WEEKLY MACRO NOTE - Elite Overproduction

Welcome to a new edition of my Macro Note, which aims to be a one stop shop for everything you need to know for the week ahead in markets. The distribution of this newsletter has changed somewhat and is now being published only once a week, as opposed to twice, as it originally was.

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TABLE OF CONTENTS

• ELITE OVERPRODUCTION

• WEEKLY WRAP UP

• SENTIMENT

• CORRELATION MATRIX

• LIQUIDITY

• ECONOMIC CALENDAR

• THE ROAD AHEAD

ELITE OVERPRODUCTION

I thought I would share an interesting concept I came across in Peter Turchin’s latest book, End Times. Turchin and his fellow researchers have attempted to understand the cycles of political integration and disintergation to see if there are consistent, recurring and thus predictable patterns, across history and around the world, that drive state formation and state collapse.

“History rhymes” as Mark Twain says. Nothing new there.

The particular dynamic I want to highlight today is what he calls Elite Overproduction, which if married with what he calls Popular Immiseration, can be an explosive combination.

Elite overproduction is a condition in which a society is producing too many potential elite members relative to its ability to absorb them into the power structure, which as the problem grows, leads to social instability and unrest, as those left out of power feel aggrieved by their relatively low socioeconomic status.

Let’s take the example of the US. From 1983, the number of superrich households ( with $10M+ in wealth, adjusted for inflation) rose from 66K to 690K. Decamilionirse swelled from 0.08% to 0.54% of the population. The growth slows lower down the food chain. If the households with $10M+ grew tenfold, those with $5M+ grew sevenfold, and those with $1M+ grew fourfold.

Of course, not all of these new rich will aspire for power, but no doubt plenty will. While the number of potential political aspirants has swelled, the number of seats they are competing for has stayed the same.

Have you ever played musical chairs?

Look at the potential candidates at the early stages of last year’s Democratic primary,

And look at the Republican contendents in todays.

But leaving aside the politics, surely such a rapid increase in the number of wealthy is a positive?

Well, the issue is that it has come at the cost of the middle class, a concept already widely popularised. So despite a 10-fold rise in super wealthy, inequality sits at 100 year highs.

For the money to go to one group, it has to leave another, plain and simple.

But who cares about the frustrations of a bunch of millionaires who would like a position in the power structure, but can’t, because there aren’t enough seats and geriatrichs hold on to those positions until they are no longer compos mentis?

Well, the issue arises when you combine that dynamic, with what Turchin describes as Popular Immiseration, in other words, the decline in living standards of the rest of the population.

This kind of seems like an absurd claim to make today, given all the comforts we enjoy, but you need to look at these things on a relative basis. Real Wages have been shrinking for 40 years and even life expectancy is also starting to decline, with a particularly evident trend in the US.

How does this tie in with the problem of Elite Overproduction?

According to Turchin, popular immiseration together with elite overproduction is an explosive combination. Immiserated masses generate raw energy, while a cadre of counter-elites provides the organisation to channel that energy against the ruling class. You need only to think of Trump to see the real-life example of this point.

It’s a Game of Thrones, with lots of people contending for it. No wonder Martin’s novels resonated so strongly with today’s audience.

That we are in a time of upheaval of the previous status quo I think is hard to debate, and although we do not know how this will play out, or how long it will take to resolve itself, historically, these more challenging and turbulent times, are exactly what allow for the balance of social structures to be restored, and new ages of growth and innovation to be born.

Nothing moves in a straight line, it’s a bit like the market, sometimes you need a decade or so of consolidation, to set the stage for years of expansion.

WEEKLY WRAP UP

This week was dominated by structural flows, and I want to show you exactly what I mean.

Ahead of Friday, every time the market tried to sell down, dealers stepped in and bought back the market, particularly as volatility remainder suppressed.

The moment we got to Friday, and the big quarterly options expiration hit, those supportive flows disappeared, and the market sold off into the close.

Despite the selloff post OPEX, week over week the market was pretty much flat, down only -0.16%.

In fact, we saw something quite unusual, which was the second inside week for both the S&P and the Nasdaq, with both indices trading within the range of the previous week. Consolidation or Distribution?

Global equity markets faired a lot better. The UK’s FTSE outperformed and put in a stellar 2.8% gain, the European SX5E was up 1.37%, Australia, South Africa, South Korea, Japan and everyone’s favourite India were all up. China closed down on the week, despite some decent and better-than-expected economic data.

Volatility got crushed, once again, with the VIX and other such indices made new lows. Most importantly, Bond market volatility, the MOVE index, declined further, despite rates rising, and the US10Y making new weekly highs.

Global markets witnessed quite an unusual positive correlation develop, where the Dollar was up 0.26%, Rates were up about 5bps, Oil gained about 4.25% and Gold was also up 0.29%. Historically, a rise in the dollar and rates would have spelt trouble for oil and gold, not recently - see correlation matrix further down.

The Dollar went for it’s 9th straight-up week.

Despite the strong momentum, the FX complex is not so clear cut, and as I have been saying for a while, there is not a one size fits all trade. The EUR & the GBP continued to get pounded, while on the other hand, the CAD & AUD, were up. The CNH also rallied, and so did some other currencies as well.

The EUR/AUD lost -1.22%, and is down over -3% since I highlighted this trade a few weeks ago.

The thing is, the ECB stated that they are done hiking, and European data is weakening quite evidently, meanwhile, the RBA has still left the door open to further hikes, and Australia just added 65K jobs in August, and although 90% of those are part-time, it certainly keeps the pressure on the RBA.

The Brazilian Real was the star of the show and gained 2.5%, which propelled the Brazilian Equities ETF EWZ higher by 5.5%. I’ve been quite bullish on this market for a while now, and I think this remains a great long-term opportunity.

This week the Brazilian central bank is expected to lower rates from 13.25% to 12.75%, as the economy fairs well, but inflation remains well under control. This is a positive structural development for growth, and in the immediate term also very good for their bonds.

Curiously, despite the rise in Oil of about 5%, Energy stocks were flat WoW, which confirms my view that the sector is a little crowded.

With WTI at $90, we also happen to be at the upper end of my range outlined in January, will I be so lucky as to have nailed this? I don’t know, but I think Oil is a bit overextended here.

A few weeks ago I talked about how the positive correlation between Gold and the Dollar was a good sign for precious metals, and that I wanted to see Gold hold support at $1900 and Silver and $23. Both have done so and saw pretty strong bounces off the weekly lows. $1900 remains my key level as far as trend support goes.

As I’ve said in the past, if you’re bullish on Gold, then you want to own the miners, and not the underlying. GDX (Gold Miners ETF) was up 4.8% WoW compared to Gold only 0.3%.

SENTIMENT

Still stuck in the middle.

Indecision is now at 5 month highs, with the majority of respondents being neutral.

And in this environment, asset allocators remain underweight,

Menawhile, you retail trader and Reddit crew are quite bulled up, which is a curious divergence.

From a positioning point of view, there are a few things to note:

• GBP bulls remain quite stubborn despite 7 straight down weeks for the pound

• SPX shorts decreased, but so did NDX longs = no major change.

• For some reason a massive short position in Corn has built up, if you want to go long an Agricultural commodity, this would probably be it.

• BRL Long is still quite small, despite a +2.5% week for the Brazilian Real, which could give it more room to run.

CORRELATION MATRIX

Really curious dynamic shaping up here with positive correlations to the dollar building across the board, which would suggest that even if the dollar continues to move higher, it shouldn’t be as much as a negative to other asset classes as it usually would be.

FED LIQUIDITY MODEL

FED liquidity has actually been on the rise these past few weeks, for despite the Balance Sheet making new lows, the RRP is being drained like there is no tomorrow, with the Treasury concentrating all its issuance in short term bills.

This is RRP,

and this is the Fed’s Balance sheet

ECONOMIC CALENDAR

The main event will be the FOMC. It is widely expected to pause or skip a hike this meeting, although they will no doubt remain hawkish in tone, and leave the door open for further tightening down the road.

We also get inflation data out of the Uk, which is expected to be uncomfortably hot, and the BOE is expected to hike rates again.

Most of the risk is concentrated on Wednesday, although the end of the week is heavy with economic data.

EARNINGS CALENDAR

We get some earnings this week, again Wednesday will be the more important one, with FedEx and General Mills.

General Mills is quite oversold, and although they are indeed suffering from declining pricing power, a topic I discussed a few months ago, I think this is a solid company, and the current decline should be viewed as a good long-term opportunity.

THE ROAD AHEAD

The key dynamic playing out at the moment is that as economic activity remains resilient, so does inflation remain stiky, and consequently, the Fed’s tone remains hawkish. Ironically, the worst for equities, may not occur until growth slows, inflation abates, and the data, and particularly employment, becomes so bad, that the Fed is forced to react.

With continuing claims at yearly lows, clearly, on the labour front, we are not there yet, and this cycle is taking its royal time to play out.

This is FOMC week, and quarterly Vix expiration week, so we can expect some volatility.

The key variables remain rates and the dollar.

Unless Powell comes out and surprises investors, given the divergent relationships I see in FX, I favour the Dollar index to consolidate and potentially correct a little. I think it is quite overbought right now, and should we get a spike leading into the FOMC I would be a seller, for a correction from 105-106 back down to 102-103.

Amazing how quickly narratives change. A few months ago everyone was talking about the demise of the dollar, and it just went and ripped higher in everyone’s face.

While I am starting to be sceptical about OIL, after being one of the few bullish voices in the mid-60s barely 3 months ago, if we don’t get any surprises from the Fed, and the Dollar corrects, as I think it might, then Oil could actually squeeze higher still.

The same would be true for GOLD. If gold has been supported during up days for the dollar, imagine what it can do on dollar down days… and as long as it holds $1900.

As for equities, the question is which way will the last 3 months of consolidation resolve? The SPX is still trading at the same level it was back in early June.

The two key support levels for the SPX are 4400, and the previous low of 4350.

I think, unless we get any unexpected surprise out of the FOMC, any dip into that event, might very well be bought, and see the market trade higher afterwards. If volatility rises and hedges get built up into the FOMC, if no true negative catalyst materialises, when the hedges get unwound afterwards, you know what happens.

The Bears have a shot at turning the trend around this week, but will they come out with enough firepower to do so? That’s not clear to me. They want to make a new low to show they are in control, and they really need to get the Vix moving again, which doesn’t seem to want to happen this year.

I am hearing some Covid fear-mongering resurge again, could that turn out to be a catalyst, or instead just be another wall of worry for the market to climb? Again, unclear.

The bottom line is no different than what I said last week. It’s a tough market right now, with no clear trend, and very few extremes to bet against, which is why I remain watchful and await a more glaring opportunity.

Have a great week,

and if you enjoyed this or found it useful make sure you upgrade to premium.

Antonio