ReSolve Riffs with David Cervantes of Pinebrook on the Increasing Importance of Political Economy

Our guest this week was David Cervantes, founder of Pine Brook Capital Management. With a rich and diverse background within the investment industry, in the last few years David has dedicated his time to managing his family office and has been developing a macroeconomic framework that considers the objectives and incentives of policymakers as the primary economic drivers. Our conversation included topics such as:

  • Empirical economic analyses and insights from the ‘school of hard knocks’
  • Fundamentally, a process of elimination – determining first what not to do
  • Less theory, more data
  • Where his approach materially diverges from traditional economics
  • Cognitive Perspective – treating models with respect, but never reverence
  • Macroeconomics is basically ‘political economy in drag’
  • A dynamic process of incentives and decisions made by political actors
  • The role of ‘timing luck’ (or misfortune)
  • A stroll down history lane – from WWII and the Great Society to the present
  • A closer look at the gargantuan US federal budget deficit
  • Current backdrop – an ‘inflationary supernova’ fueled by fiscal impulse
  • The Fed’s current reaction function
  • Home prices, OER and how they affect CPI
  • Why interest rate volatility matters significantly more than absolute levels
  • How interest rate vol spills over into the risk premia continuum
  • And much more

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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David Cervantes
Founder of Pinebrook Capital Management.

David Cervantes is founder and manager of Pinebrook Capital Management. 

Pinebrook is David’s vehicle for managing his family’s assets, as well as those of a few partners. 

At Pinebrook, David focuses his attention on asset allocation and on managing various systematic trading strategies. 

Prior to starting Pinebrook, David was in fixed income sales at Morgan Stanley, covering middle-market financial institutions in Latin America.  Before going to Morgan Stanley, David was in cross-asset sales at UBS and JP Morgan.  

David started his career at Well Fargo Bank, going through their middle-market commercial lending & credit training program. 

David is a graduate of UC Santa Barbara, where he double majored in economics and international relations.  He also has an MBA from the University of Wisconsin, Madison and completed some of his graduate work at National University of Singapore.


Rodrigo:00:01:56Hello, Hello. Adam, you are muted. Welcome everyone to another episode of Riffs. We are here with David Cervantes or Da-vid Cervantes as I would say today. But before we do begin let’s do the regular disclaimer that I think Adam has memorized at this point and I have not. So, Adam, why don’t you go ahead?

Adam:00:02:17Yeah. This session is for educational and informational and entertainment purposes only and should not be construed in any way as advice or advice on any of the topics we cover tonight. Please consult your financial advisor. And I’m super excited to have David on because we’re going to talk about zero delta vol selling and meme stock strategies right, David?

David:00:02:42Totally, 100%.


Adam:00:02:46Just kidding, just kidding. We’re going to — David’s passion is in macro and asset allocation and investing, and so we’re going to spend most of our time there. But before we get started, maybe David just give us a little bit of background on how you came to be in your current position.

David:00:03:07Sure. Before we get started, I’ll just give a shout out thank you to my good friend Mike Harris. We’re good Twitter friends, chat a lot, and he’s actually the one that introduced us, helped put this together. So, thanks a lot Mike Harris. So, my name is David Cervantes. I’m the founder of Pinebrook Capital Management. Pinebrook’s my personal vehicle for managing some family assets as well assets of a few partners. Prior to starting Pinebrook I was at Morgan Stanley. I was in fixed income, middle market sales covering Latin America. So, I spent a lot of time in South America, predominantly in Argentina, Peru, Colombia, a little bit of Chile as well. Part of that I was at UBS both after grad school and before graduate school. I was in their cross asset sales team also covering the offshore middle market space. And prior of that I got my start at the JP Morgan private bank. Started as an emerging market fixed income sales trader, then went to cross asset sales from there.

First job out of college was with Wells Fargo. I went to their credit training program. So, I am or I was credit trained. I don’t know how much of that I still remember but I did go through their program. And finally, I am a UC Santa Barbara alum and University of Wisconsin alum as well for graduate school. So, go Gauchos, go Badgers and here we are.

A Different Macro Strategy

Adam:00:04:51Awesome. And I think mostly we and others may have gotten to know you from Twitter where you do share your views on a fairly regular basis. And my view is that you’re — the angle at which you approach macro is a little different than what we see from a lot of the other macro analysts. So, I thought it might be useful for us to start off for you to just — what is the sort of etymology of your macro framework? You know, how did you come at macro? And why do you think that your framework maybe a little bit different than many of the other macro strategists that people follow?

David:00:05:40Yeah, so first and foremost, I’m not a trained economist. Obviously, I have a finance background and went to business school and have an undergraduate degree in economics, but I’m not a trained economist. So, a lot of my macro insights are, I would say empirical, which is code for the school of hard knocks. Learning through doing and spending a lot of time doing it and making a lot of mistakes and knowing what not to do primarily. What to do is secondary, what not to do is primary because that involves loss for, or potential for loss. So, I would say — …

Adam:00:06:21It’s a much longer list too.

David:00:06:23Yeah. So, I would say first and foremost, I’m less theoretical and more of an empiricist versus your traditional strategist that has formal economics training and super-duper high level maths. They tend to be heavy on the theory. Now, that’s not to say I don’t appreciate theory. In fact, as — when we chat — as we get more into our chat, I will rely heavily on theory, but the theory will have empirical basis for it. So, that’s probably, I’d say, what differentiates me from your typical macro strategist, particularly on Twitter.

Adam:00:07:04Well, Paul Samuelson would have something to say. I recall reading — I think it was Samuelson. Maybe I’m slandering the wrong economist, but I think I recall that Samuelson once said the validity of an idea is in no way based on whether we observe what we expect empirically, but rather on whether the theory is internally consistent.

David:00:07:32Well, that’s… unfortunately that could get you in trouble in the risk markets. So…

Adam:00:07:39Yeah, absolutely.

David:00:07:41I’ll stick with the empiricists and you know, yeah, go that route.

Adam:00:07:48Right. So, how does an empiricist approach macro in a way that maybe — because I know that there are many trained economists now who do focus pretty intently on the empirical data. But I happen to believe that having not been educated in the canon of neoclassical economics or the traditional economics canon, does give you cognitive degrees of freedom that you may not otherwise cultivate, if you are sifted through or filtered through that traditional canon. So, I actually think that many macro analysts who didn’t grow through an economic background, are able to bring a unique perspective on macro that they just might not have been able to cultivate effectively if they’ve gone through more traditional channels. So, yeah, would you agree with that? And if so, sort of how does that manifests in your own work, do you think?

David:00:08:55Yeah, 100%. You know, a lot of classically trained economists or strategists, they’re going to really rely heavily on maths and models, which I think it has their place, right? Models help give us a stylized version of the world so that we can try to make some sense of it, right? But at the same time, if you become a slave to the model then you kind of become blind to — you lose cognitive perspective if you become a slave to the model. So, it’s a fine line, I think, where acknowledge the model, respect the model, but don’t be a slave to it. So, with that said, I start to approach macro, not from an economics approach, but from really a political economy approach. It’s really — I like to say that macro is really political economy in drag, right? It’s a function of political decisions that have monetary, economic, financial consequences, but ultimately it’s a series of political choices.

And these choices, their quality, their timing, their implementation, they determine the distribution of costs and benefits of these economic choices across society. So, in other words, fiscal budgets are a function of political goals, whether these goals are financing the United States in World War II or Great Society programs in the 1960s. And make no mistake, the US — the current US budget is, let’s say it’s about — it was $6.8 trillion in 2021. We’re still processing 2022, but I mean, that is the largest single economic entity on the planet. There is no greater entity than the US federal government, the budget of the government. So, it is the 800 pound gorilla in the room.

To understand the flows of the economy, you need to understand the principal driver of those flows. And I would say it’s the federal government as a single entity, obviously, the private sector collectively is larger than that. But the single biggest economic entity is the government. And then like I mentioned that $6.8 trillion figure, that’s a staggering amount of money. Japan’s entire GDP is $4.9 trillion. Germany’s was 4.2 trillion. So, it is just massive. And monetary decisions are equally political.

You know, when the US entered World War II, the Fed said they would pretty much do anything and everything they could to support the war effort. And we also saw this more recently with the pandemic shutdown, right. Both the government, the federal, the fiscal authority as well as the monetary authority used their collective powers to support the economy and avoid potentially a massive, if not depression, certainly a massive recession. So, having that framework to start, where you understand you have political actors engaged in economic activity, helps with reading the tea leaves and understanding what are the potential goals, what’s the political endgame for what the government is trying to accomplish. So, that kind of sets the stage for how I approach macro first and foremost.

Adam:00:12:43So, at what level of granularity do you think it is helpful to analyze the political machinations in Washington? Does this come down to observing the number of Democrats and Republicans that are aligned on different bills? Assessing the probability of different bills or different qualities of the bills passed? Or is it a level of abstraction higher than that? How do you think about that?

David:00:13:18I mean, I think there’s space for both. I don’t do the former, I focus on the latter. Meaning, I don’t sit there and watch C-SPAN, I don’t sit there and read the Federal Register. I’m not trying to understand what defense contractor is going to get funded for whatever project. There are people who do that, they do it well, and they probably make a lot of money doing it. Nancy Pelosi certainly does, as we know, but that’s not my jam. I look at more, I take more of a big picture approach. So, getting back to the example of the fiscal and monetary support that was spent on the economy, if you look at the first slide I have on inflation, right, having an understanding of what was coming down the pike made the resulting inflation mostly predictable.

I mean, we didn’t — there’s a lot of uncertainty. It’s easy to sit here and look back and say, oh, yes we knew this massive ramp in CPI was coming. It’s easy to say that in hindsight, but I think it was not an unreasonable view to take if you could understand how much money was being spent during the pandemic, right? During the pandemic, 22 million jobs were lost in the first few months of the crisis. Unemployment went from a 50-year low in 3.5 — 2.5% in February 2020 to a peak of almost 15% in just two months. So, with that happening, they were looking at a black hole of real economic loss. And they threw the kitchen sink at the problem. Between 2020 and 2021, Congress passed three separate fiscal support packages totaling $5.8 trillion. It’s about 28% of GDP. Right. So, when you have that kind of money, that kind of helicopter drop and you have a compliant, supportive monetary authority, this inflation graph should not be a surprise. And so having a big picture, political economy understanding, I think, can help set the stage for understanding what could be coming down the pike for the macro economy.

Adam:00:15:59So, David …

Rodrigo:00:16:00Can we — Can I zero in on just that? So, you just made a statement, it’s not unreasonable to expect inflation to go up. I mean, we’re sitting there in 2022, I think the zero hedges of the world have been talking about inflation for 10 to 12 years. You know, what was unique about that analysis, that political analysis that changed if for you from not likely to highly likely?

David:00:16:32The zero hedge … types focused on typically Fed balance sheet activism, so QE, right. So, when QE came on the scene in 2013, there was a plethora, it wasn’t just zero hedge. I mean, we had the top of the food chain of economists and market practitioners go against QE. In fact, I think it was in November of 2010 there was a very famous Op-Ed in the Wall Street Journal about how all this quantitative easing would result in a potential debasement of the dollar, it would result in potentially an inflationary supernova, right. So, back then, the focus was solely on one side of the ledger, which is the monetary side. I think what was different was the fiscal side this time.

And I think the — from a political standpoint, we had somewhat of a lost decade with low to moderate growth, labor force participation shrinking, people permanently out of the labor force. And I think they recognized that the austerity programs that followed the global financial crisis were a big contributor to this and they didn’t want to repeat this. So, what made it different was the fiscal involvement. And fiscal has a much more direct powerful contribution to the economy versus monetary in the short term. A helicopter drop, you put money in people’s pockets, they’re going to spend it. You cut rates, you know, maybe it’ll lower the credit card bill a little bit. That’s obviously a very simple way to describe it, but it’s pretty effective I think. So, just to answer your question, what made it different, it was the fiscal activism that we saw?

Adam:00:18:55What was interesting to me was how slow the markets caught on to this impulse because I mean, as you say, we knew back in 2020 and 2021 the size of the stimulus bills. We knew that the Treasury’s balance sheet was going to be expanding with deficits by this massive amount. But markets didn’t really seem to begin to internalize the consequences until the calendar transitioned to January 1st 2022. How do you count for that lag between knowledge entering the system of a certain thing occurring and the market’s recognition that it matters?

David:00:19:46You know, I haven’t given it that much thought, but I think off the top of my head, I’d say you know, in the context of the pandemic where, you know, I’m just shooting from the hip here, I don’t have data to back this up. But I’d imagine as the stimulus was getting deployed, people were scared, people didn’t want to spend the money perhaps, they were probably hoarding money. I don’t have an empirical basis for making the statement, but just off the top of my head thinking through this, to me, that seems like a reasonable explanation. But I don’t have an empirical answer for you.

Governments’ Goals and Objectives

Adam:00:20:24Right. So, understanding the government’s goals and objectives is sort of the critical input to your framework, right. So, how have you seen those goals and objectives shift over the last few years, maybe as a result of the pandemic or maybe as a result of a build up in forces over many years that have kind of come to a head because of the pandemic and the resulting fiscal and monetary expansion. But what are you seeing now that’s different about the government’s goals and objectives relative to maybe what we are used to over the 2010s?

David:00:21:13So, that’s a great question and it’s very relevant. I think right now we’re engaged — our society’s engaged in what’s called a distributional conflict, right. And there’s different groups that have opposing interests that our government and its agencies will have to arbitrate. And what I mean by that, I mean — the most classical one is the face-off between providers of labor, work, workers, and owners of capital, right. So, when you have high nominal growth that is inflationary, they’re going to have diametrically opposed interests, right. If you’re a saver, you don’t want inflation. It’s going to lower the present value of your investments. If you are a worker, inflation may bite into you, but at least you have money illusion. What’s money illusion? Your nominal income is going up even if your real income maybe declining.

But we live in a nominal world, we have nominal debts, we have nominal fixed obligations such as rents. So, in the near term, workers will focus on the nominal. So, that’s one distributional conflict. Another one is the conflict between creditors and debtors. And it’s the same dynamic. If you’re a creditor, you don’t want inflation, right. It’s going to erode the value of your coupons, of your income stream. If you’re a debtor, you want inflation because it’s going to erode the real value of your debt, right? We all hear stories about people back in the 70s had these crazy high mortgages, 18%, 17– whatever it was. And as interest rates fell, we had a disinflationary process… I’m sorry. Let me back up.

When rates were going up, if you had a fixed obligation the real value of that obligation went down in an inflationary environment. So, that’s another example of a distributional conflict. So, getting back to your question, we’re seeing a lot of that now, right. How do we attack, and this is core to part of my framework. How do we manage inflation, how do we bring down inflation without putting a lot of people out of work? That’s the classic distributional conflict. Who’s going to take the hit for the inflation? Savers and owners of capital, or providers of labor? Ultimately that’s a political decision, who takes the hit and over what period of time? So, that’s a classic political economy view to distributional conflicts within the economy.

Adam:00:24:18And I mean, I think — would you agree that the prevailing view over the past several decades until very recently was that decisions should be made that if in this distributional conflict, we’re going to make decisions in favor of capital. And as a result, labor’s share of economic prosperity diminished, right, between call it the mid-1970s or late 1970s and say 2020, right? Would you say that that set of priorities is changing? Like, are we observing that on the political stage that there’s a recognition that that’s gone on too long, and part of the political objective here is to rebalance or redress that disequilibrium?

David:00:25:21I mean, 100%. You hit the nail right on the head. The post — after the global financial crisis, the recovery was just awfully slow. People that fell out of the workforce, once they fell out, they had a hard time getting in. It coincided with peak globalization, offshoring. You heard about the horror stories in the news about midwestern towns being hollowed out, industry moving overseas, communities being chewed up by substance abuse, deaths of despair. I think this is somewhat amplified by social media and regardless of what you think, I think the election of Trump, whether you like him or not, the idea of bringing in an outsider to upend the status quo that a lot of populists are unhappy with was kind of the crowning moment of that, right, where people just said enough, even if we had to bring Donald Trump in, he’s better than the other person because we’re done with the status quo.

And I think in hindsight, between the very slow recovery, the structurally low inflation of the post GFC period, the political situation. I think when the coronavirus pandemic hit, there was kind of a view of we don’t want to do that again. We don’t want to do that again. It’s not good for society, it’s not good for the economy. We’re the only industrialized nation in the world that has a declining life expectancy. Why is that? We’re supposed to be the richest, wealthiest, best-off country on the planet, but somehow our life expectancy is getting worse. So, I think the idea of trying to return some of the pie to labor was part of that calculus, was part of that rescue package that was put together. Here’s our chance, don’t let a crisis go to waste, we’re doing the helicopter drop. We’re doing what we didn’t do 10 years ago, and we’re going to go big. So, I think you’re absolutely right on that point.

Rodrigo:00:27:55And 10 years ago throughout that journey from the credit crisis, I guess — was it a combination of ignorance and not recognizing what was necessary to be done to keep that middle class safe, and no lack of political will or a lack of political will to be able to execute on a strong fiscal package? And which weighed more there? Because obviously it was much easier to do this time around. It was like a no brainer. Everybody was doing it, might as well do it and do it hard.

David:00:28:23Yeah, I think it was — some of it was a hangover of the global financial crisis, right? Because ultimately, the global financial crisis was a credit crisis, right, it was a big credit event. You know, obviously Lehman and Bear Stearns being the kind of poster child for that. But you know, it was a widespread credit event. And typically, when you have credit events, the orthodoxy has been austerity, right. Rodrigo, you’re probably familiar with Latin America, right? Every time there’s a devaluation it’s austerity. You got to protect the currency, you got to protect — keep interest rates low, blah, blah, blah. Ultimately, these things become self-defeating. We saw that in Europe in 2011. And I think austerity was the raining orthodoxy, and I think that the mindset was, all right, we are pigs in the trough gorging on credit, leveraging everything we could and that blew up in our face, so we shouldn’t do that again. And I think that expressed itself in the politics and the policies that were pursued.


Adam:00:29:37I want to pick away at this objective to redress this imbalance between labor share and capital share in economic flourishing because I mean, on the one hand, dropping money into people’s bank accounts in the short term puts people on a better footing. And on a marginal basis it puts those with the least amount of current savings on an incrementally better footing than those who already had lots of savings, right? That extra money doesn’t matter much to them, right. But, I mean, I’m sure everyone in power had to know that via the Kalecki equation, eventually that entire budget deficit was going to end up as cash flow and on the balance sheets of US corporations, right. So, in the end, the capital class benefits from those deficits much more than labor does. So, that’s one point.

The other is that the Fed, certainly at the moment, seems to be most concerned with the potential for labor costs to accelerate. Right? Another way of saying that is the Fed is most concerned that the labor share of the economy is going to grow in real terms, relative to the capital share. So, how do you — well, first of all, maybe you disagree that that is the nature of the Fed’s posture. But assuming that you agree that that is, in fact, the Fed’s posture, how do you square that circle that governments are recognizing that we need to redress this imbalance? And yet they continue to take action that is trying to at least put a cap on the ability for labor to get a foothold.

David:00:31:47Sure. I mean, it’s a contradiction and I think there is a way to square the circle. And this goes back to some of the abstractions I mentioned earlier that even though I like to be an empiricist, I respect the abstract. So, let’s take a step back and look at the Fed, its reaction function and whether or not they have a working theory on inflation. And that’s debatable. So, I don’t know if you’ve heard of a Fed staff economist named Jeremy Rudd. He’s a very senior staff economist. Back in 2021, he published a paper, and he just came out swinging. He caused a stir saying that the idea that household and business expectations matter for inflation was just bunk. It was theoretically shaky and empirically unsupported. I mean, this guy is the top of the food chain. He advises the board, Jeremy Rudd. And it was one of these, like, holy cow. He just said what everybody knew kind of moments.

And part of that, I’m sure you’ve heard of Daniel Tarullo, a former federal governor who’s now or I don’t know if he’s still at Brookings. But in 2017, when he was at Brookings, he pretty much said the same thing. You know, he gave a speech at Brookings titled “Monetary Policy Without a Working Theory of Inflation”. And his basic message was that while policymakers have a working theory of inflation, it’s not one that works well enough in real time to make good policy. Right? So, in effect, the Fed is fighting with its hands behind its back. You know, it doesn’t mean that they don’t have a model. Doesn’t mean they don’t have a reaction function, it just means that it’s very imperfect. And once you recognize that they don’t have a working theory of inflation, you kind of realize that they’re kind of shooting in the dark a little bit, making up as they go along a little bit. Not fully, but partially. Right? I mean they got —

Rodrigo:00:34:12Or they don’t feel like they’re doing it, but in fact, that’s what they’re doing. They feel like they’re hitting the bull’s eye based on their models, but they’re actually quite in the dark and having random effects on the economy, especially in the last few years on inflation. Right? It’s just a poorly working model.

David:00:34:33Correct. So, I’m just looking at my notes here, one second. So, the way I approach the problem set is I’m not smarter than the Fed, I’m not smarter than the army of PhD economists that they have. I think it’s over 400 at the board alone. So, I don’t have an edge against them. My best bet is to try to understand them and understand their reaction function so I can best gauge and manage my risks. Right. So — I think that when you go to at least undergrad, maybe not in PhD level economics. In undergrad, you get exposed to a lot of simple approaches that really we just kind of take for granted and accept them as being true.

You know, for example, the simple macro 101 one narrative about M2 in the money supply being the end all be all of inflation. That is one area that I like to debate a lot on Twitter because it’s not empirically, you know, the causality, I don’t know if it’s been established. I think we see M2 monetary indicators as coincident as what’s happening as a function of these other policies that are being made but it doesn’t really explain how inflation actually works, how it leads to a price spiral. You know, the other approach is that credit and financing have an effect on households and an expansion of credit will cause inflation. So, I kind of find those propositions to be empirically shaky.

And luckily, there’s a 2020 paper written by two economists named Slack and Watson. And their paper is called Slack and Cyclically Sensitive Inflation. And their finding was a big whopper. So, most of the total components that make up aggregate price indices don’t really move reliably with the business cycle. The most reliable cyclical inflation components are not the ones that fit into the conventional wisdom of how the Fed might influence inflation. And the bottom line is they found out that the most cyclically sensitive parts of the economy to inflation are actually rents and food. Now we know that rents are affected through nominal wages. Right? Because you don’t pay for rent through your savings, through your wealth. You pay for rent through your current income.

So, going back to the Fed’s reaction model and reaction function and how they view the world, if the Fed really is looking at inflation, they need to look at the parts that are cyclically responsive to inflation. And as I said, that’s rents and food. The Fed influences rents vis à vis the labor channel, which in turn is influenced through financial conditions. So, going back to the question of how does — how has the Fed looked at inflation? It’s really looking at the labor market, it’s really looking at wages and employment growth. That’s really what they’re looking at and that’s actually consistent with their dual mandate, right? The dual mandate is stable inflation and maximum employment. So, that’s really the reaction function.

Adam:00:39:15So, the reaction function is dictated by a recognition, do you think that this is widely recognized at the Fed or at least by those who are primary decision makers at the Fed that rents and food are the components of the consumption basket that require the greatest scrutiny and that employment is the biggest driver of rents. Right? I mean, as you were talking about whether employment was the primary driver of rents, it occurred to me that cost of capital must also factor in pretty heavily into the cost of — into rents, right? Eventually, if you’ve got homeowners or building owners that are — or condo owners that are earning a negative cap rate, then you’re going to see a shift in rents to redress that imbalance. Right? Rents are going to have to go up so that we get positive cap rates unless we’re going to make it up on volume.

David:00:40:28Sure. I mean rents actually follow house prices, which are influenced by the cost of capital. Right? The cost of capital drives fixed residential investment. And rents typically follow house prices with the lag of 12 to 18 months. So, that is a factor for sure.

Adam:00:40:52Right. So, it’s a tension between or synthesis between labor income being able to afford higher rents and nudging rents higher and the ability to build more buildings and or homes to rent, which is a function of the availability of credit and the cost of capital and somewhere in the middle there, you get — there’s an equilibrium that is found. But at the margin, labor’s ability to spend more on rents is what makes the rent component of the consumption basket so much more sensitive to cyclical factors.

David:00:41:36Absolutely. And that was actually the premise of the Watson paper. In fact, on the next slide, Rodrigo, I think you’ve got the control there. You know, there’s a link to — you don’t have to link to the paper, the paper’s actually god awfully boring. But that’s their kind of the money shock quote there. “Prices are determined largely in local markets such as housing, and prices at restaurants and hotels have large cyclical components.” So, as the Fed tries to manage the inflation cycle, what they’re really doing is managing the labor cycle. And with that in mind, if you go to the next slide, Rodrigo, in the Feb– I’m sorry, the December summary of economic projections, the Fed came out and said they’re targeting 4.6% in U3 unemployment this year in 2023. Right?

So, right now, we’re at 3.5%. So, just back of the envelope math, assuming constant labor force participation, a 1% increase in unemployment is about 1.5 million lost jobs. Right. That’s a big deal. And the reason it’s a big deal is because it’s potentially, you know, recessionary. You know, first, we got the Sahm Rule named after Claudia Sahm, and that size job loss signals the start of a recession when the three-month moving average of the unemployment rate rises by 50 basis points or more from its low during the previous three months. So, if the Fed is targeting that level of increase in unemployment, they’re effectively telling us, they’re maybe not saying we want to throw the economy into recession, but they’re basically telling us labor has to pay up. Labor is going to take a hit, maybe not the hit, but labor has to make a contribution to this inflationary issue.

I think the problem with the Fed’s forecast is that every time we’ve had 1% increases of unemployment, we’ve had 12 episodes in the post war period. In 11 of those episodes — I’m sorry. In every single one of those episodes, the economy went into recession. And in 11 of those episodes, that increase did not stop at 1%. Unemployment kept on rising. So, going back to the Fed’s reaction function, going back to how they’re approaching this problem, they are putting the brakes on labor in their attempt to put the brakes on inflation. That’s really what they’re doing.

Adam:00:44:55Okay. So, this is interesting because I think we’re hitting on your assertion that the Fed’s reaction function is actually primarily focused on labor market tightness or maybe even the unemployment rate. So, if they expect that they’re going to need an unemployment rate of 4.6% by the end of 2023 in order to bring inflation back in line with their targets, that if they begin to perceive that their current rate trajectory is unlikely to achieve that unemployment rate because the labor market is much more resilient than they had expected then presumably they’re going to have to go higher and hold rates higher for longer in order to be able to achieve their unemployment rate target and by proxy their inflation target. Is that — …

David:00:46:00That’s not a 100% correct. So, 2022 was a boom year for employment. Let me look at my notes here.

Adam:00:46:14Yeah. I mean, we hit a, what, seven year low or something in U3 in December?

David:00:46:21Hold on, one second. I may have misplaced the slide. But…

Rodrigo:00:46:29It was December — It hit 3.5 in December according to your slide.

David:00:46:33It did. Correct. It came down — I believe it was 3.9 at the beginning of the year and 4.5 million jobs were created. I think I misplaced that slide somewhere. But the bottom line is despite a — the most aggressive tightening cycle in 40 years, the labor market boomed, 4.5 million jobs, 3.9, unemployment down at 3.5%. Right. So, if we —

Adam:00:46:00And we’re touching. Like, we just troughed. Right? Like, we just hit the alternate low. So, even the second derivative is not even moving in the right direction.

David:00:47:09We hit pre-pandemic levels of unemployment which is also 3.5 in February of 2020. So, those jobs have been recovered. Obviously, if you adjust for labor force participation and people are exiting the labor force. But for the most part we’ve recovered. So, you had a bull market in labor and a bear market in financial markets and a slow expansion in the real economy. So, if we extrapolate that to 2023, which may or may not happen, then that makes the case of higher for longer for sure. And I think what lends credence to that thought is that over the pandemic, people accumulated around $2.1 trillion in excess savings. Right? We’re down to about 950. So, let’s just say, let’s just use round numbers. We’ve gone through half of the excess savings that were accumulated during the pandemic. That is dry powder for the economy, for the consumer. That could extend the bull market and labor, which will keep the Fed on its hiking path.

Adam:00:48:38I’ll add something. I’ll add a dimension to that too because I’ve been really harkening on this point as well, right, is just the size of demand deposits. But what is also important is where those demand deposits are or rather which cohorts of society it sits with. Right? Because there was a time about a year and a half ago when the first quartile by income had the largest amount on deposit at banks in the history of the series. Right? And over the last 18 months, that first quintile has whittled it down and they’re now beginning to draw down on credit availability. Right? Meanwhile, those at the third, fourth, and fifth income quintiles in the sort of middle to upper income levels are still sitting with huge excess savings, huge excess demand deposits. Right?

So, what I’ve been sort of hypothesizing is that the middle class and the rich tend to spend overwhelmingly on services, or at least their marginal spending is on services and less on goods. And therefore six or eight months ago, we did a lot of talk about where we should begin to see inflation shift to services over goods. Right? Now are we — I know we have seen some of that. Are we still seeing the services that one might expect to be more likely to be spent on by those in the Q3, Q4, and Q5 income categories being a lot more persistent in their price raises? And then do you see any of that trickling down into labor market dynamics?

David:00:50:43So, the answer is we’re definitely seeing a shift from goods to services — spending from goods to services. So, I know retail sales got printed earlier and there is a lot of sky is falling type commentary on Twitter and another media. But I think that covers up some of the underlying dynamics of this aggregate spending numbers, shifting more towards services.

Adam:00:51:17Right. So, …

Rodrigo:00:51:18Can I just…

Adam:00:51:18retail sale doesn’t really capture services spending very well.

David:00:51:22What’s that, Rodrigo?

Rodrigo:00:51:43Yeah. I just want to get your view in what you think the Fed’s level of understanding of the lags between a tightening cycle and earnings and the tightening cycle and its impact on labor. And I’ve heard numbers being dropped, like, the lag on average is from the moment they start tightening, it’s 12 months before you start seeing earnings shift, and around 18 months where you start seeing a labor impact. And not to mention what you guys discussed, which is the amount of savings that there is. That’s probably going to extend that a little bit further. Right? And so if you don’t have a good grasp for that as a policy maker, you could easily make mistakes as you start seeing earnings go down and take your foot off the pedal before you’ve actually done what you wanted to do in the labor market. So, where do you think their understanding of those lags are? And how does your framework kind of —

David:00:52:18So, that’s a good question. If you go to slide number six, called — it’s titled US Nominal Domestic Spending, Year over Year. Or seven. Let’s see here. All right. There you go. So, that’s basically nominal — these are my proxies for nominal spending. It’s nominal GDI, nominal GDP, and consumer — producer, I’m sorry, PCE expenditures. So, you can see we were — I think the graph before that one, the chart before that one, that’s the indexed chart. Prior to the pandemic, you can look at the slope of how nominal spending was increasing every year. And after the pandemic, you can see the steeper slope. Okay. Those are indexed numbers. If we make those numbers in the following slide, year over year numbers, you see nominal spending just go through the roof. Right?

So, why is nominal spending important? Because nominal spending is highly correlated with market earnings. So, going back to the timing, we’re going to keep going — the Fed with its rate hiking cycle is going to try to bring those lines back to their historical trend, back to a nominal growth target of 4 to 5%. Right now based on December PCE was 5.7%, real growth somewhere between 1% and 2%, I would ballpark nominal spending right now at around 7%, give or take. So, these figures are quarterly, last updated third quarter. So, we’ve come down from there. But let’s just say we’re at 7%. We’ve got at least 200 basis points more to go to decrease nominal spending. So, in terms of the timing, I think it’s really going to come down to at what rate in the Fed — how aggressively can the Fed slow nominal spending? And that’s going to translate into when we see revenues and earnings on the S&P 500 tip-off or rollover.

So, I think it’s — this is a stated policy objective of the Fed. Going back to our macro framework of understanding the Fed’s reaction function, understanding the strategic objectives, they have made it very clear that they want to slow inflation vis á vis the labor market and that’s going to impact nominal spending and drag nominal spending down. So, in a long-winded way, I’d say we still have a ways to go before we see earnings rollover just because of the strength in nominal spending that we still have to slow down.

Rodrigo:00:55:43Right. And I guess that the question really for me is if that overshoots on the other side. Right? Because that’s an aggressive slope down now that we’re right? You’re saying we’re going to get down to seven next month. The tightening cycle began maybe early 2020 to in real terms, right? So, we’re kind of hitting that 12-month mark.

David:00:56:07That’s right.

Rodrigo:00:56:08If they overshoot and they get spooked, like, there’s an op — there’s a possibility here that they get spooked before the labor numbers come in, right, before they actually hit their mark on the labor side. And could they get spooked and stop their hawkish stance earlier than they should? It’s a thing that’s in the back of my mind anyway.

David:00:56:29I think it’s a high probability. Here’s why. I didn’t include it in the chart pack, but on Twitter I’ve been following what’s called OER, owners’ equivalent rent. Going back to our macro framework of understanding the cyclical impact of rents on inflation, owners’ equivalent rent is basically it’s kind of like one of these economic abstractions like … star. It’s not something that we really see. It’s something that we make up to try to have a stylized view of the world because I, as a homeowner, don’t pay rent, I pay a mortgage. But that is still a part out of my monthly income stream that I need to pay. So, the Fed basically comes up and says, okay. We’re going to somehow try to approximate what homeowners pay in rent even though they’re really paying a fixed contract known as a mortgage.

In any event, OER is about 40% of core CPI. And as I mentioned earlier, rents follow home prices with about 12 to 18 month lag. So, home prices peaked in, I believe it was July 2021. So, that flow through and a decrease in owners’ equivalent rent is set to start right around now. In fact, on one of my Twitter postings, Larry Summers had a graph of his model on OER showing that this is really going to accelerate starting February or March of this year. So, going back to nominal spending, which is, obviously, takes into account inflation, if this kickoff in OER really kicks in, then we could see a short-term drop in inflation that slows nominal spending and spooks the Fed.

Adam:00:58:45Now what if that coincides with sustainably resilient labor markets? I mean, one of the things we haven’t talked about is that we’ve had about 1.5 million excess retirements post COVID. Right? I mean, we know demographically, we can model pretty closely the expected number of retirements every year. We’ve had about 1.5 million more retirements in the last 18 months to 24 months than expected. So, there’s just a lot fewer people in the labor market and there’s a question about whether they’re going to come back or when they’re going to come back. And the other thing is they tend to be more experienced higher wage earners. So, how do we — what if the labor — what if the unemployment rate is persistently low? It hovers in this 3.5-3.6 range for many more months. And at the same time, we do see some of this slowdown in OER and a couple of the other bigger categories of the core CPI basket. How do you think the Fed’s going to navigate those conflicting views?

David:01:00:05They’re going to be in a real pickle is the answer. Because they will be forced to acknowledge the pullback in nominal spending. Right? But that will create a feedback loop where easing financial conditions will reignite spending. And we will see that primarily in the mortgage market. Right. So, the housing market in 2022 right around June-July of this past summer, when mortgage rates started going parabolic, the mortgage market pretty much froze up back in September of last year. You had record high contract cancellations, you had declines in home purchases. And then right around October, mortgage rates started to come back down. They’ve come back down by over a 125 basis points, and that’s been very stimulative to the economy. Right. We’re starting to see mortgage activity, home activity pick up again. And so that’s going to create this feedback loop in that market, which will be very supportive. And it’s going to be hard to navigate is the answer.

Adam:01:01:41Yeah, it’ll be especially supportive of employment. Right? So, this is where I think things get tricky. I also — I mean, we talked already about excess savings, but why should we expect the year over year rate of growth in consumption to decline substantially while there is still such a huge amount of excess savings and therefore excess purchasing power by US consumers.

David:01:02:19And the answer is we shouldn’t. And that’s why I mentioned that level of excess savings. And I think there’s a — I myself am conflicted. Right? I mean, I’m not married to any one outcome of a soft landing or a hard landing. I’m trying to be as data dependent as I can. And you’ve got this potential for an OER drop off, a pullback in nominal spending, but if the excess savings can serve as bridge to get us over the hump, so to speak, then that strengthens your soft landing case and it’s going to be interesting. I really don’t have an answer. I know what to look at though. I know, as I said, I’m looking at the housing market, particularly OER and its impact on inflation. I’m looking at the labor market and its impact on nominal spending. So, while I don’t have a crystal ball, at least I know which direction to look for, before getting slapped in the face.

Adam:01:03:35An interesting question that I’ve been asking people in my circle is, would a soft landing be necessarily beneficial for equities? And the reason why I ask is for the economy, a soft landing might be a drop off in inflation. Right? Inflation sort of slowly comes back down close to target. Unemployment stays tight but neither of those dynamics give the Fed a catalyst to cut. Right? So, it could be, you get a couple more rate hikes and then we just stay at whatever, five or five and a quarter percent for a long time. Is that a necessarily positive outcome for — …

Rodrigo:01:04:37Well, if rates go to two, if rates go to two, I don’t think they’re going to leave the real rates of return at 3%. I think the economy couldn’t sustain that. Right? So, they’d have to cut if they’re actually … inflationary rake hike.

Adam:01:04:48No, no, no. Hold on, hold. We had rates of 8%, 6%, 5%, 4% all while inflation was around 2% for decades. Right.

David:01:05:02So, it goes back to my view on nominal spending, right, and the rate at which we return nominal spending to its historical trend. If it’s done over a long period of time, where revenues don’t, you know, the hit is spread over a longer time for firms, then it could be okay for equities. If it’s done quickly, if there’s a rug pull in nominal spending, then equities will take it on the chin hands down.

Adam:01:05:31Well, there’s two dynamics at play, right?

David:01:05:34Even if the economy doesn’t go into a formal recession, if that rate of decrease in nominal spending takes place over a short period of time, then I think there’s a high probability that equities take it on the chin despite an economic soft landing.

Adam:01:05:50I guess where I’m going is there’s two dynamics at play. One is the risk premium and one is earnings growth. Right? But certainly a soft landing would be beneficial for earnings and cash flow. But high rates is a negative for multiples. Right? We’ve got the S&P still trading, I think, the last time I looked at a PE ratio of — a CAPE ratio of, like, 27. Right? So, if we’re going to hold rates at 4% or 5% going forward and not at 0%, then what kind of multiple would we expect on US corporate earnings? Would we expect them to stay near 27 or would we expect them to work through their way back to some number that is more in keeping with a 5% risk free rate and something like an 8% or 9% cost of capital?

David:01:06:44So, I think it has less to do with the absolute level of interest rates and more to do with the volatility of interest rates. I think the volatility of rates is the primary driver of risk premiums on the fixed income side. Which in turn, spill over to the equity side. So, off the top of my head, I don’t have the answer for you on that front. But I will tell you that it has less to do with the absolute level of rates and more the volatility surrounding the policy making process, policy outcomes, and risk premiums in fixed income markets.

Speaking of risk premiums in fixed income markets, if you scroll down to slide number 15 or 16, the next one after that probably. There you go. So, that’s the real risk free neutral rate. It’s a mouthful. It’s basically a real rate adjusted for risk premiums. That’s kind of a pure view, in my opinion, a cleaner view into what’s happening in fixed income markets. So, despite the pullback in nominals that we’ve seen in the past couple of months, despite break evens, I think if you go about the slide before that, you’ve got the — two slides before that, you got break events coming down significantly. The slide after that you’ve got five year, five year forward inflation expectations pretty much stabilized in a tight range. The real risk free rate continues to go up. That is — a cleaner view into what’s happening into the rates market because it takes out the impact of risk premiums. So, this is what I’m watching as one of my proxies for how risk premiums behave going forward.

Adam:01:09:01Can you explain what goes into this calculation? What is this?

David:01:09:05Yeah. It’s pretty — all it is, is — so, the New York Fed publishes what’s called the ACM term premium model. You can go on their website and find it. They publish the term premiums, and I did some simple algebraic manipulation, stripped out the term premium from the real rate to get this figure here. So, all it is, is a real rate minus the term premium. And the term premium is calculated using a trinomial model that the egg heads at the Fed publish every day.

Adam:01:09:44Okay. And so you’re proxying term premium for risk premium then?

David:01:09:51On the fixed income side, correct. Yes.

Adam:01:09:53Gotcha. I mean, obviously, there’s a credit premium in fixed income and then there’s the term premium.

David:01:09:58This is the complete — I mean, according to the New York Fed, this is the complete premium set package. So, that embodies inflation premium, it embodies, term premium, liquidity premium, whatever other premium that they deem appropriate or relevant. So, I’m looking at this as a proxy for what I was mentioning earlier about the importance of rate volatility and risk premiums.

Rodrigo:01:10:37And so the higher the rate volatility, the higher the risk premiums, and that spills over into equity markets as well.

David:01:10:43I’m sorry, I missed that.

Rodrigo:01:10:46The higher the volatility, the higher the risk premiums and the higher the equity risk premiums as well. It spills over into the equity markets. Is that what…

David:01:10:54That’s correct. That’s correct. So, if we see more — if we continue to see inflation, I’m sorry, interest rate volatility elevated, then I don’t think we get the relief in risk premiums that we’re looking for.

Adam:01:11:14Yeah. I mean, risk premia are already very high still, right, in equities and credit. Right? I mean, it’s or sorry, very low rather. Right? I mean the — …


Adam:01:11:24The two-year rate is already higher than the dividend yield on the S&P. And the credit spreads are almost back to where they were pre-COVID, or back in 2021. So, risk markets are saying there’s no risk in this market. Right? They’re not pricing any risk in this market. So, it’s — I guess, I’m just wondering what the bull case is for equities here if we don’t see rates go quickly back to zero, and alternatives like safe instruments end up having a higher expected return than equities at a fraction of the risk. I just think that other asset classes are going to compete for equity bid in this kind of rate environment unless the Fed goes, pivots pretty aggressively and we go back to the 2 to 0% rate environment that we were in before. Is that something that you anticipate? Something like if we were to sort of look out three to five years from now or you expecting rates to kind of normalize at the abnormal levels we’ve seen over the last decade?

David:01:12:40The answer is — I’ll take a step back to respond to your comment about the risk premium. So, yeah, risk premiums on the fixed income side have compressed. They’re according to this model, as of yesterday, minus 78 basis points. And we saw them just as recently as, you know, back in September, they were kind of at a minus 40 handle. So, we have seen this kind of flight to safety, strong bid for treasuries, and that’s coincided with the pullback in the ten year. Now going back to your other question, what happens in three to five years? Honestly, I don’t have a crystal ball. I don’t. And I think it’s very hard to, you know, we’re still trying to figure out what happens to nominal spending and when it happens And I think without having the answers to that side of the puzzle, it’s really hard to make it a case for one way or the other, three to five years out.

Rodrigo:01:13:43So, this is a good transition for me. And whenever we speak with and we speak about macro, there’s a lot of data points. Every macro analyst has their own set of data points and 20% of them are new to me every single time. And you’re trying to kind of make sense of what they’re saying and where they lean and what their time horizons is. So, I guess we never asked you, like, what do you trade in, first of all, that you use in order to express your macro views, and what is your time horizon? Like, how is it that you put — how does the rubber meet the road with your framework and what you invest in?

David:01:14:22Yeah. So, and this kind of goes back to my ambivalence about making a forecast for three to five years out. So, day to day, I’m not a day trader. I use this macro process for really determining how much leverage I want to use, how much risk will I use. I implement a series of systematic trading strategies, mean reversion, some trend following. So, that’s kind of — that’s somewhat generic rules based, weekly and monthly trading. But I use the framework to determine my risk budget. How much — …

Rodrigo:01:15:01Is this on US equities, on global futures contracts? Like, where…

David:01:15:06            US equities primarily. Yes.

Rodrigo:01:15:08US equities. Got it.

David:01:15:09The reason is they have the most data points to data mine. Foreign equities, I guess developed Europe is data rich, but US equities have a lot of data points to use for simulations and strategy development. So — …

Rodrigo:01:15:29And is this on indices or individual equities that you — …

David:01:15:33Both, both indices and individual equities. So, again, the macro framework really comes down to trying to manage my risk. How much, not just leverage, but also time horizon. If I’m ambivalent about what’s happening in three to five years that also affects asset allocation for some passive accounts that I manage.

Rodrigo:01:15:57Right. So, you’re looking out — you’re data driven, you’re — everything is systematic on your trading side, but how much you put pedal to the metal is dependent on your macro view. And right now —


Rodrigo:01:16:10And you’re looking out over the next few months as you make your leverage decision?

David:01:16:17Correct. So, a good example is back in March of last year, some of my strategies were down between 2 and 6%. After March, I was in cash primarily — mostly until August where I did some small discretionary trading, but the volatility environment was not really conducive to implementing the strategies. There was too much whipsaw. So, understanding that we were in a hiking cycle, understanding that the Fed was going to go after labor, would try to slow down nominal spending, would have some impact on equities, rate hiking cycle, housing, that to me was a signal to say, okay, I’m not going to override my systems. I’m just going to hang out.

And unfortunately, it was summer so I couldn’t snowboard, but not a whole lot of trading was done last year for that reason. But the — you know, I had a modestly down year and last year, but for the most part, came out with the skin on my back with no problem. And that is entirely due to my framework for understanding and managing risk, when to trade, when not to trade, how much leverage to employ or not to employ for that matter.

Adam:01:17:42Yeah. I mean, I guess the answer to the questions about where the natural equilibrium rate is, whether it’s in the zero to two range or the three to five or five to eight range is going to dictate whether — which sectors of the economy, which asset classes are going to dominate over the next several years. Right? So, yeah, it’s a very challenging environment.

David:01:18:13Well, not only that, but I think last year the 60/40 portfolio got shot in the head. Right? So, that’s going to impact how portfolios are constructed going forward. Right? If the covariance matrix — if bonds don’t provide the same level of diversification, then that’s going to affect — have huge impacts on portfolio construction.

Adam:01:18:38Yes, sure. But I guess the point is if your anticipation is that inflation is going to moderate over the next year or two, it’s going to go back into the box, then there’s no reason to expect bond and stock correlations to stay high. Right? They’re more likely to revert to their — …


Adam:01:19:03— pre-pandemic, Goldilocks relationship. Right?

David:01:19:08Sure. If we can get inflation to moderate without putting the economy in a stagflationary type situation. I mean, I think the probability of that is — the answer is I don’t know. I don’t know. And that’s why I stick to, for trading purposes, I stick to systematic trading. Because even though I have a macro view, I think it’s very — going back to this whole notion of formal economics training, I think it’s very easy to get anchored into a narrative. And I think maintaining some level of ambiguity keeps me from falling into a narrative trap of drinking my own Kool Aid, and that’s not a position I can afford to get into.

Adam:01:19:58On that we can certainly agree.

Rodrigo:01:20:02Macro trading is just such a difficult thing when you come up with a framework and narrative, you get married into it. And you act on it and it doesn’t go your way. If you don’t have any sort of systems behind it, I’ve always found that, you know, … it’s I don’t even know where you’re anchored to. Right? So, it’s always interesting to see what the actual systems that macro traders implement to safeguard themselves against their own undoing and their own narrative.

David:01:20:31Sure. I mean, I take some small puncher type discretionary bets, but these are lotto’s. These are things that I can walk away from. This is pizza and beer money kind of thing. You know, I don’t take serious bets — …

Rodrigo:01:20:47Bragging rights.

David:01:20:48Yeah. I don’t take serious bets on narrative because it is what it is.

Rodrigo:01:20:57Got it.

Adam:01:21:00Great. Well, this has been very elucidating. David, thank you so much for sharing your framework with us. And —

David:01:21:08Thanks for having me.

Adam:01:21:10— and helping us to understand the potential evolution of the economy in markets over the next few months. It’s going to be very interesting to watch. I think we’re all aligned on that. So, yeah, with that, Rod, are you — …

Rodrigo:01:21:27Where can we find you, David? Is there — What’s your Twitter handle to get some more information for people to get to know you some more?

David:01:21:33Yeah. It’s David@PinebrookCap.

Rodrigo:01:21:37David at Pinebrook … Pinebrook Cap.


Rodrigo:01:21:41Awesome. Okay.

Adam:01:21:42And a special thank you to Michael Harris who has been in the chat, but also made the introduction to David. And so kudos and much appreciation in that direction as well.

Rodrigo:01:21:54Yeah. Thanks all for coming live. Make sure you like and subscribe. And we shall see you on next Friday.

Adam:01:22:03We’ve got Andy Constan on live next Friday too. So — …

David:01:22:05Oh, wow. Great.

Adam:01:22:06Tune in to that.

David:01:22:07More macro.

Adam:01:22:08That’s right.

David:01:22:10Then in that conversation, I’ll have a beer with that one.

Rodrigo:01:22:12Yeah. There you go.

Adam:01:22:13All right. Fantastic. Yeah. Okay. Thanks, guys. Have a great weekend.

David:01:22:17Take care.

Rodrigo:01:22:21Sorry, guys, we’re going to — I’m in charge today, so it’ll be a bit of a lag.

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