The complexity of trade - not always simple

 

Those imports are taking away good jobs. We have to impose tariffs to stop the invasion of foreign goods to our shores. These comments all sound good, but the reality is more complex. It is usually always that way. One chart that caught my attention showed that many good imports are intermediate goods rather than final products. We take in components and assemble the final product. As an intermediary good, a tariff will increase the price of the final good. The answer could be to produce these intermediate goods in the US, but they are often specialized and may be hard to produce at low cost. Some industries are very dependent on these imports, and they do not fit the usual trade story being used to justify tariffs. Think about complexities and realize most problems are not easy yes or no answers. 

The relative US - EM inflation story

If I asked the simple question, "Is EM inflation higher than US inflation?", most would say that EM inflation is higher. It has been, and always will be, yet the reality is different. US inflation has been higher than EM for almost 5 years. That is right. The Fed manages an inflation regime that is worse than that of the combined EM economies, and the gap is widening. Do you have to wonder why the dollar is falling? 

What driver performance of machine learning

 

A recent paper, "What drives the performnce of mchine learing factor strategies?" seeks to disentangle two key ingredients in modeling: expanding the dataset and allowing for flexible functional forms. Now, as expected, as you move closer to a realistic setting, you find that the value of both deteriorates. However, this research finds that the value of an expanded dataset is more persistent than the functional form employed. While many may think that machine learning is a form of holy grail for investing, the reality is that real-world constraints and transaction costs are key drivers of performance. Reality indicates that adding nonlinear complexity does not add value, whereas being non-sparse is beneficial. 

Risk appetite is always worth following - Currently, normal

We have been following the Wilmot Risk Appetite Index for decades, when it was first called the Credit Suisse RAI, as developed by Jonathan Wilmot, who is now in private practice. It will be provided to investors through HedgeIndex LLC in the coming weeks, along with their broad set of alternative indexes. The basic construction is provided below. 

The current reading indicates that risk appetite is within the normal range, though it is rising. There may be individual assets with extreme values, but the RAI does not indicate a general market extreme.

 

China growth coming in lower

 

ChinaNow is a real-time, alternative measure of Chinese real GDP designed to capture business cycle dynamics in China that are not readily observable in official GDP data.  The authors employ a dynamic factor model (DFM) that draws on a broad set of high-frequency indicators informative about the Chinese economy and its business cycle.

Many are skeptical of the official stats coming out of China. In addition to methodological issues, these GDP data are politically sensitive; therefore, it is important to identify alternative growth indicators. The ChinaNow index appears to closely match official figures but provides more timely and higher-quality data, particularly during periods of slowdown. 

If there is a slowdown in China, there are stronger incentives to push exports at lower prices to keep factories humming. Hence, China's domestic growth has a strong impact on the rest of the world. 

Asset allocation of university endowments

 

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A recent survey from NACUBO-Commonfund Study of Endowments provides interesting insights into the asset allocations for university endowments. Clearly, the larger funds have allocated more to alternatives and private assets and less to bonds, while the smaller funds appear to follow a more traditional allocation.

Nevertheless, the performance of endowments is not markedly different from that of a 60/40 portfolio. In fact, over three years, the endowments underperformed the classic mix, and over ten years, only the largest endowments seem to have beaten the simple benchmark. Does that mean 60/40 is better? No, but it does indicate that adding alternatives should be done carefully, with an eye to how they may compare to a simple approach.

King dollar - can it be toppled

 

I was expecting a standard book on the history of the dollar’s rise, and the reasons it should be a dominant currency, as well as why it will fall. I have read many articles on this topic and thought I would get more of the same with King Dollar: The past and future of the world’s dominant currency. I was surprised by something different. While I don’t always like the breezy approach of new reporters to complex economic topics, I found this an interesting read. 

Blustein takes the reader on a different ride, focusing on the plumbing of banking through SWIFT messages and CHIPS. It provides a unique look at the history of clearing and the ascent of the dollar that many monetary theorists avoid. More importantly, the author focuses on how the anti-money laundering efforts of the US Treasury have an important impact on banking and the use of the dollar. There is a vast amount of behind-the-scenes efforts to control the flow of dollars for the benefit of the world economy, yet this interference has a dark side that leads some state actors to avoid surveillance. The attempt to restrict Russia from global banking and trade shows how regulation and oversight can affect the flow of money. The author also reviews the work to develop CBDCs, central bank digital currencies.

As alluded to in the final chapter, for the "king currency" having a throne comes with great responsibility.

 

Buffered ETF - the product of 2026?

 

For better or worse, the top ETF product for 2026 may be the buffered ETF. At a very general level, a buffered ETF, is one that provides downside protection versus some referenced index. That is, there is a buffer on the losses associated with the ETF. However, in exchange for this protection, the investor wil give-up some of the upside. The market has grown from approximately $5 billion in 2020 to a $90 billion AUM as of the end of 2025.

This type of protection can be achieved by managing the portfolio. There is a cost with having the ETF provide you protection, yet there always seems to be a need for these products. First, the mechanism for offering this protection is systematic and removes emotion from any allocation decision. Second, the timing of the protection is well-defined. Yet the payoff structure is complex and comprises multiple option positions. There are parts of the distribution that are protected or buffered, parts that are exposed to risk, and an upside portion that is capped. The folks at Alpha Architect provide a good overview of the problem. 

Realize that if you want protection from downside risk, there is no free lunch. If you move to cash, you lose the upside. If you buy derivatives, there is a cost. If you allocate to alternatives, you are at the mercy of their return profile. Choose your protection wisely.

What are the big risks of 2026?

Each year, the World Economic Forum provides a global risk perception survey. This is one of the most comprehensive risk surveys, and it provides useful context on what business leaders are thinking about potential disruptions to the global economy. The benefit of this survey is that it provides overall rankings for each year and measures change from the prior year.

By far, the current global risk landscape identifies geoeconomic confrontation as the top risk, followed by state-based conflict. Now, for anyone reading the news, this seems very logical, but it is sobering to see it in print. It has moved up from the eighth spot last year to number one. Along with confrontation, economic downturns, inflation, and bubbles pose key risks. These risks are important in both the short and long term, although climate change is still considered a long-term risk.

What does this mean? First, it is hard to believe that risky assets will continue on the current path with these views. Second, as noted in a recent post, Bonds are not always a safe asset; holding bonds may not provide the desired safety during an armed conflict or war.

 

Credit spreads tells about financial risk

 

The paper, “Credit Spread News and Financial Market Risk,” examines a simple issue. Do the changes in bond spreads tell us something about financial risk that we do not already know? The answer after significant analysis clearly indicates that there is something in credit market pricing that provides insight into the behavior of volatility, as measured by the VIX, realized volatility, and GARCH modeling. If there is a shock to credit spreads, there will be a spillover to higher volatility. Now, this shock effect is centered on recessions, but the evidence is clear. Follow debt markets as another tool to tell you something about financial risk. 

Bonds are not always a safe asset.

The new paper "Are Government Bonds Safe in time of war and Pandemic?" examines the behavior of bonds during periods of war and other non-financialcrises. Not surprisingly, there is a difference. Wars are associated with sharp declines in real returns and with returns that lag growth. The reasons are clear. There is elevated surprise inflation during a war, and governments impose financial repression, which creates a wedge between real returns and grwoth/. The bondholders bear the cost of war, even relative to risky assets. That is not the case during a financial crisis or a pandemic. Pandemics are similar to war in that they entail labor supply constraints, trade restrictions, a surge in spending, and significant increases in central bank balance sheets. 

All risks are not equal. Bonds are not always safe. The assumption that government bodies are always safe will be costly. Now, the war scenario may be easy to adapt to, but the real question is whether there are other government or geopolitical-induced events that are adverse for bonds. That is the real current question. When is the environment not safe for bonds? 

China is run by engineers - the US by lawyers - a different perspective

 

Dan Wang, a China-based reporter for many years, writes an insightful book about his impressions of the Chinese economy and political system in Breakneck: China’s Quest to Engineer the Future. The premise is that China's economy and political system are run by engineers, who are the key filter for understanding their leaders’ actions and behavior in addressing problems. In contrast, the US is driven by lawyers who are not builders and doers but activists who want to stop and control the economy and politics through the legal and regulatory system. On the surface, this dichotomy seems simplistic, yet Wang makes a strong case that this is an effective characterization. He does spend most of his time using the engineering framework to explain China, the center of the book, and his contrast with the US is not as well developed, yet I found this may be a good way of thinking about actions within China.

This is a short, very personal book, so do not expect deep analysis. Yet the presentation is compelling, and for those who want another perspective on the Chinese economy, it is a good read.  

Hedge fund rotation in 2026

 

Every year, we see investors change their appetite across hedge fund strategies, and 2026 is no different. There generally is a momentum component to hedge fund allocations. Strategies with strong performance will see strong interest in the following year.

For 2026, we are seeing increased interest in European hedge funds and in multi-strategy and event-driven strategies. There is also increased demand for digital assets, but we believe the current sell-off has cooled interest in these strategies. Interest in multi-strategy strategies has been the strongest among hedge fund strategies over the last few years. The low volatility and strong Sharpe ratios have been the primary drivers, despite the strategy’s high fees.

The value from trend-following is in the quintiles

 

The Mann Group provides another simple chart that explains why investors want to hold trend-following managers. We have seen the quantile chart before, but the comparison with global bonds and multi-strat provides more insight. First, we have higher-yielding investors who think they can just hold bonds as a safe asset. Bonds will not help you at the downside extreme. The darling of hedge funds has been multi-strat firms. They will do well in most cases except for the lowest equity quantile. When you need protection wuou will not get it. 

Strategy blend is important. Take a combination of trend and multi-strat, and you will be well served across all states of the equity market. 

“Low-hire, Low-fire” labor environment - Labor gridlock

In a K-shaped economy, we are seeing labor market gridlock. Job openings are falling, and separations are low. Quit rates are also at the lowest levels since the pandemic. Workers do not want to leave their jobs. Firms do not want to hire workers, nor do they want to fire them, because they don’t think they can find better workers. Turnover is a good sign for a labor market, and we are not seeing this in the US economy. The economy is gridlocked on uncertainty. If you don’t know what the future may hold, you don’t want ot make new investment decisions in labor or capital. 

Putting Fed dissent in perspective

 

Whenever there is dissent with Fed votes, there is an uproar by market analysts who are trying to make sense of why someone would have a different opinion. Indeed, dissents have increased, but the absence of dissents was unusual during the Powell period. If you look at other periods, the number of dissenting votes was greater and more often. Greenspan was the exception with few dissents, but that was only later in his tenure as Chairman. During the Volcker period, one could say the Fed was in revolt. 

The lack of consensus is beneficial. Yes, it creates uncertainty, but it also tells us there is honest debate.

New CME margin for silver and gold futures - fixed percentage of noitional

The CME has set new margin rules for gold and silver. The CME says this is a procedural change with no significant impact on the margin market, but we think it is a much bigger issue and will eventually affect all markets. Traditionally, margins are set as a dollar value tied to the contract's notional value and volatility. It should cover more than the expected most significant one-day move. The link between VaR and margin in this setting is unclear; there is no direct link, and it is determined by a committee. There is a process, but it is not mechanical, and the underlying assumption is that margins will remain relatively stable over time unless market behavior changes significantly.

The new procedure that went into effect for the gold and silver markets is now based on a percentage of notional value. Hence, if the value of the gold or silver contract increases, there will be a corresponding increase in margin. In a rising market, the longs will have to post more margin on their gains instead of being able to take their notional gains out of the market. In practice, most traders will not take excess cash from their margin account until there is a gain in cash balances. In the case of shorts, when there is a gain in the market, there will be a need to post more money. The average cost of shorting will be higher.

Now, at the end of the month, the CME increased the margin percentage for gold and silver, so the margin required for those contracts needed to be posted again. 

Gold margins rose to 8% of the value of the underlying contract from the current 6% for a non-heightened risk profile, and the heightened risk profile margins increased to 8.8% from the current 6.6%.

Silver margins climbed to 15% from the current 11% for a non-heightened risk profile, while the heightened risk profile margins moved to 16.5% from the current 12.1%. Platinum and palladium futures' margins were also boosted.

Are we creating the wrong macroeconmic statistics?

 

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The book The Mismeasurement of America: How Outdated Government Statistics Mask the Economic Struggle of Everyday Americans, by Gene Ludwig, the former Comptroller of the Currency and the Ludwig Institute for Shared Economic Prosperity, is a thoughtful, concise analysis of a critical issue. Do we measure unemployment, median wages, and inflation effectively? The answer is no. Before you say this is only a policy issue, consider the current discussion of a K-shaped economy.

The simple question is: why do American workers feel so stressed when employment, wage, and inflation numbers are either positive or tame? The answer is that our statistics on these key issues are problematic. 

They tell a story, but reality may be different. For example, inflation appears to be under control, although it exceeds the 2% target; however, if we focus on a basket of everyday necessities, inflation is much higher. Unemployment is low, but if you adjust for part-time and low-wage work, the functional unemployment rate is higher. If we consider an alternative wage scale based on actual time worked, we would see wage earners falling behind.

We need better, more informative data. We can address the fallout from politics, but we first need better facts.

The crowds, momentum, and risk in markets

 "These heroes of finance are like beads on a string - when one slips off, all the rest follow." - Henrik Ibsen during the early phase of the Great Depression 

An insightful comment from someone not in finance. Ibsen was mainly a playwright; however, he was aware of the goings-on in Europe and the world. We have heroes of finance, but they are not the contrarians. They are the ones leading the crowd or banging the drum to move the crowd. Everyone likes the person who reflects their thinking. I follow Bob because Bob's thinking is consistent with my view of the world. Show me the person who is thinking differently. They are the people who will move me to think better. 

Global Capitalism - we may never go back the the early 20th century world

 

Jeffry Friedman is one of the leading economists on the history of the international global order. His book, Global Capitalism: Its Fall and Rise in the Twentieth Century, is now 20 years old, but it is a good read if you would like to know where we have been before the current globalization upheaval. Global capitalism is not natural. It was fought for by a few visionary bankers. These bankers made money, but they also saw a more connected world. Unfortunately, the Great War destroyed the high point in global trade and reset the world financial order. The depression forced new isolation. The Second World War again led to a new, more controlled international order under U.S. dollar hegemony. This system broke down, but we saw a new emergence of global capitalism following the fall of communism, cheap transportation, and a world willing to cooperate. The story ends before the Great Financial Crisis, which again led to a shift in global capitalism toward autarky, neo-mercantilism, and non-cooperation. We are observing a decline in trade volumes. We may never see coordinated global capitalism, but we do see bastardized forms of public-private coordination imposed on economies. 

Hedge funds taking on long equity exposure

Hedge fund strategies are often purchased because there are expectations that they will exhibit a beta similar to that of equity markets. Not all the betas will be the same, but they will generally run between .5 and .6 on the high side to zero or slightly negative on the low side. CTAs usually have the lowest beta but also likely have low alpha. 

These betas or correlations will change with market conditions. The hope is that if there is an increase in beta, it is not because hedge fund managers are chasing the equity market with momentum trades, but rather because they are showing some market-timing skill. Evidence on market-timing the overall market is weak, so there should be concern when hedge funds exhibit higher short-run correlations with equity markets. Of course, hedge fund managers may have timing skills, but this is not the reason why most managers are buying these strategies. 

Investors seek uncorrelated returns, so there is a general expectation that betas will be low and stable. Yes, that means that hedge funds will underperform versus the overall market on an absolute basis, but investors should not pay for unwanted beta.

 

The K-shaped economy - Wall Street versus Main Street

 

I normally hate the comments about the difference between Main Street and Wall Street. Usually, it is a false dichotomy, but the current environment suggests that the average consumer or wage-earner is having a harder time than wealth-holders. This is what happens when we are in a more inflationary environment. Yes, inflation is off its highs, but the average inflation for this century is closer to 4% than the 2% Fed target. 

The labor markets are looking weak and confidence is weak, yet the stock market is higher based on strong earnings from those economies that have network effects and represent the tech industry. Two-income households may be doing well, but the rest of the country is trying to hang on and deal with recurring price increases that do not appear in the CPI indexes. 

A strong stock market may pull the economy higher, but that is unlikely. The higher stock market is likely the result of too much money chasing existing assets. The good markets may not be seeing all of the inflation, but the financial markets are seeing "asset inflation.

Is there a story for small caps?

 

If you look at the Shiller CAPE P/E values, the large-cap market looks expensive. If you look at small-cap stocks excluding the largest Mag 7 stocks, the market seems better positioned. Now that the small-cap risk premium has fallen, some have questioned its validity, but the number suggests a closer look.

If we just look at the 493 SPX stocks outside the Mag & there seems to be more value broadening investor focus. Of course, earnings for the Mag 7 have been higher, which justifies holding these stocks. Additionally, small-cap value and growth have not been rewarded. To hold these smaller-cap names, you truly have to believe that current P/E valuations are a strong predictor of short-term stock performance. Perhaps that is the case over the next five years, but it is a stretch for the next year.

Gold central bank holdings - Saying no to fiat money

The perception of the gold market has changed radically since the Great Financial Crisis (GFC). During the first 10 years of the century, central banks sold gold. Who wants gold when you can have dollars, euros, or yen? Who wants a real asset with no yield when you can have a financial asset with a yield? Who wants a real asset when inflation was under control and less than 2%?  

Now, we know who wants these assets - central banks. These institutions create fiat money, and they don't want it from their peers. Of course, rates were set to zero and, in many cases, moved to negative values during the period of QE. If financial assets can yield negative returns, a hard asset with zero yield looks pretty good. If government debt reaches a new high well beyond GDP, we can suspect it will not be paid with taxes, and governments will have to default on the debt or inflate their economies. The pandemic suggested that governments will go to any lengths to boost the economy with new money. 

The central banks are acting rationally and not telling the public what they really think. Fiat money is out, and hard assets are in. 

JGB rates starting to matter to the rest of the world

Japanese 10-year JGB yields are now 2.34, the highest this century. An end to loose monetary policy, continued loose fiscal policy with the expectation of a tax cut, the "Takaichi Trade", and persistent inflation that is currently at 2.9% means that there is a strong reason to see yields move even higher. The rising JGB rate is having an impact worldwide as money starts to flow back to Japan. Now, it is hard to say this is a complete reversal when real rates are still negative, but the global financial landscape is changing, putting pressure on Treasuries and rates in other countries.

What if we have clarity on Treasury rate direction?

 

We have been strong believers in using volatility, whether the VIX or the MOVE index, as a strong indicator of fear and uncertainty. This is a nonlinear relationship. An increase does not necessarily mean a decline in prices, but once volatility exceeds a threshold, there will be a strong price reaction. Now, we can look at the decline in the MOVE index and infer that the term premium should decline. Since September 2004, short rates have declined by 175 bps, yet long-term yields have increased. This is not what should be expected. Lower volatility should reduce risk and lower yields. This is not happening. 

So what is the reason for the higher, longer-term yields? Well, if volatility measures uncertainty, perhaps there is no uncertainty at all, and bond investors are clear. Bond buyers believe there is greater risk in holding Treasuries, that inflation is rising, and that the safety of dollar Treasuries does not exist. In that case, volatility can be lower, and rates trend higher. Lower volatility and lower uncertainty do not mean clarity is good. 

A link between policy uncertainty and gold

 

"A bet on gold is really a bet that the people in charge don't know what they're doing."

- Matt O'Brien, 2015

'The monetary order is breaking down,' - Ray Dalio

Gold prices have reached uncharted territory amid US policy uncertainty and trade tensions. You could look at headlines and make some connections, but more importantly, we can examine objective measures of uncertainty as indicators of a change in the monetary order.

The trade policy uncertainty index has fallen from high levels, but remains at extreme levels. The global economic uncertainty is also high and at extremes. 

If the monetary order and policy framework is breaking down, there will be a search for safety. However, if the safety of holding dollars and Treasuries is no longer present, we will see a search for alternatives, and right now that is in precious metals. 

Gold allocations will rise, and even a small increase across many portfolios will create demand that current mining production cannot meet. This is fueled by increased demand from central banks.