The abnormalities in labor markets are not changing with rising rates

The current labor markets are not easily understood. The economy has been slowing down, yet unemployment is low, job growth is good, participation is still below pre-pandemic highs and quit rates are still high. 

Jobs are available, but there are segments of the market that are not going back to work or not happy with current jobs and quitting. McKinsey has referred to this as the Great Attrition. Despite the efforts of the Fed, labor has not significantly changed in response to rising interest rates.  

Perhaps workers are so used to an environment where it is easy to find new jobs that they do not fear quitting, but the workforce is not deeply engaged with employers. There is a disconnect on the causes and what employees and employers think are important for sticking with a job. 

Our fear is that this uncertainty or disconnect leads to false signals on link between policy, markets, and the real economy. What happens if quit rates are high but hiring slows quickly? There can a strong surprise increase in unemployment. Similarly, if quit rates slow, hiring will quickly fall. The likelihood for large labor dislocations is high.

Moving beyond a binary world - a slow speed of adjustment year in 2023

In the summer, we discussed the world being binary - inflation / no inflation; recession / no recession; geopolitical crisis / no crisis. The world threats were between extremes. See Global macro decision choices - A binary world? Now we are entering a new world that is not about binary choices but about the slow grind of reality versus expectations. Uncertainty is elevated and will stay elevated.

Inflation may have mixed rates around the world, but the focus is now on the grind lower for inflation not whether it will be present. It is being viewed as a speed of adjustment process. 

A recession is expected in 2023 by most market analysts. The focus is on how fast economies will grind lower. The stagnation is not about a strong or deep recession but focused on slow growth with a shallow recession. It is not a question of whether it will occur, but when and how deep.

Geopolitical risks such as war are now focused on the grind from stalemates and gridlock. Geopolitical risks will be with us for the year and not have easy solutions.

The energy shock is now about dealing with lower temperatures and the fact that stocks will be depleted as we move through new year.  Energy shortages will be present even with natural gas and oil prices currently almost unchanged for the year. It is a matter of when and how bad. 

Policy choices were about strong inflation fighting or weak inflation fighting. Now we are about focused on terminal rates and length before loosening and how to smooth the effects of monetary policy.

Getting forecasts right or wrong were a big deal in 2022 because the cost of being wrong was so high. The forecasts of 2023 will be more subtle and take more work at getting right but the costs of being wrong may be less as speed of adjustments slow.

VUCA and VUCA prime - more on Volatility Uncertainty, Complexity and Ambiguity

Coach Lasso’s paradigm appears to be the personification of “VUCA Prime,” a countermeasure created by Bob Johansen. In his version, VUCA stands for “vision, understanding, clarity and agility.” Leaders like Ted Lasso who apply VUCA Prime can thrive and create opportunities for success instead of suffering from terminal paralysis by analysis. 

-"Commentary: How can we thrive in a VUCA environment?" Dayton Daily News 

We have been a strong advocate of using VUCA (Volatility, Uncertainty, Complexity, and Ambiguity) as a guiding framework for discussion concerning the investment environment. The world can have more or less VUCA, but you will always have to deal with the four factors. The VUCA prime concept attempts to address how an investor should behave to offset the problems of VUCA. 

Vision is not just strategy but seeing the environment for what it is, good or bad. 

Understanding attempts to make sense of the world even if it is confusing. 

Clarity is what an investor strives for, although it is not clear whether it can be achieved.

Agility is how you need to behave in a VUCA environment. VUCA means that any investor may need to quickly change and adapt to the market. 

Being a successful trader or investor is not about being a better predictor but being better at dealing with the things we do not know, and the complexity of the environment faced. The best strategy may be to walk-away and hold cash given the level of uncertainty faced.

(See Living in a VUCA world - This is the core problem for investors.)

There is more than one way to measure inflation

 

Inflation is starting to come down, but there is a lot in the inflation numbers that we just take for granted or that we do not think about. For example, if we use the shadow stats which calculates inflation using the basket devised in 1980, we will much higher inflation. In fact, inflation will be at the highest levels recorded. 

A new paper shows the deviation of the adjusted core inflation versus the real Fed funds rate is at the greatest levels ever recorded and similar to what we have seen in the 1970's. See "Comparing Past and Present Inflation". This paper uses the current methodology and applies it back in time to find that the current inflation peaks are closer to past inflation peaks than the official series would suggest. The official series makes adjustment along the way. The Volcker era rate of disinflation is significantly lower because the peak was never as high.

This data can lead to several interpretations. One, the 1970's inflation was not as high as official reports. Two, the current inflation is more dramatic than believed when compared with a similar methodology. Three, to get the same decline in inflation may require more draconian Fed policy action. Four, the size of the current inflation mistake is more like the inflation mistakes of the 1970's.

The inflation problem is far from solved. 

Inflation and the tightening cycle - Just too early?

Several good graphics places the current Fed tightening in perspective. 

First, the current tightening cycle has a long way to go when we look at the actual inflation levels. The tightening cycles over the last 30 years have all been at inflation rates below 4 percent. 

Second, the amplitude of this tightening is now near all-time highs, but it has been achieved much quicker than any other tightening cycle. This speed may suggest that the Fed may slow increases so that it can determine the impact of policy. 

Third, there is often a long delay between the first price hike and the peak in inflation and a recession. It is hard to link fed action with what may happen in the real economy. 

Investors should accept that high rates from the Fed may be with us for some time. 

Consumer debt risk - Not seeing a problem, provides recession protection

A recession spells disaster for consumers, and the deterioration of consumer balance sheets is a good indicator that the economy can turn. It also tells us the potential size of the recession. Poor balance sheets going into recession will mean the downturn will be deeper and longer. 

We are looking at consumers that are in good shape. The number of foreclosures and bankruptcies are low by historic standards. Delinquencies are loan with a big decline in student loans given the government pandemic moratorium. Total debt balances are rising, but wealth has also increased so the balance sheets are in better shape.

The problem will come with the repricing of debt with the rise in interest rates. Consumers should borrow less, and interest expenses will take a bigger chunk form income, but rates that are fixed at low levels will protect consumers from Fed policies. Inflation is eating into the purchasing power of assets, but it also reduces the value of liabilities for creditors. It is possible that a soft landing may occur given the better consumer balance sheet characteristics.   

The disconnect between hard and soft data

There is a strong disconnect between hard and soft data in the US. Soft data is telling us that we are surely heading for a recession. The hard data is still looking strong albeit well off the highs from the post-pandemic surge. Usually soft and hard data are generally consistent with the soft data usually leading and more volatile. This does not seem to be the case currently. The divergence tells that there is a high degree of uncertainty regardless of market forecasts.

The St Louis Fed first wrote about hard and soft data and provided measures for each index. See "Hard Data, Soft Data and Forecasting". The measure for hard and soft can change. I like survey data for soft and actual collected data for hard. A diffusion index can serve as an alternative to the principal component approach. Soft data usually has a shorter lag and will be a better representation for the current environment. 

Consumer expectations matter and the equity downturn in three parts

 

Households have become less important to the overall stock market and represent only 37% of ownership, albeit this is higher than ten years ago. Nevertheless, the stock market will still be sensitive to consumer expectations. If there is growing consumer pessimism, then there will be less demand for risky assets. This pessimism will drive non-recessionary bear markets. 

The current equity environment is turning into three parts - a consumer pessimism caused by inflation, a discount rate repricing, and finally a bear market from an earnings recession slowdown. We have seen two of three parts to the current equity tilt. 

Is fixed income the play for 2023?

 

What are cheap, bonds or stocks? This a key question as we enter the new year because that will determine where many investors place their marginal dollars. There are several ways of measuring cheapness, and one is presented as z-scores for equities and bonds. Cheapness for asset classes is not easy to measure but the chart is consistent with the thinking of many at this time. By this measure stocks are still relatively expensive versus bonds that are cheap. The relative allocation suggests a tilt to bonds. This is not a bad baseline approach.

The actual returns of stocks and bonds plotted on a 2x2 table shows that 2022 was one the worst years on record for the combination of stocks and bonds. There are only three years which have both stocks and bonds negative, 1931, 1969, and 2022. 2022 was the worst year for bond performance from the data set which began in 1926.  

The big question is whether bonds will become a safe asset if inflation continues to fall, and whether equities jump higher once a recession starts. If inflation continues to decline and there is a further slowdown, bonds may be the superior investment. While higher stock and bond returns may be in store by the end of 2023, the path for returns is not clear given policy and economic trend paths.

Should I be worried about the housing market?

The housing market has been shocked by the increase in interest rates. Homebuilders have been crushed and home prices are coming down after the post-pandemic spike, but this time is very different from the last housing bubble. The equity value versus debt has a huge positive gap. Housing price declines will eat into consumer balance sheets, but it will not lead to household failures. More homeowners have locked-in low interest rates which also helps. However, there will be problems. The credit quality of new buyers has been high for the last decade, so homeowners at these higher prices can weather any decline. Nevertheless,

1. Housing is still more important for middle- and lower-income households. A decline in home value will translate into lower spending, but the wealth effect decline will be limited since we are just seeing a reversal of a pandemic spike.

2. New home buyers cannot afford current housing which reduces demand.

3. Existing homeowners cannot afford to move which reduces supply and will translate into less labor mobility.

Overall, there will not be a leverage problem but there will be a housing gridlock problem that will translate into a lower wealth effect for spending. Housing will not as big a drag on GDP as the seen during the GFC.

 

Equities still too high? - Classic measures say yes

By three classic measures of value equity markets do not offer investors much opportunity for upside especially given the terminal interest rate from the Fed will be higher than current levels and will likely be at higher rates for longer.

1. The dividend yield is low especially given that rates are rising. The market is close to one standard deviation below the long-term average. The yield is low even for the last ten years.

2. Earnings yield tells a similar story with values below the long-term average. The CAPE is a long-term measure but does suggest that the yield is low versus current rates.  

3. The classic Buffet measure of equity to GDP shows that the market has come off the extremes, but the value is still above one standard deviation from the norm.

There can be improvement in equities during 2023 but it is not happening if the current environment and policies are maintained. 

 

Looking beyond Phillips Curve - Sector shocks and inflation

The classic Phillips Curve has not done well to explain inflation since the GFC nor during the pandemic. Economists have started to look at alternative ways to think about inflation, its measurement, and where it comes from. For example, the simplest case is that current inflation is closely associated with an oil price shock. Oil price increases spilled over to other sectors and to the inflation indices which caused a rise in the general price level. There is more going on with inflation, but an energy shock especially in Europe is closely tied with the magnitude of the inflation shock.

The shock to inflation post-pandemic is associated with a series of sector shocks which culminated in a higher inflation number. Inflation could be related to housing, used cares, supply chain bottlenecks. This is part of the transitory inflation story. 

From a policy perspective, if sector shocks can be controlled, then inflation can be dampened. For example, better or at least energy policies can dampen the impact of an oil or natural gas price shock. 

From a practical point of view, this shock story is true and has filtered through inflation indices. If we know the weight for energy in inflation indices, and we look at the size of energy shocks, the impact on inflation can be calculated. This approach, however, does not address or thinks about the causes of general price increases. 

There has been growing research on the propagation of sector shocks to help understand inflation. Sector shocks will impact pricing in a select group of markets which can translate into inflation because the speed of adjustment for allocating between sectors can be slow and prices in underperforming sectors can be sticky. 

In "Inflation in Times of Overlapping Emergencies: Systemically Significant Prices from an Input-output Perspective", the authors look at systematic price shocks that impact the economy. There are market sectors that have a strong impact on inflation.

In the paper, "Monetary Policy in Times of Structural Reallocation", the authors focus on what happens when there is an asymmetric shock to a sector that impacts prices. The result may be a monetary policy response because there is an impact on inflation. The monetary policy response will impact the sector adjust in prices, sector and aggregate demand, and labor market adjustments. The strong monetary response to the pandemic has implications on sector adjustments which are affected by the reallocation of resources. 

In both these papers, the authors focus on the impact of sector shifts to inflation which may better explain some of the current inflation extremes. Investors needs to think about the micro causes and effects of inflation, but also remember that inflation is always connected to money albeit with lags and impacts that are not always clear.

Slow burn versus fast burn equity drawdowns - The timing and depth of a decline are both important

 

There has been increased discussion about downside protection strategies during 2022. Why have trend-following done so well in 2022 but poorer during the pandemic crash? Will a put strategy do better during a drawdown?

 

Strategy performance will differ based on the length and depth of any equity drawdown. All equity declines are not alike. If there is a slow grind, the trend-following strategy will do better. If there is a strong quick shock, trend-following may not have enough time to allow for profits to be generated and an option put strategy will be more helpful. 

With an option strategy, the investor must get the size of move and timing right. With a trend strategy, there just must be enough time to generate a signal and a size large enough to generate a successful reversal signal. 

This issue is well-described in the paper by AQR "Should Your Portfolio Protection Work Fast or Slow?" In the last two years equities have had two strong drawdowns - the 2020 pandemic and the 2022 bear market. The sharp drawdown was good for tail-hedge funds while the current bear market has been good for trend funds. 

Strategy selection includes guessing what type of tail event you may face. Predictions are necessary even when trying to protect against uncertain downside events. 

Managed futures and regimes - Exploiting transition

“Managed futures do really, really well in a regime shift, Regime shifts seem obvious in hindsight, but they’re very hard to manage.” - Andrew Beer, managing member of Dynamic Beta Investments (WSJ 12/14/22)

This is a broader variation on the "crisis alpha" story. It is not a crisis that creates opportunity for managed futures and trend-following but the switching between one regime and another. A more violent and pronounced the transition will cause more market dislocations that will lead to trends. Of course, we need to define a regime, but works has been done in this area.

The usual regime identification approach is to think about the economy being divided into four states or regimes: expansion, contraction, recession, recovery. Research has found that alternative risk premium as well as sector behave differently across the business cycle based on these regimes. The same can be done for trend-following. There is little doubt that during a recession trend-following will do better given the diversification of opportunities and the ability to go short. 

Regime transitions or shifts will cause capital to move between asset classes which cause price adjustments and trend opportunities. A business cycle recovery will move capital form safe to risk asset. The opposite will occur during a contraction. A key is that when there are regime transitions there will also be higher uncertainty. Periods of heightened uncertainty will cause investors to slow decisions which will likely result in trends. Holding a diverse asset set increases the trend opportunities. 

Focus on the capital flows - The core of global macro investing

 

The whole world is simply nothing more than a flow chart for capital.

Paul Tudor Jones

Perhaps an exaggeration, but it is not far from the investment truth. Global macro managers are not a strategy classification but a way of looking at the entire globe as an opportunity set based on money seeking opportunities. The flows across the globe, regardless of asset class, will drive prices. You may be a trend-follower, but the markets are impacted by global flows even if you do not track the flows. You can be a value manager, but the hope is that global flows will move to cheap stocks after you have placed your positions. 

• Treasuries - It's a global market based on seeking yield.
• Equity indices - It's a global market based on best return to risk. 
• Currencies - Foreign exchange is global trade and capital sensitive. 
• Commodities - They are driven by global demand which moves commodities from producers to users. 
• Credit - The choices are based on global opportunities for relative risk.

The global macro manager who is not a global flow junkie will not likely last long in the markets.

The gold and dollar negative correlation and cointegration

The dollar is coming off its high based on the expectation that the FOMC is going to slow their rate increases starting today. With less upward rate pressure, dollar buying has declined, and gold is making a comeback. There is a strong inverse relationship between these two "safe" assets. You may prefer holding dollars given you get a nominal return on assets, but with inflation still at 7%, gold is a good alternative especially if the short-term rate increases will slow. Real rates are attractive versus a year ago, but a slowing of Fed rate increases suggest that the march to the 2% target may take longer than expected and gold may look more attractive.

FX swaps and forwards add to off-balance sheet risks

FX swaps, forwards and currency swaps are forward dollar payment obligations which do not show up on the balance sheet. They are hedging, speculative and funding vehicles, and not the same as debt, yet they are obligations that must be met and usually have maturities less than a year. Under a stressed environment like the GFC, these obligations will lead to financial risks which may require central bank intervention. 

Forward swaps are dollar repos but not recorded on the balance sheet. As a funding source, there is a payment obligation which can be a risk flashpoint. As the dollar rises, the risks associated with these often dollar liabilities increase. 

Are the size of these FX these swaps a point of crisis? No. Is there a potential for a crisis? Yes. The Fed will likely have to be a the lender of last resort, but before that liquidity comes available offshore bank and non-bank institutions will be stressed. 

The limitations of economic models - Economists are not physicists

It is always important to think about the limitations of models. It not just that economic models are approximations of reality. It is that economic models have some specific ambiguity because we cannot adequately describe the changing behavior of market participants. We assume rationality and approximate the interaction across different market participants. The difference between reality and a model, forecast error is the behavior we do not understand. 

Physics is easy by comparison. We are not physicists. We can use their tools, but we must grapple with deeper problems. 

 

EU bonds are being repriced at higher spreads based on higher risks

The EU bond market has exploded with well over 200 billion euros in just two years. However, there is a problem measuring how they should be priced. These bonds have a triple-A rating but they do not trade like other triple-A issuers. They used to trade with a premium, but not anymore. The markets perceive these bonds as riskier. See "Do financial markets consider European common debt a safe asset?"

These euro bonds have different issuances and guarantees so they are not alike. For example, the European Investment Fund (EIB), the European Stability Mechanism (ESM), and the European Financial Stability Facility (EFSF) have all issued bonds. The last two entities were started to help vulnerable countries during the euro debt crisis. There are also the Support to Mitigate Unemployment Risks in an Emergency (SURE), NextGenerationEU (NGEU), and the Macro Financial Assistance (MFA) bond programs. The market has treated this as close substitutes, but they have now moved to levels higher than even single-A corporates.

Without the ECB buying the bonds, private investors must the funds to buy this debt and they don't seem to like the terms. It could be a liquidity issue. It could be associated with the newness of the issuer, but the supposed safe asset in Europe may not be that safe, and the Euro bond market may be more segmented than believed earlier. Without the ECB being the buyer of first and last resort, the market is radically different and not as well-structured as the US bond markets.

Gaslighting is all around us

 

The Zen of reading current news comes from gathering correct information without being gaslighted by misinformation, news omissions, falsehoods, exaggerations, and self-interested biases. Gaslighting is defined as “the act or practice of grossly misleading someone, especially for one’s own advantage”.

There is the potential for gaslighting from any narrative, so the focus must be on the data not the story. Read a story and ask for the data. The value of information is impacted by the chance that there is a "lemon" in the story. Gaslighting distorts the value of all narrative information because you don't know for sure what information is true.

The history of the word, "gaslight" is very interesting. Hat-tip to Bob Seawright on his sub-stack essay "Financial Gaslighting" who focuses on the hedge fund marketing. It may have come into use through the play and movie "Gaslight" where an evil husband distorts reality to drive his wife mad. He would lower the  gaslights and when asked by his wife whether the room was darker, he would answer that nothing changed. Belief the messenger not your own senses. In the financial world, some want you to believe the words not the data.

SBF just did not know what was going on with FTX because he was so busy. Raising interest rates 500 bp is unlikely to have severe consequences. The Inflation Reduction Act will reduce inflation. We could do this to news every day.

The topic has a much broader importance then saying an investor should be wary of narrative. It has an impact on fundamental discretionary and quant investing. Focusing on the quant data reduces the chance for investment gaslighting.