Just read the newspaper - Signal on the count of the word "recession"

Read the newspaper every day. It is a good habit, yet with an efficient market, the news you are reading is old and should not be of much value. However, a recent paper suggests that if you just count the number of times the word "recession" is used in the WSJ and FT, you will have a pretty good recession indicator. In fact, a media recession indicator (MRI) is as effective or better than many of the well-known financial indicators. See "What is the value of financial news?". 

Is this useful? The authors show that if you are willing to follow their raw score, it can give a good indicator of recession six months in advance. Value can be generated by selling risky equity assets when the count reaches a threshold. Now, I don't know if I will do the count for 10 years waiting for that one trade, but it does provide a clear indication that following the themes and memes in newspapers can be helpful.   

The most provocative part of this paper is that a MRI may be a better indicator of recession than some of the market based measured. At the very least, tracking the MRI will enhance an investor's ability to track a recession. This is just an enhancement of using news headlines, when converted into an index, can provide unique information. 

Mentions of the word recession clearly increase before a recession. There is greater focus on the business cycle. The MRI clear matches other measures of recession such as term premium, default spreads and the GDPnow nowcasts. When investment decisions are conditioned on MRI, there is significant value-added relative to a buy and hold strategy. Watch news stories. 

Investors always face regret - It needs to be controlled

 

There is not enough discussion on the impact of regret with investment decision-making. Regret is focused of many parts of life, and it haunts many through their lives. A regret survey program suggests that there are regrets that linger for decades for some people. So why wouldn't regret play a meaningful impact on our trading decisions.? It does but we often don't discuss it. We often don't us the phrase, "I regret that trade...". Of course, many behavioral biases are tied to regret. 

Regret aversion suggests that investors are not willing to decide because of the fear that the decision may turn out to be wrong and then you will have to face the consequences of your actions. Regret can be a powerful and discomforting state. 

Regret aversion is the action we take to not have face uncertainty. Uncertainty causes us to delay decisions because we fear our actions will then lead to regret. It is not just the result being wrong but that we are responsible for that wrong result. 

The prospect theory of Kahneman and Tversky is a method of measuring regret given there is more pain from downside than gain from upside. The disposition effect of prematurely selling asset that have gains is a result of regret. Classic utility theory does not match the human behavior that suffers from regret. 

A good simple book on regret frames the broad problem that everyone faces, see The Power of Regret: How looking backwards makes us move forward by Daniel Pink. This is not an investment book and will not give you secrets for making more money; however, it will provide some food for thought on the regret problem that is different from the cold testing of behavior biases. It does try and offer some methods for dealing with the pain from regret.

Regret will focus on counterfactuals and is tied to emotions. There is the "if only" and "at least" counterfactuals. The "at least" focuses on the fact that some situations could have been worse. The "if only" counterfactual haunts us with the damaging, if only I did more. Thinking about "if only" situations is personal and what we most want to avoid. 

Regret creates emotions. If these emotions are ignored, we are delusional. If regret feelings are fed, it can turn to despair. If the feelings are focused on why the regret occurred, it can turn into something positive. Regret is something natural and must be controlled and channeled to reach better future decisions.

Monetary policy as triage

 

Think of the central bank as an emergency room doctor with the economy as its patient. This is the analogy used by MIT professor Kristin Forbes at the recent State Street Bank conference. The patient comes in as a different code which determine the severity of the emergency and the requirements for the doctor.

Code Red - The patient is near death and critical condition. Emergency work needs to be done immediately and with urgency. The perfect recent example is the gilt crisis in the UK. There was a major bond crisis which needed attention through purchase of bonds regardless of current policies.

Code Orange - The patient is sick and needs immediate care, but it is not a life-threatening crisis. Providing liquidity through repo and reverse repo could be thought of as a reasonable response to a problem that could turn into a crisis if action is not taken. 

Code Yellow - The patient is coming to the emergency room with ill health, but it does not mean there is a crisis or severe sickness. It is an issue that must be attended to, yet it may not require extra focused attention. In this case, the economy could away from full employment or inflation is away from target and the Fed needs to take action to reach policy goals. The issues can be dealt with through the regular central bank meeting schedule. The patient must be given medicine and treatment. There is a potential problem, but it is not severe if addressed.

Code Blue - There is no serious problem but there needs to be a discussion and action to maintain long-term health. The Fed balance sheet needs to be adjusted back to the core through QT. This is not a crisis, but if no action is taken the health of the patient will turn negative. 

Of course, this analogy assumes the central bank / doctor is not the cause of the problem. The central bank has not taken an oath to do no harm. If the central bank does not stay attentive, you can see how a code blue or yellow can move to orange or red. The central banker always must stay attentive to ensure he does not fail the patient.

Doves, hawks, dragons, and pigeons - the state of the Fed

 

We usually make the distinction between Fed officials as either doves or hawks. Hawks focus on inflation while dove are easy on inflation and more focused on employment. Our scorecard of Fed presidents and board of governors place them on a dove/hawk spectrum. However, we may have to broaden or enliven the spectrum. 

Perhaps chairman Powell is not a hawk but a dragon who will go scorched earth on inflation. Rates will rise until inflation is broken and we get it back to the 2% target. There will be no prisoners, no pause. The Fed will accept a recession albeit the forecast is for a small one. 

The Jackson Hole comments and September FOMC press conference represent a dragon not a hawk. With the November meeting, we will learn if he is still a dragon or just hawkish. The latest GDP number suggests that the dragon will remain.

There are also central bank pigeons, birds that peck at issues but do not seem to have any direction. We have the BOC and the Aussie central banks pulled away from higher expected hikes. They are not doves, but worried pigeons. We have the ECB suggesting a possible pivot and not following through on a strong QT plan. They raise rates but almost apologize for having to do it. They are not doves. They are not really hawks. They are worried birds who are afraid of making a mistake. 

Overall, a simple dove/hawk spectrum is not helpful in these complex times.

Issac Newton and FOMO - Don't get outsmarted

Isaac Newton was a smart guy. Everyone would like to be thought of as a newton. He is one for the greatest mathematicians ever, yet he had a varied past. Surprisingly, he was a worldly person who had a career that when well beyond math. He was Master of the Mint in England and was instrumental in the recoining of the currency. He was also a speculator albeit it is questionable whether his skill as a speculator matched his skill as a mathematician, 

I recently became aware of an interesting chart which shows Newton’s skill as a speculator during the South Sea bubble. The South Sea debacle is one of the great speculative bubbles of all time and is often referred to as a poster child for extreme bubbles and price declines. Newton got in during the early part of the bubble and then was smart enough to take profits; however, he got in a second time at a much higher price. Newton suffered from FOMO. He had to get in a second time which led to his demise. Not only did he get in near the high, but he held way beyond the peak to lose all his gains and then some. No risk management. No stop loss. Newton was not a genius in this case. We don’t have information on what Newton was thinking other than he suffered from regret and stated that he could not predict stocks. That was after the fact. 

The FOMO effect will impact even smart investors which means that trying to buy dips, or jumping on stock rally bandwagons is a dangerous game. Remember Sir Newton fell to the temptation to get rich. Fear when others are greedy is a good policy.

Can we learn something from newton? Smart people can loss money. Smart people can suffer from behavioral biases. 

Inflation as a global phenomenon - Do not forget

We cannot forget that inflation is a global phenomenon. I listened to MIT professor Kristin Forbes, who is an expert on inflation, at the latest State Street conference reinforce this point. She emphasized that CPI inflation as measured by PCA is a growing global issue. The first principal component can explain about 60% of the variation in the CPI. The latest updated numbers are even higher. We cannot get away from the current global inflation shocks that are coming in the form of an oil price shock, pandemic residuals, global supply chain issues, and a general commodities shock. 

Central banks are all fighting the same problem, but the response will be different because the impact of these shocks will be different. This is why the first principal component varies over time. We do not dismiss the impact of surging monetary liquidity over the last decade, but the inflation catalysts were a complex set of shocks over the last two years. 

The policy hope is that the global shocks will dissipate. The policy fear is that inflation expectations rise and inflation gets embedded in wages. The critical macro thinking combines acceptance of the global inflation story coupled with the reality that the inflation impact and policy response will differ around the globe.

(See her work "Inflation Dynamics: Dead, Dormant, or Determined Abroad?" we have referred to it in the past See Inflation is a global issue, but what if globalization reverses?)

Credit markets - If the funding is tough, the spreads are wider

Credit markets are all at elevated spread levels versus the pre-pandemic period; nevertheless, the spreads are still less than the March liquidity shock. We are not at pandemic levels but certainly higher than the lows when rates were near the bottom of the cycle and liquidity was flowing. What is important is the relative spreads across ratings. Investment grade spreads have moved higher, well over a 50% increase from the lows last year, but the absolute change is spreads have been modest, so the price impact has also been constrained as measured by the spread times duration. For CCC-rated bonds, the spread increase has been substantial with a strong price impact. 

Equity prices have fallen which indicates firm values have declined, but the real problem is higher rates from the Fed and any constraints on credit. The cost of refinancing has surged, so highly levered firms will see more cash flow go to paying bondholders when debt is rolled forward. A problem also exists if fixed rate debt was swapped to floating. Financing costs are going up which means there is less cash to invest in the business. Default risks are rising, and spreads are doing the same. It is not a good time to be an existing high yield holder until rates start to stabilize.

The Bond King and flying to close to the sun

 

The Bond King is the compelling story of Bill Gross, the man who built PIMCO into a premier bond manager, and then fell from the heights of fixed income. While the story is about the bond king, it is also about the politics and dynamics of PIMCO. Anyone who worked for a high energy take-no-prisons money management firm will relate to the story and behaviors of the principals. Anyone who has worked for a singular-focused entrepreneur will also get Bill Gross. He had an outstanding run as a bond manager, but ultimately hubris, ego, and a difficult personality created a toxic environment where there were no winners. 

I wish the book focused more on the decision process of a great bond trader and less on the politics of PIMCO, but you must give readers what they want. Juicy politics and battles sell books. That said, the excess focus on details, counting pennies, deep research, and figuring odds with a focus on finding structural alpha provide some of the details for how a great track record was created. Unfortunately, the relentless pushing and size led to an environment and fund that could not be sustained. 

The lesson for any money manager is that it is hard to sustain success. Markets change. Mistakes will be made. There is luck and the edge of today may not exist tomorrow. Always watch your back, not against your partners, but with the market. Watch the culture you create, because the people you hire and nurture will turn-out like you, and that may not always be a good thing. 

This is a sad story with a bad ending. I wish it was different, but the shocking truth is often more compelling. Bill Gross was a king, but there is a time for retirement. Market timing also requires knowing when to walk away.

When faced with uncertainty, investors delay

“Investor behavior in recession is . . . a cautious probing, an avoidance of commitment until the longer run status of both the national economy and the investor’s own fortunes are better known...by waiting, the potential investor can improve his chances of making a correct decision.”

- Ben Bernanke quote from the Undercover Economist "Uncertainty delays investment. If only UK government grasped this"

Uncertainty harms. It is not a direct harm, but a harm of timing. Increase uncertainty and most will react through delay. Why commit today if you can put-off until tomorrow? Growth delayed is growth denied. This applies to policy uncertainty and the overall real economy uncertainty. If there is a threat of recession, delay. If there is unclear inflation, delay. The delay can be waiting on investment projects, making projects smaller, or scrapping the projects. It could be ordering less. It can mean buying less. For investors, it can mean averaging into projects. 

Who wants to make a mistake during a period of high uncertainty? Wait for the time to pass. Of course, there will be winners based on those who act. We will often read about those who act. We will not read about those who delay. Is there a neat solution for dealing with uncertainty? No, we must accept this reality. 

Nowcasts - Helpful or just extrapolation?

“The investment management industry thrives on the expedient of forecasting the future by extrapolating the past.”

“Is this a forecast or a nowcast?” If the former, and if it is correct, it may have material value to an investor because current market prices may not reflect the insight. If it is a nowcast, it will be of no use if it is correct—the nowcast is already reflected in current prices—and will hurt us if it is not correct."

- from "Where’s the Beef?" by Rob Arnott, Amie Ko, Lillian Wu of Research Affiliates

Arnott provided a harsh critique of nowcasting, and it is appropriate. Nowcast has become a buzz word on Wall Street and with central banker for its humble roots with the field of meteorology.

Nowcasting is a combination of two terms: “now” and “forecasting.” Economic indicators are often released with a considerable delay, but there is usually intense interest in knowing what a given indicator is before its official release. Nowcasting refers to the prediction of the present, the very recent past, and the very near future—in essence, trying to fill in that missing data point with an accurate estimate. Often, nowcasts take advantage of higher-frequency data that are informative about some other economic indicator to predict what the next release of the indicator of interest will say. -from Cleveland Fed 

It is important to first determine whether a macro forecast is just an extrapolation given another name. There is nothing wrong with employing extrapolative forecasts. Many managers use them all the time. Macro data do show trends and should be expected to have some memory. An extrapolation or some form of exponential moving average is a good prior no different than a view of no change can be a good prior. These simple views should be acknowledged as base cases and as an extrapolation. An extrapolative can be called a nowcast, but not something unique or special.

Nowcasts that are just extrapolative should generally be embedded in market prices. This is the fundamental difference between adaptive and rational expectations. Nowcast as forecasts should weigh or include other high frequency data to provide insight on the future. For example, PPI and market inflation breakevens can be used to predict the next CPI number along with a trend. This can be considered as a simple nowcast for the next CPI. However, this approach has been used for decades and is not something new. It can be called a nowcast, but it is just another name for a short-term forecast. 

Like in meteorology, the critical issue associated with any nowcast is the short-term and local nature of the forecast. A nowcast is not a large model looking to explain many economic phenomena. Rather the nowcast is a short-term immediate forecast of a specific event. In the case of macro data, another example could be trying to forecast the weekly initial jobless claims. It will likely be extrapolative and try to include recent data that has arisen since the last report. Given the limits and delays with data, this will be a simple focused model.

Using the word nowcast is somewhat a fad and forecasters should be careful with how they use the term, but it is a useful tool that can add value when thinking about how to forecast short-term macro variables. Just beware of false gifts given fancy names.

Provocative question for any manager - Who is taking the other side of the trade?

• Who is taking the other side of your trades? 
• And why are they willing to lose so that you can win? 

- from "Where’s the Beef?" by Rob Arnott, Amie Ko, Lillian Wu of Research Affiliates

These are interesting questions that should be asked of any hedge fund manager. Especially for short-term trading for every winner there has to a loser. The loser may just be asking for liquidity, the cost of the trade, but there is a penalty when a hedge fund wins. If the hedge fund says that he is smarter and that is his edge, then you must ask who is dumb. If the hedge fund says that he has an information edge, then you must ask why others do not have this information. If the hedge fund says that it processes information better, then you must ask why others cannot do this processing. For every reason given for an edge, there must be a reason why others do not or cannot have that edge. There edge can make good sense, but what are the restrictions on why others cannot do it?

The corollary to who is taking the other side of the trade is why are they willing to lose to you. The liquidity story makes sense, but it cannot be used in all cases. Is it ignorance that creates losers? Friedman would say that there is a limited number of losers, so markets will become efficient and move to equilibrium. Does there have to be an endless supply of losers for the winners to make their alpha? 

These are worthy questions that should be posed during any due diligence. Structural reasons are good. Liquidity is a good answer. Just saying that you are smarter than the average investor or hedge fund is harder to believe. 

Raise rates until something breaks - Liquidity may be the catalyst

 

There has been the view that the Fed should raise rates until something breaks. We have precedence from the BOE with the recent gilt crisis. Investors should realize that we already have the catalyst for a break - the fragile liquidity in financial markets. The days with low liquidity in 2022 as measured through top of the book orders by SocGen are like crisis periods. 

The same can be said for bond liquidity especially in Europe. There will be a crisis event which will require investors to move asset to protect principal, yet the liquidity may not exist and there will be then a negative feedback loop. Sellers will not find liquidity which will push prices lower which will then attract more sellers. The only solution is for prices to decline to such levels that buyers will be found. If uncertainty is high, buyers will be scarce. If financing is scarce, buying bonds or any asset will be expensive. if volatility is high, the risk assessment will also be high, and prices will have to fall to compensate buyers. The only solution is for the central bank to again play the role of lender of last resort, end QT, and rethink rate increases.

60/40 allocation disaster - Is it too late to change?

 

You have heard it before - the 60/40 stock/bond portfolio mix is dead. It was the go-to portfolio structure. Start with the 60/40 and make allocation adjustments around it but keep that core mix as a base case. It was hard to beat for a long time, but 2022 is different. The combination is now down 20+% and a good portion of the losses is coming from holding the "safe" bond assets. This bond problem is only exacerbated because the correlation between stocks and bonds has turned positive. Investors were willing to hold low yielding bonds because of the diversification gain. That does not exist.

The best investors can do is increase alternative investment exposures under the low bar that these strategies beat the poor bond performance and offer some lower correlation. Any trend/macro strategy that allows for shorting of assets would have added value to the 60/40 mix. 

However, the past may not reflect the future. As yields increase and the duration of bonds fall, there may be a new appeal for bonds. A decline in inflation or a pause by the Fed may also offer bondholders some advantages. These pro-bond stories, nevertheless, are based on inflation being tamed. If the inflation problem is not controlled, there is no advantage with the classic allocation. The new 60/40 mix will be to hold a high allocation to cash or liquid alternatives.

The "Everything Bubble" and the "Great Repricing"

I have been calling 2022 the year of the "Great Repricing", but that begs the question of what has caused or what is the reason for these large adjustments. Of course, interest rates are moving higher which changes the present value of all future cash flows; however, I will provide the quick shorthand primal answer, the "Everything Bubble". The Great Repricing is offsetting the Everything Bubble which is leading to the "Everything Bust".

Given we have had a decade plus of zero interest rates followed by a short period of rising rates which were cut-off before markets could adjust, followed by a second zero rate period related to the pandemic, we have seen 14 years of low rates and excessive credit. The entire financial history since the GFC has been characterized by not just low interest rates but zero rates. The result has been an equity bubble, a fixed income bubble, and a credit bubble. The bubbles are now coming to an end.

We are now seeing increases in rates as the Fed attempts to stop inflation, but this is really a normalization away from extremely low negative real rates; well below the low rates estimates for r-star.

The Great Repricing is the bursting of the Everything Bubble and a return to normalization. There will be no relief, even if the Fed pauses, until the bubble extremes are extinguished. 

In repricing mode, trend-following works versus other factors

 

Data from Premialabs show the value of trend when there is a major repricing in the market. In September the trend factor was the best performing factor across any asset class. Credit value and equity momentum also did well but when the market is focused on macro events and repricing of risk, the trend is your friend. We cannot say that will apply for all months, but the conditions of high volatility, uncertainty, and asset repricing like from an interest rate shock will provide good trend conditions across all asset classes.   

Back to Square One - Incentives Matter

 

I was sitting in a volunteer meeting for an organization where the discussion was focused on event attendance. The elephant in the room rapidly became clear. There was no incentive for the organization to go out and do the work to get new members or encourage old members to increase attendance. There were a broad number of excuses, but it was clear that there was no push to have people work at getting bodies in the door. No one was accountable. There were no incentives positive or negative. Whether public or private, the Munger quote is appropriate. If incentives are not in place, you will not get a positive outcome.

Next meeting you attend, look at the incentive structure and then determine why something is or is not getting done. The answer will be clear. No incentives. However, money may not always be the right incentives and sometimes the incentives may not be immediate, or the incentive could be to save oneself from being fired or demoted. 

Dig deep and look for the incentives. Nevertheless, for incentives to be effective, they must be clear and connected to the action required.  

Other comments on incentives:

Incentives matter - So always looks for the incentives

Understand the incentive and you understand the analyst - Incentives create forecast biases

Prices and incentives - Cannot separate the two

The Why Axis - Incentives are complex

Money, incentives, and motivations - the new complexity

Neon swans - "unthinkably rare, immensely important, and blindingly obvious"

 

We have heard about Black Swans, White Leopards, and Grey Rhinos. We should now add Neon Swans to the current list. This animal is an older concept from Jason Zweig in a 2011 WSJ "Forget About Black Swans, the One Floating Ahead is Neon".

The neon swan, according to Zweig, is "unthinkably rare, immensely important, and blindingly obvious". For example, an energy policy failure could be a neon swan. An energy crisis would be rare. It is important to our economy, and it is obvious that we have a problem with the current direction. 

Any issue that we kick down the road could be considered a neon swan. We know that a crisis will be rare, important, and obvious. Problems with social security funding and pensions may be neon swans. There is a neon swan with the large government debt build-up. The impact of a major financial crisis from rising rates could be a neon swan. A crisis may be rare since we have not had one, yet these economic issues are important and obvious. 

The issue which could be in dispute is whether these neon swans are rare. There may be a lot of neon swans, we are just not willing to accept that they are in the pond. We would like to ignore these neon swans given there is a high level of uncomfort associated with them. They are close to the grey rhinos in characteristics, yet these swans are more glaringly obvious. Markets certainly ignore them; consequently, trying to protect a portfolio from them will be costly in the short-run. 

Other writing on swans:

 

An Animal Kingdom of Different Risks - White Leopards, Grey Rhinos, and Black Swans

Black swans and white swans - managed futures

Understanding China through changing development models

The economics of China are a mystery to most investors. It has grown so fast that many do not fully digest the magnitude and influence of China on the rest of the world economy. Even for those who do understand the impact of China, there is limited understanding of how it got to its position and its economic development through time. As important, understanding the relationship between China and globalization is critical.

Yeling Tan, non-resident senior fellow, PIIE, discussed "China's Development Models in an Era of Global Disruption" and concluded that China has had a conflicted relationship with globalization and has engaged in a hybrid development model. 

The 1980's were a period of reform and opening especially with trade liberalization along the coasts. The 1990's saw an explosion of growth based on coastal development followed by a retrenchment during the Asian financial crisis that focused on state-led spending. The period of WTO entry was another era of strong growth but with a resistance to true opening of trade. The global financial crisis again caused a shift away from external growth thinking. The Belt and Road Initiative was another outreach for growth but on terms favorable for internal development. The Trade War with the US again caused a change in globalization focus with more emphasis on diversity and decoupling. Currently, the COVID pandemic creates a focus on internal systems and structures and less engagement. 

Globalization and engagement have had a mixed history with China's development. It is important to understand that China swings between external and internal focus which impacts growth, development, and integration with the rest of the world.

Is quitting underrated? A new book takes a new perspective

Annie Duke, the professional poker player and popular author on decision making, has written a new book, Quit: The Power of Knowing When to Walk Away which addresses a provocative question. Is quitting underrated? We celebrate those who are not quitters, those who persevere, and those who will never give up, yet success may come to those who give-up, quit, and throw-in the towel. 

For Annie Duke, heroes are usually made from those who learn to walk-away. This is not what you would expect as a good answer. This is not what you would expect as a book worth reading, but it provides some useful thoughts that make sense and should be incorporated in your decision-making. In fact, quitting is an important tool in your decision-making box of choices. 

For investing, there is a special valor with learning to quit. We often call it risk management. Stop-losses are a mechanistic form of quitting. Lose a set amount of money and walk-away from a trade. The investment quitters enter a trade and think about an exit upon putting the trade on. Behavior finance has focused on the disposition effect of selling winners and holding onto losers. We quit on our winners and do not quit on our losers, yet quitting is a decision skill that adds to our return potential. Every good trader thinks about opportunity cost and exit strategies. In fact, quitting is the core skill for protecting principal. 

Keynes talks about changing his mind which is a form a quitting. "When the facts change, I change my mind." There is no evidence that Keynes actually said this, but it has been attributed to him and seems to fit. Quitting is not just an action but part of good thinking. We must learn to quit on bad ideas or quit on views as data are updated.

Quit is skill just as betting is a skill. Knowing when to stop losing is as important as when to act. I have started the Duke book, but I am excited by the whole concept of quitting. It is so simple to have this discussion, yet it has been avoided when talking about true heroes and great traders. 

Periods, Ages, and Regimes

Periodization, the identification of ages that have commonality, is a part of understanding history. We look for commonality and factors that can describe or define a time. We don't much think about periodization in finance and economics, but it has an impact on how we look at the past and affects our ability to understand the present. 

In finance and economics, we also like to talk about business cycles as if there is a natural periodicity that recurs on a regular basis. We also refer to business cycle periods as regimes, yet regimes are also influenced by the age or period that surrounds the business cycle. 

The recession of 2008 is called the Great Financial Crisis (GFC). The period of QE is a policy age that distorted the normal behavior of the business cycle. Hence, an age is more than just a historic naming convention but serves as another conditional variable. The 70's were dominated by the inflation. The 80's have been described by Reaganomics, dollar distortions and budget deficits. All data during the 90's should be looked at through the lens of inflation targeting. The 1990's also was the period of the Great Moderation as defined by Ben Bernanke. The early 2000's reflect a period of loose regulation. We will talk about the Lost Decades in Japan. We will define the post-WWII period as the Bretton Woods period. These names provide shorthand for all that occurs during the period.

A period classification can be determined by a single event, a policy regime, a level of calm or turbulence, or events like a war. There usually is a beginning, middle, and end which is the transition for another period. For finance followers, it can surround a bubble. For policy people, it can represent a regulatory or policy environment. Political disruptions can spillover to finance and define an era. Some environments will be subtle and not earn the word great like the Great Depression, Great War, or Great Financial Crisis. Some may be related to a single event like the Tech Bubble. 

Even quants should think beyond the business cycle regime and focus on the broader context of factors that overlay investment and business decisions. Unfortunately, it takes a special investor to understand the common factors for a financial age. Additionally, there is little agreement about the beginning or the end of an historical period. This may be especially true when it comes to finance and economics as opposed to politics and culture. An era is not defined by investment returns because the returns may be the result of the environment.

It is worth thinking beyond a business cycle to classify a longer era or period. If clarity does not exist, it could be a period of transition which may result in extra uncertainty and opportunity. Naming and definitions matter and support better understanding of investment environments.

The reemergence of OPEC - Western energy policy

 

OPEC+ has decided to cut production quotas by 2 million barrels a day which is the equivalent of 2% of total world oil production based on the large decrease in demand from China and other parts of the world. The world is awash with oil which pushed WTI prices below $80 per barrel despite the disruptions from the Ukraine-Russia conflict. Since all the quotas for members have not been used, the actual impact may be closer to 600,000 bpd. 

China is expected to see a decrease in demand for oil for the first time since 1990 and be down about 420,000 bpd as reported by the IEA in September. Overall global demand for gasoline has been slow to rebound as users have learned to be more conservative in their use. The US has decided to extend the release of 10 million more barrels from its SPR through November to stabilize prices. This a game that cannot be one if OPEC+ decides to further cut production. 

The US fracking revolution changed oil dynamics and took pricing power away from OPEC, but the policies of renewables switched the emphasis away from oil production to other energy sources albeit less reliable than oil and natural gas. The dynamics of the shift in the balance were not immediately evident given the pandemic and the Ukraine-Russia war, but now oil economics are becoming clearer. OPEC+ can cut production to help tighten the oil market and raise prices and the rest of the world does not have the power offset cartel behavior. Hence, prices will stabilize for now at a higher price and be more likely rangebound instead of heading lower. A deeper recession can change these dynamics, but that is a demand issue and not a supply response. 

The West may want to be less oil dependent and less natural gas dependent, but the transition matter. The switch can be a good goal, but the logistics are what matters if you want to minimize the disruption on energy users. Goals must face the reality of markets.

Group Dynamics and the Fed - If everyone is thinking alike, someone is not thinking

 "If everyone is thinking alike, someone is not thinking." - General George Patton 

What would Patton think about the consensus building at the Fed. Votes are often unanimous. There is seldom any dissension. 

Fed regional presidents seem to now come from other Fed banks or from the Fed staff. There is a culture that is based on getting along with the crowd. Fed officials seem to love to give speeches between FOMC meetings, yet few say anything controversial and in the case of regional Fed presidents even fewer focus on local conditions of their constituents. 

Many of the president are from the Fed system and did not get moved to Fed presidencies through questioning policy decisions. Most have never underwritten a loan or run a profit and loss for a business. They cannot appreciate community banking because they never were community bankers. They cannot appreciate job loss or hiring issues because they never had to hire from a diverse pool of workers. They never had to deal with regulation because they are the creators of regulation. Of course, regulation does not have costs when you don't have to bear the costs.

The Cleveland Fed president, Loretta Mester spoke at a MIT Golub Center for Finance and Policy conference in Cambridge. Did the conference need her unique Midwest perspective? I don't think so. She spent her entire career at the Philadelphia Fed as an economist before moving to Cleveland. She is a competent economist and a good administrator, but does she offer an alternative perspective and a Cleveland regional view? 

Another Fed president states in her bio, "has charted a vision as a premier public service organization, dedicated to helping create unreserved opportunity for all Americans". Worthy goals, but is a local Fed bank a public service organization? Could this just be done better at the Board of Governors and eliminate any regional banking duties? 

Is it wrong to hire economists from within the Fed? No, but like any excess too many leads to wrong thinking. A few internal hires are good. All hires from within is bad for gaining diversity. 

There is noise when there is less agreement, but is it more important to have consensus with a wrong policy or conflict which may lead to the right policy?

Should we have more dissension about current Fed policy? what is the role of the regional banks when there is a major policy shift? 

Negative asset class, equity sector, and country returns - The repricing of risk

The repricing of risk has impacted all markets - equities and fixed income. Even commodities have declined on the recent Fed action.

The repricing impact applies to all market sectors. There is some value with holding defensive sectors, yet absolute returns are all pointed lower. The same repricing impact can be seen in country equity returns. All countries especially in Europe are going through the Great Risk Repricing.

 

The Fed inflation fight forces the repricing of risk

There are few times in a year or in a decade where is there is a general repricing of risk across equities and bonds. We are in one of those times. The Fed is changing is changing policy in response to past excesses. In June, the market said it did not belief the Fed, but after Jackson Hole, the latest 75 bp change, and the dot-plots, the markets are getting the message of central bank resolve. 

September returns reinforce the early basis to repricing of risk. The world has changed with a policy and repricing bias. Portfolios will continue their adjustment process.