Equities at the half year mark

 

Even with the Iran War, the equity markets are generally up double digits for the year, with the only laggard being the S&P top 50 firms. June seems to be seeing a notable rotation out of information technology and communication services and into other sectors, such as industrials and health care. There also seems to be a rotation from growth into quality, although momentum was still a market leader. The rotation theme also seems to indicate a shift from large-cap stocks to small caps. In fact, small caps have been the best-performing sector. 

US stocks are still performing well versus the rest of the world in June and for the year. Nevertheless, international equities showed strong performance for the quarter. Fixed income showed slight gains for the month and quarter, but commodities have continued to slide. 

Our biggest concern for the second half of the year is the risk of a correction from high valuations. A rise in rates or a slowdown in credit growth to stop an inflation surprise is a likely downside surprise. 

Hedge funds and AI

 

HedgeWeek with Arcesium published a survey titled "Age of AI II: Understanding Hedge Funds' AI Capability versus Usage." It is a short piece, but what stood out for me was the interesting fact that smaller firms are embracing AI use more than large firms. The smaller firms are not only more active users but also seem willing to train employees in AI use. They are usng technology to potentially punch above their weight. The large firms do not seem as agile in using AI and are more concerned with data and output integrity. Will this translate into better returns? Harder to measure, but AI may be a disruptor to hedge funds.

Did we grow our way out of WWII debt?

 

We are facing a major debt crisis in the US, yet the alarm bells don’t seem to matter. The argument is that we run the economy hot, and stronger growth will get the debt issue under control, or at least allow us to see a decline in the debt-to-GDP ratio. 

The argument for growing our way out of the debt crisis rests on the view that we have seen high debt before and solved it through growth. The WWII debt was huge, but the debt-to-GDP ratio declined during the post-WWII expansion. The COVID debt expansion was like a world war, yet we can solve the problem through strong post-COVID expansion. 

In an interesting paper, “Did the United States Really Grwo out of Its World War II Debt”, we find that this argument may be wrong. Debt/GDP would have declined much less if not for the policies of the pre-Accord peg (financial repression) and the distortion of real rates from surprise inflation. 

The debt/GDP ratio fell from 106 to 23 percent in actual history, but if not for the rate distortions, it would have declined only to 74 percent.

This is an interesting application of counterfactual analysis, yet it is a sobering thought that solving the debt/GDP problem will have to come through surprise inflation and financial repression.

From theory to reality - the ineffectiveness of socialism

 

Chantrill's four laws on the ineffectiveness of socialism. 

1. Socialism cannot work because of prices for multiple goods (Mises)
2. Administrative government cannot work because of the Knowledge Problem (Hayek)
3. Regulation does not work because of “regulatory capture” (Stigler).
4. Government programs cannot work because you can never reform them (Chantrill).

There is the positive economics of what we would like the economy and the normative of what it actually is. Reality often gets in the way of theory.  All things are flawed, and systems are broken. Economies are often inefficient due to structural issues rooted in human behavior. Our job in finance and economics is to determine how to navigate an inefficient system to move capital and resources to the places where they will have the greatest impact.