ReSolve Riffs with Alfonso Peccatiello (aka MacroAlf): Liquidity and the Global Macro Landscape

In this episode, the ReSolve team is joined by Alfonso Peccatiello, a macro strategist and the creator of the popular Twitter account @MacroAlf, to discuss liquidity, the global macro landscape, and the implications for investors. We delve into various topics, including:

  • The role of leverage and cyclical growth in shaping the global macro landscape
  • The impact of demographics and debt on economic growth and the challenges faced by countries in maintaining living standards
  • The significance of the Global Liquidity Index in understanding rapid changes in equity market behavior
  • The orthogonal approach to the traditional All Weather framework, focusing on credit-oriented growth measures and policymaker stances on inflation
  • The Forever Portfolio allocation and the importance of adjusting it using macro analysis to apply tilts based on the current macro cycle
  • The labor market dynamics reflecting a bifurcation due to the lag in the dispersion of the $5 trillion capital injection into the economy
  • The potential impact of US fiscal deficits on nominal growth over the next decade, influenced by demographics, private sector leverage and productivity growth

This episode is a must-listen for anyone interested in global macro trends, liquidity, and investment strategies. Gain valuable insights and strategies to navigate the complex financial landscape and better understand the intricacies of the global macro environment.

This is “ReSolve Riffs” – live on YouTube every Friday afternoon to debate the most relevant investment topics of the day, hosted by Adam Butler, Mike Philbrick and Rodrigo Gordillo of ReSolve Global* and Richard Laterman of ReSolve Asset Management Inc.

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Episode Summary

In a recent discussion on liquidity and the global macro landscape, several key themes emerged, including the importance of mental frameworks and market regimes in portfolio construction, the role of leverage in driving cyclical growth and the potential impact of US fiscal deficits on nominal growth over the next decade.

One crucial aspect of building robust portfolios is identifying mental frameworks and recognizing different market regimes. Over the past 20 years, global disinflation and volatility compression have dominated the risk and return distribution in the market, leading to the success of the traditional 60/40 portfolio. However, as the financial landscape evolves, investors must adapt their mental frameworks and consider the influence of central banks and fiscal policies on the market.

An orthogonal approach to the traditional All Weather framework can provide a more comprehensive understanding of the global macro landscape. This approach focuses on credit-oriented growth measures and policymaker stances on inflation, which are essential factors in determining the performance of various asset classes. By considering these factors, we can better anticipate market trends and make more informed investment decisions.

Leverage has played a key role in driving growth in the face of declining demographics and productivity, leading to disinflationary tailwinds. As economies continue to rely on leverage to maintain living standards and offset demographic decline, it is essential to recognize the role of leverage in shaping economic outcomes and consider its implications for future growth and inflation trends.

The Global Liquidity Index, which tracks the change in G5 bank reserves, serves as a valuable metric for understanding rapid changes in equity market behavior. By monitoring these changes, we can gain insights into the financial landscape and predict potential shifts in the equity market.

A Forever Portfolio allocation, designed to perform well in all market conditions, can be adjusted using macro analysis to apply tilts based on the current macro cycle, providing a robust investment strategy. This approach not only helps protect wealth in challenging market conditions but also allows investors to actively engage with their investments, fine-tuning their strategies based on data-driven insights.

Demographics and debt play significant roles in economic growth, with countries leveraging up to maintain living standards and offset declining demographics and productivity. It is crucial for investors and policymakers to consider the interplay between demographics, debt and economic growth when making decisions and crafting strategies for the future.

The labor market dynamics reflect a bifurcation, with cyclical industries experiencing strong hiring trends due to the lag in the dispersion of the $5 trillion capital injection into the economy. However, it is important to consider the potential long-term effects of this capital injection on productivity growth and the government’s role in the economy.

In conclusion, understanding the global macro landscape requires a multifaceted approach that considers mental frameworks, market regimes, leverage, demographics, and debt. By incorporating these factors into investment strategies and policy decisions, we can better navigate the complexities of the global economy and make informed choices for the future.

Topic Summaries

1. Mental Frameworks and Regimes in Portfolio Construction

Identifying mental frameworks and recognizing different market regimes are crucial in building robust portfolios that can withstand various market events.

Topic Summary

In the world of investing, it is essential to have a solid mental framework to approach the construction of a portfolio. This involves identifying the different market regimes that a portfolio will have to go through in order to be robust against various events. Over the past 20 years, there have been two main forces that have dominated the risk and return distribution in the market: global disinflation and volatility compression. These forces have led to the success of the traditional 60/40 portfolio, which has delivered excellent returns in a global disinflationary environment. Market cap weighted indices have performed well, rewarding tech stocks and benefiting from the low volatility trend. Bonds have also served as a good hedge due to global disinflation, allowing central banks to ease financial conditions and intervene when necessary. However, as the financial landscape evolves, it is important for investors to adapt their mental frameworks and consider the influence of central banks and fiscal policies on the market. By acknowledging the changing dynamics of the global economy, investors can better construct portfolios that are resilient and capable of extracting risk premiums without facing significant drawdowns related to market volatility.

2. Orthogonal Approach to Traditional All Weather Framework

An orthogonal approach to the traditional All Weather framework focuses on credit-oriented growth measures and policymaker stances on inflation, providing a more comprehensive understanding of the global macro landscape.

Topic Summary

We believe that an orthogonal approach to the traditional All Weather framework can provide a more comprehensive understanding of the global macro landscape. This approach focuses on credit-oriented growth measures and policymaker stances on inflation, which are essential factors in determining the performance of various asset classes. By considering these factors, we can better anticipate market trends and make more informed investment decisions. In our framework, we emphasize the importance of credit-oriented growth measures, which are financial system-oriented rather than real economy-oriented. This perspective allows us to better understand the underlying drivers of economic growth and the potential impact on asset prices. Additionally, our approach takes into account the stances of policymakers on inflation, which can significantly influence the direction of monetary policy and, consequently, the performance of various asset classes. By considering these factors, we can better anticipate market trends and make more informed investment decisions. In summary, our orthogonal approach to the traditional All Weather framework offers a more comprehensive understanding of the global macro landscape by focusing on credit-oriented growth measures and policymaker stances on inflation. This perspective allows us to better anticipate market trends and make more informed investment decisions, ultimately leading to improved portfolio performance.

3. Leverage and Cyclical Growth

Leveraging economies has been a key driver of growth in the face of declining demographics and productivity, leading to disinflationary tailwinds.

Topic Summary

In recent years, we have witnessed a significant shift in the global economic landscape, with leverage playing a crucial role in driving growth. This has been particularly evident in the context of declining demographics and productivity, which have posed significant challenges to economic expansion. To counteract these headwinds, we have leveraged up both the public and private sectors aggressively, replacing structural growth with leverage-driven growth. This approach has led to disinflationary tailwinds, as leveraging economies has helped to offset the negative impacts of demographic decline and stagnating productivity. As we continue to navigate the complexities of the global macro landscape, it is essential to recognize the role of leverage in shaping economic outcomes and to consider its implications for future growth and inflation trends.

4. Global Liquidity Index and Equity Market Behavior

The Global Liquidity Index, which tracks the change in G5 bank reserves, serves as a valuable metric for understanding rapid changes in equity market behavior.

Topic Summary

The Global Liquidity Index is a crucial tool for analyzing rapid changes in equity market behavior. This index focuses on the change in G5 bank reserves, which include the United States, Europe, China, the United Kingdom, and Japan. By monitoring these changes, we can gain insights into the financial landscape and predict potential shifts in the equity market. The index is particularly useful for identifying rapid changes in market behavior, as it can help explain stock market returns and provide valuable information for investors. However, it is important to note that the index alone cannot fully explain stock market returns, as a more comprehensive approach is necessary. Nevertheless, the Global Liquidity Index remains a valuable tool in our arsenal for understanding the global macro landscape and making informed investment decisions.

5. Forever Portfolio Allocation

A Forever Portfolio allocation, designed to perform well in all market conditions, can be adjusted using macro analysis to apply tilts based on the current macro cycle, providing a robust investment strategy.

Topic Summary

In the ever-changing global macro landscape, it is crucial for investors to have a robust investment strategy that can adapt to various market conditions. One such approach is the concept of a Forever Portfolio allocation, which is designed to perform well in all market conditions. This allocation serves as a benchmark for investors, allowing them to make informed decisions about their investments based on the current macro cycle. By using macro analysis, investors can apply tilts to their standard allocation, adjusting their portfolio to better suit the current economic environment. For example, if growth is decelerating, investors may want to reduce their allocation to stocks. This approach not only helps protect wealth in challenging market conditions but also allows investors to actively engage with their investments, fine-tuning their strategies based on data-driven insights. By incorporating a Forever Portfolio allocation and applying macro analysis to make informed tilts, investors can create a more resilient and adaptable investment strategy that can weather various market conditions.

6. Demographics and Debt in Economic Growth

Demographics and debt play significant roles in economic growth, with countries leveraging up to maintain living standards and offset declining demographics and productivity.

Topic Summary

Demographics have a substantial impact on economic growth, as a booming labor force can contribute to increased productivity and overall economic expansion. However, in recent years, many countries have experienced declining demographics and productivity growth. To counteract these challenges and maintain living standards, countries have opted to lever up their economies, making it more politically acceptable to achieve nominal GDP growth through leverage rather than organic growth. This approach has led to an increase in debt, which can constrain the private sector’s ability to deliver strong organic growth and foster unproductive business models. As a result, the global economy has become more reliant on debt and leverage, creating a complex and potentially unstable macroeconomic landscape. To navigate this environment, it is crucial for investors and policymakers to consider the interplay between demographics, debt, and economic growth when making decisions and crafting strategies for the future.

7. Labor Market Dynamics

The labor market dynamics reflect a bifurcation, with cyclical industries experiencing strong hiring trends due to the lag in the dispersion of the $5 trillion capital injection into the economy.

Topic Summary

The current state of labor markets has been influenced by the lag in the dispersion of the $5 trillion capital injection into the economy. This has led to a bifurcation in the labor market, with cyclical industries such as manufacturing, construction, trade, and financials experiencing strong hiring trends. These industries have been doing very well, which can be attributed to the delayed impact of the massive capital infusion. As a result, recent non-farm payroll prints have exceeded expectations, reflecting the strength in the service sector and the overall economy. However, it is important to consider the potential long-term effects of this capital injection on productivity growth and the government’s role in the economy.

8. US Fiscal Deficits and Nominal Growth

The potential impact of US fiscal deficits on nominal growth over the next decade is influenced by factors such as demographics, private sector leverage, and productivity growth.

Topic Summary

Over the next decade, the impact of US fiscal deficits on nominal growth is expected to be influenced by several factors, including demographics, private sector leverage, and productivity growth. Demographics play a crucial role in determining the structural growth of an economy. Between the 1940s and 1970s, the working-age population as a percentage of the total population increased, providing a tailwind for structural economic growth and inflationary growth. However, since the late 1980s, this trend has reversed, resulting in a drag on structural growth. To offset this decline, economies have relied on leveraging up their public and private sectors to drive growth.     In the case of the US, the Congressional Budget Office (CBO) projects that fiscal deficits will lead to higher nominal growth if they materialize as expected. The US has a couple of tailwinds that could support this outcome. First, the private sector is not overly leveraged, which means it may not need to deleverage and offset fiscal deficits. Second, US demographics are less of a headwind compared to countries like Japan, which experienced a decline in population growth. However, the productivity of the money transferred through fiscal deficits is another important factor to consider. The impact of fiscal deficits on nominal growth depends on how the private sector utilizes the newly created money. For instance, Japan has been running fiscal deficits for decades without generating significant nominal growth, as the private sector has chosen to deleverage instead of participating in the leverage game. In conclusion, the potential impact of US fiscal deficits on nominal growth over the next decade will be influenced by demographics, private sector leverage, and productivity growth. If the private sector in the US decides not to offset fiscal deficits and demographics continue to provide a tailwind, higher nominal growth could be expected. However, the productivity of the money transferred through fiscal deficits and the potential decline in productivity growth due to increased government intervention should also be considered when evaluating the future trajectory of nominal growth.

Alfonso Peccatiello
Founder & CEO, The Macro Compass

Alfonso Peccatiello is the Founder & CEO of The Macro Compass, a disruptive investment strategy firm whose mission is to democratize professional macro analysis, tools and portfolio strategy.

The Macro Compass leverages Alf’s experience running large pools of institutional money and offers financial education, unique macroeconomic insights, and actionable investment strategy.

Before launching The Macro Compass, Alfonso was the Head of Investments for a $20 billion portfolio for ING Germany.

TRANSCRIPT

[00:00:00]Adam Butler: Welcome to Friday, folks. Macro Friday. We’ve got MacroAlf on with us today. Alf, thanks so much for joining us from sunny Italy.

[00:00:11]Alfonso Peccatiello: Yes, that’s exactly where I’m joining you guys from. Hi, Adam. Mike, Richard. Always a pleasure to be here with you. Let’s have some Friday macro fun.

[00:00:20]Richard Laterman: Where in Italy are you, Alf?

[00:00:22]Alfonso Peccatiello: Okay, I’m going to make you jealous now, I hope. I’m originally from close to the Amalfi Coast, so that’s where I’m right now. It’s very cool. It’s a nice place for holidays. I…

[00:00:32]Mike Philbrick: There’s some good food in that region.

[00:00:34]Alfonso Peccatiello: I can back up that.

[00:00:35]Adam Butler: Can verify that. That’s good.

[00:00:37]Mike Philbrick: I’ve been there a couple times and you had to pry, you had to pry me out of there. You have to leave now. Your visa’s up. You…

[00:00:44]Adam Butler: I can picture Mike clinging to a lamppost or like a tree or something. Lemon tree. Yeah.

[00:00:49]Mike Philbrick: No, it was a lemon tree. Clinging.

[00:00:52]Adam Butler: A truffle pig under your arm. And…

[00:00:54]Mike Philbrick: They, the netting they set up. Yes. You have to see the netting too. The netting into the hills and the lemon trees and the lemons fall, and then they bounce down the netting to the spot where they go collect the lemons. It’s the…

[00:01:07]Alfonso Peccatiello: Home. Home feelings. Home feelings, for me.

[00:01:09]Mike Philbrick: Yes.

[00:01:10]Richard Laterman: Is that where you spend most of your year, Alf?

[00:01:12]Alfonso Peccatiello: Yes. I used to run money for ING, Dutch Bank, a global bank, but it’s based in the Netherlands. So when I did that, I lived most of my time, obviously, in the Netherlands. But now that I don’t work for them anymore and I have my own firm, I can work from wherever I want. And that tends to be very often, the South of Italy.

[00:01:30]Adam Butler: Who can blame you?

[00:01:31]Mike Philbrick: Yeah, it’s a solid spot. It’s a solid spot. I look forward to a shot of a beautiful pizza later today. You’re, you’re dining and hit us up with that. And whilst we’re on that, the topic of me talking, but anyway, just give the disclaimer that yeah. I was going to, I was going to segue it into something, disclaimer about pizza.

You’re not supposed to get either food advice or investment advice from this, these four dudes at lunchtime, or, whatever time it is in Italy. Yeah. Afternoon. That frees us up to have a nice, wide ranging conversation. It’s not investment advice, we’re just throwing around ideas, anyway. What else you working on besides tonight’s dinner, Alf? What else is, what else is cooking?

Backgrounder

[00:02:12]Alfonso Peccatiello: As people might know, I run this company called the Macro Compass, where I provide macro strategy and investment strategy as well, to clients. And these clients range from institutional investors, family offices, hedge funds, but also to retail investors, right? So what I try to do is break down macro in plain English. See where we are in the cycle, see what the funkiest parts of the markets are telling us, break them down all in English and try to make a strategy out of that.

Lately, I have been approached by many clients that have asked me about portfolio construction and what they really want at the end of the day is something that gets them off the big equity beta that is inherently built in most of the portfolios that have been advised to buy. At least that’s been true for the last 34 years, in particular. And that got me thinking, that got me thinking about what is my process of portfolio construction? Whether there is a smart way to go around creating a portfolio that is robust and that is able to extract risk premium from the market without facing the typical big beta related drawdowns that you see in the portfolios we’re all used to watching. So that’s what I’m working on in brief, trying to come up with a version of what you guys and others in the street out there do very well. And there are several angles to approach this and I would love to have a chat.

[00:03:41]Adam Butler: Me too.

Mental Frameworks and Regimes


[00:03:42]Richard Laterman: What’s the current outline that you’re working on? Where has your framework led you currently? Where do you find yourself in that thing?

[00:03:50]Alfonso Peccatiello: So what we are doing right now is first of all, identifying your mental framework to approach this buildup of the portfolio, because to say a portfolio is robust against different events, you first need to identify what are the regimes that your portfolio will have to go through. This is a very interesting exercise because for the last 20 years it has been one big underlying regime, which has been global disinflation. And then there have been a couple of events around those, I would say, right? So you had the 2000 tech bubble and then the tech burst, and you had a labor market driven recession in 2001. Then you had periods of extremely low vol between 2002 and 2007. One can say were actually, you had emerging markets doing well.

It was a non-US exceptionalism kind of period, which was also interesting to a certain extent. Then you had the real estate bubble bursting in the US. You had taper tantrum, QE, QT, You had a bunch of monetary policy experiments. You had the European debt crisis. I mean there have been quite a lot of events happening over the last 20 years, but there has really been one main, two main forces I would say, that have been underlying most of the risk/return distribution. Global disinflation and volatility compression.

Those have been really the two main regimes we have lived in, has obviously led the 60/40 portfolio to deliver excellent returns because in a global disinflationary environment, market cap weighted indices that tend to, of course, reward in our case. Tech stocks, a lot have performed very well, backed by the same global disinflation trend and the low volatility trend.

Bonds have served as a good hedge because of global disinflation, which obviously meant that central banks could ease financial conditions. They could intervene if they wanted to. They weren’t constrained by inflation and anything else that instead had delivered quite some positive added value in terms of diversification and shallowing your drawdowns in the previous 20 years, or 30 years, from the seventies to 2000.

It was completely forgotten. I think maybe between 2000 and 2010, there were rumors about, ah, okay guys, but we need to look at buying some, buying a, rolling some out of the money puts, just to have some tail protection in our books. We should look at that. Over the last 10 years, I don’t think that’s been a narrative going around there because you have consistently bled carry and premium by doing that, getting almost nothing in return. Even in 2022, with the stock market drawing down that much, buying puts hasn’t delivered anything of that protection you were looking for.

But at least, and that’s what’s getting interesting now, in 2022, you have lived again through that period where all of a sudden bonds and stocks go down together. And then many people have realized, oh, I don’t have a diversified portfolio. I have a levered beta to global disinflation. That’s what I’m running basically.

And that has worked gradually well for the last 20 years. But all of a sudden in 2022, people recognized they need an exposure to commodities, for instance, or to inflation driven returns. So I think, look, the next 10, 15 years are going to be very interesting from a global macro perspective and all these forces driving returns.

So that’s where I am right now. Sorry for the long answer, but it’s a very interesting topic.

Times They Are A-changin’


[00:07:25]Mike Philbrick: No I love it. And it’s such a hard question because diversity, risk management over the last 10, 20 years in particular, since 2009, if you look at here’s a diversified, whether it’s risk parity or some other macro regime aware approach, where you have assets that will thrive in these different environments, has looked like chronic and persistent underperformance of a broadly accepted, de-facto 60/40 portfolio. And so if you have been in that and you have taken advantage of that, it is a wonderful time to start to think and consider how you’re going to add to that portfolio, reduce portions of that.

But I don’t, I think those types of investors who are, and allocators who are thinking that way are largely quite unique and are still going to face some short- term challenges. The present moment included where you’re starting to question those diversifiers, they worked great in, as you say, 2022.

And the AUM in those diversifiers was quite low. It expanded dramatically, and now it’s shrinking again pretty dramatically, as people are running back to what has treated them so well for so long. And diversity and risk management has appeared to be just this persistent and pervasive drag on performance for the last 10 years. So it is an incredibly nuanced and rich tapestry.

[00:08:53]Adam Butler: It does seem to be that we’re in, we’re, we’ve moved into a cycle where, there is a time for global cap weighted, or US cap weighted. Keep in mind, if you weren’t in US cap weighted from 1995 to 2000, then, and you’re an advisor, you lost all your clients in that five years, right?

If you were not in global, in US cap weighted equities from 2014 to 2021, right? If you were underweight, you’re bleeding clients out right now. What is often missed is that from March of 2000 until late 2011 cap-weighted US equities had zero returns, nominal and negative 25% returns, net of inflation, right, total return net of inflation between 2000, 2011. So that’s almost 12 years. And that has been completely forgotten, right? It’s just everyone sees what is directly in the rear view mirror without having any sort of context for history. And so I think people are still in that mindset that, we’re just going to go right back to the disinflationary, vol compression, muddle along growth environment that we experienced during the times, like the 2010s.

And in some ways we’re seeing that validated, right? We’re right back to where we were in the late 2010s, with seven mega cap tech stocks holding up the entire global cap weighted equity index. And it’s really hard. Its, diversification looks ridiculous much of the time, but it has looked particularly stupid from 2010 to 2020.

Any effort to try and admit humility, to try and say, I actually don’t know. The future has looked outrageously stupid from 2010 till 2020. And anyone who’s tried to take that position and create portfolios accordingly has looked commensurately, with egg on their face.

Extracting Risk Premium, and Drawdowns

[00:11:05]Alfonso Peccatiello: The problem has really been the length of apparent under performance by having a more nuanced view. By, for instance saying, I’m not sure what the future is gonna hold and therefore I’m gonna hold a bunch of risk weighted assets out there, the periods of what I call apparent on the performance. Because look, at the end of the day, what long-term investment portfolios should be doing is extracting risk premium from the markets at acceptable levels of drawdowns, so that you don’t do stupid things when those drawdowns happen.

This should be, in my opinion, the aim of most investment portfolios out there. The other important aim that many people actually forget is that they inherently, on their balance sheet, run the very same beta to the S&P 500 that they tend to run as well in their investment portfolio. How well most of their income is related to jobs.

And the correlation between the S&P 500 and the job market is obviously there because earnings also drive the S&P 500. So the stronger the labor market is, generally the stronger the S&P 500 might be over time. So you are inherently exposing your life in your cash flows to a good outcome for the S&P 500 that you are then building, as well in your portfolio.

Not to talk about real estate and the beta it has to risk assets. Most of people’s wealth and liabilities as well are linked to the real estate market. People have businesses as well. That is linked to the cycle. So you are basically piling up on your already existing labor driven cash flows, companies driven cash flows, real estate, you’re piling up the same equity beta in your portfolio.

And I don’t think that should be the aim of a portfolio. The aim of a portfolio should be to extract long-term risk premium from markets, avoiding 15/20% plus drawdowns, so that you don’t freak out when they happen and you don’t take out exposure from market. I run an analysis on the 60/40 portfolio and that was quite telling.

Let me see if I can show my screen here to you. Probably have done this plenty of times and people are aware of that, but I want to take…

[00:13:23]Adam Butler: Yeah, people…

[00:13:24]Alfonso Peccatiello: … past…

[00:13:24]Mike Philbrick: They’re never aware enough. Alf, they’re never aware enough. And I would, while you’re pulling that out, Alf, I would also encourage everyone as they’re thinking through this problem, to go and go to ReSolve Asset Management Portfolio Optimization, a General Framework for Portfolio Choice.

I highly recommend folks take a look at that piece that we wrote a number of years ago, because it delves into some of the things that you’re talking about, of the choices that you have to make. And those choices should be based on somewhat on some of your beliefs as an investor. What do you believe to be true?

An initial one is active versus passive. Do you believe that you could actually extract some sort of alpha from markets and that’s going to, that’s going to inform how you might build a portfolio?

[00:14:07]Adam Butler: Yeah, man. Let’s see it.

[00:14:08]Mike Philbrick: it. But anyway onto the 60/40….

[00:14:10]Alfonso Peccatiello: If you guys can see the screen here, and for people who can’t and are only listening, I’m gonna walk you guys…

[00:14:15]Adam Butler: Alf, someone is not sharing, because we can’t see it. There it is. It’s coming up. Here we go.

Decades of Negative Returns

[00:14:21]Alfonso Peccatiello: …share it from my, there it is. It’s now on the screen. Great. So this is an analysis of 60/40 portfolios returns, adjusted for inflation in each decade, going all the way back to the 1880s. So that’s a lot of decades. Okay. Just to really widen our perspective here, and something that Adam was saying before, between 2000 and 2009, the 60/40 portfolio returned negative 3.5%, adjusted for inflation.

Those periods of negative or very low positive real returns have actually been much more frequent than people are aware of. So between the 1880s and 2020, there have been 1, 2, 3, 4, 5, at least five periods of either negative real returns or mildly positive. And I’m talking about decade long periods, right?

So, of course, you would expect a portfolio of stocks and bonds to return positive real returns in an average decade. But there have been periods in which this allocation hasn’t really been enough for you to deliver positive real returns or to extract risk premium in a smart way from the market. So this has been one of the first considerations. Like, it’s okay what attackers and what defenders do. I need in a portfolio to be equipped against regimes that are not the regime of 2010, 2019, where the 60/40 has delivered a whopping 12% real return for an average vol that was, top of my head, of low, low double digits.

So you were looking at Sharpe ratios that were incredible drawdowns that were pretty much limited. And the other thing to consider is that the 60/40 portfolio, if you look at drawdowns in the past, because we’re talking now about returns adjusted for inflation, but those are the drawdowns of a 60/40 portfolio, has gone down 50%, 70% from the top. At some point in the thirties and even more recently, it has drawn down over 30%. Now 30% is a drawdown that wipes away a third of your wealth basically. And a lot of people can’t take that. They will make decisions which are detrimental to their ability to generate long-term returns. All of that to say the 60/40 portfolio worked great. It doesn’t mean it’s going to work amazingly well over the next decade. So you should…

[00:16:43]Adam Butler: Are these nominal drawdowns, Alf, or are they real?

[00:16:45]Alfonso Peccatiello: And…

[00:16:46]Adam Butler: Yeah, nominal. Yeah.

[00:16:47]Mike Philbrick: Yeah these are…

[00:16:48]Alfonso Peccatiello: …are nominal

[00:16:49]Adam Butler: A lot.

[00:16:49]Mike Philbrick: Interesting, when you make them real, it actually, the seventies, the seventies are actually almost as bad as the thirties because you have deflation in the thirties and whereas you have inflation in the seventies, so they’re almost equivalent. That seventies drawdown, in real terms, is almost equivalent to what happened…

[00:17:07]Adam Butler: Thirties looks a little better because you actually had deflation. But the seventies looks a…

[00:17:11]Mike Philbrick: Yeah.

[00:17:12]Alfonso Peccatiello: Yeah. Deflation. Yeah. Yeah.

Leverage and Cyclical Growth

[00:17:14]Richard Laterman: Alf, to what extent, sorry to interrupt, but I just wanted to get a sense. To what extent do you consider, or do you look at the changes that we’ve had since, particularly the 1970s and perhaps later on, particularly in the seventies, the change the end of the Bretton Woods era and lack of gold backed currencies. And then the globalization trends and the entry of China into the world Trade Organization and the deflationary…

[00:17:44]Adam Butler: …to skip ahead, Richard. No, skipping ahead man.

[00:17:46]Richard Laterman: …received. Now, I’m just wondering if that is part of the of the analysis, to what extent demographics, I think also play an important role in some of these inflationary events.

[00:17:56]Alfonso Peccatiello: Yeah, look, you could draw a chart of which unfortunately I don’t think I have readily available, but I can walk people mentally through it. If you look at working age population as a percentage of total population, so you’re basically measuring how many people actively contribute to economic growth in an economy. And you draw this chart between the forties and the seventies for every country you want, US, Europe, Japan, it looks all the way up, and that’s a tailwind for structural economic growth. That’s a tailwind for nominal growth. For inflationary growth as well.

Why? Because, how do you generate growth from an economy? It’s either more people or more productivity, or a combination of both. The periods between the forties and the seventies were excellent for both. It’s  post Second World War period. So demographics was booming. The labor force was expanding. You had this nominal growth impulse. If you then look from the eighties onwards, late eighties onwards, you can plot the same chart for demographics and it’ll look exactly the opposite.

So deducted as a drag on structural growth, which was then offset by leverage. We basically levered up either our public sector or our private sector pretty aggressively to offset this drop in structural growth and try to replace it with leverage driven growth. And that’s what we did. Everybody did the same.

And if you tell me no, dude, what you’re talking about, Australian debt to GDP is very low. Overlay the private sector and let me know how that looks. Canadian debt to GDP is very low. Overlay. The private sector. Let me know how that looks. If you plot a chart of total debt to GDP, and I challenge you to do all the economies you want. In developed markets, you’ll see the same thing, why everybody had to do the same, lever up.

[00:19:44]Adam Butler: They chose to lever.

[00:19:45]Alfonso Peccatiello: What that does…

[00:19:46]Adam Butler: …the same standard of living, rather than deal with the fact that we weren’t investing, and therefore we weren’t getting any material. In fact, we had a major downshift in productivity growth, right, in the eighties, and it’s never really come back.

[00:19:58]Alfonso Peccatiello: That is correct. So you had two drags, you had demographics acting as a drag and productivity growth as acting as a drag. Something that people don’t appreciate too much is that we still became more productive year after year, but the marginal increase in productivity had already done its best impact through the economy in the nineties, and it kept declining after that.

Then we chose, as Adam says, to lever up economies because it’s more politically acceptable to achieve a nominal GDP growth of 3%, even if you do that through leverage, than to achieve one of 0%, Japan-like without leverage. And so that’s what we chose to do. And obviously that is inherently disinflationary because you have structural nominal growth moving to the downside, and then you add often very unproductive leverage exercises to try and produce some sort of cyclical growth.

But you also add a large amount of debt, which constrains the ability of the private sector to deliver strong organic growth. Everybody’s levered to their nose and they don’t make productive choices. We rather foster the bunch of zombie companies that were very happy in Europe.

You could borrow as a sub investment grade corporate between 2014 and 2021, you could borrow for five to seven years paying 2% interest rate. I want to repeat this. As a zombie below investment grade corporate, you could borrow at 2% for five to seven years. Many business models work. They work when borrowing is basically negative in real terms.

Everything works when credit is so cheap. But you also become much more unproductive as an economy and that obviously exacerbated this inflationary tailwinds, I would say, Richard, and that’s where we are today. Today though, a lot of things are changing in the global macro landscape, starting from labor and starting from the fight between labor and capital.

So you have the offshoring/onshoring discussion, something we didn’t have basically over the last decade, where globalization was a one-way street. Can you now say it’s a one-way street? It’s obviously still the prevalent outcome out there, but there have been quite some hiccups on the global supply chain.

So are we sure that some of the CEOs are not going to even try to onshore or to change at least the supply chains away from China to someplace else? So do you own these countries in your portfolios when capital is flowing there? Do you own Indonesia in your portfolio? Do you own a place that has basically said, look, all the commodities have been exporting out there without getting any CapEx back in Indonesia.

You can still take my commodities. That’s fine. I understand. That’s the thing I have to sell. But now you got to build plants in Indonesia. Otherwise you can’t export things or any other commodity they have. Do you own part, at least some exposure to these teams in your portfolio so that if it’s not a one-way street of this inflation over the next 10 to 20 years, you do have some exposure in your portfolios? That’s one of the questions people should ask themselves.

[00:23:03]Richard Laterman: So you’re making the case for…

Building Blocks and Forever Portfolios

[00:23:05]Mike Philbrick: Alf, what are the big, the bigger building blocks here then? It’s one of what I, if growth continues or we have growth shocks or robust growth, something in your portfolio for, that there’s inflationary drivers. They come from sub drivers within the inflation complex. Then there’s probably a liquidity function that you have to think through. And how are you in a, what else am I missing in the framework that you’re constructing as you go through this process of the kind of Forever Portfolio, if you will?

[00:23:36]Alfonso Peccatiello: Let’s get into the practical discussion because so far it’s been very nice talking about why the 60/40 is not great for the next decade, but more practically, how do you approach this? The basic starting point of my macro modeling is a very simple quadrant model that has on one axis, nominal growth impulse, and on the other axis, it has the monetary policy … and an appreciation for global liquidity drivers. So it is basically financial money, the financial side of things, the monetary side of things against the real economy side of things. And you basically plot those two onto axes and you get a quadrant.

[00:24:18]Richard Laterman: And inflation expectations are built into the vertical axis I guess, the liquidity, the monetary policy stance axis, I think is, yeah.

[00:24:27]Alfonso Peccatiello: They’re mostly built on the Y axis because central banks will basically maneuver around monetary policy. Also, looking at inflation expectations. And therefore the right side of the quadrant also keeps track of real yields, and real yields against equilibrium interest rates, and rapid changes in real yields and the monetary policy stands.

And an index I’ve built on the …, tracks global changes in bank reserves. So not only bank reserves, or so-called liquidity in the US, but also global changes of bank reserves. So that axis, basically it’s a blend of several monetary policy stands indicators across the world. And the other axis tries to track where are we going in terms of growth impulse.

So it statistically ranks for statistical significance, leading indicators of growth across jurisdictions. One of my preferred ones is credit. So the amount of credit creation. The more credit we pump towards the private sector, generally the more spending you can expect later on. And we have seen that happening in 2021, 2020.

We inundated economies with fiscal stimulus, which is one form of giving resources to the private sector. You cut their taxes, you send checks at home, you basically make them have more spendable money. And yeah, of course wait six to nine months, people are likely to increase their nominal spending. And then you have earnings going up and then you have a positive growth impulse.

You do the opposite, which is a bit what we are doing today, you tighten credit conditions, you make credit more difficult to access, you tighten a bit your fiscal stance as well. And on a rate of change basis, the credit impulse will look more negative. And also growth will decelerate. It doesn’t mean it throws you in a recession straight away, but it’ll decelerate at least.

So that’s how you move on that other quadrant. Now, there are also markets considerations into that, but we’ll get to that a bit later. You identify four quadrants out of this very simple model. Okay. There is the top left quadrant that has been the prevalent one for the last five to six years, at least when global growth is decelerating. So it’s basically growing, but a bit below trend. And that’s where we have maneuvered around for most of the time over the last six or seven years, with some periods of acceleration. So, 2017 was a period where global growth was accelerating. Late 2018 in the US as well, but in most cases global growth has been relatively poor over the last seven years, before the pandemic, that is. So you are in the top left part or during the left part of the macro compass. But also, you had monetary policy authorities that were trying to stimulate economies that were trying to get back inflation to 2%. They were trying to lower real yields to have an a commodity monetary policy stance. They were expanding their balance sheets, so global bank reserves were often increasing.

That put you on the north part of the quadrant, so that meant you were in the top left, which is what I define as quadrant one. In quadrant one, what works the best is what people love to have. So that’s bonds, mega cap tech stocks. So that’s like growth stocks that benefit from low interest rates, and they benefit from an economy that grows, but it doesn’t roar.

And they are the, yeah, the place to be. Basically the blue chip names, let’s say. What also works is carry trades, in that environment. That’s because volatility is very low. One of the ways to make money when nothing happens is to sell insurance premiums back to markets. So any derivative of that trade tends to work pretty well, and those can be corporate bonds.

So not only the duration part, but also the credit part, because you don’t have many defaults and you know you can pocket in the Carry, and there are many other expressions of that. And you sell volatility, it works well. What doesn’t work well, generally speaking here is sectors that are driven by real economic growth.

So let’s say industrial commodities, small cap stocks, some of the emerging markets don’t work very well. If you move around this quadrant, we have been recently, for instance, in quadrant four, that’s the bottom left. That’s the worst of them. That’s where we have been in 2022. A situation where growth was decelerating, but central banks couldn’t ease at all because inflation was a problem.

So you had real yields in the US going up, up and up, way above equilibrium. Europe was also joining the party in tightening monetary policy. Growth was decelerating, and in that environment there is not much in traditional portfolios that work. Bonds can’t work because central banks are raising real interest rates.

Equities don’t work because we are decelerating in growth and monetary policies, not a commodity at the same time. But what works in that case is, for instance, the dollar, something that could act as a defender in some situations in a diversified portfolio. What also worked well, could work well in that environment could be commodities.

If it’s particularly inflationary, it could be volatility. Instead, market reaction is a jump risk rather than an inflation driven drawdown like we had in 2022. So the reason I’m presenting these potential scenarios is in each of the quadrants, you’ll have certain asset classes that will perform better or worse. But if you look at this macro compass model, you don’t only find bonds and stocks in there, you find volatility. Emerging markets, Carry trades, gold, high beta stocks, industrial commodities so on and so forth. So you need a lot of derivatives, a lot of different orthogonal expression of beta in different regimes to make sure that your portfolio is really equipped for each of these environments.

Orthogonal to the Traditional

[00:30:20]Adam Butler: I like this framework. It’s actually, in many ways, almost orthogonal to the traditional All Weather kind of framework that’s driven by growth and inflation, right? Your growth measures tend to be credit oriented. In other words, sort of financial system oriented rather than real economy oriented.

And your inflation dimension tends to be less about the inflation, more about the policymaker’s stance, either against or tolerating that inflation, or stimulating, right? So it’s a really interesting, I do think that it does get complicated. So for example, in 2022, we had what many would think would be net tightening. But we had high inflation.

[00:31:12]Alfonso Peccatiello: Yes.

[00:31:13]Adam Butler: Commodities worked as you mentioned, commodities worked very well in the first half of 2022, even though the Fed was still quite accommodative in terms of having still very negative, real rates. Took it, took them very, quite a long time to catch up, and we still have substantially negative real rates.

I guess there’s some ambiguity now about whether or not we’re pivoting from a net tightening stance to a net neutral stance, which sort of the market perceives as de-facto easing. But the interplay between inflation and monetary policy here, I feel is a dimension that is, you could almost use a Z dimension, which is inflation because you might have a situation where the Feds are allowing inflation to run hot because, for example, they want to deflate away the value of the debt, or they can allow, they want to be fighting inflation. They want to have quite positive real rates.

So there’s this sort of interplay that I think is difficult to capture exclusively with this framework, but it does capture, I think, extremely important dimensions that are not captured well in the more traditional All Weather framework. I think the two are highly complimentary.

[00:32:31]Alfonso Peccatiello: So the way you need to think about inflationary, the way I think it in this model is basically a diagonal dimension that goes through all four quadrants because it hits on the growth side. That is real growth, but also nominal growth as a dimension in all of this. And it also influences, on the right hand side, the monetary policy decisions. So it, you need to think it through as a, basically as a diagonal overlaying dimension that you always need to bear in mind.

[00:32:59]Richard Laterman: A third…

[00:32:59]Alfonso Peccatiello: …other thing about this…

The Third Dimension

[00:33:00]Richard Laterman: I think, which is also something that we’ve discussed a few times on air, off air, the fact that the traditional framework that we espouse, and that has what Adam was describing in the Y axis, you have inflation on the excesses. You have growth. We’ve of often joked that you need that third dimension, right?

You need three dimensions in order to accommodate liquidity, which is what you have in your vertical. But I’m wondering if the example that we’re using for 2022, the fact that it was, to a meaningful extent, largely a supply driven shock because of the war, and because of the initial thrust of lack of supply from Russia, and the scare of not having enough grains and the concern with energy. To what extent do, can we use 2022 as an example for contending with this framework?

[00:33:51]Alfonso Peccatiello: Yeah, so the way I think about this framework is when people look at it, they’re like, oh, okay. So if you say that we are in quadrant one, then I’m gonna load up on mega cap tech stocks and I’m gonna sell down all the vol. No, those are the tilts that you need to apply to an All Weather portfolio, to a Forever portfolio, given what macro cycle we might be in.

Those are the tilts. Those are not the only allocations you need. So all the assets that you see on the quadrant, they all belong to a certain proportion in a Forever portfolio. The macroeconomic analysis based on where we are in the macro cycle, where we are in inflation. This third basically overlaying dynamic we discussed where are we in the monetary policy reaction.

All these considerations serve as a potential tilt to the standard allocation that is able to perform relatively well in all of the four quadrants. So in 2022, for instance, you walk into 2022 with a standard Forever portfolio allocation, which we might discuss how that looks like in my framework and the framework I’m working on.

So you walk in with a Forever portfolio allocation. You look at the cycle, you look at this model and it says, Alf, growth is decelerating. Or that’s what your overlooking indicators are saying. Inflation is actually picking up. So watch out the third dimension, and that influences, by the way, both the assets you want to buy in an inflationary environment, but also the reaction function of the central bank.

So the other axis of your quadrant. So with all that in mind, you basically land as your standard definition, in quadrant four. You want to reduce your allocation to stocks. You want to reduce your beta to stocks and bonds. Basically, in that environment, you want to increase your allocation to the dollar.

That’s what the model is saying. And because of this third dimension, the inflationary part, you want something that does well when inflation becomes the driving force. That’s what you want. So in that environment, it would’ve suggested your standard allocation to industrial commodities should have been increased a bit, that your beta to equity and bonds should have been decreased.

Given the circumstances that you should have had some optionality to dollar appreciating because of the reaction function of the Federal Reserve, and then you would’ve perhaps been able to adjust the portfolio so that you’re still able to survive what has been a pretty bad year for most of the 60/40 portfolios.

That’s what happened, at least to me last year. I wasn’t able to generate heart shuddering returns or risk adjusted returns, but having a robust portfolio to start with, that’s the Forever portfolio. And then being able to apply the tilts, which sometimes might be able to add additional risk adjusted returns to your choices, was a way to protect wealth basically in that environment. So that’s it. It’s not like a bible. It’s a way to approach things.

The All Terrain Portfolio

[00:36:54]Mike Philbrick: There’s another s ancillary effect that comes from thinking through the problem like this. And I think, we’ve termed this the All Terrain portfolio. So you’ve got All Weather, but if you think about the layers on top of this and tilting, you get to maybe a more All Terrain portfolio, where it doesn’t matter what the weather is, you’re gonna get to work in your four wheel drive car.

And if it’s July and it’s sunny and the roads are cleared, you know you’ll get there. But if it’s in a middle of winter, you’ll still get there. But the other thing that this framework allows you to do is measure or be aware of the tilts and their value add or their negative value add, because you’ve got a framework where you say this is the Forever type core portfolio.

This is the thing where I’m gonna wrap my arms around the world. The neutral. Yeah. This is the Do No Harm in neutral. And I wrap my hand around, arms around all the world. And every day people are fighting and they’re selling gold and buying dollars and doing all these things. And you’re just capturing the risk premium across all of these various dynamics of the market, trying to get these little edges in the portfolio.

You wrap your arms around, they’ll let everybody fight it out. And then on top of that, you’re overlaying some thoughtful addition of what we perceive as alpha, but you can now measure that against something.

[00:38:11]Alfonso Peccatiello: That is…

[00:38:12]Mike Philbrick: And this is a huge, I think, benefit in thinking through the problem like this. You have, this neutral portfolio that you can measure your sort of, tilts against.

[00:38:21]Alfonso Peccatiello: Yes, that is exactly what I’m doing. Mike. I couldn’t explain it better than you did. So maybe when I pitch it to investors like I’m doing, I should hire you to pitch.

The Neutral Portfolio

[00:38:30]Adam Butler: Can we see it? Can I’d love to see what the Neutral portfolio looks like, that emerges from this framework, and compare/contrast with the more traditional framework. I actually really like this framework by the way. I think it’s, and I think what it does is…

[00:38:43]Alfonso Peccatiello: Thank you Adam. I…

[00:38:44]Adam Butler: …acknowledges, I think that this sort of Dalio inflation growth framework, makes tremendous sense in a global economy that is dominated by real effects, right?

By real economic growth and by real inflation, like goods and services inflation, right? What this brings is a dimension that acknowledges that we’re not really, it’s certainly not exclusively in that kind of economy anymore, right? While those things that happen on the ground, the things that are real, matter, to some extent, what matters, perhaps even to a greater extent now, is what happens in the financial economy, at least from the perspective of financial assets.

Financial assets are responding perhaps less to what’s real on the ground in terms of inflation and growth, and more to what is happening in the cloud of financial assets, in the creation or destruction of credit. And the fiscal response and the monetary response from governments.

[00:39:47]Richard Laterman: Central banks. Yeah. The influence of central banks I think is something that the original All Weather framework doesn’t really contend with. And we clearly live in a world now where central banks are dominant. They are the largest gravitational pull and now we see fiscal policies coming into the floor. But since 09, central banks have definitely been leading the charge and causing much of the dislocation across asset classes.

[00:40:12]Mike Philbrick: And at the same time, as Adam says, the financialization of the…

[00:40:15]Richard Laterman: More and more.

[00:40:16]Mike Philbrick: Just that, that is going to have an impact in that. Now the tail wags the dog to some degree.

[00:40:21]Alfonso Peccatiello: Yes. So look, the framework takes into account, it’s basically three drivers. Its real growth is this inflation overlay to the framework and its monetary policy. So that is, the pace of global liquidity, the rate of change of global reserves, real yields against equilibrium. All these dynamics that you need to take into account in an overleveraged, hyper financialized economy, you must have that in your framework.

So for instance, the other thing is that those dynamics not always can explain what’s gonna happen if they can by themselves, but they can be useful in a framework which goes with inflation and with real growth. So this chart that I put up here is what I call my Global Liquidity Index, which is the blue line, and it’s nothing else than the change in G5 bank reserves.

So those are GDP weighted bank reserves in China, in the US, in Europe, in the UK, and in Japan, all blended into an index. We are basically…

[00:41:24]Adam Butler: Is that both private and central banks?

[00:41:26]Alfonso Peccatiello: …weighted fashion. No, this is only financial money. So, we are looking at bank reserves. We’re looking at the money for banks. So this is truly financial money that we are looking at, but we’re looking at not only the US, it’s Europe, China, UK, and Japan, all blended into one index. Now what this does relatively well, is help you explain rapid changes in equity market behavior.

So the orange line is the S&P 500 returns lagged by six months. So I’m trying to see if there is any predictive ability by this variable. If you run a regression, you’ll see that the R square is terrible. It’s very low. Why? Of course, you can’t explain stock market returns with one explanatory variable that doesn’t work. You need a much more complicated approach to that.

But if you’re looking for rapid changes in equity market behavior, having this metric in your arsenal helps. For instance, you could have, in 2020, 2021, you had a constellation where global bank reserves were increasing very rapidly and at the same time, Adam, the other metric you’re talking about, credit was expanding very rapidly to fiscal transfers, to bank lending, to very low interest rates.

It was happening at the same time. So having both of these metrics into your arsenal would’ve helped you, let’s say, apply these tilts that you can measure as well exposed, whether they really add risk adjusted returns or not, and you can be honest to your macro framework and refresh it and make sure that you always fine tune it.

Private Credit and Stock Buybacks

[00:42:57]Adam Butler: So I think again…

[00:42:59]Alfonso Peccatiello: ,,,measure that against.

[00:43:00]Adam Butler: …what’s slightly different about this way of viewing, the world is that, growth in private credit used to be important because it signaled that businesses were borrowing to build things. They’re borrowing to invest in new products, in new factories, et cetera.

But in the last decade or so, increasingly, businesses have been borrowing for capital structure engineering, right? It’s not, they’re not borrowing to invest, they’re borrowing largely for kind of stock buybacks, right? And so it’s not really economic growth. We’re not that the private sector, S&P is not going up so much because the companies are borrowing and investing and those investments are paying off. Those investments are showing up in the real economy in terms of GDP growth. But rather the S&P is going up because they’re borrowing because there’s easy access to credit at very low rates. And they’re using it to re-gen their capital structure by just increasing leverage and using that extra debt to buy back shares.

And that’s pushing. So the equity prices are going up, but it’s because companies are buying back shares, not because earnings are going up at an outsized rate. Right?

[00:44:20]Alfonso Peccatiello: That’s very right. And that’s also the reason why I discern between financial money creation and real economy money creation. So that’s credit for which I have another metric. It’s my Credit Impulse, global credit, impulse metrics. Again, five largest economies. We are trying here to measure instead of the rate of change of bank reserves, so money for banks here, we’re measuring the rate of change of money for US, the private sector, and that’s what the Credit Impulse does.

The Credit Impulse doesn’t track super well. What equity markets are going to be doing, but that tracks really well, what earnings are gonna be doing, right? It tracks the real economy on the ground, which is one of the items that you need in your roster allocation model. You need a growth framework, you need an inflation framework, you need a central bank framework, and I think you guys have led the charge on adding this central bank access to many models that only look at growth and inflation.

And that’s as well the angle I’m trying to face here. Looking at growth inflation and central bank monetary policy and applying tilts that are based on what the model says, on a Forever portfolio that acts as a, let’s say standard allocation you want to have in principle, because of your market beliefs, because of trying to extract risk premium without facing drawdowns.

And then on top of it, you apply these tilts. When it comes to the Forever portfolio itself, of considerations on how I think about building that. So the first thing is you need attackers and defenders for all the possible quadrants. So the attackers are, generally speaking, two. One would be equity market risk, premium equity market beta, and the other will be expressions of carry beta.

So that can be credit spreads, FX carry, emerging market debt, carry, something that is extremely underground. I think in global portfolios, those are the two, let’s say, attackers that tend to do well when the world is doing okay, be it the US, be it emerging markets, be it an industrial driven growth, be it tech driven growth.

If you have equity beta and you have Carry beta, so that can be emerging market debt, credit spreads, corporate bonds, any of that beta, you will extract risk premium from these two factors. Generally speaking, when I talk about equity beta, you need to discuss a lot about what that is because people are accustomed to buying the S&P 500 bond, right?

Then that today is a big expression of tech. It’s basically, you’re buying a lot of mega cap tech in there, and I think if you want to be agnostic about where that equity risk premium is gonna come from, where that equity better return is gonna come from, you can’t only do that. You need much, rather, an equal weight expression of several jurisdictions. Stock markets. So the US isn’t enough just because the US outperformed anything else over the last 10 years. So from market cap US focused equity portfolios to rather equal weight US, ex-, sorry, developed market ex-US equity and emerging market equities. And when I talk about emerging market equities, I don’t mean the ETFs that you can buy out there that are mostly China, but I’m talking about going into each of the large countries in the emerging market space where you can try and allocate. A small portion Eastern Europe, Indonesia, Latin America, all these emerging markets are highly represented in most of the indices out there.

So it’s rather really a very holistic approach to where equity beta returns might come from over the last 10 years. Same goes for the Carry component. So there, it needs to be corporates and hybrids. But then it also needs to be emerging market debt, which gives you an exposure to inherently emerging market effects, being basically investing in local currency, bonds and to the emerging market bond perspective over there.

And also that needs to be done holistically. Looking at different expressions of the same theme. That’s the first approach. Then obviously you’ll need bonds in your portfolio because for these inflationary environments, bonds will help you both delivery returns and protect drawdowns. And that is really in my framework and expression of US duration and European duration mostly.

Then once you have those two building blocks, you need to work around what are the defenders, really. Bonds are obviously defenders, but you need defenders that help you deliver risk adjusted returns when inflation is a problem. So you need industrial commodities. Often you need to lever up these exposures because they can only account for as much in terms of notional exposure to your portfolio, but their returns won’t be able to offset all the remaining part of your portfolio, negative drawdowns like in 2022. So you need to think about how you basically apply a risk parity framework to make sure that these returns from this, very underground.

Asset classes like industrial commodities can protect you, large enough during periods of drawdowns. For equity of … beta portfolio, you obviously need some gold, which is an hedge against something else. It’s a hedge against a rethinking of our monetary system. It’s a hedge against very depressed real interest rates. You also will need some volatility in your portfolio because there are periods where the dollar and volatility are the only thing that will work. Think about Covid for those two months. Effectively, having exposure to tail risk in your portfolio was one of the few things that really worked. There again, you need to think about how do you invest in, how do you roll, for instance, out of the money puts.

How do you do it in the best, most optimal scenario? If those puts work, it’s because everything else is actually drawing down. So what is your strategy to monetize these puts? These puts will be able to inject cash in your portfolio. The moment where most likely risk premier, super wide, those are investing opportunities for long-term investors.

So do you have a strategy to monetize these? Puts, the dollar. Same story. Do you have optionality against large swings up in the dollar? Because the dollar itself can return 10% in a year. That won’t be enough on a small notional exposure. You need leverage to these defenders. So you need defenders, you need to boost them up with some well thought leverage and some heuristics around how do you monetize basically, once they work.

And together with commodity, industrial commodities, emerging market exposure and a holistic approach to equity and bond market exposure, I think that is how you are much better positioned to all quadrants than just owning a…

Diversification, Balance and Active Beta

[00:51:03]Adam Butler: That diversification is two things. The first one is diversity. So you’ve got to have all of the things that you just described in the portfolio, right? Domestic, foreign, emerging stocks, represented geographically and in terms of economic diversity, credit, rates, commodities, et cetera.

You’ve got to own all of these things. That’s the diversity piece. But a lot of people have diversity, some form of diversity, but what they don’t have is balance, where you’ve got, yeah, you’ve got equities and commodities and gold and bonds in your portfolio. Maybe you even have them in equal weight.

But what you don’t realize is that, for example, the bonds, the volatility of the bonds is a quarter to a fifth of the volatility of the equities. So in fact, you’re not diversified because even though you’ve got diversity, your exposures are not well balanced, so all of the different components of the portfolio are unable to express their unique personalities when the time comes.

[00:52:08]Alfonso Peccatiello: That’s true. That is so…

[00:52:10]Mike Philbrick: Yeah, the maniacs run the asylum at times.

[00:52:12]Alfonso Peccatiello: Yes, that is exactly true. And I think most of the mistake that people do is that they have some of the defenders in the portfolio. I don’t think many have a geographical, large enough diversification because it’s been all about the US over the last 10 years and it’s very hard to go around and say, do you own Japanese equities? People will be like, what? Why would I do that? They’ve been growing at 0% and it doesn’t work. Yeah, it doesn’t work so far, but what if it works over the last, over the next 10 years? So that’s already a difficult enough message to sell. The more difficult one is to say do you have some vol exposure?

They’re like no. I don’t have that. Okay. What if you would add some? I don’t know where to start, which is a very good remark I have to say. What about levering up your defenders to make sure that they perform large enough to offset big drawdowns everywhere else? I don’t think many people are even asking themselves this question.

They’re just basically accepting large drawdowns, because that’s how it is. And from time to time, you’re gonna lose 30%. When it happens, I don’t think that many people are really prepared to lose 30%.

[00:53:18]Richard Laterman: To be fair, this is also something that for the vast majority of investors out there doing on their own, can be a pretty a daunting task. So I guess another dimension of this, the framework that you’re laying out, I think makes a very strong case for owning specific types of asset classes and with geographical diversification.

The other dimension that we can add to this is passive versus active. And I know there’s a bit of a misnomer when it comes to this, but I guess what I’m trying to get at is, are you advocating for a portion of this being with active betas, a portion of it being with active managers that invest in these spaces? How do you think about that dynamic?

[00:53:56]Alfonso Peccatiello: I think if you really want to try and achieve this in a holistic way, you need professionals to do that because there are a lot of dimensions to take care of starting from, if you buy volatility, you’re basically spending premium on puts. Okay? Just let’s make it very simple for the audience. You’re spending premium on puts. Hopefully those puts will be able to protect you large enough against drawdowns in other asset clauses.

But that means you need to really calibrate how much implicit leverage are you building in these puts, how far out of the money do you go? What about the …? How much are you bleeding Carry? What is the expected negative budget that you’re putting on the side to buy and hold these premiums? How do you roll them? To be honest, all these questions are very hard for investors, but I think those are important questions and having these exposure in portfolios can be achieved, I think nowadays, through holistic asset allocators. And that’s effectively what I’m trying to build up as well by myself as we speak.

I am considering opening as well my own macro fund to try and make sure I can implement these strategies for people that are interested in having this kind of exposure when it comes to active against passive. That’s an interesting thought because my approach is not purely a risk premium passive extraction from the market, because I also overlay discretionary tilts on the Forever portfolio allocation and those derive from the quadrant model mostly that I discussed with you before.

So there is a bit of active, if you wish, but it comes from a data driven, non-only discretionary approach to asset class investing. And the thing is, you can always benchmark your active decision against the very pure passive risk premium Forever portfolio extraction over there, and see whether your models are working in adding alpha.

In my case so far, they have some additional risk adjusted returns overlay on the pure passive approach. But I think it also helps you to remain very involved in the game because by having discretionary tilts, by having these macro models, you are actively thinking about what are the dynamics which are ongoing.

Do I need to add a fourth dimension to my models? Do I need to fine tune my models? So by doing that, as long as you don’t really deprive your rest allocation from its very purpose, but you only apply tilts that are informed by these models, you can not only add some risk adjusted returns, but you keep yourself in the game. You get your hands dirty. You have to think and fine tune your models, which I think helps overall, the entire exercise.

Rebalancing and Rebalancing Premium

[00:56:43]Richard Laterman: How about rebalancing? One of the things that, yeah, cuz …

[00:56:47]Mike Philbrick: Say, Richard, that’s one of the key points to making sure that the process is integrated. But…

[00:56:52]Richard Laterman: And there’s a few ways to think about rebalancing. Some people like calendar rebalancing. Others have a strategic target that once a certain threshold is breached, they’ll rebalance back to the original weights. But I wonder if for the Forever, the neutral stance that we’ve been talking about, there’s one way to think about rebalancing.

And then for the active tilts, you might have a number of indicators that are nudging you towards those tilts. And once the strength of those indicators shift, there might be an argument to be made that it’s not calendar and it’s not based on the target, but rather it’s opportunistic.

[00:57:25]Alfonso Peccatiello: Richard, I told you guys should pitch this idea and portfolio for me because that’s exactly the way I’m doing it. So the Forever portfolio is rebalanced on a calendar based approach, because that is a risk premium extraction portfolio and therefore that portfolio doesn’t know when to rebalance. It just rebalances full stop.

So I’m of course back testing everything. It should be every month, every three months. But it is on a calendar rule based approach. The real portfolio that comes out of that, plus the active tilts, that also requires that the active tills have to have a rule to be rebalanced, right? And those rules depend on basically, the ability to achieve a certain target of risk adjusted alpha returns on top of the beta returns, and the risks you’re taking and the drawdowns you’re taking from your alpha tilts. So effectively this derives from me having, running active strategies at my previous employer and knowing that you are gonna be wrong, you are going to be wrong, and therefore you need systematic rules to stop you out and rebalance back to your standard portfolio, if you have been proven to be wrong for a long enough time.

And so that is rather based on a systematic, let’s say, risk cutting strategy at that point of rebalancing, if you want to call it like that. But it’s much more a systematic rule-based approach there.

[00:58:47]Richard Laterman: And there’s an argument to…

[00:58:48]Mike Philbrick: I think there’s a benefit to the systematic side too of, or the netting side, of having it integrated. So the passive portfolio has an exposure to asset X, whatever that is. If you were to take out, have the sort of more passive portfolio and an overlay, you could have a manager that actually has the exact offsetting short position in the active portfolio whilst you’re holding the same asset in your passive portfolio.

What you’d prefer is to net that out. You don’t want the frictions, you don’t want long/short, in the exact same asset. So from the approach of the investor looking at this, I think there’s a significant advantage to this sort of trade netting idea when you’re integrating the various systems within the system. Anyway, sorry Richard.

[00:59:31]Richard Laterman: No, I was just gonna say that there’s also an argument to be made that when you think about a truly diversified portfolio, when you’re allocating to a bunch of managers, if it’s really well diversified, you’re always gonna have some line items that are not doing so well at any given point in time. So when you think about that rebalancing aspect of it, you’re basically using, you’re taking advantage of chaos, of entropy in markets and rebalancing out of things that have done well, into things that have done poorly, momentarily.

And then within six to 12 months, oftentimes those have flipped, which gives you an opportunity to harvest a tailwind. We’ve dubbed this rebalancing premium, but there, there really is. Is that something that you’ve thought about or tried to incorporate?

[01:00:08]Alfonso Peccatiello: It’s, this would basically say that this is an extension of what I apply on tactical macro investing, which basically says that you know you’re gonna be wrong about 50% of the time in macro, in tactical, macro idea generation. And what you want to have is a systematic model that stops you out, at a fixed loss per trade. So volatility adjusted sizing is important. Once you volatility adjust the size of your trade, then you know that, let’s say at one standard deviation or one and a half standard deviations, you are going to get stopped out. Okay? So that’s not a question. What you hope for is that the remaining 50% of your tactical macro trade idea actually ends up generating more than one and a half standard deviations on the upside.

So when you sum all of that up, your gains are not more numerous than your losses, but they’re bigger in magnitude because you’re able to let your winners run effectively through, again, a systematic trailing strategy. And that’s a bit the way I think about it. So when it comes to active investing decisions, I don’t really believe in mean reversion and cutting from a winning manager to allocate to a losing manager when it comes to active decision making. I believe in stopping out religiously on a systematic rule-based approach, and also to have a systematic rule-based approach to run your profits, because at the end of the day, you’re gonna be wrong 50% of the time. The best investors out there, I think Paul Tudor Jones said is right, 56, 57% of the time.

[01:01:47]Richard Laterman: That’s a very high rate, hit rate.

[01:01:48]Alfonso Peccatiello: It’s very high as a hit rate on macro trade.

Most people out there are 50% of the time, right? So in my opinion, rather than mean reverting from losing managers to winning managers, et cetera, in terms of rebalancing, you’d rather make sure that you have a way to stick to the winning manager and to let your winning trade perform further and further.

[01:02:10]Richard Laterman: How about…

[01:02:11]Alfonso Peccatiello: One example…

[01:02:12]Richard Laterman: The, sorry. Please continue.

One Example

[01:02:15]Alfonso Peccatiello: No. One example of that is, recently, talking about tactical macro for a second, there has been a moment when it had become, at least to me, relatively clear that the Federal Reserve was done, at least for a bit, so that they would pause for three months, let’s say. Three months in tactical macro can be a very long period of time when you have come from a very uncertain macro environment before, with the Fed hiking and you didn’t know what terminal rate was.

Could be five, could be six, nobody had any idea. You move from that environment to we are at five, and we are gonna see how it plays out. Okay? So we are just gonna wait and watch. That environment for macro investors is very different because unless the economy is collapsing, what the Fed is doing is reducing uncertainty.

It is basically telling people, okay, you know what the framework is. When macro investors have growth, which is in collapsing and a predictable environment and bond volatility coming down, they generally chase Carry. They want to be in trades where they’re paid to wait, when they’re paid if nothing happens. Okay. So I started screening for what were the trades that could perform the best, and Poland popped up on my screen. Poland is an eastern-European country with very reasonably valued equity markets. I’m talking like, very acceptable forward P/E ratios. It has a currency that, the central bank is almost at 7% domestic interest rates, so it is even higher than the Fed.

They’ve had inflation running hot for a while and they have nominal growth, which looks pretty good. So Poland was actually ticking a lot of boxes on the Carry, perspective, right? So I went long Poland. Now, when I bought it, I would’ve never thought that this thing would gone up, would go up 20% in 20 calendar days.

That’s what happened. It went up 20% in 20 calendar days, which adjusted for volatility as well, was a very good trade. The reason why I was able to ride it almost all the way to the top is not because I had a crystal ball, but because when the first profit target was hit, you then have to have a systematic strategy that keeps you in the trade, and if you have a drawdown, then it also basically systematically allows you to take profits.

But it’s, you don’t know in advance which of your, which of your discretionary tilts are going to prove to be right. That’s why I think you can have a discretionary overlay tilt, but you need to have a systematic way to size these tilts to stop you down from these tilts, stop you out from these tilts, or to keep running these tilts if they’re working your way.

Currency Matters and Orderly De-dollarization

[01:04:44]Richard Laterman: I was going to ask about currency denomination, right? How do you think about the main currency for that portfolio when you’re thinking in terms of global portfolios? Obviously, the US dollar is the lingo, is what everybody thinks in terms it is the global reserve currency. Now obviously there’s this conversation about peak dollar, whether it’s Ray Dalio’s approach of empire’s collapsed, peaking, and collapsing, and he talks about the dollar possibly peaking.

We heard recently Drukenmiller, who by the way can change his mind as he often says, within a week. So we shouldn’t, we should take it with a grain of salt. But he says one of his highest conviction trades today is short the dollar. We recently had Michael Howell of Crossborder Capital here who does an analysis of global liquidity, and he drove this point home that I think really clicked for us. The fact that there’s about, I think, 330 trillion dollars, equivalent of dollars outstanding in global debt. Much of it denominated in US dollars with an average maturity about five years. About 20% of that is being rolled every year, which means there’s typically about 60, call it $65 trillion of demand for US dollars, for a good chunk of that mean, for US dollars, which tells you that there’s, it’s really hard to imagine there being a rotation, or out of US dollars.

Specifically when you consider that there’s not enough debt in capital markets for other currencies, right? Not just the government debt, the government assets, but also capital markets in general. So how do you think about that problem that US…

[01:06:11]Alfonso Peccatiello: So the, an orderly de-dollarization is a fairytale. It doesn’t work. It, the dollarization can happen, but it’s never going to be orderly, simply by the way the system is built. So think about this. There are about 12 trillions of dollar denominated debt issued by entities sitting outside the United States. Okay? So that’s Brazilian corporate that is issuing dollar bonds. So how do they actually pay and service, how this $12 trillion system is actually serviced, this true organic flows of dollars? Those are Chinese corporates, Brazilian corporates, they need dollars to pay their dollar coupons on their dollar debt.

They can’t call up the Fed and say, hey, I need dollar liquidity. They need organic dollar flows. So the moment that they would say, now I want to get out of the dollar, I don’t want to, I don’t want to invoice you for my soybean sales in dollars. Let’s do that in Renminbi. Okay, sure, you can do that. Assuming the other counterparty agrees, but then you’re gonna be piling up Renminbi’s. Then you need to pay up for your dollar coupons.

You need to service your dollar liabilities and you can’t do that without an organic flow to dollars. So as you can see, once you lever up a system around a currency like we have done for the dollar, what you end up doing is you have a lot of global trades denominated in dollars.

Which means a lot of these exporting nations sell their services and goods. They accumulate dollars, they want a safe place where to recycle these dollars. That tends to be the Treasury market. So the US has to issue, has to supply a way for this company, this, these countries to recycle their dollars. And that’s a Treasury market. These countries are gonna recycle these dollars through these markets and they’re also gonna become in dollars themselves, because that’s a way to lever up their balance sheet in their business model to a global dollar denominated trade system.

So you’re basically building leverage on the assets and on the liability side to a system denominated in dollars. In order to get out of this system, you need to deliver it. You need to get out, you need to apply a big, huge deleverage and deleveraging episodes are not orderly because what happens, think about it.

What happens when global trade slows down? Dollars are not flowing enough to Brazil because global demand is slowing down. So all of a sudden Brazilian corporates need to service dollar liabilities, will actually need hard dollars. The only way to get them is to bid them in the market. So a system that is highly levered on the dollar when it needs to lever because things are slowing down, it actually bids up the value of the collateral. It bids up the value of the very currency that underlies this leverage system. And I, you can get out of it, but it’s not orderly because you need to deliver a large, multi-trillion dollar, that system that has been built around the dollars of global reserve currency.

So it is a possibility, yes. Is it gonna be orderly? No. Do you need to have some dollar exposure in your portfolio to protect yourself against the deleveraging of the system? Funnily enough, yes. You need dollars to protect you against the de-leveraging of the dollar system. Yes. And then at a second stage, you need an exposure to a basket of assets that will potentially replace the dollar as the bedrock of our new monetary system. What is that? I think gold might be what people tend to see as an obvious candidate. It has already done so in the past, so that’s one of the reasons why gold also belongs in a portfolio in the second stage of our change from today’s monetary system to something else.

But you also need a dollar. Funnily enough, when you deliver a dollar based system, you need the dollar in the first phase of the deleveraging.

Hedged or Non-hedged Exposures

[01:09:59]Richard Laterman: So are you advocating for unhedged exposure to a lot of these country diversification exposures, to both equities and bonds and to some extent, real estate? I guess you would invest in their local currencies and keep that unhedged.

[01:10:12]Alfonso Peccatiello: The look, the problem there is that if you’re a dollar based investor, then, if you do unhedged investing into these places, then you also need to make sure that your exposure to the dollar is levered up enough, because you are inherently selling dollars to buy all these foreign assets. When you allocate to unhedged Indonesia, you are basically implicitly selling dollars and buying Indonesian Rupiah to buy the Indonesian stock market.

So by building this ex-US exposure in a world that really depends on the US, you also need to make sure that your hedge against that problem, So your dollar goals, or whatever, is your leverage exposure to the dollar is large enough to have offset these drawdowns. But in principle, yes, unhedged exposure to all these jurisdictions, with an implicitly leveraged exposure to the dollar to protect your downside, if a bad outcome happens.

[01:11:07]Richard Laterman: And obviously if you have, you have to match liability to some degree, not just in duration, but also in the currency denomination. So if you have a large liability that you need to meet on a periodic basis, then you need to match the currency exposure appropriately.

[01:11:21]Mike Philbrick: So do you guys want to switch gears now and start talking a little bit about the current macro?

[01:11:25]Richard Laterman: Adam, you’re muted.

[01:11:26]Mike Philbrick: Sorry.

Risk Based Allocations

[01:11:27]Adam Butler: I feel like we’ve buried the lead on what the actual neutral portfolio looks like. Alf, do you have an example of a general, I don’t know, I hesitate to say pie chart in risk space or capital space or something like that?

[01:11:40]Alfonso Peccatiello: Not yet, Adam. So I don’t have a pie chart or here readily available, something to show on the screen. But what I can say is that on a risk based allocation, so those are not notionals, those are risk based allocations, a neutral portfolio. Under my initial back test, a Forever portfolio would look something like about 15% risk-based allocation to equal weight US equities, 15% to ex-US DM equities, about seven and a half percent to emerging markets.

Then you have about a 20-25, so that’s roughly overall 30, 35% to global equities, risk-based, always risk-based, 25% in long duration European and US bonds, and that’s roughly 60% of the overall risk exposure. And then you have the remaining 40%, again, risk based, not notionals, that is split between, additional bond exposure that delivers Carry.

So this is credit hybrids, emerging market debt exposure. That accounts for, I think, top of my mind around 15% of the remaining 40. And then there is 25 risk based. That is long-vol industrial commodities, dollar and gold. And that’s how you, and that’s then how you look at a, if you lever up good enough, the vol and the US dollar and the commodities. Those three need to be really vol adjusted to make sure that you can deliver enough returns to have set the drawdowns from other assets, which are often correlated drawdowns in some environments. So you need something very strong on the other end that is able to really, in a convex manner.

[01:13:29]Adam Butler: So if I said that emerging market credit and corporate credit were highly connected to equity beta, like global equity beta, so we’ve typically steered clear of credit because credit can typically be explained as derived from a rate bet and a short put on corporate, a corporate capital structure, right?

And in emerging markets, obviously a short put on emerging market currencies and emerging market economic results say, so how do you think about that? Because you’re, it does seem like you’re a little bit more cyclically oriented with the credit exposure then, maybe it might seem at first glance.

[01:14:13]Alfonso Peccatiello: So look, the credit part of it, which is mostly EM credit exposure, is basically nothing else than an orthogonal bet on EM growth, let’s say that you also have through the equity lens, but EM credit is also Carry, let’s say that happens a lot in those bond markets. It’s very often overlooked.

But if you have a diversified basket of EM credit even EM sovereign bonds, I mean if you look at the total return of a Brazilian Real Bond Index this year, go have a look at it. It can be pretty interesting as an uncorrelated source of returns. So it’s rather an EM credit story because I think there is an inherent large amount of risk premium that can be built in these markets.

They’re very under-owned. I think also institutionally speaking, domestic currency, EM credit, EM debt, is not particularly largely over-owned. And I think the source of return is, while the mix of the EM affect’s Carry story and the EM credit duration story, that’s the angle I like to play, rather than on corporate credit.

I agree with you. Corporate credit is nothing else than mostly duration to be honest. And then you are selling vol, you’re selling vol, you’re basically buying Carry, you’re selling vol on something else. So…

[01:15:35]Adam Butler: You’re selling equity vol.

[01:15:36]Alfonso Peccatiello: … a large portion of your portfolio or are you…

[01:15:38]Adam Butler: Which is why it’s de facto equity beta. But even on emerging market debt, and I agree, it does emerging market debt returns or orthogonal, 80% of the time. I guess where I’m going is that where you ty, you’re typically hurt on allocations to Currency Carry, especially emerging market Currency Carry, when it hurts to be hurt, because your equity portfolio is also in the toilet, right?

[01:16:02]Alfonso Peccatiello: True. That’s, that can be true. But there are periods in which the EM Carry trade works well, while equity markets aren’t delivering much of a return at all. And that’s in general where EM growth and let’s say, where DM growth is stagnant, but EM growth is looking okay. And when monetary policy is very predictive in DM, predictable in DM, then people tend to go to emerging markets for Carry.

So there are situations in which I think EM Carry, EM credit can deliver a bit more orthogonal returns. And there are correlations obviously between EM, debt, EM credit and equity beta in general. But that’s why you have other defenders for those situations. So you are adding a bit of he same kind of risk? Not always.

So you’re adding some correlated risk to your equity beta, but I think there are some angles that you’re capturing through EM. Credit exposure that are not solely captured by the equity beta in the S&P 500. That’s why I have it in the basket Corporate Credit. DM Corporate Credit. I tend to agree with you.

Inflections

[01:17:08]Richard Laterman: The scenario you just painted is the early 2000s, right, I guess 2000 to 2007. I think the picture you just painted reminiscences of that period. Do you, how do you think about the fact that we, I don’t know how far back you’re able to back test these models and understand, but the fact that we might be coming into an inflection? I guess we’ve had a pretty prolonged period as we just talked about last 40 years of perhaps a single regime with some short bouts of escaping from that regime.

But we’ve had a period with positive nominal growth, deflation and growing and abundant liquidity in the systems, and now all of a sudden, we could be coming into an inflection point. How do you think about the potential for shifting the neutral portfolio into contending with what might be on the horizon?

[01:17:59]Alfonso Peccatiello: Oh, you, it’s a good question, but I think you shift your discretionary tilts, but you don’t shift your Forever portfolio. Because the Forever portfolio is in principle, designed to be agnostic about what will be, where your growth will be coming from, if inflation’s going to be high or low, if bank reserves will expand or not.

You have that as basically your benchmark allocation for how markets and regimes might work, and then your discretionary deals can be maneuvered around. That’s the way I think about it. And when it comes to the next 10 years, I think there are three or four themes that see discretionary tilts that people don’t expect to be the ones that perform a bit better.

So one is, as I said before, there have been some pretty relevant global supply chain disruptions. There has been some push from some of the countries to make sure some CapEx ends up in those countries. And not only they’re taking commodities from basically, so there has been a bit of this shift, and I mentioned Indonesia, but I could mention some other countries where that is working the same.

That is one shift where basically emerging markets might get a little bit more of attention and love than they had over the last 10 to 12 years. The second theme is demographics, where one can make a case that demographics look still a drag on real economic growth.

But what about wage pressures? What about inflation? Because we are having now a certain cohort of skilled labor that is very much in demand, but who, supply isn’t expanding anymore? We’ve had a lot of … over the last 20 years, and we have certain sectors of the economy where you can see initial signs of structural labor shortages. Certain skilled labor isn’t gonna be readily available like it was before. And also China, the Chinese labor force is gonna shrink dramatically over the next 10 years. So the supply of cheap labor at a macro level is not going to be to the same impulse it was over the last 10 to 20 years. So you might start to see some initial shift between the prevalence of capital, against the prevalence of labor, and if you see labor gaining some share back again, then there are certain sectors, certain industries that are, that have massively underperformed and in general, value against growth, so value, as large small cap value has been destroyed over the last 10 years. That might be one tilt and one discretionary tilt you might consider that has performed terribly and might perform a bit better over the next 10 years. I’m putting down a couple of examples. There might be more, I think people have a very short memory.

[01:20:42]Adam Butler: We lost Italy. We lost Italy. Come

[01:20:44]Alfonso Peccatiello: We are doing the very…

[01:20:45]Adam Butler: That’s…

[01:20:46]Mike Philbrick: In Italy, Amalfi Coast.

[01:20:48]Adam Butler: I think again we’re talking about, how to introduce sort of active tilts into the framework. Oh, we lost you there for a second.

[01:20:57]Richard Laterman: You’re back.

[01:20:58]Alfonso Peccatiello: There I am. I don’t know where I left the chart, but I put a couple of situations forward that could actually realize, and the tilts might actually make more sense that way than they did over the last 10 years. One additional one could be that the 2022 commodity rally has woken up some interest back into the space.

And the other might also be that if we are really doing the same trick all over again and trying to compress vol as much as we can, and people have basically given up on buying up.

[01:21:29]Richard Laterman: Oh,

[01:21:29]Adam Butler: Yeah. You just cut out

[01:21:30]Alfonso Peccatiello: Can you hear me?

[01:21:32]Richard Laterman: Oh, you’re back.

[01:21:32]Alfonso Peccatiello: Alright.

[01:21:33]Mike Philbrick: You just gave the little the nugget and it cut out right in the nugget. It was perfect.

[01:21:37]Alfonso Peccatiello: I was saying those are the…

[01:21:38]Mike Philbrick: …hanging by their fingernails.

Tilts

[01:21:40]Alfonso Peccatiello: I was like, those are two of the examples. But for instance, industrial commodities have performed very well in 2022. Some interests might have been brought back to the space. And vol is a very interesting one because, vol is a, in nature is a cyclical defender that you want to have because it is one asset that has been targeted, for the last 10 years, basically as the asset to sell to pocketing premium.

But the reality is that the more you do that, as Hyman Minsky used to say, the more a system is artificially in equilibrium, the more likely it is that this equilibrium becomes fragile. And so you might want to have some vol, something that has been slaughtered over the last 10 years. So yes, there are tilts that I think might be handy to have and applied that are different than the ones that have worked over the last 10 years.

Cyclical Perspectives

[01:22:32]Adam Butler: How about we pivot to some shorter term stuff. Where are we, do you think, in this, from a more cyclical perspective, right? Anything surprising you at the moment?

[01:22:42]Alfonso Peccatiello: Yeah. I would say so. This has been the cycle with one of the longest lags between the tightening of monetary policy, the tightening of credit, and, the on the weak, the resulting weakness in the economy. So it has definitely taken a toll on some of the economic sectors. Mostly manufacturing, the global manufacturing cycle is dead.

If you look at Sweden or South Korea, those are very open economies, very leading indicators for manufacturing cycle. They both look really poor. If you look at China, even the reopening isn’t managing to boost any of the manufacturing cycle. Even in the US manufacturing, new orders keep printing down.

So the manufacturing side of things is very poor, but the consumer and the services side of things and the labor market has weakened. Definitely that’s weakened from 2021 and 2022, but it isn’t looking weak enough compared to what the leading indicators are. Instead, suggesting, take credit, for example. So it seems to me that the lags are proving to be much longer. So that is something that is, that has really surprised me and my models are pointing to US real GDP growth trending around 1% as we speak. Is 1% very strong? No. Is it recessionary as many expected? No. It’s as low patch in growth. It’s a below trend growth.

It keeps trending down, but it has been very slow. So why the lags exist and why this bifurcation between services and manufacturing? I think it has to do with the amount of real economy money that we printed in 2021 and 2020. In 2020, 20 21, the US alone did 5 trillion. That’s a gigantic amount of real economy money that you’re giving away to the consumers and to the corporate and to the services sector. And in order to slow down from such a rapid speed, it might actually take longer than what the normal leading indicators that used to work in the previous cycles. Without such a G2 and fiscal stimulus, the leg might actually be a bit longer.

This is something that is frustrating investors. I think that they were positioned late last year a bit more aggressively, and a bit for an earlier onset of a recession, and as you unwind this early positioning, you end up seeing stuff like bonds don’t really rally that much, because positions are being unwound on how early a recession can come. And Carry traits do very well, because all of a sudden people realize that you don’t need to own volatility in this environment. It’s looking like a soft landing at this stage, much more than what people expected. My take is that we aren’t gonna get a soft landing after all. That we are in the transition phase between a strong economy to a weaker economy, and ultimately as the lags manifest themselves, you are gonna see the result of titling in monetary fiscal policy play out into a US recession. It’s just taking much longer than many people, including me, to be honest.

[01:25:46]Adam Butler: That we have, we’re starting to see an uptick in home prices. We’re starting to see an uptick in residential. And not just starting, but that’s actually been going on for several months. We’ve we’re seeing growth in residential construction spending. We’re seeing an explosion higher in private manufacturing construction spending.

These are typically some of the most interest rate sensitive segments of the economy. And yet, despite the fact that the Fed has tried to get out in front of this inflation impulse by raising rates so rapidly, they did slow down for a short time in 2022 and very early 2023. But it seems to me that even in very highly interest rate sensitive sectors, we’re starting to see a re-acceleration.

[01:26:37]Alfonso Peccatiello: In Q1 2000, if you looked at, sorry, in Q1 2001, if you looked at real GDP, the first print was over 2%. It was then revised all the way down to negative later on. But the reason why I’m mentioning this is that drawdowns in economic activity aren’t a linear story after all. The last time we have seen a recession in the US is 15 years ago.

This is a staggering number. Every time I say to them, like what, the US has gone for 15 years without a proper labor market involving recession? Yes, 15 years. And so people tend to, I think, lose sight of the fact that recessions are linear processes, Adam, and it makes sense that companies actually get a scare, and even consumers.

So maybe late last year, they got hit much more by the Volker-like moment that Powell had when he said, I’ve, I don’t know, how long do we need to go here? It might be that Fed funds are six or 7%. We maybe need to march much higher than what we think we should. And so at that point you get a big hit. And then you pare back even your planned house purchases. Because don’t forget, things aren’t linear. Also, because housing is a necessity, there will always be an inelastic demand for housing out there. At least to a certain extent, there will always be. And so when you figure out, when you prepare for a recession that the recession doesn’t hit as bad as you think it did, and it’s only a slowdown, then all of a sudden, I think after four or five months, some people come out of the woods and they say maybe I, it’s not as bad as I thought.

And so you have these temporary cyclical rebounds within the context of a broader slowdown, that has happened every time. And even with markets, because this is a very reflective mechanism, and Mike said it before, our economy is hyper-financialized. So that means that markets tend to have a sort of a signal, I think, as well on consumer confidence and consumer spending, and even in 2008 after Bear Stearns, the market rallied aggressively until we got to the real problem, which was Lehman Brothers, right? And then, we got the entire market coming down. So these periods, I think can be very challenging because we have cyclical rebounds within the context of a slowdown.

And I think that’s where we are today. But take a step back and look at the housing market. You’re looking at Blackstone and KKR that are getting redemptions for now, seven, eight months in a row to the Real Estate Investment Trusts. Is that a sign of a healthy real estate market? It’s not guys. They don’t want major redemptions because they know they otherwise need to liquidate assets into a market that has, that is very slow. So they don’t want to be the institutional guys dumping tons of real estate stuff on the market that doesn’t have a proper bid. So those are not signs of a healthy market, but it is natural, I think, to see some rebounds from extremely depressed levels.

The NAHB Index was at 30 at some point. Thirties in that index is basically like saying we are in the midst of the worst housing crisis since 2008. And so, I think the expectations weren’t really down a lot and now we are rebuilding up on some of these expectations that didn’t play to be.

Balance Sheets and Inflation

[01:29:49]Adam Butler: I think another dimension here is that we’ve got…

[01:29:51]Richard Laterman: …do you make of the labor market?

[01:29:53]Adam Butler: …6 trillion in fiscal outlays. We had a $2 trillion hit to GDP, during Covid. There was an extra $4 trillion sitting on the balance sheet, on the private sector balance sheet, that has largely over the last three years, moved onto the corporate sector balance sheet.

And that is a very large portion of what is inflating the size of the reverse repo facility. I think something that has been feared by some economists that have spoken from the Fed, and from other private sector economists is that cash, which basically just accumulated on corporate balance sheets definitionally, because it goes into private, into household savings, eventually that gets spent and things that are spent eventually end up on corporate balance sheets as profits. So corporations are cashed up. Earnings have been resilient, but they don’t even need to be because they’ve got so much cash in the bank. If they unleash an investment cycle, which we haven’t seen in so long, I don’t think anybody’s actually concerned about it.

But I guess what I’m wondering whether this burst in manufacturing construction spending as an example, might be a precursor. or a canary in the coal mine suggesting that this feared unleashing of corporate savings into domestic investment may create another wave of growth and another wave of inflation. Is that something that we should be concerned about?

[01:31:29]Alfonso Peccatiello: It’s a possibility, definitely. And we have had under-investment and low CapEx in several sectors, commodities being one of them. In some cases this is restricted by regulation. So if you want to do CapEx in oil today, in most countries, you can’t. You just can’t. The holder, the … is too high, from a shareholder return on equity, and the problems, the communication problems you’d have to face. But even from a broader CapEx perspective, what companies tend to do, I think, is they look at perspective returns on their spending.

Are they going to make more money or distribute more returns to their shareholder by buying back their stocks, or by investing in real economy stuff, CapEx, right? So it all really comes down to whether the economy has a higher potential structural growth and, or it can manage higher interest rates more structurally. Because ask anybody, two years ago, if the Fed would’ve high rates to 5%, how would you picture the economy?

90% of people would’ve told you, disaster, apocalypse. Now zombies are walking on the street with 5% Fed funds, right? The reality is the economy has proved to be much more stubborn and much more resilient so far to this very strong cycle. But I think people have to be a bit careful, not extrapolating what has happened so far with structural changes in our economy.

Because if you want structural growth to be higher, it needs to be either demographics or productivity. There are no tricks. And so maybe productivity has gotten a boost from the pandemic changes. It could be. And we are just playing now. We are seeing it play in front of our eyes. Maybe artificial intelligence will help this productivity trend, and maybe it doesn’t take a decade like it did in the past, but it’s faster because the technology is also faster, because we have adapted our economy to faster technology and faster changes.

Maybe Adam, all of that is true. I think that there is an inherent willingness in wanting some structural changes. In reality, most of the times it is macrocycles. They can last a bit longer or they can be a bit rapid, that people think, but they always caution people not extrapolating cycles into trends.

And I think that is one danger of making the assumption that the economy can run with 5% Fed funds forever. Something really important has changed.

Fiscal Dominance

[01:33:58]Adam Butler: One of the other elements is, as you said, economies can grow through demographics or productivity growth, but another way that they can grow in the short term, is through fiscal dominance, right? And if you look at the trajectory of estimated growth in deficit spending over the next seven, eight years, just look at the basic re reports from the CBO.

We’re seeing a dramatic scaling up in fiscal outlays, right? In theory, that should create nominal growth. That should translate through the equation, directly into corporate profits. And in theory, there should be a, that should create more inflation, right?

[01:34:42]Alfonso Peccatiello: So you are right Adam. You’re right, that fiscal deficits are the other side of the coin of households or private sector net worth. So what people miss is that if the government is cutting your taxes, it’s making a deficit. Yes. Is it making you richer? Yes. Does it come without a liability attached to it? Yes, unless the government wants to tax you later on. But in the first instance, you are getting money. The private sector gets richer when the government does deficits, and so the larger the deficits you do, the more money you are transferring to the private sector. The productivity of this money transfer, that’s another story.

It really depends from what the private sector does with this newly created money, basically. And that’s, I think, where we need to have a chat about, because Japan has done fiscal deficits between 4 and 8% for basically two decades. They haven’t been able to generate much nominal growth out of it, mostly because the private sector offset these fiscal deficits. So they deleverage the private sector, basically said, ah, in the nineties you made real estate prices go down 40, 50% from their peak, and you basically slaughtered me. And then I don’t want to participate into this leverage game anymore. So if you’re gonna throw money at me, I’m gonna use it to pay down my existing credit, my existing liabilities, effectively offsetting the…

[01:36:08]Adam Butler: …irresponsible of them not to continue to lever up.

[01:36:10]Alfonso Peccatiello: Yeah. Japanese people are very irresponsible. The US from a private sector debt perspective is looking relatively leveraged. It’s not a low private sector leverage. It’s not an extremely high either. So maybe it might be that US private sector decides not to offset these fiscal deficits and that will produce higher nominal growth. Yes, it will. Because simply you give the private…

[01:36:35]Adam Butler: You don’t have the same demographic issues in the US either as they had in Japan.

[01:36:37]Alfonso Peccatiello: …if they don’t…

[01:36:38]Adam Butler: So that, that was a major headwind.

[01:36:40]Alfonso Peccatiello: That is true. That…

[01:36:41]Adam Butler: Japan could spend or produce fiscal deficits of 4 to 8%, if demographically their population is dying off at some equivalent rate.

[01:36:51]Alfonso Peccatiello: Yes, so US has a couple of tailwinds. First, the private sector isn’t super leveraged. So it doesn’t need, I think, necessarily to lever down and offset these fiscal deficits. And second, demographics is much more, much less of a headwind for the US than it was for Japan over the last 20 years. So if you laid all out like that, actually, if fiscal deficits realize under the assumption of the CBO, of the Congressional Budget Office, then you are going to see higher nominal growth in the US.

And this is not an opinion, this is basically how accounting works in our monetary system. Unless really the other offsetting factor can be that productivity growth declines materially because the government is becoming bigger and it’s taking a larger share of GDP growth, that could be an upsetting factor. But I think your thesis is something to consider when looking at US, the location over the next 10 years.

Labor Markets

[01:37:43]Richard Laterman: Alf we’re coming up on two hours here, but I just wanted to get your thoughts on the labor market. We just had another print, non-farm payroll, above expectations. We’ve had several of these in the last few months. What do you attribute to this? Some people have talked about the two different surveys, the establishment surveys versus the household surveys.

There’s a double counting dynamic there that I think has led a lot of people to get their estimates wrong. But does this jive with what you were alluding to a moment ago, with regards to the lag with which the $5 trillion fire hose of capital has been dispersed into the economy and now it takes a little longer. So maybe this is strength in the service sector, but the overall economy not as much.

[01:38:26]Alfonso Peccatiello: So I think the labor market dynamics broadly reflect this bifurcation. If you look at cyclical industries and their hiring trends in manufacturing, construction and trade, and financials and all of these more cyclical industries, they aren’t really hiring at a very strong pace anymore. It’s rather flatlining to very low level of hiring.

But if you look instead at the services sector in general, it’s looking more robust. Still it’s holding on pretty well. So I think the internals of the job market are weaker than what the headline non-farm payrolls are making it look like. I think you need to have a more nuanced take on the labor market and the overall assessment.

And I look at something like 10, 11 indicators. So the labor market is weakening, but so it’s not red hot, it’s not hot as well, but it is relatively robust. It is weakening, but still relatively robust. In line with this 1, 1, 20, 5% real GDP forecast that I have for the US. So it’s below trend and it’s trending lower, but it’s still relatively okay.

That’s what the labor market is picturing right now. If you take into account a lot of nuances and indicators, one of it can be the average work week. So you have a way to calculate basically what is the nominal aggregate labor income? And that basically measures how much money are Americans bringing home in nominal terms, on a yearly basis.

So you’re measuring the work hours and the wage growth. And if you multiply the worked hours, times the wage growth, you’re looking at literally how much more money the Americans are bringing home, considering how many hours they work. And this nominal aggregate labor income is running at about 4%, year over year.

Which is much weaker than the 9, 10% it was when the labor market was really hot. 4% is a decent number, but it is the average of the last 20 years. So again, today, Americans are bringing home on a year basis, 4% more considering work hours, weeks, and average nominal wage growth. 4% on a year, on year basis is the average of the last 20 years, and that has actually been consistent with inflation between two and 3% in the past.

When you have this number around four, I think the labor market is today, looking like perfect for the Federal Reserve. It is not as hot as people want to pass it through. If you look in the nuances, it’s looking like a disinflationary labor market softening. That is exactly what the Federal Reserve wants to see.

This idea that the Federal Reserve wants to see a recession? No, ask Powell and he will tell you, my dream is that we can move the unemployment rate just a tiny bit up by mostly the means of labor supply coming back to the market. And we are seeing that the labor force participation rate between 45 and 55 years old is the highest in 20 years. So all the early EE, I think that we’re counting on forever. Real estate prices going up 10% a year, and all of a sudden they’re realizing that’s not the case and house prices have declined. Maybe they’re coming back to the market and the Federal Reserve loves that because you aren’t necessarily destroying employment. You are bringing back labor supply. You are bringing back labor market equilibrium. I think that’s exactly where we stand. I think the Fed is very happy with it. Next steps again, I think, is that the lags of their monetary and fiscal policy tightening and the credit tightening are gonna play a role in labor market dynamic.

So I see the labor market weakening a bit further as we go. It’s just taking much longer than the Fed or anybody else actually expected.

[01:42:07]Richard Laterman: Adam, we can’t hear you for some reason.

[01:42:10]Mike Philbrick: Did you hit the button on your mic or something like that?

[01:42:13]Richard Laterman: Oh,

[01:42:13]Mike Philbrick: Battery dead?

[01:42:14]Richard Laterman: We’re almost,

[01:42:15]Mike Philbrick: I think we’re here, we’re at the end.

[01:42:17]Richard Laterman: Two hours here. Alf, you’ve been very generous with your time.

[01:42:21]Mike Philbrick: Yeah.

[01:42:22]Alfonso Peccatiello: It’s been great being here with you guys and discussing the Forever portfolio and how you build that, and how you do discretionary tilts and talking about macro. It is what I enjoy the most and you guys are great at doing exactly that. So it’s a pleasure,

[01:42:38]Adam Butler: Can you guys hear me now?

[01:42:39]Alfonso Peccatiello: Here.

[01:42:40]Richard Laterman: Remind people where they can find you.

[01:42:42]Adam Butler: …microphone turned off.

[01:42:43]Alfonso Peccatiello: Oh, yeah.

[01:42:44]Mike Philbrick: Now…

[01:42:44]Adam Butler: Anyway, sorry. Go ahead. Yeah. Where can everyone find you, Alf?

[01:42:46]Alfonso Peccatiello: Oh yeah, thanks. My macro strategy and investment portfolio ideas are on themacrocompass.com. And if people that are interested in discussing as well, the Forever portfolio and the idea that I’m looking for to open a macro fund that deploys this strategy, just send me an email at fundthemicrobus.com.

So either the microbus.com or fun thebus.com and you can get in touch with me.

[01:43:15]Mike Philbrick: Fantastic. And that MacroAlf is always on

[01:43:18]Alfonso Peccatiello: Of course, on Twitter, where you’re gonna get some pizza pictures as well from time to time, together with the macro.

[01:43:23]Mike Philbrick: Thank you, sir. We have the full moon coming up 99% tonight, a hundred percent tomorrow night or something like that too. So you can have some moonlit pizza.

[01:43:31]Richard Laterman: Yeah, send us a picture of the Amalfi Coast. Post something on your Twitter. You’ve left us all with a little bit of FOMO in the introduction, so I’d love to see a little bit of that and have a great weekend, man. Thank you for coming again.

[01:43:41]Alfonso Peccatiello: Thanks guys.

[01:43:43]Mike Philbrick: Thanks all.

[01:43:44]Alfonso Peccatiello: Talk soon.

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