The current credit bezzle

 

With the bankruptcies of First Brands and Tricolor, there are clear signs that we are facing mounting credit issues. More importantly, we are seeing the classic Bezzle described by John Kenneth Galbraith in his book on the 1929 crash. We are not faced with a downturn in the business cycle. There is no recession; however, there is an exuberance that has been described by Minsky in his financial instability hypothesis. When overly optimistic views of the economy are coupled with extreme asset values, there is a higher likelihood that some will take advantage of the situation and cut corners, potentially committing fraud.

A review of the bankruptcies and new reports suggests that, in both cases, there was potential fraud or financial complexity that did not provide debtors with accurate information about the economic health of the firms. If we are seeing this under current healthy conditions, we can imagine more bankruptcies if asset prices fall. This is called the "febezzle" by Charlie Munger, referring to the false wealth created by high asset prices. If prices fall, the excessive wealth will quickly fall.

The key takeaway is that credit risk premiums should increase and investors should be paid more to hold risky debt.

John Kenneth Galbraith and the "bezzle" - It is a global issue

The bezzle and markets - Risks could be rising

Industrial policy thinking is back - Not clear that this is good

 

Marketcrafters by Chris Hughes is a quick read featuring stories of individuals who used government to shape market direction. In general, the stories are positive, yet some individuals used their power to bend policy in ways that had adverse market effects. The overall theme of this book is that effective industrial policies can influence markets for positive economic outcomes, whether in housing, monetary policy, international finance, energy, or crisis response. Hughes makes the case that good policy leads to good outcomes, but he also shows that bad policy can have severe negative consequences. Hence, a new industrial policy view will not be effective in creating a better economy. My takeaway is that industrial policy should apply the precautionary principle and be careful not to bend markets to your will, because the law of unintended consequences may lead you down a path worse than a market solution.

All bond hedges ae not the same

Most movements in the yield curve are parallel, so the correlations between different Treasury maturities and the S&P 500 will show strong co-movement. When the yield curve changes shape, likely due to a revision in monetary policy, there will be a dislocation in correlation co-movement. We are seeing this in the 2025 correlations. There is a positive correlation between 30-year Treasuries and the SPX, while there is a negative correlation for 2, 5, and 10-year Treasuries. We expect that these will converge in 2026 as the Fed stabilizes its monetary policy.

Is it always about momentum but need style/factor diversification

 

There is a bandwagon effect with the momentum factor. The momentum factor performance is closely associated with cumulative flows into an asset or asset class. Still, these strategies do not last forever, which is why an investor should diversify their sources of alpha.

The simple case is to match the fundamental and systematic components to achieve a smoother blended return. 

Money flows and market behavior will change, and it is hard to find these turning points, so the first pass for effective factor management is to use more than one factor and ensure they show natural low correlation.

Volatility good for hedge funds

 

Volatility measures risk. It also measures uncertainty or at least variation in opinions on valuation. Volatility is an opportunity because, if a manager has skill, it should be shown when markets are more volatile. If you make the right decision, you will be paid more; if you are wrong, the pain will be higher. Macro hedge funds can go long and short across asset classes, so they should be able to take advantage of volatile markets. The visual supports that case. 

Volatility is an opportunity for distinction with a manager and strategy. 

The good and bad over the last 30 years

 

No region or asset class will always dominate the markets. Even the US stocks will underperform, as seen between 2000 and 2010. This is the core lesson of asset diversification. As shown in the table, the 60/40 mix will give you the median return. It will never outperform, nor will investors live to regret it. Should investors move out of their US exposure? Timing is never easy, so the most straightforward approach would be to use a trend-relative model to help. Money will flow toward better opportunities, but diversification remains the best approach to balancing risks in an uncertain world. 

The 60/40 plus portfolio still works

 

There has been a lot of bashing of the classic 60/40 stock-bond mix amid bonds' poorer performance. It provides a nice base middle ground for any portfolio discussion. If there is a market shock, it will rebound better than moving to cash and trying to time the addition of risk exposure.

Yes, using the 60/40 as a base anchors thinking, but it can serve as a good beginning for any portfolio construction.

Can investors do better? Yes, adding alternatives provides for a better return without adding volatility. The advantage of starting with the 60/40 blend is that it allows for a careful review of how to add new strategies to the portfolio. There is no major switching from risk-on to risk-off.

Crisis cycle and the challenges to the Euro

 

The Euro experiment is not finished and may never be finished. The new book Crisis Cycle: Challenges, Evolution, and the Future of the Euro paints a bleak picture for the monetary union unless there is a fiscal union. This is not a new story, but the authors provide great detail on the problems with centrally run monetary policy and country-level fiscal policy. This is especially problematic when regulating and managing banks. There is also the issue of managing monetary policy, with country central banks still controlling bank regulation. Monetary policy has to engage with complex policies to address the fact that there is no centralized Euro debt like Treasuries. The Euro survived the post-GFC debt crisis, but the system is not really prepared for another sovereign debt crisis or debt default. While a default is highly unlikely, there is no clear policy path for addressing this type of problem.

The book provides a detailed analysis of the ECB's monetary policy and the problems of fiscal decentralization. Many will not have time to do this deep dive, but there is significant information to be gleened from this study. 

From monetary to fiscal activism or both

 

There are policy regimes that will impact markets. The post-GFC period was focused on monetary policy as the key tool, with quantitative easing and extremely low rates (negative in some countries). This was also a period of fiscal austerity, with governments not attempting to push debt-to-GDP levels to extremes. There were, of course, exceptions. The pandemic also saw quantitative easing used again to avert a crisis, along with fiscal policy as an additional tool. This was clearly the case in the US, with what may have been considered temporary turning into something that looks more permanent. 

The switch to more aggressive fiscal policy affects the central bank's independence and alters the credit risk exposure for many investors. The cost of financing is an issue, as well as the potential term premium needed to attract bond investors. The potential for a credit crisis is heightened. Indeed, there is a change in the relative safety of different sovereign debts.

The search for divesification

The ongoing issue with alternative investing has persisted for the last few decades. Can you find a better diversifier than traditional assets? The long-term trend has been for further market integration, so the demand for alternatives has been strong. You just do not get the benefit from international equity investors or holding fixed income.

While the trend toward traditional asset diversification is declining, there is an ebb and flow to this diversification. There is less diversification gain during a crisis, but there are periods when holding a diversified portfolio reduces risk; nevertheless, the demand for alternatives will be strong as long as market integration continues. 

The yield curve steepening is the dominant theme

There is only one theme in fixed income dominating the markets: the steepening of the yield curve. Two processes are occurring. First, there is a natural movement to normalcy after the excesses in monetary policy post-GFC. The QE programs drove all rates down, leading to a long-term inversion. The normal yield curve should show a term premium, and the curve should be upward sloping. Two, there is the threat of further Fed rate cuts, and investors are getting ahead of it, so we are seeing short rates move lower and steepen the curve. This one-two punch is driving all interest rate action beyond the general rate cut. 

Global debt problem or just an interesting historic artifact

 

It is time to bring out a good Reinhart and Rogoff debt scare. Excess credit is a global problem, and debt usually piles up during war. There is no war, but governments are still spending and borrowing. There is a war on for consumption today in exchange for payment in the future, and debt will have to be paid, or it will be revalued lower. The easy answer is default or inflation. It is just a matter of timing. 

The consumers and debtors outnumber the creditors, so it is unlikely the creditors will win this war. 

The hard money perspective - not a valuation tool

 

I have seen these charts, and they do not say that gold is cheap, nor do they say that gold should go higher. It does tell us that the dollar, as a fiat currency, debases our purchasing power. 

In a bubble, one of the greatest problems is determining value. Those who want ot see gold higher will trot out valuation metrics that say it should go higher. Those who think it is overvalued will bring out other valuation metrics. Who is right? It is not clear until time passes which one had the better metric, and even then, an investor could be right for the wrong reasons. All of these metrics are relative, and there is nothing to say that there should be mean reversion. 

Gold is cheap, or stocks are overvalued. Take your pick.

I am not worried about de-dollarization, I should be worried about the de-dollarization

 

There has been a lot of talk about de-dollarization amid the dollar's decline this year. The talk may be overblown. Dollar trading remains dominant, and the share of dollar-denominated assets held by central banks has only slightly decreased over the last few years. There is no dollar crisis, yet there are some concerns that investors should follow.

The dollar was not the dominant currency even when the US became a manufacturing powerhouse at the beginning of the 20th century. It took time to dominate and a world war. 

The Chinese cannot become a reserve currency, yet it is clear that it is the key currency for trade finance. Large trade surpluses mean the Chinese are dominating global trade and, with that, require financing for purchases, and importers are having to turn to Chinese funding to get it done. There is demand for the currency because importers may have to pay for goods in renminbi but finance the time between invoicing and the sale of the goods. Importers will be locked in a renminbi system.

Common knowledge problem explained by Pinker

Steven Pinker is a prolific writer on many topics, and his latest book focuses on the issue of common knowledge, When Everyone Knows That Everyone Knows... Common Knowledge and the Mysteries of Money, Power, and Everyday Life, an essential issue in information economics and game theory. Common knowledge is the shared state of understanding associated with a fact that is known by everyone, and it is assumed that everyone knows that everyone knows. This back-and-forth about what everyone knows can go on forever. It is the foundation of non-cooperative games with full information and of group decision-making. 

There can be unwritten or accepted knowledge that is common, often associated with conventional thinking or wisdom, yet, as in the story of the boy who says the emperor has no clothes, there can be a radical change in thinking when common knowledge is challenged by the truth. Assumptions about what people know and what they think others know can affect price expectations in markets and influence bubbles and their bursting. Coordination of behavior is affected by what is assumed to be common knowledge. 

There are great stories and jokes associated with common knowledge that make this a fun book to read. Still, I would have preferred Pinker to focus on specific use cases to help clarify the key problems of how knowledge and expectations are coordinated in markets.

The impact of tariffs on futures trading

 

In a global world, there should be little difference where a futures contract is traded. There are regulatory differences and legal jurisdictions that may lead to preferences for trading, and some markets will dominate based on liquidity. Still, there should be a single world price based on arbitrage, with differences reflecting only the cost of arbitrage associated with moving the product.

Arbitrage breaks down when there is a tariff threat. Look at the spring period when copper flowed to the US, as investors were copper buyers looking to front-run tariff increases. We can see it in the warehouse receipts. Buy futures, take delivery, hold in approved warehouses, and await the tariff dislocation. This worked until the copper tariff clarification, which allowed prices to return to equilibrium.  This is a clear reason for multiple markets trading different commodities.

How countries go broke - cycles or one bad policy after another

 

Ray Dalio's new book, How Countries Go Broke - The Big Cycle, is a continuation of his earlier work on credit and debt cycles across history. In some sense, what he is proposing is not new but a reformulation of many of his past ideas. Dalio is neither a historian nor a macroeconomist but a successful practitioner who has studied credit markets and debt cycles as deeply as anyone. If you are expecting a deep history of debt cycles, as one would in an academic treatise, think again. 

Through narrative, many charts and tables, and highlights from Dalio, you are reading the argument he has for big credit cycles mixed with smaller cycles. He believes there are clear, recurring cycles that are predictable through repeating patterns of excessive credit, which must be adjusted through changes in monetary policy and structural reforms. Credit cannot be separated from money creation and policies. Excess credit can be addressed, but it will be painful. In the case of excess government debt, the options are spending cuts, tax increases, or inflation. Much of the theory is well known, but Dalio focuses on the behavioral patterns that create a cycle. 

The strident tone of Dalio may be off-putting, but he clearly formulates his arguments, and you can then debate the specifics. If you are worried about debt cycles, this is a book worth reading to frame future discussions on how debt cycles may collapse.

Cockroach Theory and credit risk

 

Regional banks are under stress based on the "cockroach theory" of credit. If you find one, there usually are more. If we have one credit problem with short-term and factor lending, there usually will be other firms that may have a problem. Credit problems are generally not just one-off. There can be fraud in some cases, but fraud is usually caused by stress in the system. Firms may not plan fraud. They are forced to cut corners, which generally leads to illegal action. One cut corner leads to others, which leads to cover-ups. 

Smaller banks have diversified portfolios, but a loss across several business sectors can have an impact on earnings and impair the sale of loans. We are not near the earlier lows in April associated with tariffs. Again, selling is based on higher uncertainty.

 

Cockroach Theory or "It's just one darn thing followed by another"

Let's make the gold story simple - High uncertainty

We can make the gold story simple; there is high uncertainty. The world policy uncertainty is at extremes. The world uncertainty index is at extremes. The world trade uncertainty is at extremes. If there were a bubble measure of uncertainty, we would be in that bubble. The exponential growth is clear.

If you had a choice of assets, the safe asset associated with government debt that may be affected by world policy, and trade uncertainty, or a hard asset that should have an independent or intrinsic value that is not related to debt policy, overall uncertainty, and trade, you will likely choose the hard asset. While debt continues to grow, the supply of gold can only increase through more mining, which takes time to expand. 

An inelastic supply in the face of a strong demand shock will lead to higher prices. Cut the uncertainty, and gold demand will decline. However, uncertainty requires policy clarity, which is in short supply. 

 

No room for error in the bond market - First Brands carryover

 

There is no room for error in the corporate bond market. Look at the spreads: the market is pricing in very little corporate debt risk. 

That tightness may be changing with the First Brands failure. Most corporate debt does not present the problems associated with First Brands, but we now have an environment where every credit manager is conducting a full review of their portfolio. Go back to basics, as there's FOMO around credit. 

The FOMO of a credit event. You want to be the investor who avoids risk, so it is time to start reducing risk exposure, especially in the high-yield space. If there is a credit problem with First Brands, there is likely to be problems somewhere else. There will be specific credit risks for firms that may have to rollover debt in the next year. Short-term debt should be less risky, except when there is a near-term credit problem or a threat of new funds not being available. If bank lines are cut, some firms will have less funding in the short run. 

Gold not following fundamental model

 

The chart above is the gold attribution model for UBS. Their chief strategist notes that the residuals have gotten larger since the Ukraine-Russia War. The argument is that the buying of gold has not followed the classic link between the dollar, real rates, and uncertainty. The residuals have gotten larger and have been on one side. The residuals indicate that gold is being driven by other factors, and the link to fundamentals has weakened. If we do not have a strong reason for the delinking, then there is reason to believe that gold will mean-revert.

What is driving China stock market

 

One of the biggest surprises in the global stock markets has been the move in China. With a gain of over 30% relative to the 13% move in the MSCI world, it does not make sense. The trade war issues with the US make these kinds of moves odd. Additionally, China's internal politics are not particularly friendly to business, and global investors still avoid investing there. Nevertheless, firm fiscal and monetary policies, coupled with measures to finance share buybacks and discussions of improved corporate governance, may be making Chinese equities a better alternative to the property market. Internal money flows may be the key driver. 

Nobel prize in economics - innovation and growth critical

 

We too often focus on the macroeconomic cycle. Of course, it is immediate, yet if you want to change the lives of many and a society, you need to focus on innovation, which leads to growth and productivity. The Nobel Prize winners in economics are three economists who concentrate on this critical issue. Moyr is an economic historian who closely studies the environment for innovation. Why did innovation occur at a particular time and place? The other two economists focused on endogenous growth through a Schumpeterian view of creative destruction.

Moyr is considered part of the idealist school of thinking on innovation. The culture matters when it comes to innovation. Aghion and Howitt are viewed as part of the materialist school, which focuses on modeling growth to explain how innovation drives it. 

Innovation drives growth, and we need to always think about how to foster it to increase growth and productivity.

There are no stocks to trade

When looking at the reasons for the rise in private equity investing, we cannot dismiss the role of fewer publicly traded stocks. Over the last 30 years, the number of listed companies has declined by 50%. Of course, the decline of public and rise of private equity is caused by some other factor. It could be the cost of regulatory requirements associated with being listed. It could be an advantage to work with a limited number of investors over a diverse set, regardless of the regulation. No matter the reasons, fewer companies are easily traded by investors on exchanges. The choices have fallen, and the diversification possibilities have declined. 

 

The length of bull markets - do rallies die of old age?

There is the old adage that equity rallies will die of old age. They will come to an end, and their demise is usually related to a fall in the business cycle, yet it is hard to say anything about length when isolated against the business cycle. The current rally is 35 months old. This is longer than the last two but shorter than many rallies we have seen since 1970. It is nice to know these old adages, but that does not mean you should follow them. 

This is a stock picker's world

 

This is a stock picker's world because the dispersion of returns is abnormally high and correlation across stocks is unusually low. Finally, market volatility is below normal. The dispersion tells us there is a lot of differentiation across stocks, so if you find winners and avoid losers, you will be rewarded for your work. This is reinforced by the low correlation. The comovement across stocks is low, so they are not driven by a single factor. There is no current macro driver driving stocks to move together.

We should see this reflected in the performance of hedge fund alpha, especially in long/short and market-neutral strategies.

Fixed income - normalized curve, abnormal spreads

 

Many investors are concerned about the direction of fixed-income markets; however, it is essential to recognize that the moves we are seeing are not abnormal but rather reflect the normalization of the yield curve. It has been the past that has been abnormal. Nevertheless, the spread we are currently seeing is abnormal. They are just too tight. The economy has been doing well, yet the payment of principal is based on future events, and investors currently are not receiving much compensation for the risk they are taking.

We can still learn from Commodities Corp

 

We can still learn from old-school traders who combine fundamental and technical analysis. Do not fight the trend; instead, load up on high-conviction trades.

Hemmut Waymar and Commodities Corp  - Fortune Feb 9,1981 

Over the next few months, the trading team spent many late nights devising a framework of controls that is still in use today. It imposes two principal controls. First, each trader is a profit center. At the beginning of each fiscal year, he is handed a "trading fund," based on his prior year's performance. The system grants the trader a free hand as long as he is making money, but it bears down on him if he starts to slip. If he loses 50% of his initial capital, he must sell off his position and take a month off from trading to write a memo to a management committee explaining what went wrong.

The second control formalizes the sort of guidelines Hostetter had been using for decades. The control is tied to the signals generated by the TCS system. If a trader holds cocoa futures, for example, and TCS detects that prices are headed downward, he is forced to get all but 10% of his capital out of cocoa. If he is authorized to trade several commodities in which TCS sees a downward trend, he has to get all but 20% of his total funds out of those goods. In other words, a trader can put up very little money bucking a trend. TCS has become the traders' watchdog as well as a robotized commodities gambler. TCS's trading record has won over even Samuelson. Today, in fact, the TCS fund manages some of his personal money. 

The big events - they will always be coming

 

Graham Capital provides a simple infographic on the major market crises for the last 30 years. They happen frequently. While crises are not an annual event, investors should expect unique crisis events more frequently than expected if economic policy is working effectively. Interestingly, most of these crises can be linked to bad policy choices. There will be a reckoning when monetary and fiscal mistakes are made.

Volatility and tail risk - The need for liquidity

Graham Capital provides some helpful charts on the current volatility environment in its paper, "Tail risk as a structural feature of modern markets." The MOVE index of bond volatility has shown significant increases since 2022, following a prolonged period of benign movements during the post-global financial crisis (GFC) period. The VIX has also shown an extended period of volatility. There is an ebb and flow with volatility, but the greater concern is cross-asset volatility, which indicates that we have seen more spikes in volatility over the last five years. These spikes are particularly hazardous for investors, especially when they occur frequently.  

Graham argues for adaptive risk management frameworks that combine quantitative and discretionary approaches through both top-down and bottom-up approaches. These approaches include stop-loss and profit-taking. We agree in principle that this is an adjunct to risk management; however, it is not clear exactly how it should be implemented. One beneficial idea is that under a high-risk environment, there is a strong need for liquidity. Liquidity provides embedded optionality through allowing investors to change direction during periods of high uncertainty. When there is a breakdown in correlation and higher volatility, liquidity allows investors the chance to pivot, even if it's just to cash.