Sector and country risk repricing in July

Equity sector markets saw significant reversals from the ugly June with positive returns for all sectors. A continuation of this trend may push more sectors into positive territory; however, the euphoria of a more moderate Fed may be short-lived as we get more economic data that either confirms a likely slowdown or inflation data that shows no signs of moderation.

The impact of changing expectations on the Fed rate path spilled over to country equity returns. While Europe is facing a severe energy shock, markets moved higher for many EU countries. The only major exception was China which is dealing with continued lockdowns and a real estate market that will not easily improve and will likely further push down growth.

The repricing of equity and fixed income risk in July

In June, we were looking at major declines in equity markets from a hawkish Fed raising interest rates 75 bps and perceived to be behind the policy curve. The fear was that the Fed would drive rate increases into a recession. In July, the Fed again raised interest rates 75 bps but provided enough signals to suggest it may be more flexible with policy. There is no forward guidance and decisions will be made meeting-to-meeting. There is enough wiggle with comments to suggest that the Fed path may not be as rigid as expected just a few weeks ago. This may not be what the Fed wants, but it is reaction from markets. Combined with the threat or existence of a recession (two negative GDP quarters), fixed income also showed a reversal from its deep drawdown.

Equities are still in a bear market. Fixed income markets are still a train wreck from a total return perspective, but there has been a significant repricing of risk. Will this continue? The next Fed meeting is in September, so we will not know for six weeks what the FOMC actions will be. There are two unemployment reports and a number of inflation signals before the next FOMC, so the guessing will begin.

 

This is not a recession - It is a banana!

Alfred Kahn, a top economic adviser to President Carter, learned that lesson [using the word recession] in 1978 when he warned that rampaging inflation might lead to a recession or even 'deep depression.' When presidential aides asked him to use another term, Kahn promised he'd come up with something completely different. 'We're in danger,' he said, 'of having the worst banana in 45 years.'" - from PRWatch (When United Fruit Co., complained about “banana,” Kahn switched to “kumquat.”)

No one in government wants to use the word recession. It is a new forbidden word. It is just a matter of time before the FCC puts it on the list of what cannot be said on TV or radio. This could be added to George Carlin's "seven dirty words". That may be an extreme, but creditability is lost when there is not a clear discussion. Language is important. Candor is critical.

What would be the harm of saying, "We are in a recession based on past technical definitions, but this cycle is unusual because the labor market is strong. This may cause us to revise our view of a recession." This is not far from current thinking, but there has been verbal gymnastics to avoid a clear discussion of the issue. 

Let us say we are in a recession. What will change, given we are also at full employment based on labor market measures? If the administration says we are in a recession given conventional definitions, would the Fed change? Would there be a different fiscal policy?  Would markets change?

What is the impact of a word? 

The 40-70 Colin Powell decision rule

Colin Powell had a 40/70 doctrine for senior leader decision-making, which held that if you make a decision with only 40% of the information, you are making it prematurely, but if you still haven’t decided by the time you have 70% of the information, you are no longer in control of events.

-from WSJ 7.26.22

Of course, if you know how to calculate the 40% and 70% you know all the information that is necessary or available. The basic dictum is that you need some information but not all the information available to decide. Gathering more information takes time and money, so you must learn to make do with less than perfect information.

You will never have all the information you think you need. In fact, studies show that having more information will not improve accuracy but only confidence. Try and decide with less to take some action. However, plan to have an exit strategy if you are wrong. Make decisions faster, learn from your successes and failures, and repeat the process as a feedback loop.  See More information does not lead to improved accuracy.

This decision framework is consistent with the Bezos Rule for planning. If you have 70% of the information you think is needed, decide. See The Bezos "70 percent rule" for decision-making.

Focus on precision in your thought processes to improve decisions

"I do not pretend to start with precise questions. I do not think you can start with anything precise. You have to achieve such precision as you can, as you go along."

“To teach how to live without certainty, and yet without being paralyzed by hesitation, is perhaps the chief thing that philosophy, in our age, can still do for those who study it.”

- Bertrand Russell 

Good research should start with general questions and then add layers of complexity to be more precise. The original general question cannot be forgotten, but there should be a process of digging deeper and getting specific. 

For example, is the Fed behind the curve? The is very imprecise. The process then focuses in on what it means to be behind the curve, how much it is behind the curve, and why is it behind the curve. The investor then needs to focus which assets have priced in this idea of being behind the curve, how will prices adjust, and when will it happen. From the general there is move to the specific. If the thought process only stays general, there will never be an effective decision.

Of course, we will never get the precision needed to generate certainty; consequently, we need to accept and live with uncertainty. Accepting uncertain means we will accept that decision will be made without full information.

“One of the symptoms of an approaching nervous breakdown is the belief that one’s work is terribly important.” - Bertrand Russell

The inflation regime matters when anticipating returns across the business cycle

 

Bonds have rallied from lows and stocks have improved but both still show significant declines for 2002. The classic 60/40 seems to be showing some improvement, but it is important to remember we are still in a new inflation regime. When inflation is rising and and higher than average for the last 2 decades, the correlation between stocks and bonds should move from negative to positive. This new regime and stock/bond relationship may persist for years. (From "How a higher secular inflation backdrop may make this business cycle feel different" Fidelity Investments.)

The high inflation environment changes the expected sensitivity of bonds across the business cycle. Instead of seeing nominal yields decline during the late to recession period, we may see them rise with inflation expectations. The moves in nominal yields will be more exaggerated. If we see inflationary expectation volatility increase, there will be an increase in nominal yield volatility. We have already seen this increase through the bond MOVE volatility index.  

The asset class returns will also change across the business cycle when the inflation regime changes. The moves and opportunities in commodities become more exaggerated. Interestingly, we have seen a large commodity gain last year during the late phase of the business cycle and now we are seeing a commodity decline based on recession expectations.

The big question is whether a high inflation regime is likely to persist. Inflation may fall from recent highs, but investors are unlikely to forecast a return to a 2% target without short-term nominal yields rising to at least the expected short-term inflation rates. Long-term rates are not really controlled by the Fed, so the focus is on the ability of the Fed to eliminate negative short-term real rates. Given forecasts are already calling for rate cuts in 2023 based on an expected recession, we do not place much stock in a return to a low inflation regime. 

Isaiah Berlin as an investor - Accept complexity but focus on simplicity

"Scholars are usually at greater risk of exaggerating how complex the world is then they are of underestimating how complex it is" 

"I think politics is more cloudlike than clocklike ("cloudlike" meaning inherently unpredictable; "clocklike" meaning perfectly predictable if we have adequate knowledge."

"The more common error in decision making is to abandon good ideas too quickly, not to stick with bad ideas too long" 

"To understand is to perceive patterns."

"Philosophers are adults who persist in asking childish questions."

- Isaiah Berlin, the 20th century philosopher may have something to say to investors. He is best known for his work on describing intellectuals as either hedgehogs or foxes based on the Ancient Greek proverb.

You can substitute the word investor and markets for scholars and politics and get a good idea of Berlin's thinking. Many investors exaggerate the complexity of the world which makes it hard to generate predictions. Yes, the world is complex, but it is good to start with a simple view and then add complexity. If the complexity helps explain reality, add it. If it just adds noise, forget it.

The markets are often cloudlike and not clocklike. We must live and accept the cloudiness of markets. There is a "fog of war" with markets that cannot be eliminated when making decisions. The fog may lift after the decision is made and an assessment of success is undertaken if you are lucky.

Investors will abandon good idea because they are not patient enough to let them work. Markets will often focus on a bad idea that seems to make sense in the moment. Understanding allows us to find patterns.

The great investors will persist in asking simple questions. 

  

Isaiah Berlin's hedgehogs and foxes - Why be a top-down investment hedgehog and a bottom-up investment fox

 

One of the best classification of intellectuals was by the Isaiah Berlin who said that there are either hedgehogs or foxes. The hedgehog knows one big thing very well and tries to explain the world through or within this conceptual framework. The fox, on the other hand, knows many small things and develops explanations on a case-by-case basis as needed. The hedgehog will focus on a grand strategy or approach that both requires and generates consistency. The fox focuses on trying to find the tools or explanations that best fits the situation. While Berlin's work focuses on politics, it can provide a useful framework for thinking about investing. 

The hedgehog investor thinks about the world through a single lens or view about markets or strategy. The hedgehog could be a believer of efficient markets as his world view. He could think of the world through the framework of value investing. The hedgehog could be a trend-follower who undertakes his actions based on the direction of price. The hedgehog could have a single macro view of the world which impacts forecasts on inflation and growth. The investment fox may meld several strategies or ideas together to form a portfolio. The multi-strat manager could be considered the ultimate investment fox. 

Is one approach better than another? They will have different return profiles and make different errors. The value investor may do very well, but usually only during those times when value is in favor. There are regimes when value will under-perform. The investment fox may do better in general but will diversify away some of the potential returns that would be received by a focused hedgehog. The choice may not be an either-or decision. The important issue is knowing whether you are a hedgehog or fox and what that may mean for potential returns and volatility.

Nevertheless, I like to think that an investor can be a little bit of both. An investor could be a macro or top-down hedgehog with a well thought through framework for making broad investment decisions. The investor can also be a bottom-up investment fox who uses different models and information to make the actual purchase or sale decision. Trading requires fox skills while strategy may require hedgehog skills. The best managers may have characteristics of both.

For more on hedgehogs and foxes: 

The "Hedgehog and the Fox" revisited - Find managers with big ideas, but diversify

Judgment And Experience - A Recipe For Success For Any Strategy

Sherman Kent - The analyst's analyst - Be precise with your forecasts

 

Sherman Kent, the great trainer of CIA analysts, should be a strong influence on any investor who is making forecasts about an uncertain market future. Kent focused on the precision in language when describing future assessments and the need to think in probabilities. He also focused on the assessment of any forecast. Why did it work or not work? What has gone wrong and what can we do to provide alternative explanations? How does the evidence lead to specific forecasts and are there alternative explanations for the evidence? This can only be done through focus and precision.

It is not enough to say I believe the Fed will raise rates if you don't provide some odds for the likelihood this event. Without precision, there is no meaning. For many, this may seem obvious but any assessment of talking heads and analysts will suggest that providing precisions is not the normal approach to making forecasts. 

Sherman Kent - My guy for precision in forecasting language

For more on Sherman Kent, see:

Sherman Kent - the godfather of precision in forecasting language

"Likely" or "Probable" - there is a difference in language when talking about recommendations in the new year

Language, perception, and numbers - The translation problem

What does failed intelligence tell us about investing

We have written about Kent in the past but have come across a useful assessment of Kent by Phil Tetlock in his book Expert Political Judgment: How Good Is It? How Can we Know?.  Tetlock studies the forecasts of experts concerning highly uncertain events and provides a great assessment of Kent's thinking.

"We can draw cumulative lessons from experience only if we are aware of gaps between what we expected and what happened, acknowledge the possibilities that those gaps signal shortcomings in our understanding, and test alternative interpretations of those gaps in an evenhanded fashion. This means doing what we do here: obtaining explicit subjective probability estimates (not just vague verbiage) eliciting reputational bets that pit rival world views against each other, and assessing the consistency of the standards of evidence experts apply to evidence." pp. 238 

Go precise and deep with your analysis and always assess what is potentially going wrong. 

Greenspan puts are now Fed calls, and a likely collar

 

We have gone through decades of what was originally called the "Greenspan put". The market perceived that the Fed would step-in and arrest any major market decline to maintain financial stability and stop any potential financial crisis from spilling over to the real economy. The finance channel was viewed as a key area that the Fed could control as the lender of last resort. The Fed accepted a rising stock market as a channel for growth.

However, we may now be in a new era of the "Powell call" which will cap any gains in the stock market. The Fed's key worry is that a hawkish fight against inflation will lead to a hard landing. The key signal for a hard landing will be negative signals from the stock market. If the stock market crashes, the financial stress will lead to the hard landing the Fed would like to avoid. If the market declines slowly or the market rallies, the Fed has a signal that it can raise rates higher and faster. An up-market move will give the Fed the latitude or flexibility to be more hawkish which will cap any equity gains. Hence, the Powell call is born. 

We could go further and say there is a Powell collar. If there is a financial crisis, the Fed will protect the market, but the strike is much lower than 20%. The calls are close to being at the money. If the market stays flat for the rest of the year, the Fed would be comfortable with a continued policy of raising rates. 

Declining margin, leverage, and big unwinds - A result of rising interest rates

Leverage is a core to the financial system as funds flow from those who have excess savings with unclear views to those that have a savings shortfall and strong beliefs. Finance is all about finds funds to give to those who want leverage. Leverage seeps into the financial system in places that are not always expected or closely watched. When the cost of borrowing increases, conviction goes down and the marginal view is cancelled. When leverage is taken out of the system, demand falls and prices must adjust.

There is a great deleveraging in equity markets that started when the Fed said they would end cheap money. At close to zero rates and negative real rates, borrow. When the cost of money increases, it is time to scale back bets. Margin debt has declined by a quarter of trillion dollars since the peak, that is money not entering the markets. Every time there has been a double digit fall in margin debt, there has been a subsequent fall. The decline in debt may not be the cause of the stock decline; however, markets are driven by feedback loops. Rising borrowing costs and falling valuation from lower present values all contribute to the same result, lower prices. The hawkish Fed should lead to further declines in margin debt and less equity buying demand. 

Let prices (trends) speak for themselves - It is a good base forecast

 

In an uncertain world, the question is always the same - whose opinions do you trust? Where do you put your forecasting faith? Is it a person? a model? specific data? 

Clearly, forecasting is always hard with the potential for error increasing with uncertainty. Hence, there must be some place or base that can be used for starting the forecast or forming a null of what may happen in the future. For those who focus on market efficiency, the base is always the current price. Your best guess for tomorrow is the price today. 

I try and make this simple with a core rule for any prediction discuss. Let prices (trends) speak for themselves. The direction in prices is the null or base for any for forecast, not the current level. If prices are moving higher (lower), then our base case is that prices will continue to move higher (lower). Of course, this single direction cannot continue forever. That is not the point. The point is that any forecast other than the trend needs to have a strong justification. 

Trends can take prices away from fair valuation, but the first view is that trends are pushing prices to a new valuation. If they continue to trend, then the market has not taken it to this new valuation. Prices move toward the new fair value not back to an old fair value as measured by a past price level. You may forecast that the speed of adjustment is faster or slower, but the first pass is that prices are telling you something about the aggregate behavior of investors or the weighted opinion of speculators.  There will be deviations from a base for fair value, but a sustained price move is forecast for a new valuation. The fact that a trend-follower uses a longer-back test is just a process for eliminating short-term noise.

Let the data speak first, then adjust forecasts only if you believe you have an edge with incorporating new information.

Ensemble models - A form of forecasting risk management

 

An ensemble of models is the equivalent to an investor having a diversified portfolio of stocks. A single stock may have a higher return, but the risk of failure is much greater than a portfolio. A portfolio of models will on average have a lower mean squared error relative to a single model. The manager of an ensemble is not wed to a single point of view or technique but can take a diverse set of model approach to forecast the same target variable. 

There is the view that ensemble modeling is a machine learning technique (for example random forest models and the use of bagging, boosting, and stacking approaches to model building), but the idea of bundling is an old forecasting tool. The idea of using more than one model and weighing the output to form better forecasts predates any machine learning. Machine learning has developed methods of employing more data and better search techniques to broaden the ensemble of possible models. 

Ensembles can first be used on a simple basis, bundling a limited number of models, before employing machine learning. A measured approach will allow for better understanding of forecast dynamics. Econometric classes do not focus on ensembles because the focus is on testing specific models and hypotheses and not on just forecasting performance. 

For trend-followers, the ensemble approach can have more than one trend look-back period to measure the trend. The position will be related to the number of models that are providing the same signal. This is consistent with the idea of preponderance of metrics. 

A macro forecaster could use different variables to measure an interest rate change. One could be focused on inflation expectations, another could use trends, while a third could be related to the interest rate curve. Different models are based on different views of the world and how markets operate. An ensemble will say that different views of the world can compete and be bundled to limit the risk from holding just one view of the world.

"Preponderance of metrics" approach to investment forecasting - A simple approach

 

A different way of improving forecasts that is also model agnostic is looking at data that have similarity that can be bundled as an index. It can take the form of a count indicator that can be described as the "preponderance of metrics". 

I first heard this term in a NY Fed research piece "Measuring Corporate Bond Market dislocations" but have not seen any other reference from a literature search. The researcher's idea is that several metrics that focus on market dislocations can be bundled to form a better index than using the metrics individually.

There, of course, is the term "preponderance of evidence" from a legal perspective but nothing on metrics. The preponderance of evidence is elusive because it does not tell us exactly how the idea is formed or reached. One man's preponderance is another man's uncertainty. This can also be called the weight of the evidence, but this idea of weighting does not focus on forming metrics. 

Nevertheless, there is a strong body of work on preponderance of metrics with diffusion indices. A diffusion index bundles a set of like factors and then measure the count of ups and downs. If the number of up is high relative to the total or number of downs, there is a preponderance. We see this is the PMI data which is an effective tool for measuring macro risks.

A simple monetary metric is the count of central banks around the world who are tightening or loosening policy. The Fed uses a preponderance metric with their financial stress indices (St. Louis and Kansas City Fed) or the financial conditions indices (Chicago Fed). 

The advantage of this forecast approach is that it is model agnostic. There is a creation of a metric but no fitting of the data to a dependent variable. The metric can be simply compared with a return series to measure forecasting success. Does the metric do better than a flip of the coin?

A trend-follower that bundles trend models that have different look-back periods creates a preponderance metric. If the multiple trends all point higher, then the forecast is for higher prices. 

Preponderance metrics can be created simply and without much technical expertise and easily tested if the bundle of metrics have some commonality.

Financial stress - Different Fed measures provide warnings for investors

 

There are several financial stress indices provided by the Federal Reserve Banks which will often be correlated at the extreme but may provide useful unique information on financial markets. We look at three major indices: the St Louis Fed financial stress index, the Chicago Fed financial conditions index and adjusted financial conditions index, and the new NY Fed corporate stress index.

The St Louis Fed financial stress index - The index consists of 18 weekly data series; seven interest rates, six yield spreads, and five other indicators. There is also a Kansas City stress index, but it only comes out monthly. 

The Chicago Fed financial conditions index (NFCI) - A comprehensive weekly update of financial conditions in money markets, debt and equity markets, as well as the shadow banking system. The Chicago Fed also produces an adjusted financial conditions index uncorrelated to economic conditions. This index is broader than the St Louis Fed index.

The NY Fed corporate bond market distressed index (CBMDI) - The distressed index focuses on seven corporate bond indicators to measure liquidity and stress in a corporate debt market. It is not a stress index across asset classes rather it is focused on liquidity and stress in corporate credit. The NY Fed has a general index as well as investment grade and high yield indices.

The NY Fed distressed index shows the most variation and has the slowest speed of adjustment after a stress shock. Market liquidity comes back slowly after a market shock. The correlations between these indices are high. The high correlation between stress indices (St Louis and Chicago Fed) and corporate bond spreads is related to the fact that these indices include short-term spreads while the distressed indices have exogenous factors from spreads. 

These indices can provide a simple way of efficiently looking at stress from a set of indicators. If these are stress indicators are moving higher, market risks will have to be repriced. 

Global macro decision choices - A binary world?

 

Without oversimplification, the current global macro world can be viewed as a set of binary choices. Your trades will be determined by where you stand relative to these binary choices. Of course, the world is not binary, but this is a good way to first think about the world.

• Inflation - Persistence versus transitory. The transitory inflation crowd was absolutely destroyed in the first half of the year, but the choice is still present. Commodity prices have declined from extremes in the spring and goods congestion has fallen. The goods market inflation is likely to fall, and it is now a question of service inflation. 
• Inflation - Anchored or unanchored. Inflation expectations as measured by breakevens have fallen from highs in the spring. The question is whether markets believe the Fed can raise rates and show resolve at getting ahead of current inflation.
• Recession likelihood - Hard or soft-landing. We are now seeing a soft landing recession with GDP likely to show another quarter of negative growth. Labor markets are still strong, so the impact may be mild. A harder landing is being priced in 2023 given the strong Fed rate increases.
• Recession length - Short or long. The soft crowd believes that any recession will be short and not last more than 6-9 months. The other extreme is that we will be in a long recession with a slow recovery that will last for well over a year.
• Monetary policy - Resolve versus cave. The choice is between an unconditional resolve to beat inflation versus the Fed caving some time at the end of the year or first half of 2023.
• Policy shocks - There has been little change in fiscal policy nor has there been any discussion of alternative monetary policy. QT has begun, but it has not received much attention.
• Geopolitical risk - War or peace. The Ukraine-Russia War is not going away and if it continues into winter, the global economic cost will be significant. Of course, a quick resolution may not result in oil flows moving back to 2021 levels.
• COVID - The never-ending pandemic - There is talk of further lockdowns in China, and a new variant, BA.5, is now taking hold. The question of whether we will be in another lockdown this winter is real.
• Equity bear market - The choice is more a matter of degree. If earnings are adjusted downward, the bear market will continue. A controlled slowdown with inflation falling will allow for market stabilization.
• Bond bear market - The bond market performance for the last six months is still one of the worst recorded. Further contraction is function of inflation persistence. A bond rally may be related to a recession. 

Each of these binary choices are not mutually exclusive especially when we discuss the equity and bond bear market. There is some consistency with the choices made.  Answer these binary choices is a good first step for managing any global macro view.

Why are trend-followers having a good year - A rationale, not a description

Trend-followers are having a very good year with many generating double-digit gains and almost all beating a classic 60/40 stock-bond portfolio. Any investor who had trend exposure would have seen stronger performance this year as well as in 2021. Trend-followers have done what has been expected of them - strong diversification and returns during a period of market turmoil.   

Many managers have written about their strong returns this year but have focused on performance contribution - an analysis of market gains and losses. For investors, the key question is why are trend-followers doing well now? What are the characteristics of markets or the environment that now make trend-following successful? We will provide context on this question with some broad conceptual thinking and then move to some specifics.

We start with the simple investment framework that there are two types of traders or strategies, convergent and divergent. Divergent traders make money when markets move away from current equilibrium prices while convergent traders profit from prices moving back to equilibrium after some disturbance. Trend-following is a divergent strategy because it capitalizes on dislocations or tail events. It is long volatility. 

The cause for trends are clear in hindsight although not apparent in real time. Unexpected changes or surprises in fundamentals will lead to price changes. However, because changes in fundamentals are not always obvious, the process of price adjustment may take time. The market does not wake-up one day to a recession risk or a Fed change. Changes in fundamentals occur slowly one data announcement or adjustment at a time. Not all traders discount information the same way or at the same time. One investor's interpretation of an inflation report may be viewed as transitory while the next suggests persistence. Smart money thinking is not always immediate or sizable. Market beliefs evolve over time.

Trend-followers will do better when there are a sequential set of fundamental shocks generally in the same direction as opposed to a single large shock. The sequence of small shocks will lead to a sequence of price changes from which trend direction can be extracted. 

Large unanticipated shocks, big moves like March of 2020, are not always good for trend-followers if the shock is reversed quickly or the shock leads to an immediate new equilibrium where investors all agree on new valuations. If the trend-follower is wrong-footed going into the shock, loses may mount and if the shock is truly a surprise, gains are not obtained from prior price information. The trend-follower may be luckier than right. 

If information is revealed slowly through time, then prices will adjust slowly. The fact that there is disagreement on whether inflation will be transitory is good for creating price trends. If there is no agreement on price direction, the price discovery process and move to some equilibrium will take longer. The trend-follower will extract all necessary information from the slow adjustment as opposed to trying to decipher the fundamentals.

The transition of policy is another reason for trends. The slow adjustment in central bank action will lead to slower adjustment in prices. A central bank that is behind the curve is good for trends. If policy is up to date with the current environment, trends will not exist. If the central bank will make a strong immediate adjustment, prices will move but trends may not provide signals.

Trend-following needs uncertainty in markets. Trend-following needs volatility. Trend-following needs ambiguity and complexity. A lack of market clarity concerning the current and future market environment will generate slow price adjustments; an environment for the trend-follower to exploit.

Look at the current environment. The lack of consensus and clarity make for a better trend environment especially for macro markets like rates, indices, and currencies. The same applies with markets hard to value like commodities, currencies, rates, and indices. The link between inflation and markets is hard to measure. The threat of global economic slowdown is hard to discount. The price of money across two countries is difficult to forecast. The best way to track the impact of fundamental changes to price is through following the price action.

So, what kind of market environment have we had over the last year? 

• Unprecedented moves in inflation relative to the last 40 decades and little understanding of cause and effect. A divergence.
• A growing threat of recession as the Fed starts a tightening cycle. Another divergence.
• A truly uncertain geopolitical environment marked by a war that may not have an immediate winner. A market dislocation.
• Ambiguity on economic growth after a pandemic. Unprecedented.
• A high level of complexity in commodity and market logistics which create demand and supply chaos. A truly infrequent environment.

This is not an environment for the convergent mean-reverter and it is not an environment for the global fundamentalist or for the value player. Some managers and strategy may succeed, but the landscape is focused on divergences which are hard to assess given volatility, uncertainty, complexity, and ambiguity. It is an environment where the trader who follows the evolving weighted opinion of investors moving prices as trends will have a greater chance for success. The focus on performance analysis may be on where money was made, but it all starts with a divergent environment.

  

Commodity super-cycle decline - Looking at individual markets

The BCOM commodity index is in a 15% drawdown from its high, but that does not tell the real story of price destruction for many individual commodity markets. The index is a basket of commodities with a weighting based on usage, production, and liquidity. It has a heavy energy weight and is structured to be tradable. It has been in a major up cycle for the last two years. See "Is the commodity super-cycle over or just a correction?"

Trading the individual commodities show commodity markets in transition and not representative of a run-away inflation story. It is hard to argue for persistent inflation story when many commodity markets are in double-digit declines.

A representative sample of commodity declines from 52-week high as of July 1 tells a messy story, (from @macroalf). Of course, the last two years have been one of the best bull markets in commodities since before the GFC. 

Looking at the last few months tells a story of major repricing in commodities since the beginning of the Ukraine War. It is notable that oil and RBOB gasoline are both below the Ukraine War spikes in early March. The same applies to wheat where supply is blocked from moving out of the Black Sea. NYMEX natural gas is down over 35% since its high last month.

The commodity markets are signaling excess supply, a decline in global demand from recession fears. These prices are consistent with a transitory inflation story and not a sustained increase that will persist into 2023. These down price trends will be a function further economic slowdown; however, the current price falls look like a normalization after inflation and war extremes. 

Is the commodity super-cycle over or just a correction?

 

Commodity super-cycles do not occur often and are not associated with the business cycle; however, commodity cycles are arrested with a global downturn. The commodity super cycle is a general increase in commodity markets related to a combination of increased demand combined with supply shocks from weather and or under investment. Inflation periods may be associated with commodity super-cycles but are not a necessary condition as seen in 2002-08 period. 

What we do know is that the gains in the BCOM commodity have been one of the strongest on record with an over 125% gain in two years. The current drawdown is only 15%, yet it is a meaningful correction. However, there were several 10% plus corrections during the great commodity bull cycle of the 2000's.

This correction will have an impact on PPI numbers and may dampen inflation. This correction will continue if central banks continue to raise rates. However, commodity declines have been linked with low rates, see 2011-2020 period.

For those who invested at the beginning of the Ukraine War, this feels more like a commodity bear market than a time of commodity shortage. Nevertheless, a reversal of the commodity bull cycle seems premature from a supply perspective. The oil and grain logistic problems from the Ukraine War have not been resolved. 

However, the threat of a recession and a reduction in global growth is a reality. Demand destruction can significantly lower prices if a slowdown is on a global basis. A further decline that will result in a drawdown of 40-50% from the highs seen last month is possible when reviewing past declines during a recession.  

Normal versus Cauchy Distribution - Trend-followers as traders against normalcy

I want to fit the world into normality, yet it could be a Cauchy distribution and have properties that exhibit extreme risk, tails. The Cauchy or Lorenz is stable and has a probability density function that can be expressed analytically like the normal distribution, but as some would say, it is pathological with extreme oddities. The tails of the distribution are heavy, show slow decay, and can go to infinity. There are other heavy tailed distributions, but the Cauchy is the extreme.

The distribution of returns in financial markets is critical issue for risk management and performance. Life is easy if the world can be described as normal. The central limit holds, behavior is symmetric, and the moments of the distribution are measurable. Even if the distribution is not symmetric, if the moments of the distribution are measurable, an investor can calculate mean, standard deviation, skew, and kurtosis. 

However, there are some distributions that are not well-behaved. The Cauchy distribution looks fairly normal but is actually the evil cousin of the normal distribution. It is more peaked, and does not dampen in the tails of the distribution. Hence, the mean and standard deviation cannot be calculated. Anything is possible in a Cauchy world, and it is not measurable.

What does this mean for a trend-follower? If you believe the world is not normal and may exhibit fat tails like the Cauchy distribution, you will want to hold a large portfolio of assets awaiting the chances that a fat-tailed event will occur. With the Cauchy, the center of the distribution will be very peaked and the general returns will be close to zero, yet evidence suggests that non-normality is a reality, fat tails do occur. To capture these heavy tail returns, the trend investor has to hold positions in long-term trends even if it seems odd under the assumption of normality. 

Because there is a higher likelihood that some assets will move to the extremes and those moves may not be capped, the divergent trend-follower holds a well-diversified portfolio and waits to exploit these big moves. Their implicit assumption is that a non-normal world with fat tails will generate outside returns much greater than anything likely in a normal world. Expect and trade (hold the trend) for these heavy tails. A belief in heavy tails is an underlying assumption for many trend-followers. 

Credit spreads and corporate bond distress - A non-linear relationship

 

There is a strong link between the NY Fed corporate distressed bond index and actual spreads as measured by the ICE BofA BBB and CCC OAS spread indices. For more information see New NYFed Corporate Bond Distressed Index provides context for spread increases.

The correlation with the distressed index is relatively high, but more importantly there is a non-linear relationship between stress and spreads. The core relationship is slightly positive but above a reading of 50 there is a significant increase in slope. There is a lever of distress and risk that converts into increased spreads. 

Corporate spreads will increase during economic slowdown and greater risk of defaults, but spreads will also increase with the endogenous risk from declines in trading liquidity and increased bid-ask spreads. The trading structure matters especially when markets are under financial stress.