent cheques to its citizens, American people literally saw the amount of their spendable money increase out of nowhere.

Deficit spending increases the amount of non-financial private sector deposits (i.e. real-economy money) as long as households don’t need to purchase the Treasuries issued by the government itself - which in most cases are anyway bought by financial institutions or the Central Bank.

This means deficit spending prints real-economy money, and it increases the net worth of the private sector as households don’t experience an increase in debt.In other words, government deficits boost the financial wealth of the private sector.

As shown, banks and the government print real-economy money.Credit creation boosts aggregate demand and it can lead to inflationary pressures.That's exactly what we have seen in 2020-2021: massive fiscal deficits & government-sponsored bank lending ended up overheating the economy, resulting in super strong real GDP growth and inflationary pressures on top.

My Global Credit Impulse tracks the pace of real-economy money creation in inflation-adjusted terms in the 5 largest economies in the world.As you can see: rapid changes in the amount of real-economy money anticipate rapid changes in economic growth - pretty relevant for asset allocation.

#2: Central Banks Print Financial-Sector Money

Central Banks can increase or decrease the amount of financial-sector money.

Via QE and other monetary policy operations, Central Banks print bank reserves - you can think of them as money for banks.Banks use reserves to settle transactions and engage in monetary plumbing operations with each other: reserves can only be used by entities with a Central Bank account.

With QE, the Central Bank changes the composition of the asset side of the financial institutions' balance sheet: it takes away bonds, and swaps them for reserves. The interbank system as a whole can't refuse this transaction; there is always a marginal clearing price for QE transactions.

As said before, banks don’t lend reserves to the real economy: you can throw as many as you want to them, and it won't change their stance when it comes to lending.Japan showed us that in the early 2000s already. Bank reserves (red) doubled (!) in 5 years as the BoJ went on with QE, and yet bank loans (blue) shrank by 25% in the same period. With double the amount of reserves, banks lent less.

The other important and less known form of financial-sector money is bank deposits held by non-bank financial institutions (e.g. asset managers, pension funds etc).

When the Central Bank purchases bonds from a pension fund via QE, the fund now owns less bonds (purple) but more deposits (red).These deposits are not real-economy money: the pension fund can’t directly spend them in activities boosting nominal growth.But it can use them to purchase other financial assets.

Bank deposits held by non-banks financial institutions are financial-sector money.

If financial institutions are deprived of their bonds and stashed with excess reserves or deposits, as long as volatility is low and the economy is not falling apart they will try to rebalance their portfolios back to risk assets over time.

The more financial-sector money out there, the more likely financial agents will be over time to engage in riskier activities and to chase riskier assets in an atte…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Hi all, and welcome back on The Macro Compass!

A quick reminder that from January 1st, getting access to this content (and much more!) will require a paid subscription.

The exclusive offer to get in by paying 8 months instead of 12 runs for only 7 more days, and 86% of the available spots have already been taken.

Not much time left: check out which subscription tier suits you the most and take advantage of this exclusive offer!

Ok, Recession: But When, and How Hard?

Audio note not available due to Substack technical issues.

As my mentor used to say, any market practicioner can make headlines by screaming something wildly out-of-consensus but conveniently leaving the details of his forecast out of the equation.

How many times have you heard that ‘‘the US Dollar will fall apart’’ or that ‘‘the real estate bubble will burst’’ over the last 10-20 years, yet without a clear time horizon for this call to play out?If only you got 1 USD (pun intended) for every time you heard something like this, you’ll be rich by now.

Now, it seems most analysts ‘‘expect a recession’’.

Ok, but when will it hit and how hard will it be?The answers to these two questions are very important for asset allocation in 2023.

In this article we will:

* Refresh 5 forward-leading indicators within our macro framework, and assess their diagnosis for when and how hard the next recession will hit;

* Present our conclusions and discuss the principles for asset allocation going into 2023.

The Diagnosis

First of all: shall we agree on what characterizes a recession in the first place?

While many refer to 2 consecutive quarters of negative GDP growth as the main signal for a recession, the US National Bureau of Economic Research (NBER) instead looks at a wide array of real economic activity and precisely: real personal income and expenditures, employment, inflation-adjusted retail sales, and industrial production/corporate profits.

In other words: it focuses on consumers, the labor market and corporate activity.

I agree with this broader assessment of a recession.

The labor market, real consumer spending and earnings have materially slowed down in the last few months but we aren’t in a recession yet - no widespread job losses, no materially negative EPS growth yet.

Yet, the direction of travel is definitely negative - so, when recession and how hard?

Let’s try to answer these two questions by refreshing 5 of the most relevant leading indicators within my macro framework.

#1: The Global Credit Impulse

Every real recession brings negative earnings growth with it.

My preliminary results for the October update to my flagship Global Credit Impulse index point to a further deterioration of the pace of real-economy money creation.

The global credit impulse (blue) leads S&P500 earnings growth (orange) by roughly 9-10 months, and given its rapid decline in 2022 it’s now pointing to negative YoY EPS by March 2023 already.

How bad?Historically, rapid declines in the Global Credit Impulse to negative levels have preceded YoY earnings contraction in the 10-15%+ area.

Pretty bad.

#2: The Conference Board Leading Indicator Index

The US Conference Board puts together a leading index which incorporates the top 10 statistically significant forward-leading indicators for the US economy.

Its track record in anticipating recessions is very solid: over the last 50+ years, every time the YoY series of this index prints in negative territory for 2+ consecutive months a recession is guaranteed.

That trigger was hit in August 2022, and the median lead time is 7 months.

Recession starting in March 2023?

As this indicator keeps dropping, it’s hard to estimate the magnitude of the recession yet - it first needs to bottom, and then we will be able to quantify that.

For the time being: recession to start in March 2023, according to this forward-looking indicator.

#3: The Housing Market

In 2007 Edward Leamer of the University of California stated that the housing market IS the business cycle.I believe he is fundamentally right.

Housing-related jobs and economic activity represent anything between 12-15% of US GDP and employment alone, and the interest-rate sensitive nature of the real estate business makes it very prone to rapidly respond to changing economic and financial conditions.

The NAHB housing index (orange, inverted) leads trends in US unemployment rate (blue) by roughly 12 months.

According to the Sahm Rule, a recession starts when the 3-month moving average of the US unemployment rate (U3) rises by 50+ bps relative to its low during the previous 12 months.

In this case: 4.2% unemployment rate would suffice.

Looking at the sharp deterioration in housing activity and the usual 12-month lagged effect it has on the labor market, we should get there by Q2-23.

How bad?Unemployment rate is set to rise to the 6-7% area by late 2023, which would be roughly double where it stands today.

Pretty bad, according to the NAHB housing market indicator.

#4: Philly Fed New Orders

The Philadelphia Fed survey is a very interesting soft indicator: it goes out to only 125 individuals, but these are Chief Executives of relevant companies and hence tend to have a good grasp of where economic activity is headed.

One of the most important parts of that survey is the ‘‘Forecast for New Orders’’ subsection: C-Suites get asked about what they see ahead for business activity.

Over the last 40+ years, every time the 12-month moving average of the Philly Fed New Orders dropped below 15 for 2+ consecutive months, a recession always followed.

That trigger was hit in September 2022, and the average lead time for a recession is 8 months: Q2-23?

How bad?Again, early to say - but judging by how fast this index has declined already, it won’t be a very mild one.

#5: The Guts of Mr. Market

Stanley Druckenmiller once said the best economist he knows is the guts of the stock market.

I love that quote, and I think it can be extended to the guts of Mr.Market in general.For instance, the Copper to Gold Ratio does a good job at telling us whether the real economy is set to deliver an acceleration or deceleration in growth.

The chart below shows the Copper/Gold ratio (orange) against the YoY EPS growth in the S&P500 companies (blue): the recent underperformance in Copper suggests earnings should soon flatline and head into negative growth territory by March 2023.

How bad? Hard to say - but continued industrial commodities underperformance against precious metals would be a red flag.

Finally, any meaningful yield curve slope has been deeply inverted since April 2022 already - another harbinger for a recession in 2023.

But what happens to asset classes and portfolios during a recession?

Conclusions & Asset Allocation

Updating my macro framework and refreshing some of my leading indicators, the base case seems to be a relatively severe recession hitting around March/April 2023.While we have recorded two quarters of negative GDP growth this year, the upcoming economic contraction is likely to involve job losses and negative earnings growth - hence fulfilling the broader criteria for a recession.

Is it priced in?

No.

The direction of travel is correct: analysts expect earnings and GDP growth to slow, and markets have priced in mildly wider credit spreads and the Fed to gently cut rates by ~50 bps in the second half of the year.

The magnitude isn’t.

If you want to get a better idea of how markets and policymakers react to a disinflationary recession, one of the best parallels would be 2001.

In 2000, the Fed hiked to 6.5% and took off the excess animal spirits in markets.In 2022, the Fed hiked to ~5% and took off the excess animal spirits in markets.In 2001, job market losses and earnings contraction followed.In 2023…

…the economy is going to be a reflection of the massive monetary and fiscal tightening in 2022.

In H2-23, I expect the Fed to really start pivoting exactly like it happened in 2001.Here are the asset classes returns for 2001:

Bonds were the clear winners, and USD cash also did well.Despite the massive Fed pivot, the S&P…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Hi all, and welcome back on The Macro Compass!

From January 1st, getting access to this content (and much more!) will require a paid subscription.

As a loyal newsletter reader, you can sign up now and get access to the TMC services for the entire 2023 paying only 8 months instead of 12.This offer is limited in both time and spots available.

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Intro

In this business, we are often inundated by countless news headlines telling us all about what’s happening…now. It’s a never-ending process that invites market participants to spend time and energy dissecting how new information affects the investment landscape.

For a macro investor though, every now and then taking a step back is crucial: with a 30,000-foot view, the macro big picture becomes increasingly clear.

Hence, in this article we will:

* Assess the structural trends underpinning our economic and monetary system, and how the 2020-2021 tectonic shifts interplayed with them;

* Present our conclusions and discuss how the upcoming macro cycle is likely to play out.

The Macro Big Picture

Long-term economic growth is a function of the growth in labor supply and total factor productivity.

In other words: it’s highly influenced by how many people actively contribute to generate economic output, and how productive the labor force and the use of capital are.

Until the mid-80s, the ability to generate organic growth in most Western economies was very solid: a combination of strong working-age population and good productivity trends led to high levels of potential GDP growth.

But things rapidly took a turn for the worse in the late ‘80s.

By the early ‘90s, the post-WWII demographics boom had exhausted its positive effect.Fertility rates decreased, longevity increased and hence the share of working-age population dropped by several percentage points in a few decades.

The number of people actively contributing to GDP growth wasn’t growing fast anymore - but perhaps an upward trend in productivity growth could offset this?

It could, but it didn’t.Especially in the 2010s, productivity growth was relatively stagnant: we made some progress, but the marginal productivity gains were rather small and definitely not enough to push structural GDP higher given the demographics headwinds.

The permanent scars left by the Great Financial Crisis, and the capital misallocations that partially generated from monetary policy decisions such as the Zero Interest Rate Policies (ZIRP) and QE were amongst the many factors that acted as a drag on productivity growth.

Remember: long-term economic growth is a function of the growth in labor supply and total factor productivity.After the ‘90s, as both demographic and productivity trends materially weakened so did the ability to generate structural economic growth amongst advanced economies.

Today, advanced economies are looking at potential real GDP growth in the 1.0-1.25% area (left chart) and required equilibrium real rates roughly around 0% for that to happen (right chart).And given the demographics headwinds ahead, these numbers might well look even lower in the next 1-2 decades.

Low levels of GDP growth are socially unacceptable in capitalistic societies.So, what’s the fix?

Debt.

Between 1990 and 2020, all major economies went ahead with an extensive use of credit in an attempt to cyclically boost economic growth way above its poor structural trend - Europe, Japan, US, UK, and even China saw their total economy debt as % of GDP rise from 100-150% to 300-400% in a few decades (left chart).

But if the underlying economic activity and wages don’t rapidly rise, how could these economies sustain such a massive build-up in leverage - especially private sector agents, which can’t print money to refinance or service their debt?

Easy: real yields were pushed lower and lower every time.

After all, if you make 100k/year you can probably afford a 400k mortgage at 4%.At 2%, with the same 100k/year salary you can now take on 600k in debt.

The fix was ‘‘straightforward’’: more and more debt, at lower and lower real interest rates (right chart).

Can this go on forever?

There are three main elements that could disrupt this fragile and leveraged system:

A) Excessive levels of (private) debt;B) Higher real rates;C) Recessions and de-leveraging episodes.

The policymakers’ reactions to the pandemic led to a sharp increase in debt levels: public debt soared due to unfunded fiscal deficits, and in certain jurisdictions there was also a bump up in private debt due to government-sponsored bank lending to corporates and households - checkmark on A).

Gigantic injections of new real-economy money in the private sector (~$5 trillion in the US) coupled with re-openings led to a rapid surge in demand.Bottlenecks in the global supply chain compounded the problem, and inflation skyrocketed and became broad and persistent over time.

This forced Central Banks to tighten policy and rapidly raise real interest rates - checkmark on B).

Tighter monetary/fiscal policies and higher real rates took a big toll on hyper-enthusiastic markets and the over-leveraged private sector slowly froze as borrowing costs became prohibitive for many businesses.

Many leading indicators are clearly pointing to a recession in 2023 - checkmark on C) on its way.

A trifecta of disruptive forces, all at once.

Are we looking at a regime change?

Conclusion: Cycles ≠ Trends

Over the last 30+ years, we have made extensive use of debt and lower rates to overlay cyclical growth boosts on the poor structural growth trends due to worsening demographics and stagnant productivity.Recently, the pandemic and subsequent fiscal/monetary policy reactions have shaken the foundations of this very fragile system.

My assessment is that we are looking at a rapid turn in the macro cycle: from a strong nominal growth environment in 2021 to a disinflationary recession in 2023.

But when it comes to long-term macro trends, the story is different.

The secular disinflationary trend might take a marginal pause in the coming decade.On the margin, these factors might contribute to a higher trend level of inflation:

* The de-globalization process and onshoring of labor and supply chains;

* The rapid decline of the (cheap, think China) labor supply growth ahead;

* The concerted efforts and investments needed to transition to Net Zero Emissions

The secular trend down in growth has instead further accelerated, in my opinion.Amongst other reasons, think of:

* Higher levels of (unproductive) public and private debt;

* Lower labor supply growth, and an ageing population;

* Less global trades in a more polarized world

This leaves us with a slightly different long-term macro backdrop ahead: lower trend growth, higher trend levels of inflation.

Yet, the most notable change is not in long-term macro trends.Instead, it’s in how more powerful macro cycles ahead will be.

Think of a pendulum: the swings around its resting position will get bigger.

As we will keep testing the fragilities of our leverage-based economic model, policymakers are likely to react more aggressively at each iteration: an even bigger QE, an even bigger fiscal stimulus, an even faster QT, an even more acute fiscal drag.

This is likely to cause more boom-and-bust macro cycles, like the one I expect for 2023: to bring down inflation quick, history teaches us we need a severe recession.

In the 2020s, wealth preservation will be much less about buy-and-hold and much more about macro risk management.

And this was it for today, thanks for reading!If you enjoyed the piece, please click on the like button and share it with friends :)

Finally, a quick reminder.

From January 1st, getting access to this content (and much more!) will require a paid subscription.

As a loyal newsletter reader, you can sign up now and get access to the TMC services for the ent…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Hi all, and welcome back on The Macro Compass!A warm thank you to the many subscribers who secured their spot to continue this macro learning journey together in 2023 by signing up for our premium products.

From January 1st, getting access to this content (and much more!) will require a paid subscription.

As a loyal newsletter reader, you can sign up now and get access to the TMC services for the entire 2023 paying only 8 months instead of 12.This offer is limited in both time and spots available.

You have until November 30th (13 days left) to be amongst the only 2,000 subscribers who will exclusively benefit from this offer (~950 spots left, 50%+ taken in 5 days).

Check out which subscription tier suits you the most and take advantage of the exclusive offer here:

Intro

The bond market is often wrong.Yes, you read that right.

Many believe fixed income investors have some esotheric power that allows them to always have an edge in anticipating how macro conditions will evolve.

The reality is that understanding the signals bond markets send across their many dimensions is not akin to looking into a macro crystal ball, but rather a very useful exercise because bond markets are the biggest and most liquid asset class in the world.

And if you want to get a better shot at piecing together the very complex and dynamic global macro puzzle, you’d better make sure your instruction manual is good.

The bond market is your instruction manual.

Hence, in this article we will:

* Assess the current state of the US bond markets, with a particular focus on three interesting dimensions - curve slopes, volatility and implied Central Bank rates;

* Discuss portfolio allocations and trade ideas.

When The Bond Market Talks, You Better Listen

Over the last 30 days, a lot has happened under the surface in bond markets.

And no, it’s not as simple as ‘‘bond markets now think the Fed will pivot’’.

Let’s instead look into three interesting dimensions that carry a lot of informational value: curve slopes, volatility and implied Central Bank rates.

To break them down, I will use the Rates section of my Volatility Adjusted Market Dashboard (VAMD) - an interactive macro tool which will be available to paid subscribers in 2023.

In the picture above, I focused on the rolling 30-days move across many segments of the US fixed income market. One of the most important features of the VAMD is its color-coding mechanism.

The VAMD color-codes market moves based on their magnitude: the darker the color, the bigger the move in standard deviation terms and hence the more interesting market action to focus on.

Let’s cover the 3 areas circled in black.

#1: Market-Implied Path for Fed Funds

The bond market is getting around this idea that the Fed won't massively pivot.But instead, it will go for a long, very long pause.

As you can see in the VAMD (Forward OIS section), market-implied Fed Funds have rallied significantly over the last 30 days.Yet, putting things in context: bond markets are now expecting Fed Funds to peak at 4.9% in 6 months and then to remain above 4% until Q1 2024!

Rather than a sharp pivot, this is fixed income investors assigning a higher and higher probability to a long pause with Fed Funds rate well in restrictive territory for the entire 2023.

For comparison, if you are looking for a true pivot have a look at 2001 (a historical parallel The Macro Compass models are strongly pointing to for what’s ahead in 2023).Back then, the Fed cut rates by 475 bps (!) in 12 months as earnings and the labor market were materially weakening, and inflation was slowing down too.

In other words: long pause now priced as the base case, while a true pivot only remains a tail risk.

This stance is also reflected in implied volatilities - let’s have a look.

#2: Implied Volatility

The option market in fixed income is very large, and it involves a variety of actors: hedge funds, banks, insurances, pension funds and more.Hence, it’s a very important dimension to consider.

The Volatility section of the VAMD screenshot shows the implied annualized volatility priced for the next 3 and 12 months in various segments of the curve: a 1y2y swaption ATM vol would reflect the implied volatility priced in for the next year for 2-year rates, and so on.

Notice how the 12-month implied volatilities for 2, 5 and 10y rates have recently staged a very significant downward move: why, and what does it imply?

If the main theme is a long Fed pause, Powell’s volatility around monetary policy decisions in 2023 will likely be much lower than in 2022.And when there is less uncertainty around such an important market driver, investors can be marginally more aggressive in taking risks as the bond market behaves better and it reduces some of the explosive volatility it brought to their portfolios in 2023.

The chart above shows how equity investors (S&P 500, blue) got rattled by a higher and higher bond market implied volatility (orange, inverted) throughout 2022.Recently, the ‘‘long Fed pause’’ narrative and its subsequent lower bond market volatility has helped equities rally on the margin.

Generally speaking: lower bond market vol = stronger risk appetite.

Finally, if the Fed is seen to pause soon and pause for a while the yield curve can behave funnily. And it did - let’s have a look.

#3: The Yield Curve

The yield curve moves are truly fascinating here - as you can see in the ‘‘OIS Curves’’ section of the VAMD screenshot we saw the following:

- An aggressive flattening in the 2s5s and 2s10s curve slopes;

- Aggressively steepening in the 5s10s, 5s30s and 10s30s curve slopes.

That's really interesting, and again it revolves around the strong consensus fixed income investors are forming around a ''long Fed pause'' narrative: why?

If the economy is slowing down but Powell keeps insisting on setting monetary policy looking in the rearview mirror and waiting for core inflation to consistently drop towards 2%, he is going to pin 2y yields at high levels and nobody can fight that.After all, the Fed has a strong influence on the very front-end of the curve.

But 5-year and 10-year bonds start to reflect growth and inflation expectations further down the road, and a very restrictive Fed compounding economic weakness is going to leave some long-lasting scars on the economy.As that gets reflected in lower 5y and 10y yields, 2s5s and 2s10s aggressively flatten.

So, how come the curve is steepening in 5s30s then?

The thing is bond markets are NOT pricing in a true recession, but just a marked economic slowdown coupled with a Fed mostly on hold in 2023 and perhaps easing a bit into 2024 to gently accompany a slow recovery.

Under the assumption the economy won't fall of a cliff, a less aggressive Fed from 2024 onwards might coincide with a slow return to slightly higher nominal growth in the long-term, and hence curves can steepen a bit in the long-end.

Looking at the big picture though, 2s10s are more inverted than in '00 and could be heading to Volcker-era inversion levels if the Fed doesn't really back off.

Now, what does it all mean for portfolios?

Portfolio Implications

Across their many dimensions, bond markets are discounting a high probability of a long Fed pause in 2023, accompanied by an economic slowdown (but not a real recession) that will require some mild accommodation in 2024.

On the other hand, equity markets are priced under the assumption that the slowdown will be even milder (SPX 2023 EPS growth still at +5%) and lower bond volatility coupled with seasonal institutional behavior has spurred a rally to ~4,000.

The Macro Compass models indicate this combination is NOT a high probability outcome in 2023.

After an unprecedented tightening of monetary and fiscal impulses in 2022, and a dramatic slowdown in the housing market the TMC models are pointing to a macro base case encompassing:

* A disinflationary recession in the US (even more acute in H2-23);

* S&P 500 2023 EPS growth to be in the -15% (!) area;

* US unemployment to rise towards 6% in 15-18 months;

* Core inflation to sit ~4% until m…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

Hi all, and welcome back to The Macro Compass!

Do you remember July?

Here we are again: left to assess whether we are looking at a bear market rally or a sustainable turning point for the stock market.

Last week’s softer than expected inflation print spurred a massive rally across asset classes: the 60-40 portfolio posted one of its strongest 2-day performances ever, precious metals zoomed higher while the US Dollar took a beating.

The magnitude of the market reaction was exacerbated by technical reasons we will discuss, but to assess medium-term implications we need to break down the CPI report and take a broader look at the global macro puzzle.

Hence, in this article we will:

* Decompose the latest CPI report looking at the drivers behind the surprise, with a particular focus on the inflation features the Fed is the most interested in;

* Contextualize the markets’ reaction, taking into account cross-asset signals and keeping an eye on lessons from the past;

* Look at Long-Term ETF portfolio implications and tactical trade ideas that could be considered going forward.

A Breakdown of The CPI Report

Core CPI came in at a monthly pace of 0.27% for October 2022, the lowest monthly print since summer 2021.

When it comes to inflation, growth and other macro drivers here on TMC we prefer looking at momentum rather than one-off prints: this helps smoothen volatility and seasonality, and Powell told us he’s looking at inflation the same way with a particular focus on the 3-month moving average.Here is how it looks like now:

Using this momentum metric, we are still far from levels consistent with 2% YoY core inflation (see 2017-2018) but the pace has undeniably slowed down from its peak.

As we had two false positives in late 2021 and mid-2022, it’s worth looking into the underlying drivers and the breadth of this inflation surprise - the Fed is also very attentive to how broad inflationary pressures are.

The biggest negative contributors of the core CPI print were goods (especially transportation, i.e. used cars) and medical care services, while the most positive topline contributor was shelter inflation.

The positive news is that goods disinflation is finally here - and it was about time.The transition from a pandemic, goods-centric world to a post C-19 services driven economy and the decongestion of global supply chains will ensure further weakness in goods prices.

The NY Fed Global Supply Chain index is now sitting at only 1 standard deviation away from its long-term mean: we are not totally out of the woods yet, but definitely making progress there.

The less positive news is that almost 70% (!) of core CPI components still run at above 4% annualized inflation rates, which makes inflationary pressures still broad.

And most importantly, as shelter inflation lags house prices and on-the-ground negotiated rents it’s very unlikely its monthly pace will markedly slow down before ~6 months from today.

Ex-energy core services CPI is running at 6.7% YoY, the fastest pace in over 40 years.

Going forward, as goods disinflation accelerates and the momentum of core services inflation stabilizes we should expect MoM core CPI prints to range around 0.3-0.4%.

That implies YoY core CPI will be slowly trending down towards 4% by June 2023: a welcome development, but still way too high for the Fed to feel at ease.

By the end of 2023 though, my models point towards a rapid drop in inflation at or below 2% coupled with a likely earnings recession.The very negative Global Credit Impulse print in July 2022 leads YoY CPI by 5 quarters and it therefore suggests a major downtrend in inflation and nominal growth in Q3-Q4 next year.

On the inflation front, we can expect only partial good news going forward followed by a rapid disinflationary trend in the second half of 2023.But that second leg will be also associated with higher unemployment rate and an negative EPS growth.

In other words, a recession.

How did market react to the CPI print?Let’s take a look.

The Celebratory Rally Explained

Think about this.After the softer than expected CPI print, the GS Unprofitable Tech Index rallied 25% in two days and the 60-40 portfolio had one of its best 2-day streak ever.

The market exploded higher across the board.But while the extreme bond market reaction can be somehow rationalized, the equity market rally was also due to technical reasons.

The downward surprise in CPI led to a decline of US inflation expectations, with 1-year forward 1y inflation now priced at only 2.65%.Despite the outsized front-end rally, market-implied real Fed Funds rate ahead (e.g. my Powell Credibility Indicator) remain comfortably high.Coupled with terminal Fed Funds still priced in the 4.9% area, this provides context to the bond market move: it was very large, but it leaves fixed income pricing within the realm of acceptable outcomes for the Fed.

The equity market rally was instead much more pronounced and mostly driven by technical and institutional reasons.Let me explain.

As I’ve run institutional money, I am very familiar with these incentive schemes: money managers’ annual compensation is largely dependent on bonuses that are mostly paid as a % of calendar year (over)performance.In 2022, you either traded very well being prudently short risk and made a killing through October or you traded poorly and you are now hoping for a quick turnaround.

In the first case, your incentive is to protect your hard-earned bonus: your downside is a face-ripping Nov/Dec bear market rally that wipes out a lot of your P&L and hence your bonus. You will likely buy upside exposure to the market and chase it higher.

In the second case, your job is anyway at risk and you can only hope for a quick turnaround at year-end: your incentive scheme is also to buy convex structures benefitting from an outsized bear market rally that could save the day.

This phenomenon is easily captured by the skew in 3-month S&P500 options: the implied volatility of 20% out-of-the-money puts has never been this cheap relative to the implied volatility in 20% OTM calls.In other words, at this point of the year incentive schemes drive people to be much more willing to pay and chase upside moves than they are to chase downside moves.

This largely exacerbated the equity market rally, whose extent is also visible in the SPX equity risk premium which just hit the 4.5% area - the lowest level since summer 2021 and in the 1-sigma expensive territory using a 15-year time horizon.

This leaves us with the 1 million dollar question: any actionable trade ideas ahead?

Portfolio Implications

Short-term, this bear market rally might extend a bit further.I do not exlude the SPX to test 4150, but the air becomes pretty thin above that.

In markets, the best trade opportunities arise when either markets have largely mispriced the direction of travel or they are under or overestimating the speed and magnitude of the moves ahead.

Here, two trades stand out to me - both are medium-term trades that one could consider as backbone in their books for the next quarters.

One benefits from markets mispricing the direction of travel ahead: I expect a sharp nominal growth slowdown ahead, only likely to intensify in H2-23.Yet, the bond market believes the Fed is going to keep rates in the 4%+ area while this significant and disinflationary recession hits.The Fed forced to cut rates from 4.5% to 1.5% in a capitulation move similar to 2001 is only priced with a 10% probability in Jun-24 SOFR call spreads.

I disagree, and I bought these call spreads.

The second trade instead should benefit from markets being aligned on the direction of travel ahead, but largely underestimating its magnitude in my opinion.

I am talking about the real estate market.

This intuitive chart shows what happens when mortgage rates quickly move higher: give it 9 months, and real estate prices materially suffer.My expectation is for a 15% move lower in house prices across many developed markets, and the recent monster rally in HomeBuilders and Real Estate ETFs offers a good opportunity to build some medium-term shorts.

Mid-2023 puts and put spreads on XHB (for Americans) and D5BK (for Europeans) start to look attractive here.

If you are a less tactical investor and you own real-estate related exposure, using this strong rally to reduce that might be a good idea.

Analysts are expecting a mildly weak 2023 for the real estate market.Forward-leading indicators suggest they are still in La-La Land.

Thanks for reading, and now an important message below!

If you enjoyed this and the other 40+ pieces I’ve published this year, a reminder that from January 2023 this content (and much more) will require a paid subscription.

As a newsletter reader, if you are amongst the first 2,000 subscribers (~1200 spots left) you can get a 20% discount using the code ‘‘TMC’’ at checkout.The offer is valid until November 30th and applicable to all the tiers below.

* The Long-Term Investor: weekly macro & market insights, long-only model ETF portfolios and 25% permanent discount on all macro courses. Full price in January: €399/year (39/month)Using the ‘‘TMC’’ discount now: €319/year (26/month)Subscription link here

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DISCLAIMER

The content provided on The Macro Compass newsletter is for general information purposes only. No information, materials, services, and other content provided in this post constitute solicitation, recommendation, endorsement or any financial, investment, or other advice. Seek independent professional consultation in the form of legal, financial, and fiscal advice before making any investment decision. Always perform your own due diligence.

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

For years, I was blessed with the opportunity to run a $20 billion multi-asset institutional portfolio.And yet, something didn’t feel right.

The amount of information, data, and knowledge available to financial institutions is unparalleled…and yet, strictly reserved only for The Ivory Tower members.I didn’t like that.I grew up in a humble background in the South of Italy - my father is a forklifter, and he taught me the real joy in life is not to be privileged, but to share with others.

And that’s why in December 2021 I took a massive, scary leap of faith - I left the industry and started sharing my insights with you on The Macro Compass.

It was one of the best decisions of my life.The response was incredible: in only 11 months The Macro Compass has become one of the biggest macro newsletters in the world with over 115,000 subscribers.

Which brings me to what comes next.

A newsletter is not nearly enough to fill the gap of macro knowledge, portfolio construction, risk management and access to data and tools between financial institutions and regular investors.

Today, The Macro Compass graduates from a newsletter to an all-round macro platform whose aim is to send retail investors through a holistic macro learning journey and provide institutional risk-takers with a pro, tailored service.

It’s time to step up the game.

The Macro Learning Journey Ahead

(If you are a pro investor, scroll down below - there is a dedicated section for you).

Educational. Interactive. Actionable.These are the three features of the macro learning journey ahead of us.

The Macro Compass will cover them all, and provide you with:

* Macro Reports

The idea is to provide unique insights and break down what’s happening in macro and markets around the world.

A weekly big picture report for long-term investors, and more frequent and timely updates covering macro events as they happen and also highlighting tactical trade opportunities for all-round investors.

* Macro Courses

There is no Global Macro University out there, and I want to fix that.The aim is to deliver an educational journey that encompasses monetary mechanics, the functioning of all asset classes, principles of portfolio management and much more.

* Interactive Macro Tools

Professional investors have access to incredibly expensive platforms (e.g. Bloomberg) and therefore have an edge in analyzing macro and market data.I want to fill that gap.

The Volatility-Adjusted Market Dashboard (VAMD) will allow you to track cross-asset moves and easily connect the macro dots out there, and most importantly to interactively play around with bond market and derivatives data so far only accessible to financial institutions.

In the pipeline, we have many more tools: for instance, an interactive Macro Database where to access, analyze and chart all macro and market data out there.And much much more!

* Actionable Investment Strategy

The Macro Compass is not only talking the talk, but also walking the walk.There is no proper macro learning journey without getting our hands dirty, and hence The Macro Compass will deliver both a Long-Term ETF Portfolio and Tactical Trade Ideas generated through a data-driven approach and with a keen eye on risk management.

In other words, The Macro Compass graduates from a newsletter to a holistic platform that allows you to really step up your macro game.Delivering all the above involves facing significant expenses, including hiring an amazing team of people and paying the hefty subscription fees to many services required for me to close the gap between Wall Street and you.

Hence, from January 1st stepping up your macro game will require an investment from your end.

But.

As you have relentlessly supported me for 11 months, the least I can do is to give the 115,000+ TMC subscribers a highly preferential treatment.

Using the code TMC, the first 2,000 subscribers will get a 20% off on all products.This code will be only available to subscribers of The Macro Compass newsletter - only to you, and not to people following me on social media for instance.The offer is anyway valid until November 30th, and after that prices will increase.First come, first served.

What tier to choose?

The Long-Term Investor subscription gives you access to weekly reports, ETF-only portfolios and 25% discounts on upcoming macro courses - it’s designed for long-term investors and using the TMC code it will cost EUR 319 for the calendar year 2023.

The All-Round Investor subscription gives you access to much more on top of that: timely macro reports around big events (e.g. Fed/ECB meetings), tactical trade ideas, access to the interactive macro tools, 50% discounts on macro courses and a monthly Q&A Zoom call - it’s designed for all-round investors and using the TMC code it will cost EUR 999 for the calendar year 2023.

If you want to be amongst the first 2,000 subscribers and make use of the exclusive TMC discount code, the link to The Macro Compass website is here.

From Risk-Taker to Risk-Taker

I have been an institutional investor myself: we are always short of time, and yet inundated with (mostly useless) information by counterparts trying to lure us into making business with them.

I feel you, and that’s why I am going to do something else.

The Pro Investor subscription encompasses the following:

* The entire All-Round Investor service (see above);

* Additional 5-minutes quick notes only when I can add value to your framework;

* Timely and concrete trade ideas solely designed for institutional investors;

* An exclusive monthly deep dive piece covering all asset classes in depth, and zooming in on alpha-generating institutional trade ideas;

* Pro Interactive Macro Tools to facilitate your risk-taking duties and help you find strong risk/reward trades;

* The possibility to book me for 1-1 calls in a flexible manner.

It’s a package designed for risk-takers, from a risk-taker.For instance, the first readily available Pro Interactive Tool will be the Probability Distribution Tool (PDT).It will allow you to analyze past and present option-implied distributions for any liquid market and hence greatly facilitate the study of market-implied probabilities and tail risks necessary to find alpha-generating trade ideas.

And there are many, many more Pro Tools that will be available in 2023.

As you have relentlessly supported me for 11 months, the least I can do is to give the pro investors within the 115,000+ TMC subscribers a highly preferential treatment.

Using the code TMC, the first 200 subscribers to the Pro Investor tier will get 20% off.This code will be only available to subscribers of The Macro Compass newsletter - only to you, and not to people following me on social media for instance.The offer is anyway valid until November 30th, and after that prices will increase.First come, first served.

Using this discount, the TMC Pro Investor subscription will cost you EUR 4,000 for the calendar year 2023.

What’s the Pro Investor+, you might wonder?

It’s an enhanced subscription that guarantees you regular Zoom meetings (also possible in person) and a direct communication line with me, and most importantly the access to the exclusive Macro Roundtables: every quarter, we will gather with a group of selected top-class macro investors and brainstorm about macro and trade ideas in a relaxed, informal setup.Seats are limited for the Pro Investor+ subscription.

If you want to be amongst the first 200 subscribers and make use of the exclusive TMC discount code or enquire about the Pro Investor+ service, the link to the Pro section of The Macro Compass website is here.

To Wrap It Up

Today, The Macro compass graduates from the biggest macro newsletter in the world to an all-round platform whose aim is to help investors fill the data, tools and macro knowledge gap they unfortunately face versus financial institutions.

As you have relentlessly supported me for so long, I chose to create an exclusive discount code only valid for The Macro Compass newsletter subscribers.The first 2,000 retail and 200 pro subscribers will get 2…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com

‘‘It is VERY premature to think about a pause in our interest rate hiking cycle’’

Jerome Powell - FOMC November press conference

Hi all, and welcome back to The Macro Compass!

We finally got a pivot - but it wasn’t the one many investors were hoping for.

At the FOMC press conference, Powell pivoted from hawkish to…more hakwish.

Through the use of 3 unambiguous punchlines, Chairman Powell made sure to convey one clear message: we will get it done, whatever it takes.

As investors entered the meeting with a complacent attitude and the initial press release seemed to back the idea of a ‘‘dovish pause’’, the press conference served as an abrupt awakening to the new/old reality: this is not the time to reload on (risk) assets.

In this article, we will:

* Go through the Fed meeting and the bond market reaction, step by step;

* Discuss how the reiterated Fed hawkish stance will interact with the liquidity backdrop ahead (Treasury buybacks, QT, reverse repo etc), and how this affects portfolio strategies goind forward.

Keeping At It

Actually, before we jump right in.

Dear community: mark your calendars.November 10th, 2022.An email from The Macro Compass you really don’t want to miss.

Back to it: the press release seemed to be dovish.

But as soon as Powell started speaking, things dramatically changed.Jerome threw 3 major punchlines that inequivocally signalled to investors that yes, there was a pivot. But not the one they were looking for.

The pivot was from hawkish to…more hawkish.

Let’s go through these 3 key moments.

#1: It’s Very Premature

‘‘It’s very premature to think about a pause in our interest rate hiking cycle’’.

I suspect Powell looked at his screens before entering the press conference room and saw rates rallying, the USD weakening, equities zooming higher.And he must have been very much…p*ssed.

Indeed, in the Q&A session he used one of the very first chance he had to completely dispel the idea of a ‘‘dovish pause’’ in the Fed hiking cycle.

The Fed is setting policy looking at core inflation and the labor market - those are coincident to lagging indicators, which means the Fed is driving the car looking in the rearview mirror.But as my mentor often said, investors trading based on what Central Banks should do are bound to underperform - as the labor market remains hot and core PCE is trending at 5% annualized rates, there is no evidence at all that would support a data-driven Fed pause, let alone a pivot.It’s not about what the Fed should do, but what they will do.

Check for yourself how markets digested Powell’s first punchline: the Fed Funds terminal rate aggressively moved higher and never looked back.

A more aggressive Fed in the short-term is likely to cause more long-lasting economic damage in the long-term, and this is reflected in relentlessly flattening yield curves.

Here is where we stand in the Overnight Index Swaps (OIS) curve:

2s5s: -60 bps (inverted since April)2s10s: -86 (inverted since March)5s30s: -77 (inverted since March)

US Treasury curve slopes are also inverted across the board.But to show there is no room for nuances, Powell cherry-picked a very special curve slope: gaslighting at its best, in an attempt to dismiss evident and persistent curve inversions as a reason to slow down.

Yet JPow can’t gaslight the TMC community - here is the long term chart of Powell’s preferred curve slope: the 18-month forward 3-month rates minus prevailing 3-month rates (using OIS, as it should be done).

It might not be inverted (yet), but it soon will.

#2: Higher For Longer: Got It?

'‘The incoming data since our last meeting suggest the terminal rate of Fed Funds will be higher than previously expected (4.63%), and we will stay the course until the job is done''.

The other ‘‘pivot’’ dimension investors were looking for was a remark of financial stability risks that arise from keeping rates in the 5% area for too long - effectively, a step back from the higher for longer mantra.

They got the opposite.

Powell reiterated the Fed will ‘‘stay the course’’ and ‘‘keep at it’’ until the job is done - did you know that ‘‘Keeping At It’’ is the name of one of Volcker’s books?!

The chart below shows how the bond market digested this message: the Fed was not only repriced to hike rates above 5%, but to keep them at least around that level for 6 more months all the way until the end of 2023.Try to picture this: Fed Funds ≥ 5% for the entirety of 2023.

The higher for longer mantra is important to Powell because it reduces the possibility of financial conditions preemptively easing well ahead of time, potentially spurring an uptake in economic activity which is undesirable given the Fed’s willingness to bring inflation down to 2% as soon as possible.

When a journalist asked about markets rallying (although they weren’t…) during his press conference, Powell’s reaction was unambiguously along the same lines: strong pushback against easing of financial conditions.

Higher for longer: got it?

#3: Risk Management = Over-Tightening > Doing Too Little

''Prudent risk management suggests the risks of doing too little are much higher than doing too much. If we were to over-tighten, we could use our tools later on to support the economy. Instead, if we did too little we would risk inflation getting entrenched and that’s a much greater risk for our mandate’’.

This was the most nuanced and yet the most relevant punchline, in my opinion.

Again inspired by his ‘‘hero’’ Volcker, Powell understands that doing too little is way more risky than doing too much when fighting inflation.In the 70s, Volcker made that mistake and was then forced to tighten even more aggressively to bring inflation down once and for all.

Powell wants to go down as somebody who successfully slayed the inflation dragon, and in order to do that he must regain credibility with markets in the first place.

The Powell Credibility Indicator (PCI) looks at market-implied 1-year forward, 1y nominal Fed Funds minus inflation expectations: if forward real Fed Funds are priced to be comfortably in positive territory, it means the market believes Powell will keep policy tight enough for long enough to bring inflation down.

And the Powell Credibility Indicator made new highs today.

Another way to look at it is through the lens of the US Real Yield curve.If real yields are markedly positive across tenors, borrowers will experience tight financing conditions across the board and hence be more reluctant to access credit and leverage - resulting in a more likely economic slowdown.

While 6 months ago the US real yield curve was still in negative territory until the 7y point, today US real yields are in the +2% (!) area across the entire curve.

Powell likes this.Don’t fight the Fed.

Time to look at market implications now, also taking into account the important developments ahead in the US monetary plumbing world.

Conclusions & Portfolio Implications

Yes, there was a pivot: from hawkish to…more hawkish.Powell is ‘‘keeping at it’’ as his hero Volcker would do, and he doesn’t want to hear it - he’ll keep driving the car looking in the rearview mirror and he is well aware of the risks of overtightening.Yet, he will stay the course.

On this monetary policy backdrop, there is something very interesting going on in the monetary plumbing arena too.

Investors can now get 4%+ returns parking money in short-term Treasuries or money-market funds (MMFs) against getting rewarded almost nothing for keeping money at US commercial banks.While short-term Treasuries or allocations in MMF are slightly more illiquid than a bank deposit, the pros are very compelling:

A) 4%+ additional returns

B) Less (!) risk, especially if savings exceed $250,000 (FDIC insurance threshold): over that amount, bank deposits are effectively an unsecured liability of a commercial bank while allocations in short-term Treasuries or highly regulated MMFs are effectively a liability of the US government and hence a less risky form of money.

Why is this relevant?

Because if investors allocate a portion of their bank depos…

This is a public episode. If you would like to discuss this with other subscribers or get access to bonus episodes, visit themacrocompass.substack.com