Macroeconomic uncertainty still high post pandemic

 

Using the latest index of macroeconomic uncertainty that is based on over 132 macro time series, we can see that unlike other post-recession periods, uncertainty has remained elevated. The only comparable period is the early 1980's when there were twin recessions. All other periods show a decline to long-term averages. This elevated uncertainty is applicable for 1-mont, 3-mont, and 12-month horizons although the data end at the end of 2022. 

The high uncertainty has clearly impacted investment allocation decisions; however, it is still surprising that risky asset returns have moved higher. Perhaps an updated series will show a decline consistent with the fall in VIX and MOVE index and thus create normalization and a demand for riskier assets. 

The unnatural yield and yield curve environment

When will we have a normal yield and yield curve environment. First, we lived in a zero interest rate environment that created perverse incentives for investors. There was movement out of cash and bonds - the reach for yield. Now, we have another unnatural yield environment, the strong inverted curve. An inverted curve creates a different set of incentives, the reach for cash. Instead of investing out the yield curve or buying risk assets, there is an incentive to hold cash. 

The natural yield and yield curve environment is a nominal yield that is equal to the long-term growth rate plus the expected inflation. The normal yield curve is upward sloping where longer maturities provide investors with higher yield. If there are large deviations from normal you must ask the central bank; what the heck are you - overreacting with loose and tight policies. 

Fitch rating downgrade of US to AA+; The spotlight is on debt

 

The Fitch rating service lowered its sovereign rating on US debt from AAA to AA+. S&P lowered its rating on US government debt a decade ago to AA+, so this is not the first rating downgrade. The market reaction was muted on the announcement, but it seems the current market talk is causing some market uncertainty on the future debt picture. 

Hard to say there was any surprise with this change. The report was very clear in its analysis. The argument for the downgrade was based on the likelihood of further deterioration of US finances over the next three years given tax cuts, spending increases, potential economic shocks, and the ongoing gridlock associated with debt ceiling crises. Treasury Secretary Yellen disagreed with the Fitch assessment and said the downgrade was "arbitrary" and "outdated".

 Of courses the Treasury is planning to float over 1 trillion in new debt this quarter and over $850 billion in the fourth quarter.  This is just after the recent debt ceiling deal was closed. I guess a trillion dollar in one quarter is just not a big deal anymore. 

There is the adage that governments cannot go bankrupt. Obviously, the power to tax can solve any problem, but we were just on the brink of a default two month ago and nothing in the financial picture changed.

The market already believes what Fitch has stated in its report. To a degree, the US Treasury is too big to fail. As the most liquid debt market, there are no alternatives, yet it is likely that we could see a default in the next three years. Anyone who does not believe the probability of default is meaningful has just not been following the bond market or followed any of the debt ceiling debacle. 

What if you don't want believe? The problem of motivated investment reasoning

It takes more information to make you believe something you don't want to believe than something you do....

Motivated reasoning is a pervasive tendency of human cognition...People are capable of being thoughtful and rational, but our wishes, hopes, fears and motivations often tip the scales to make us more likely to accept something as true if it supports what we want to believe.

-  Peter Ditto

We often have all the information in front of us, but we just don't want to follow it. We don't want to believe. There is a problem with data that contradicts our narrative. We will not believe it. It must be flawed. It must be an outlier. It should be discarded. We are motivated by what we want to believe not what contradicts our current wisdom., 

From a narrative, investors will often search for information that confirms the story. The opposite is a better approach. Start with data and then form the narrative or story. Unfortunately, the process of moving from data to narrative is often messy because the data is messy. Data will often contradict. There is little clarity. On the other hand, a good narrative or story is consistent and makes sense. We develop this story and then look for the evidence that will be supportive. 

The value of quant work is that there is no motivated reasoning. A trend is either up or down. A signal is yes or no. Of course, there is personality with any model, but the focus is on following the count. If the numbers tell you the odds are favorable, you do the trade. There is a belief - a belief in the system.