WEEKLY MACRO NOTE - Regime Change

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HAPPY NEW YEAR

Let us take stock of 2022, and resolve to be better versions of ourselves in 2023, for it is only by looking inwards that we can project outwards.

As humans, we tend to extrapolate recently observed trends and project them far into the future in a linear fashion and in perpetuity. No wonder we are so easily surprised by change!

Yet in nature, there are no straight lines.

Instead, if you observe the real world, what you find are cycles and fractals. Applying this more complex way of thinking to finance and economics radically changes the way you look and think about your investing activities and risk management processes.

This has nothing to do with predicting when something will happen, but it has everything to do with understanding what could happen.

Few saw it coming, and yet 2022 was a year of great change, a regime shift.

TABLE OF CONTENTS

• THE MOST CROWDED TRADE IN HISTORY

• WHAT VOLATILITY?

• AN EASY PREDICTION FOR 2023

• 2022 RETURNS BY ASSET CLASS

• SENTIMENT

• ECONOMIC CALENDAR

• THE NEW YEAR

THE MOST CROWDED TRADE IN HISTORY?

And no, it is not Apple, AAPL is possibly the second most crowded trade in history, and is likely set for a rude awakening in 2023, but it is something else I want to talk about.

"Buy Bonds, Wear Diamonds" or such was the mantra.

For the past 40 years, as interest rates declined, deflation persisted and central banks backstopped the market at every glitch, bonds have enjoyed one of their best runs in history.

The house of modern finance is constructed around the efficient market hypothesis and modern portfolio theory where government debt is considered a risk-free asset and is a core holding in every portfolio.

Treating bonds as risk-free assets has allowed even the most 'risk averse' institutions, such as pension funds, to take on tremendous amounts of leverage to make up for the lack of yields these offered.

But nothing is risk-free.2022 turned out to be the worst year for global bonds in over 50 years.

US government bonds lost the most value since 1948.

But the real data point, and the rude awakening, was that in 2022 stocks and bonds combined had their worst year in over a century.

The result was the worst annual performance of the 60/40 portfolio ever.

If it seems odd to you that combined asset returns were worst than in 2008, look at the following breakdown to understand why.

To think that bonds had even worst returns than in the 80s, when interest rates soared to 18% may seem remarkable, and yet this was very much the case. This is due to the convex relationship between yields and prices. The lower the yields, the more longer-term bonds become sensitive to even small changes in interest rates.

So as rates on long-term (>10Y) UK GILTs went from 1% to 4% this year, the price of those bonds dropped by -50%.

Safe you say...The reality is that the lower the interest rates the riskier bonds were, the opposite of conventional wisdom.

The irony is that at higher interest rates you would expect pension funds to be net buyers, attracted by the better yields.

Instead, the opposite was true, as bonds sold off and yields rose, pension funds became forced sellers due to the leverage they had taken on. Remember what happened in the UK? As yields on UK GILTs rose above 4% pension funds were getting margin calls.

I think one of the greatest questions we are faced with as investors, or as business owners, over the next decade is whether we have entered a persistently higher inflation & interest rate regime.

Over the last 40 years, the financial economy and the asset-owning class have benefited tremendously from declining interest rates, the consequences of which I explored in this article earlier this year (one of my favourites of 2022).

But with higher interest rates the rules of the game change. At the simplest level, if you can earn a decent return in an interest-bearing account are you as willing to push yourself as far out on the risk curve as you were with interest rates at 0?

At higher interest rates even the value of a company and its cash flows change, as money tomorrow is worth less relative to money today.Investopedia has a great starter on this concept - LINK

So the question is, are we in a new regime?Look at the trend of US 10Y Treasuries, it has broken out after 40 years of steady declines.

The biggest takeaway from 2022 may well be this change in inflation and interest regime.

I think the chances that we return to 0% are quite slim, and 3/4% may well become the new norm, with both inflation and rates periodically shooting above and below. This requires a dramatic shift in the way we approach our inventing activities.

WHAT VOLATILITY?

2022 may also be remembered as a bear market without volatility. But is that really accurate?

Bear Markets have typically been associated with huge spikes in volatility, and the chart that everyone keenly keeps an eye on is the VIX, or implied equity volatility.

But there are other asset classes and other gauges of volatility.

In line with what we were discussing above, the bond market saw the most volatility, the MOVE index for example, which measures the implied volatility of the US Treasury market rose to multi-year highs. Imagine what the same graph of the UK GILT market might look like...

Euro Volatility also rose to multi-year highs.

Meanwhile, the VIX, or equity volatility, remained subdued.

This means that while the equity markets declined, people's hedges did not pay out. The result is that as we enter 2023, investors are not hedged. I know I am getting repetitive on this point, but I think it is one of the most important risks to be aware of for 2023.

Tail Hedging (TDEX) remains at all-time lows.

Looking at 2023 I think it is not difficult to imagine a scenario in which at some point equity volatility spikes. When it does, you do not want to be caught long.

A likely stampede could occur, where everyone rushes to buy insurance at the same time, a behaviour which will only serve to exacerbate a drawdown.

Personally, I want this risk to be in the rearview mirror before I can think of buying assets in any meaningful way with a long-term view in mind.

AN EASY PREDICTION FOR 2023

INFLATION DOWN, RECESSION UP

At the risk of sounding contradictory to the earlier statements, in 2023 we will likely see inflation decline, primarily due to base effects.

By May of this year, we have a CPI print of 8.5% to compare against, so unless prices rise another 8% above that, inflation could easily drop to about 5% YoY, maybe even the high 4s by the summer.

A lot will depend on the resilience of the economy. Recession = lower prices.

The real economy has been surprisingly resilient throughout 2022. The housing market may have come to a complete standstill, with home sales in the US down -40% YoY, but the labour market has held up strongly, and unemployment is only now starting to tick up.

I think it is relatively easy to estimate that growth will slow further in 2023 and unemployment will rise modestly, but it is much harder to gauge by how much.

The key thing to keep an eye on in my opinion will be credit & collateral. As money shrinks & the cost of capital rises, this will put increasing amounts of pressure on existing debtors, and as we discussed in my Data Dive a few weeks ago, debt is money, and when someone goes bankrupt, there is an equivalent amount of money which ceases to circulate. The anatomy of a crisis is often preceded by a credit crunch.

So I think I can be quite comfortable in saying that in 2023 while inflation might decline, the economic slowdown will accelerate. Hopefully, this also means that the downturn will have run its course, the stock market will bottom and front-run the start of the next economic cycle.

2022 RETURNS BY ASSET CLASS

Here are the absolute returns by asset class in 2022, presented without comment.

SENTIMENT

Tuning to sentiment, some degree of fear has returned to the market

Despite that, bullish sentiment is at 5-week highs according to AAII.

Active investors only marginally increased their equity exposure following the big selloff two weeks ago.

From a positioning point of view overall there was not much change. While investors increased their S&P shorts, they remain net long the NASDAQ and got even longer the Euro.

ECONOMIC CALENDAR

THE NEW YEAR

The next few weeks could be quite volatile, with bulls and bears stuck in a tug-of-war.

However, if I look at the first 6 months of this year I see tremendous amounts of risk.

Why?Because liquidity is what matters most to financial markets.

One chart to tell it all, M2 (Money Supply) has turned flat YoY, after the biggest rate of change decline in history.

so compound the above with the size of the Fed Balance sheet having turned negative YoY due to QT,

and the Reverse Repo, which is basically the Fed selling assets and pulling liquidity from the markets, having just spiked higher into year-end,

and the real question you should be asking yourself is, do you really want to fight the Fed?

The relationship between money and the stock market is clearly illustrated by this chart from Hedgeye.

While a short squeeze is certainly plausible, what comes after that will most likely be a new low.

Furthermore, the US is the only central bank shrinking the money supply in earnest, so while the Dollar has come under pressure these last few months, I expect it to rise again during the first half of the year, although it is not clear as of yet whether it will make a new high or not. Above all, I am bearish on the Pound and Swiss Franc, although I also suspect the Euro could trade back at parity at some stage.

Thank you for reading,

Antonio

P.S. Last week I published my Macro Note to the blog page but clicked the wrong setting and it did not send it out as an email. You can find it here if you are a premium subscriber.

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