Did we grow our way out of WWII debt?

 

We are facing a major debt crisis in the US, yet the alarm bells don’t seem to matter. The argument is that we run the economy hot, and stronger growth will get the debt issue under control, or at least allow us to see a decline in the debt-to-GDP ratio. 

The argument for growing our way out of the debt crisis rests on the view that we have seen high debt before and solved it through growth. The WWII debt was huge, but the debt-to-GDP ratio declined during the post-WWII expansion. The COVID debt expansion was like a world war, yet we can solve the problem through strong post-COVID expansion. 

In an interesting paper, “Did the United States Really Grwo out of Its World War II Debt”, we find that this argument may be wrong. Debt/GDP would have declined much less if not for the policies of the pre-Accord peg (financial repression) and the distortion of real rates from surprise inflation. 

The debt/GDP ratio fell from 106 to 23 percent in actual history, but if not for the rate distortions, it would have declined only to 74 percent.

This is an interesting application of counterfactual analysis, yet it is a sobering thought that solving the debt/GDP problem will have to come through surprise inflation and financial repression.

From theory to reality - the ineffectiveness of socialism

 

Chantrill's four laws on the ineffectiveness of socialism. 

1. Socialism cannot work because of prices for multiple goods (Mises)
2. Administrative government cannot work because of the Knowledge Problem (Hayek)
3. Regulation does not work because of “regulatory capture” (Stigler).
4. Government programs cannot work because you can never reform them (Chantrill).

There is the positive economics of what we would like the economy and the normative of what it actually is. Reality often gets in the way of theory.  All things are flawed, and systems are broken. Economies are often inefficient due to structural issues rooted in human behavior. Our job in finance and economics is to determine how to navigate an inefficient system to move capital and resources to the places where they will have the greatest impact.

Earnings sustainability and equity returns

Nothing lasts forever. Many believe that trends are sustainable over the long term, but that is not the case, so today’s trend or growth rate may not tell us what will happen tomorrow. Too often, analysis compares two variables with the same timeframe when it is important to look to the future. In the case of long-term earnings growth, strong earnings today are not linked with strong forward performance. The chart above shows long-term earnings growth and compares it with forward earnings. There is a strong negative relationship. We should see forward earnings versus forward returns, and current earnings growth versus current returns, to close the loop on different combinations.

The end result is the same. Stock returns are tied to forward expectations, not what has happened currently or in the past.

Kahneman's solution to system1 thinking

 

Daniel Kahnemena came up with the idea that people either use system 1 or system 2 decision-making. In system 1, the brain makes impulsive decisions with little analytical thought, leading to behavioral mistakes. In the case of system 2 thinking, the brain slows down and uses analytics and logic to mkae decisions. There is nothing wrong with system 1 thinking when appropriate, and using system 2 for all thinking may be exhausting. Nevertheless, to combat the problems of system 1 thinking, Kahmean uses the SODAS problem-solving framework.

The SODAS acronym stands for situation, options, disadvantages, advantages, and solution. To bypass the automatic System 1 mind, the decision-maker should first define the exact problem faced, then review or brainstorm possible options to handle the situation. Third, the decision-maker should list the disadvantages and then the advantages for each available option. Finally, the decision-maker should select the best solution after the review. The SODAS method. It’s not the first, nor the last, method for making better decisions. It is simple and direct, and anyone can try it. 

Follow those small cap stocks; not the overvalued mega-caps

 

With all of the talk about the AI revolution and the Mag 7 over the last year, many investors have missed a really strong investment story - the rise of small-cap stocks. 

There has been a strong move in 2026, but more importantly, there is strong outperformance versus the megacaps. The market is signaling it wants to rotate out overvalued large caps and start putting money to work in smaller caps. Whether the story is about extreme overvaluation or opportunities in smaller, riskier names, the result is an opportunity that we have not seen for some time. There has been the view that the small-cap premium is dead, but there seems to be new life in these names that requires a second look.

Gun violence - the solution is following the research

Finished reading Unforgiving Places: The Unexpected Origins of America's Gun Violence by Jes Ludwig of the University of Chicago and I am once again awed by the power of good economic research. I may have had some biases before starting the book, but I had an open mind to learn about one of the worst problems in America. 

Ludwig also presents his case and evidence without any political bias. He wants to get to the heart of the issue, and, as with many economic problems, the obvious is not always right. Most of our views on many topics are, at best, only partially correct and do not serve as the only answer. Ludwig presents all sides of the argument about why there is gun violence and what possible solutions there are, but the main driver is behavioral economics. Gun violence is not about rationality but often irrational or, as Kahneman says, system 1 reactionary thinking. You put guns in the hands of people that have different reactions to situations not based on rational but on react, fight or flight thinking, and there will be a problem with tragic results. He makes a strong argument that many current models cannot explain why two neighborhoods that are adjacent and have similar demographics can have very different gun violence statistics. The only explanation is behavioral and social interaction between individuals. The poverty argument cannot explain gun violence - there are too many contradictory facts, and the idea of "bad people" does not explain the majority of violence, nor can using jails be the solution. 

For something inherently political, this book is well-written, thoughtful, and shows the power of good research that is able to separate common opinions from real facts. 

The end of forward guidance - Good, let's use rules

 

Recent comments from Fed Chairman Warsh suggest that he is not in favor of the current forms of forward guidance. No dot plots, or perhaps not in the current form. The Fed has proven to be a poor forecaster, so the guidance may not be helping the market. It does not make sense for Fed governors and presidents to give speeches on their views of the economy when most are wrong. Let’s not have the market hanging on guidance that may be wrong. 

I have always been in favor of having a more rules-based approach that provided clarity on the general direction of policy. Can there be deviations from the rules? Yes, but there have to be good reasons that are infrequent. Of course, many governors and presidents like to give speeches, so there has to be a change in the messages to the market.

Gold overtakes Treasuries as central bank reserves

 

From work done by the ECB, gold has now overtaken US Treasuries as the largest reserve asset for central banks. This is driven by the strong price appreciation of gold over the last year, even with the recent declines. US Treasuries have seen yields rise, reducing the value of the asset. This is not surprising, given the strong buying by central banks, especially over the last four years, amid rising inflation. Still, it suggests that central banks have less confidence in government debt as a safe asset.

Safety is relative, and from the perspective of central banks, it makes sense to hold an asset that is likely to preserve its value during periods of higher inflation. Is the inflation-gold link strong? Not really, but it does seem to be a better inflation hedge than bonds when an inflation shock is expected. Gold can earn some yield if it is leased, but generally there is no yield, whereas bonds may earn a positive real yield.  

Central banks are telling us they lack confidence in their ability to control inflation globally.

Forming better decisions through known, unclear, and presumed framework

 

This book, Thinking in Time: The Uses of History for Decision Makers is now 40 years old, yet it provides some good, simple insights on how to make better decisions. You may not be interested in the political stories provided, but they provide context on how best to use the Neustadt and May framework.

The method is defined as the K-U-P/L-D, or the known, unclear, and presumed, which is then used to compare with likeness and differences. 

Determine what is known, define what is unclear, and then assess what is presumed by the decision maker. The decision-maker should then look for likenesses and differences in history, which can be used to define what is now of concern and what will be new objectives. 

The authors suggest the Gldberg rule: don't ask "what is the problem?" Rather, ask, "What is the story?" by using a timeline from now to the start of the story.

Be a journalist and ask when, what, where, who, how, and why. 

While this is not a quantitative process, it can be useful for framing discussions. 

The current inflation divergence - trimmed mean versus core PCE

The preferred inflation measure for the Fed is core PCE. The idea behind using a core measure is that it filters out extremes that may be driven by supply shocks. Fed Chairman Warsh has a different preferred measure: the trimmed mean, which includes food and energy but removes extreme values, both high and low, from the inflation index. If food and energy are on the high end, those prices will be trimmed, but that need not be the case. 

History shows that the trimmed mean is smoother and will lag the core PCE, but now we are seeing something different: the core PCE is rising while the trimmed mean is falling. Which one you place more stock in will drive your decision on Fed action and the direction of rates.

There will be politics over whether Warsh will be able to get others on board with the trimmed-mean measure, and that will determine any Fed action. 

Warsh politics starts inside the Fed

 

The most important political issue for Fed Chairman Warsh is not working with Congress or keeping President Trump happy, but working on the politics within the Fed. While not like the Volcker period, the current problem is the uptick in no (dissents) to yes votes during the last year of the Powell era. While dissent does not make the Fed ineffective, it creates more market uncertainty. A high dissent ratio indicates disagreement over policy direction, which will spill over into market thinking. Is consensus necessary? No, but it is helpful, especially if there is a change in policy direction.

Follow the equity risk premium

 

There should be an equity risk premium over bonds. Equity is riskier than bonds, yet the current market does not suggest this. The bond market has disconnected from equities. One can always say that bondholders are pessimists relative to equity optimists, yet there is more going on than just behavior. 

Bonds are pricing stagflation, while equities, through cap-weighted indices, are pricing an AI productivity revolution. Perhaps both can be right, but that does not bode well for holding equity in traditional companies. 

The politics of the Fed run through Congress

 

This is an interesting chart on the politics of the Fed. Clearly, Powell is a political animal. There is nothing wrong with being political. It is important to maintain good communication with politicians to ensure they understand the Fed's role and mission. One of the key Fed battles has always been the level of oversight from Congress. (I was involved in that fight in the 1980's when consulting for the GAO on primary dealer oversight. Getting data from the Fed was an ordeal.)

Powell needs to limit interference from the executive branch and ensure there is limited oversight from Congress. Independence takes work. 

So bonds are not the solution?

The chart from Nicolas Rabener of Finominal compares the drawdown from bonds versus managed futures. If you ask most investors, they would say that a managed futures fund is riskier, yet when you look at the long history of bonds, it does not look attractive. There can be drawdowns for decades. It is unlikely the 10-year will get out of this drawdown in time in the near future. Of course, it is critical to think about upside and what a bond drawdown means. 

Edmund Phelps - more than a macroeconomist

Edmund Phelps died this week. Unfortunately, many may not remember his path-breaking work in macroeconomics, which opened the door to neo-Keynesian models. His most important macro work examined the inflation-growth trade-off through the lens of inflation expectations and addressed the natural rate of employment. First, if inflation expectations rose, there would be a corresponding impact on wages, leading to a wage-price spiral. Second, if central banks attempt to maintian emeplyent above the natural rate (the equilibrium rate) there will be a surge in inflaiton. 

While he was viewed early on as an important macroeconomist, he provided significant insights into innovation and creativity as drivers of economic dynamism. Few economists have had many important pieces of research across fields. 

He could not be placed in any school of thinking and should be viewed as one of the few truly independent thinkers on a range of topics. 

Large moves in the FX markets

 

In the paper “Large Moves in the Foreign Exchange Market", the researchers show that large currency moves are not random but related to the term structure of option-implied volatility. The difference between short-term and long-term implied volatility is a good predictor of the absolute value of current moves. Given this information, investors should buy straddles when the volatility curve is inverted. Being long the straddle allows for gains in either direction.

The implied volatility inversion provides useful information that can be exploited through straddles. It makes sense that high short-term volatility will likely see greater-than-average moves. 

Unsustained sales growth and AI

 

We are seeing very strong expectations for AI sales growth. There is no question that new technology will see stronger sales growth than the average firm and that, during the initial growth period, sales may be well above average. The question is, how do you temper these sales expectations to form more realistic estimates? The power of compounding will work against you. You can, of course, rely on some form of mean reversion, yet this can be guesswork.  

This problem was addressed in two papers by Counterpoint Global - Bayes and Base Rates: How History Can Guide Our Assessment of the Future and Bayes and Base Rates 2.0  I like this work because it takes the emotion out of the sales forecasts associated with AI and focuses on what we know across decades of data, within different industries, and with major changes in technology. We can form base rates using priors and then derive normal forecasts. The conclusion is that the sales forecasts are just too large, even if we isolate new technology, focus on specific industries, and account for the very best historical events. 

This does not mean investors should short these companies. It is unclear when reality will be realized, but arriving late is problematic, shorting can be a fool's game, but buying on these aggressive growth forecasts will be disappointing.  

The time series of risk shocks

In an earlier post, we discussed the differences in risk regime through decomposing the VIx index. 

The time series of risk regimes

We can also do the same for risk shocks, which are measured by changes in the VIX. We use bin analysis based on quantiles to form three groups of risk shocks. 

Again, a simple null hypothesis is that risk shocks occur during periods of market extremes, such as recessions and market turning points, yet we find that the time series of changes in the VIX, or risk shocks, appears more random. 

There is a different market response to risk shocks than to the risk regime; more simply, positive changes in the VIX index are associated with large market downturns, but their clustering differs from what we see in the risk regime.

The time series of risk regimes

The VIX index has been used as a fear index, but we believe the best way to view it is to define risk regimes. There are periods of normal, high, and low risk and the behavior of markets during periods of high risk will differ from periods of low risk. Before we start examining the market response to different risk regimes, we should examine the time series of risk regimes and determine when high- and low-risk regimes occur. 

A good null hypothesis is that market returns are independent of the regime. We assume there is no relationship. However, we do expect there is a trade-off between risk and return. The market will react to risk, and the reaction should be stronger for high-risk regimes.  

We take a long time series of monthly VIX returns and divide the series into quantiles, with the low risk being the lowest quantile, the middle range being the next three quantiles, and the high risk representing the highest VIX value quantile 

We find that high equity risk will coincide with turning points in the stock market. Specifically, a high-risk regime will be associated with recession and drawdowns in equities. There will also be low-risk clusters, and these are associated with higher return periods.

Returns respond differently to high-risk periods than to low-risk periods. This is a piece of ongoing research we are focusing on. 

EU Geopolitical risks - different from Anglo geopolitical risk

There has been a boom in indices that measure risk by analyzing news story words, yet not all news is created equal. There can be big regional differences, and recent research shows that geopolitical risk measures in one region may not align with or accurately reflect those in another. The recent research paper, Geopolitical Risk in the Euro Area: Measurement and Transmission, shows that there are differences between EU and Anglo geopolitical risk. Clearly, some events are more important to Europeans. We can see this in the residuals from a simple regression. The more recent history shows a strong divergence in risk. There are also clear spikes in the daily data that indicate European risks differ.

The risk differences have clear macroeconomic effects. European geopolitical risks show a stronger influence on industrial production and inflation.

Causal inference and critical statistical thinking

Causal inference is one of the most important topics in finance today. There is a difference between what correlates with or is associated with X and Y and saying that X causes Y. We can thank the work of Judea Pearl for truly focusing our attention on causality rather than correlation. 

You should not ask what tends to happen to Y when X is high. Of course, you can ask, but that only refers to the association. The real question for causality is, "What will happen to Y if we set X to a specific vlaue and all other factros are held constant?". To answer that question, we have to consider the relationship between X and Y, and also ask what other factors may influence Y, such as variable Z. Does Z cause X, which then affects Y? Does Z affect Y directly? This type of thinking is not about fitting a set of past data into a relational model, but about asking the primary question of whether there is a reasonable link between these variables. 

Before you run a statistical test, think about causal relationships and how they may be linked together. What type of relationship are you trying to find? 

Hedge fund strategy rebound

 

There has been a strong rebound in hedge fund strategy performance in April after poor March returns. All the HedgeIndex Main strategy returns were positive for the month, with especially strong performance in emerging markets, global macro, and long/short equity. Of course, the overall equity market showed strong April gains, so the market exposure for these strategies provided a tailwind, and positions placed at the end of the market were able to take advantage of the stock market improvement despite the continued uncertainty associated with the Iran War.

Commodites versus stocks - Go with the real economy?

 

The power of supply shocks and the real economy can be seen when we compare the BCOM with the NASDAQ and SPX. Since the beginning of the year, there has been a strong acceleration of commodity prices. This momentum was even before the Iran conflict. A combination of strong demand and a supply shock has been driving the commodity market, even amid all the buzz about AI. Of course, AI is driven by electricity (energy) and infrastructure (metals). 

So ends the view that inflation is tamed

 

So ends the view that inflation is tamed and rates should fall. The PPI is accelerating and moving back to the type of supply shocks that we saw post-pandemic. The CPI is also heading higher and moving further away from the target with a 3-handle. There is no room for a Fed rate cut, and with real rates now near zero, there is a strong case for a rate increase. 

We do know what the Fed hates - supply shocks. Monetary policy is a tool that is not built for supply shocks, yet here we are.

Why nothing works - We cannot decide whether we are Hamiltonians or Jeffersonians

 

Why Nothing Works: Who Killed Progress and How to Get It Back by Marc Dunkelman is one of the more interesting books on politics that I have read this year. It is thought-provoking and can help explain the problem in getting things done in the US. It may not solve the problem, but it offers a plausible framework. 

The progressive movement, now well over 100 years old, is driven by conflicting philosophies about the role of government. These two approaches, Hamiltonian and Jeffersonian, represent very different views on how government should be used to solve problems. The Hamiltonian approach is a top-down, big-government approach that seeks to offset large private-power and control projects through experts. The Jeffersonian approach to government looks at large institutions and power as corrupting. The power should be dispersed and controlled by the people, not by experts or large institutions. 

How can you get something done if top-down control by Hamiltonians is viewed with suspicion by the Jeffersonians? You may not be able to have ot both ways, and vacillating between the two will lead to inaction and program failure. The train to nowhere in California is all about the Big project, Hamiltonian government micromanaged by Jeffersonian rules and regulations to get local input. 

No one seems to want either extreme, but the middle ground leads to an environment where Nothing works.

The Doom Loop - Explaining the dollar

 

The Doom Loop: Why the World Economic Order Is Spiraling Into Disorder by Eswar Prasad is a good book for explaining the current trouble with a dollar for anyone who wants a non-technical read on the subject. It focuses on the intersection of economics, finance, and geopolitics rather than on the theory of international finance. 

The book’s main focus is that we are caught in a destructive feedback loop driven by a changing geopolitical environment. The movement away from US hegemony in globalization is now being replaced by a fragmented system with more dispersed economic and financial power. It is not that we should go back to the old system, but globalization caused fissures that cannot be replaced. The backlash to a global hegemony of rules and governing institutions means that a single currency cannot dominate the world and create a stable world order. 

Can the dollar be replaced? The answer is no: the dollar cannot dominate, which means there will be more financial instability in a world order that cannot be controlled. 

What are equity markets discounting? it is not risk

 

The Iran conflict is not over, yet the markets are optimistic. Perhaps it is because we don’t know what to call this oil crisis. Is it a war? A dispute? A current pause? The SPX was up over 10% for the month. The high beta names were up over 15%. For the sector extremes, the communication services sector was up over 18%, while the energy sector was down 3.45%. Surprisingly, emerging markets were also up over 11% for the month and strongly higher over the last 12 months at 32%.  Even bonds were slightly higher for the aggregate index.Yet the market is facing a significant commodity shock, with the DJCI up 31% so far this year.

Is there anything to worry about? Central banks? Growth? Inflation? The markets are either looking through any negativity or do not believe it even exists. This is a path that should concern any investor. 

Periods of Stagflation - there have always been with us

Despite strong performance in equity markets, there is still considerable talk of stagflation. The stagflation story is not just a 70's problem. It can happen in other countries and almost any time. It is more likely that we have a supply shock that can affect both prices and growth. The longer the oil crisis in the Middle East lasts, the greater the likelihood that we will see stagflation. Stagflation has generally been short-lived because the underlying cause changes. An energy crisis is averted through a new supply or a solution to the initial problem. 

Right now, we are not close to the 2% inflation target, and the cost of higher energy is just starting to bite. The likelihood of a stagflationary period in the second half of the year is increasing.

Risk aversion index worth a look

 

There is a growing number of risk measurement indices, although the definitions of these risk or uncertainty indices are not always clear. We can start with the VIX index, which is not really an uncertainty or risk index but a proxy for option volatility and is often called a fear index. There is a set of policies and economic indices, derived from news scraping, associated with countries and topic areas.  

Another entrant to this field is the risk aversion index.

The general estimation philosophy is as follows:  

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(1) The risk aversion coefficient is utility-based, reflecting the time-varying relative risk aversion coefficient of the representative agent in a generalized habit-like model with preference shocks.                                                          
(2) Given the no-arbitrage framework, asset prices, risk premiums, and physical/ risk-neutral variances are exact functions of the state variables, including risk aversion, in the dynamic (exponential) affine model.

(3) Financial variables are observable. Thus, the market-wide risk aversion should be spanned by a judiciously-chosen instrument set of asset prices and risk variables. We use the Generalized Method of Moments to estimate their optimal linear combination given asset moment restrictions that are consistent with the dynamic no-arbitrage asset pricing model. The instrument set includes a detrended earnings yield, corporate return spread (Baa-Aaa), term spread (10yr-3mth), equity return realized variance, corporate bond return realized variance, and equity risk-neutral variance. 

I find this risk aversion index fits the story expected when there is higher uncertainty, and could be worth following as another indicator of changing behavior in financial markets. 

Trading with signal and price impact uncertainty

 

When you want to make your model practical, you have to look at signal uncertainty and price impact. If you use any model, your one-step-ahead forecast may have some uncertainty because the average coefficient may not accurately represent the true coefficient sensitivity at a given time. Similarly, for any model there is going to be a prcie impact from trading. If the signla is weak then iapct uncertainy is not that important but as the siganl strengthens, the effect price imapct will become more important. See “Trading with uncertainty about signals and price impact.” These real-world effects are important if you want to trade a model.  

Expectation Bias and short-term Momentum

 

Machine learning can be used to predict analyst forecast errors. These forecast errors can predict cross-sectional returns and abnormal returns. There is an underreaction to fundamental news, which is amplified by overconfidence, sticky beliefs, and information uncertainty. This expectation bias can explain short-term price momentum in high volatility stocks. From expectation bias comes a rationale for trading patterns in price. See "Expectation Bias and Short-term Momentum". Past forecast errors have a critical impact relative to other features.

Attention versus earnings and momentum

 

One area of increasing research is the attention that is given to a specific market. Investors cannot follow everything, so there are different levels of attention. Given changing attention, there should be different levels of efficiency. What is found in the paper, "A Tale of Two Anomolies: The implications of investor attention for price and earnings momentum," is very interesting. Stocks that receive more attention exhibit greater price momentum and weaker earnings momentum. The authors make the following claim: investors pay less attention to earnings news, stock price underreacts, leading to stronger earnings momentum, but when attention is high, behavioral biases intensify, which fuels overreaction and price momentum. Depending on the type of attention, the effects will vary.