Skidelsky provides a readable book on money and government

Money and Government: The Past and Futures of Economics by Robert Skidelsky is a very readable review and critique of monetary economics and Keynesian policy that can be enjoyed by a non-technical reader. Skidelsky is famous for his biography of Keynes, but this book shows his skill and confidence at explaining monetary economics and what have been the policy mistakes over the last 100 years. Even if you think you know macroeconomics well, there are plenty of useful insights that will improve your understanding in historical context. While Skidelsky is a Keynesian, his presentation is even-handed, and he describes both what Keynes got right as well as what could be improved. We need to place more emphasis on radical uncertainty and the difficulties with implementing policies.

Skidelsky shows that a gifted writer with a strong grasp of theory can provide insightful narrative on many of the vexing macro problems of the past and future. 

Ages of American Capitalism - A great economic history

 

I just finished the long but comprehensive economic history of the United States by Jonathan Levy, Ages of American Capitalism. If you want a review of economic history in the Unites States, this is the one book that should be on your reading list. I may have some issues with the interpretation of events by Levy especially since the 1920's where I have spent more time reviewing the history, but the depth of this work cannot be denied. The work breaks US economic history into four parts or ages. It stops with the 2008 Great Financial Crisis, but we can say that the Age of Chaos continues as we feel our way through deciding what is the proper level of regulation, innovation and change for the current era. The four ages are:

The Age of Commerce spans the colonial era through the outbreak of the Civil War and describes how the US moved from a colony to growing emerging country.

The Age of Capital traces the impact of the industrial revolution as it shapes the US economy. The volatility of the Age of Capital with labor strife, recessions and the growth of big business ultimately led to the Great Depression.

The Age of Control as a response to the Great Depression during which the government took on a more active role in the economy to solve the Depression and respond to WWII. 

The Age of Chaos came upon the US as deregulation and the growth of the finance industry created a booming economy for those in finance but also significant inequalities and a lack of oversight that created the environment for the crash of 2008.

This book provides a good a good framework for thinking about US economic development and should serve as a background for thinking about business history.

Private versus public markets - the new blending

 

There has been a flood of funds into private equity markets under the belief that there is some special investment magic with these firms and the managers who build these portfolios. The recent data suggests that this is not the case. The rationale for private equity is simple. Buy new quality firms vetted by managers who will engage with these firms to turn them into successful investments that can then be IPO'ed as an exit strategy. Investing in a private equity portfolio will have an illiquidity premium, you will be paid for your patience and inability access your money. Some of the latest evidence provided by Macro Hive suggests that the key assumptions do not work.  

Investors are not receiving the returns expected relative to public investments which would not be troubling in the short run if you were getting your money back. Unfortunately, are seeing long holding times because there are no exits. 

Perhaps holding liquid strategies may not as some have thought. Yes, you face mark-to-market risk, but if you are unhappy with returns, you can get your money back. 

Trend-following and equity markets - control the costs

 

There is money to be made trading long-only trends in equities but like all trading it is not easy and driven significantly by cost assumptions. In fact, it is the cost control that may be the most important alpha producer. Take what may seem like a good model without transaction costs and then add realistic slippage and trading costs and you will see significant alpha deterioration. Redo the analysis but then add a set of rules that account for turnover and costs to reduce the number of trades, and you can add back alpha. Of course, you will never get back to the original theoretical performance without any trading costs, but the number may still look attractive. There is no free lunch and there is no hidden lunch. Perhaps the easiest place to find alpha is through optimizing for costs. 

While cost analysis was not the main goal of the paper, "Does Trend Following Still Work on Stocks" it may be the key takeaway. The model is simply based on looking for new highs for stocks with an ATR stop exit strategy. There are no special features, but it does work until we add reasonable cost assumptions. Nevertheless, simple rule changes can get the strategy back on the right track through minimizing turn-over. Along with entry and exit signals, place turnover constraints into the model.

Scaling volatility - not just the square root rule

 

You look at daily volatility and you want to turn it into an annual number. That is easy, just multiply by the square root of 252 and you are done. Well, we sort of know that this may not be exact, but we like the idea that there can be a quick adjustment, yet investor should understand what the risks are with making this simple transformation. See, "Converting 1-day volatility to h-day volatility: scaling by square root of h is worse than you think".

Whether you can scale volatility is based on the assumption that the daily returns are iid; that is, the series is independent and identically distributed random variables. If there is a trend component or mean-reversion, then the series is not iid and the scaling rule will not give you an appropriate estimate. In simple terms, if there is mean reversion than actual volatility will be lower than scaled volatility. The idea that actual volatility will be different from scaled volatility has been used as a test of market efficiency. 

In the simple case, if some time series follows a GARCH process, then the scaling will not work. For example, if a series is GARCH (1,1), then volatility today will be related to past volatility and past errors. The memory will change the scale effect. This was explicitly modeled by Drost-Nijman who show that a short-term GARCH will scale to a GARCH process. You cannot avoid the memory. 

The long and short of what this math says that temporal aggregation of a GARCH process may cause volatility fluctuations to decline while the scaling rule will magnify volatility fluctuations. Because you may get different quality volatility forecasts through scaling, it seems that if you want to look at longer volatility, then calculate the longer volatility and if possible, avoid scaling.

Market reactions: It is always about the surprises

Markets are driven by macro data, specifically, the macro data surprises. If the data surprises to the upside there will be a corresponding positive reaction by markets. Similarly, if there is surprise negative news, the markets will decline. These surprise events have been embedded in surprise indices developed by banks and Bloomberg. 

Unfortunately, the creation of these indices often mixes different types of data, so it is hard to link the surprise index with market behavior. The above chart suggest that the survey and business cycle indicators are showing a marked negative bias. I would place more stock in survey data given its timeliness and close link with consumer and business behavior. Generally, after a strong showing post the election, the surprise index has turned negative and suggest that any euphoria embedded in the new media should be taken cautiously. 

As a coincident indicator especially for bonds, the surprise index should be watched especially when there is a switch from positive to negative and at extremes. This current data suggests that the move toward higher long-term bonds may be coming to a peak.

The different presidential ages and finance

 

Monday starts Trump 2.0. Many are expecting a new regime or world order. Certainly, there are clear signals of significant change. Many are thinking this will be an extension of Trump 1.0. Still others just want to return to some bygone era that did not exist. Most investors do not want to see big upheaval in policies and prefer slow transitions. 

I don't want to provide an exhaustive description of different regimes but open a discussion on different time periods based on presidents. Unfortunately, many presidencies are not determined by the personality of the man but by the events that are faced. In fact, every presidential regime is clouded or burdened by some singular economic event. Interestingly, most look at presidential periods based on a cultural lens and not a policy perspective. These comments to describe the periods are focused on economic events.

Reagan- Bush - The change away from big government that did not occur; currency upheaval, interest rate upheaval and then decline, stock increase, stock market crash and thrift crisis. 

Clinton - the peace dividend, The Great Moderation, but also the EMS crisis, Mexican debt crisis, Asian and LTCM crisis, end of deficits. a Democrat extension of the Reagan-Bush period

Bush-Obama - The great pivot to Middle East tensions and the end of the peace dividend and singular US hegemony; the Great Financial Crisis and the new era of QE. 

Trump-Biden - Period of adjust and rethinking impacted by the singular event of the Pandemic. The move to a bipolar world with a breakdown of global organization. 

Trump 2.0 - The new world of trade and further erosion of the great period of globalization. the furthering of a bipolar world.  

The world of polar regimes impacts capital flows

 

When describing global power politics across nations and regions, most analysts like to keep it simple. The world is often divided into a bipolar world of great powers. There are periods of transition and change, but the general view is that there are dynamics between two great economic systems and the rest of the world aligns itself across this great divide. 

In the post-WWII period until 1990, we lived in a bipolar world between the US and the Soviet Union. The period post the end of the Soviet Union turned into a single polar world for the US only to see a new bipolar world between the US and China. There is no single date when there are switches in polarity, but these regime shifts impact investment strategies. The unipolar world was the period of great globalization and now we are seeing a change in trade flows and globalization as countries adjust and realign to the different spheres of power. While this may not be an immediate trade, it does represent shifts that will impact all markets. 

Commodity flows will be become more strategic as countries determine how to source raw materials from friendly areas. This is clearly seen in the energy trade flows and the sourcing of rare minerals. Capital flows will change with lower direct investment across poles. The capital flow changes will occur for both equities and bonds as money avoids China and looks for other emerging markets. These shifts will increase in 2025 as alignments, tariff, and sourcing changes continue.

Where are trade flows going?

 

Everyone has been talking about tariffs, but the larger issue is how trade flows will change over the next decade. Follow the trade flows and you will be following the geopolitics of nations. We are not living in a mercantilist world, yet the dynamics of trade will influence the relationships of nations. BCG has done a good job of describing this issue with their white paper "Great Powers, Geopolitics, and the Future of Trade".

The BCG report does a good job of describing and putting numbers to the key trade drivers that will drive geopolitical issues over the next ten years.  We will see the forming of stronghold North America which will isolate itself from the rest of the world through tariffs. Second, we will see a continuation of the great China pivot away from the US. This will be matched by the rise of the global south, the ASEAN growth transition and the ascent of India trade. Finally, there will a new focus on EU competitiveness to offset the losses from trade with Russia and China. 

These changes will have an impact on commodity flows as well as finished goods. We should also see these changes impact capital and equity flows. 

The Great River - the Tale of the Mississipppi

 

I was recently in New Orleans standing in front on the banks of the Mississippi River by Jackson Square and I was in awe of the power of this majestic river. I was watching an ocean freighter slowly moving upriver. This is a river of commerce, yet there is more to the story of this great river system. Later, poking around the library, I found The Great River: The Making and Unmaking of the Mississippi by Boyce Upholt. This is a book of history, ecology, geology, and nature as Upholt walks through the story of taming the Mississippi. From discovery to control, Upholt provides a compelling story that makes the reader want to paddle down this great river. If you have any interest in this great river, put this on your list for the year. 

The Great Volatility Adjustment in CTAs

Once again, it has been noticed that the volatility of CTA's as measured by the SG CTA index continues its decline from above 15% to the magic 10%. Call this the "Great Volatility Adjustment". Of course, with the volatility decline, there has been a decline in rolling returns; however, the overall impact on Sharpe is a slight increase. 

Some have argued that the lower volatility is a result of a strategic change by CTA managers to lower volatility to make funds more palatable to institutional investors that have a strong desire for low volatility products. While there has been a conscience effort by some managers to lower volatility, some of the decrease in risk has been associated with more diversification through trading more markets, better risk management, a decrease in market volatility, and in some cases lower correlation between markets. 

Is this lowering of volatility a benefit for investors? I don't think so. Managers should always try and increase the Sharpe ratio of their strategies. This is the holy grail of investing, yet volatility is a good thing when it comes to futures trading and portfolio allocation. First, using derivatives means that you don't have to borrow to gain leverage or volatility. The financing costs for a fully funded account do not come into account. Second, the investor gets more exposure for the same price if the manager increases risk. Third, for same dollar allocation, the investor will get more trend diversification benefit which is a great benefit for the overall portfolio.

Investors have to get over the issue of looking at line-item performance and think about overall portfolio risk. This broader view is never easy to digest, but all an investor should care about is how the CTA manager fits within the portfolio and if it is negatively or zero correlated with the rest of the portfolio, you want to bring on the exposure. 

So, what why do managers target the magic 10% volatility over 15% or 20%? As managers have matured and grown in AUM, they have become more risk averse to protect the management fees given their higher fixed costs. There is a desire to play it safe, and the investors are disadvantaged. Of course, do you want to be the manager that tries and move volatility to a higher level and see business at risk? Seems like it is better to follow the pack and hug other managers at the 10% target and hope to differentiate on alpha or marketing.  

Stock-bond correlation and term premium

 

The negative correlation of the past two decades is ending albeit the five year numbers still show a negative relationship. We may be moving back to the 1970-1997 period, one of positive correlation between stocks and bonds. This is still the key issue of asset allocation. If there is no negative correlation between stocks and bonds, there is no great advantage with holding the 60/40 stock portfolio. The idea of risk parity gets called into question, and the portfolio volatilities will be higher. 

There will be a higher term premium because the hedge value of holding bonds is diminished. If you are not getting an equity hedge, and there is a positive link with equities, there will be needed extra return for holding bonds.

The current positive relationship can move to negative if we move back to the low inflation period of the post-GFC period, but the evidence suggests that the last mile problem of moving to 2% or under will be harder to achieve than thought.

See previous thoughts on stock-bon correlation: 

Forecasting the stock-bond correlation

Looking again at the stock-bond correlation

Changing stock bond correlation and macro factors - what has to happen

Fisher Black's thoughts on stock bond correlation

Stock-bond positive return correlation a reality

Stock-Bond Correlation - An inflation regime change will push it higher

The stock-bond correlation curve - risks from the Fed?

Yes, the stock-bond correlation is rising, but let's have some perspective

What do you really get from bond diversification in the 60/40 blend?

Normalcy for stock bond correlation says you need other forms of diversification

The problem with a 60/40 asset allocation - correlation

The Trump tailwind from Biden

 

We are starting a new regime. There has been a large upward change in consumer expectations, and there is a split between the economic views of Republicans and Democrats. Still, we should place this new beginning in the context of what the Biden administration left in terms of economics. This does not change the upheaval over the last fours. Rather, we need to focus at the end point and the new starting point. BCG does a good job of showing that the current economic backdrop is very positive and there will be a high burden on Trump to make the economic environment better than the current numbers. 

Is forecasting entertainment?

 

“We want a lot of things from our forecasters, and accuracy is often not the first thing. We look to forecasters for ideological reassurance, we look to forecasters for entertainment, and we look to forecasters for minimizing regret functions of various sorts.” - Phil Tetlock

Forecasters often get it wrong, so why do we follow them? There must be other reason we listen or follow forecasts in our decision-making. We should be able to do the job ourselves. Is it just the expectation that there is a chance that the forecast will be right and that will make all the difference? We are will not take a low chance of success because the gain when right will be so much greater. This seems like an odd way of thinking. It can minimize our regret. We can place the blame for a bad forecast on someone else. It is human nature to not take responsibility for our mistakes. It could give us reassurance. Investors look for validation from others. This makes sense. Perhaps we ask for or need dialogue. We want to hear about the opinions of others to make a better decision. Is this entertainment or is it an important part of the deicsion process? 

The one thing we do know is that we don't need forecasters for their forecasting skill. 

World uncertainty and trade uncertainty rising

 

The World Uncertainty and Trade Uncertainty Indices are both showing increases over the last quarter consistent with the new era of Trump. The uncertainty is nowhere near the levels seen during the first Trump Administration, but we are early in the process of determining what will be the policy actions. The World Uncertainty index is pushing to levels seen during the first Ukraine War, yet the level of uncertainty is not near the Brexit levels. 

While this index may not help with trades, it does provide information on how to adjust asset allocation. Higher uncertainty will create an environment that should be focused on holding cash and lower risk assets. The range of possible returns should be widened for 2025.

Irving Fisher's view on valuation

 

when values are considered, the causal relation is not from present to the future but from the future to present. - Irving Fisher 

While Irving Fisher in the investment committee is best known for his bad predictions before the 1920's stock market crash where he lost everything, he was towering force in economic pre-Keynes. Unfortunately, trading is not the same as theorizing. Nevertheless, his insights on looking to future expectations discounted back to the present is the critical idea behind all financial valuation. 

The focus on any valuation is not about looking at the past and not extrapolating but a focus on discounting the future cash flows or future expectations. An expectations market can move in a lot of direction and requires more work because an investor has to measure the expectations of others and weight their own view with the view of others. 

Financial Contagion - It is has not gone away

 

 

We can think of the 21st century as the age of financial contagion. Perhaps we have not seen more contagion in the 21st century, but it seems that they when they do occur, these contagion events have been more impactful over the last two decades. Information moves more swiftly through markets. Investors react more quickly to these new events which change expectations. There are more short-term agents in the marketplace. All these factors contribute to the large potential contagion events in currencies, the stock market, and banking. With contagion comes crises, there are spillover effects that create adverse markets moves. 

There are several definitions for a contagion event. Contagion is a significant increase in the probability of a crisis in other markets, when there is a crisis in one market. Put differently, a contagion is an increase in the volatility of associated markets or spillover from an increase in volatility in one market. A contagion will lead to higher cross-market correlations, co-movements, or an adverse price move when one market is hit with a market shock. A contagion occurs when the transmission channel changes after a shock in one market. 

The cause of a contagion is based on financial interdependence either through similarity in information shocks or portfolio effects. If there is a shock with one market, there may be a change in the probability of a down moves in other markets which may have similarity with the shocked market. The shock will be based on new information that shifts expectations. This new information will change the expectations for a broader set of markets and lead to a more general sell-off. Along with the expectational channel, there is also a leverage and portfolio effect. if there is a decline in one market which increases portfolio volatility, there will be a corresponding in position risk as an investor delevers, or adjusts allocations. There will be an income and substitution effect. The price decline in one asset will lead to a position adjustment as part of risk management. The portfolio effect of higher volatility may lead to closing multiple positions. A good review article is "A Primer on Financial Contagion"

Are exchange rate models better today?

 

Is there hope for exchange rate forecasting? A recent paper suggests that exchange rate models, the traditional ones that have been used for decades, are actually getting better at doing their job. The relationships between exogenous variables and exchange rates are more well-behaved, or put differently, the economic relationships are stronger than what they have been in the past. See "Exchange Rate Models are Better than You Think, and Why They Didn't Work in the Old Days".

Specifically, the global risk and liquidity do a good job of predicting exchange rates in the 21st century. Both home and foreign economic variables do a good job and are significant in empirical models using monthly changes in log exchange rates. The change in fit is found through looking at 20 years rolling samples. 

So, what is the cause for this change in the quality of empirical models? The paper suggests that central bank creditability associated with inflation targeting and the Taylor principle is the cause. The strengthening central bank independence is also associate with the improvement. The exchange rate models did poorly because the monetary variables were insignificant and the wrong sign. Exchange rates have been more closely linked with Taylor Rule modeling and thus with inflation surprises which has translated to better empirical models. Stay calm and follow empirical exchange rate models and you will be rewarded with better forecasts. 

Random walk and exchange rate predictability - trend with mean-reversion

A recent paper, "Reconciling Random Walks and Predictability: A Dual-Component Model of Exchange Rate Dynamics", provides some interesting insight on the time series properties of exchange rates. The paper finds that exchange rates have a unit root but there also is predictability at different time horizons.  This seems odd given the history of exchange rates which suggests that they are hard to predict, and that a random walk is the most effective prediction. 

The model presented combines a stochastic trend which represents the slow-moving change in equilibrium exchange rates with a stationary cyclical component that captures the temporary deviations from the long-term equilibrium. This model shows that expected exchange rate changes are not zero and persistent and there is a strong relationship between exchange rate levels and expected future changes. This may not help with forecasting in the short run, but it does suggest that there are systematic changes in exchange rates that can result in predictable moves over a random walk. 

There is hope for exchange rate forecasting. Now, for many forecasters and traders this support their thinking, but the important part of this paper is that there are two key components, a long-term trend which is based on fundamentals and a cyclical component that suggests mean-reversion to the long-term trend. Always think of exchange rates as this two-component model.

Supply of advice exceeds supply of information

“Advice is the only commodity on the market where the supply always exceeds the demand.” Anonymous

Investment advice is not the same as investment information. Advice may contain information significant and be based on facts, yet it is subjective interpretation of information. Call it processed information. Investors can gather information and do the processing on their own, or the investors can let others do the processing. Since there are many individuals processing the same information and then expressing their views, the supply of advice can easily exceed the actual or raw information. One of the key characteristics of a good investor is having rational inattention - knowing what information or advice to exclude from a decision versus using all of the opinions or advice that is present. 

On Draghi competition thoughts - Part 6 - Productivity Differences

 

The Draghi report provides a set of policy idea that will support stronger growth and productivity, yet the problem of EU productivity is not a recent phenomenon but a problem that has existed for decades after the productivity catch-up miracle of post-WWII. This problem is well-documented in "The Lack of European Productivity Growth: Causes and Lessons for the US", "Labour productivity growth in the euro area and the United States: short and long-term developments", "Keeping Up with the US: Why Europe’s Productivity Is Falling Behind", and "Productivity growth in Europe: low, uneven and slowing". For the period of 1996-2109, US labor productivity per hour increased at 2.1% while EU productivity was only 1% per year. The cumulative effect is huge. 

There are large differences in productivity across the EU, but the overall level is still consistent with Japan and the UK. It may not be that EU is doing something wrong, it is, but that the US is doing something right. This means that there is opportunity to copy US policies but there is also a problem that the EU is not able to differentiate itself versus other parts of the world.   

One of the key differences between the US and EU is that in the EU there is less investment in new technologies and low levels of spending on R&D and R&D spending that is focused on auto manufacturing and less on new technologies. 

On Draghi competition thoughts - Part 5 - EU and US investment differences

The EIB Investment Survey for 2024 provides some interesting differences between the US and EU.  I highlight some of the survey results that caught my eye for trying to explain the difference in the economic and financial environment between the two. First, there is higher level of uncertainty in the EU associated with the Ukraine-Russia War. Second, the cost of energy is a major obstacle in the EU unlike the US. Third, the availability of finance is a much greater concern in the EU.  

What is surprising is the fragmentation of requirements and standards in the EU. It is not really a single market in the same way as the US. This generates a significant amount of costs for any business that is trying to grow and innovate in the EU. 

 

The amount of time and effort to meet regulatory requirements in some EU countries is staggering. While the number does not seem out of line for the EU versus the US, the variation is surprisingly high. 

The regulatory burden for small firms is especially high. These are the firms that are expected to be innovators and drivers of future growth. It is likely that small firms in the US have to spend more time and effort on regulatory issues relative to large firms, yet there is not the problem of dealing with intra-EU regulatory problems.

On Draghi competition thoughts - Part 4 - Growth Differentials

 

While there has been much discussion about EU competitiveness since the Draghi report was released in late September, it is important to remember that the shocks since the Great Financial Crisis. For example, we can look at the growth between the US and EU surrounding the pandemic and see the strong difference in economic behavior. 

The US saw a negative pandemic shock, but the real GDP jumped back quickly to trend. The EU also came back to trend albeit in a more muted fashion given the slow GDP prior to the pandemic. What is truly noticeable is the slow gain in productivity but again this is from a slow trend prior to the pandemic. See "An Investigation into the Economic Slowdown in the Euro Area". 

Much of the difference in growth and productivity has to do with the composition of the EU economy relative to the US. First, there is a heavier emphasis on manufacturing which has been hurt by the slowdown and impacted by higher interest rates. Second, the EU has been hurt by the strong energy shock from the spike in natural gas prices from the war between Ukraine and Russia. Third, the EU is more sensitive to trade with China. This differential may not be an innovation problem but an economic composition problem.

Experience does not always make you a better decision-maker

 

“In times of rapid change, experience could be your worst enemy.” - J. Paul Getty

Most people believe that more experience is better than less experience. Hire the older portfolio manager or trader and you will do better. This has strong logic and makes sense; however, experience can be harmful if you learn the wrong lessons, or the lessons of the past do not apply to the future.

Experience depends on the learning environment and how you learn. If the past repeats itself, then experience matters because you will see the same problem with the same answer. A static world is good for the experienced manager. On the other hand, if the link with the past changes, then experience will work against the manager.  What worked in the past may not apply in the new environment. Learning from the past will be a hinderance and the less experienced manager may do better.

If experience supports how to deal with change, then it is helpful. If experience wants to replicate the past to find answers, it will fail and create bigger problems.