[00:01:19]Joaquín Kritz Lara: Absolutely.

Backgrounder

[00:01:20]Richard Laterman: Yeah, thanks Mike. And maybe Joaquin, you can start us off by giving us a little bit of your background and what got you at Numera today, and tell us a little bit about Numera itself.

[00:01:30]Joaquín Kritz Lara: Yeah. So I’m an economist by training. My sort of formal background would be in what is known as applied macro econometrics, which is basically model building for economists applied to macro themes. And so it’s more on the quantitative side, if you will, than your standard economists appearing on CNBC and so on. The, so I’ve been working at Numera for over a decade now. We started off, so originally it’s a macro shop but geared towards commodities. And then about five years ago we launched our global macro practice if you will, and that extended to basically all major asset classes.

So we look at commodities of course, but also equities. We do fixed income, local hard currency, debt currencies and so on. And obviously it’s a global picture and so we’ll have views on key region or worldwide specific macroeconomic themes. And then we’ll attach, as Mike was saying, sort of investment ideas surrounding that.

The key thing behind our approach, if you will, is, the macro research space for those who are familiar with it, it’s very crowded, if anything because the large banks are a part of that. And so what you really want to do, I think if you want to excel and distinguish yourself in the space, I think has to do much more with process and approach than it has to do with coverage.

Really, there’s a lot of shops that will cover the same asset classes and regions. The investment horizons are usually the same. In macro, the sweet spot is usually 6 to 12 months. If you’re dealing with hedge funds, it’s shorter than that. Pension funds may be longer, but it doesn’t, that doesn’t really change much. What does change is the approach to thinking about economics and applying global macro to markets. And traditionally I would say, you have these two big camps. A lot of the top-down investment research stuff, I would say is very qualitative in nature. By that, I don’t mean that it’s not that they entirely disregard models, but it’s much more charts based, right?

Where they look at these sort of standard correlations between things and then hopefully try and get some predictive content, how the leading indicators to see where markets are heading and based off that and based on some, and experience and preconceived notions about how the economy works.

They’ll put on some views, right? On the other hand, you have outfits that typically don’t deal with the buy side, who would, are more formal in nature in the structure of what they do, right? It would be more quantitative, more model-based, but usually that doesn’t really translate to financial markets, right?

So you’ll have shops that have these large econometric frameworks, like I’m thinking like, Moody’s Analytics, that, that sort of thing, right? And what you’d get from that is, views on growth, inflation and so on. And then it’s up to you, Mr. Investor, to decide what that means for markets.

Even in that space though, the sort of, the missing link in our view was that there is a disregard. Uncertainty, right? Economists, a lot of, especially macro guys, they’re very opinionated usually. I’m sure that you’ve dealt with them. And so they have this sort of very strong belief around how the world works.

And then often they will adjust their views and suggestions and even seek causality and certain correlations when that doesn’t really exist. And that’s because they have a preconceived notion around, hey, inflation is driven by monetary factors, or demographics, or whatever the case may be.

Commodities depend on certain type of dynamics. And they have these pre-built notions and that misses out on the fact that us, as an asset allocator, as an investor, you’re facing so much uncertainty about the future. And that’s typically not quantified. And so what we bring to the table is this probabilistic approach that Mike was mentioning where we’ll apply modeling techniques that are rooted in economic theory.

And they, they’re cutting edge quantitative techniques, some that sort of akin to machine learning type things, in some cases. But the, we’re really interested in basically being able to quantify or monitor the full range of potential outcomes you face in evaluating a particular asset price, and the potential impact that shifts in the macro landscape may have on that, right?

And so what that allows you to do is to monitor risk, right, because let’s say that I want to, you wanted to get my thoughts on where I think oil prices will move from here to six months from now. If I tell you it’s going to be $83 per barrel or $92 per barrel, $71, that’s a total shot in the dark. If you look at the, so if you look at futures, for instance, I, this is nuts. The average error in prediction of the futures curve in forecasting oil one year out is 50%, so you miss by 50% on average, the market does. How does that, how is that helpful in any way? What is helpful is to monitor the likelihood of oil, say, exceeding a certain threshold or even you getting positive or negative returns.

That is much more informative, I think, in being able to make accurate decisions and being able to monitor downside risk. And so the techniques that we use is, will sometimes exploit theory. Sometimes it’ll be more statistical, but it’s always back tested. It’s always tested what’s called an out of sample.

So the models are checked for accuracy and then off that, we’ll map basically what global macro dynamics mean for financial markets and whether we suggest you should be overweight weighing certain asset classes in the same way that, that, multi-asset shops would do. It’s just that we add this sort of probabilistic layer. I think some people call it quantum mental, it’s this idea between machine and human. That’s our sweet spot, if you will.

[00:07:23]Mike Philbrick: So that was one of the things that attracted me most to the framework at Numera as I received some of the information, is the fact that you take a probabilistic view and listen, there’s actual marketing and then there’s actual implementation in portfolios. And I think there’s a tendency for portfolio managers, hedge fund managers to have to say something compelling or controversial, have lots of confidence in that in order to get the sort of the buy-through for their strategies.

And we don’t perceive that as a, it’s always tough, right? You’ve got the, I’m talking to investors and I need to have an opinion versus really, my opinions are probabilistically based, so I’m not, I’m a certain confidence in them. And when we look at our systems, our confidence interval will affect our position size.

So they’re related, right? You want to relate the confidence interval you’re getting from your various signals with a position size so that they’re talking to one another. I think there’s, there is that group of portfolio managers, hedge fund managers that will say the things that will go out there.

Ackman’s been out there. I’m short, long bonds, right? We’re going into an inflationary segment. I think that’s marketing. I recall him being on the day low of the Covid crisis. This is way worse than everybody thought. Meanwhile, he was covering. You always have to be very careful of those types of information you might be receiving, is that someone else might be talking their book. What I liked about Numera, what attracted me to you and wanting to have this conversation, I love the probabilistic aspect of it because that’s the way we think and that’s the way you want to think as an investor. And that’s the way you always frame a lot of your sort of insights.

You’ve got, bell curve on a lot of them. You’ve got a shaded portion underneath. You say, here’s how we view the probabilities of this coming to fruition. And then that allows the investor to take the bet appropriate with that. Do they agree with your particular probabilistic outcome? Do they think it’s a little better, a little worse than that? And so that framework was very compelling to us, I think. And that’s a very, I think, a very important framework when you’re thinking about your allocation framework. I don’t know, Richard, if you’ve got some thoughts on that.

[00:09:31]Richard Laterman: Yeah. I was actually thinking about something Joaquin said a moment ago regarding sometimes leaning more on the probabilistic framework, sometimes leaning more on the fundamental models, and I’m wondering, do those weights shift over time? When do you lean more on one versus the other? Does it, is it asset class variant? How do you go about determining when to weigh one over the other?

[00:09:53]Joaquín Kritz Lara: So it, I guess in every case we’ll have a probabilistic framework regardless of the model we’re using. I guess what I meant more is the, some models are deeply rooted in theory, right? So if I’m, in some cases, let’s say our, what say some of our frameworks on you were mentioning the Ackman call on inflation. On inflation and yields, like a few of our long-term yield models will very deeply be rooted on an estimation of the neutral rate of interest, the Taylor Rule, that sort of thing. But even there, they carry uncertainty around future dynamics, right? The Fed’s reaction function depends on certain things, right?

It depends on how unemployment moves in the future, how that interacts with inflation. There’s, there might be a threshold above which the Fed may start prioritizing again job creation over inflation and so on. But to answer your question, we often, so to deal with that kind of, uncertainty around model choice we often use what are, what is called dynamic model combinations. Meaning we’ll, for any one framework we, we deal with take 10 year yields or it doesn’t matter, 10 year yields is good. We’ll have not just one framework, but let’s say five or six that work well on average in, out of samples. So back tested, and then we’ll recalibrate the importance that we attach to the signals.

Some signals may say, hey, you’re going to five and a half, the other ones may be no, you’re going back to two, based on the actual predictive content that these things have exhibited in the past or the recent past. And so it will recalibrate the weight based on actual predictive content. And so there’s this thing called like a forget multiple death factor, which is the speed at which you forget past information.

So maybe, things that happened 30 years ago, you won’t really care that much about your performance in the last year or six months, maybe is really important. And so that kind of dynamic approach is pretty novel to economics. It’s much more common, there’s other disciplines in physics, it’s used quite, quite a bit.

[00:11:54]Mike Philbrick: For example, Information Science

[00:11:56]Joaquín Kritz Lara: Yeah, exactly. So the idea basically is acknowledging that you are not a genius and you don’t know the full truth. And that kind of it’s like a Bayesian way of thinking, right? So it’s like I have a probabilistic view of the world, but I may adapt those priors based on new information that I observe.

And so it’s that kind of adjustment that is done within a modeling framework, right? Because you actually track performance, right? So if one of your models performs really badly you can actually, you quantify, you measure the error and the prediction and you reduce the weight, and then you keep, you raise the weight otherwise.

And so the beauty of this, especially when you have, I would say, models for assets that you have a long history for, inflation for instance, is a great one. It allows you to revive the importance of certain frameworks that you thought maybe were useless. Inflation is an excellent example because in the 1970s, and it was basically before Volcker monetary frameworks, so the ones that Friedman pushed were actually very useful at forecasting inflation because in a high volatile, in a high volatile inflationary environment, it, monetary factors typically will matter more for the inflation process.

So like in Latin America, for instance, which is a region with has high structural inflation, monetary factors usually matter more. But then as inflation expectations become anchored, those frameworks typically will become less useful at forecasting, inflation and by extension yields or policy rates.

But then lo and behold, we got Covid and then you had all this excess stimulus being pumped into the system again. So things that were really not very useful for 30 years suddenly became really useful. So instead of you completely discarding that signal, what you’re basically doing is just reviving it, because that signal starts gaining predictive content once again. That’s the idea. So it’s like a natural adjustment to structural change, if that makes sense.

[00:13:54]Richard Laterman: It does, and it, it sounds very much like a more humble approach. Like it, it ex it explicitly recognizes the inherent uncertainty of what you’re doing and it allows, we actually espouse a very similar notion. We call it ensemble methods, which we borrowed from information science and operations research and things along those lines where you want to be broadly correct as opposed to risk being specifically wrong, picking the single parameter that stops working under a certain set of conditions.

[00:14:23]Joaquín Kritz Lara: In the space, the term is model hedging. So essentially you’re hedging your bets on, taking a very strong position on something that turns out to be catastrophically wrong.

[00:14:36]Richard Laterman: And does that…

[00:14:36]Joaquín Kritz Lara: The bet is probabilistic itself.

[00:14:39]Mike Philbrick: Yeah, right?

[00:14:39]Richard Laterman: But as you shift across the variant models that you might have, depending on circumstances, does that then affect the predictive power in terms of the time horizon, the accuracy and the time horizon that you’re able to more confidently predict a certain set of outcomes?

[00:14:57]Joaquín Kritz Lara: Absolutely. And that’s where it starts becoming really complex. We have these discussions internally all the time. It’s, you adapt your frameworks dynamically, but let’s say one of our big pieces, we have this monthly global asset allocation piece that will give you what we call tactical and cyclical weights. So the weights vary by time horizon. Some are really short term. They other ones are 6 to 12 month type thing. You could extend it to five years if you wanted to. But then the weight, the underlying weights, the behind the scenes work, it, they may not be the same for 6 months and 12 months than they are for 1 to 3 months. It could be that certain frameworks are better suited at forecasting, like medium term horizons, but they not, might not be very effective in the very near term and vice versa. That often happens.

Like for instance, right now we’re thinking about, we’re doing some work on Europe. We’ve had, the European equity space has done exceptionally well in the last year and a half. But there are now concerns that the European economy is starting to stall, and we’re doing work specifically on Germany right now. And the framework that we have for Germany, and I guess it applies for Europe as well, the relative importance you attach to structural trends like labor productivity is much higher in my 3 to 5 year view than it is in my 1 to 3 month view, where the signal is essentially useless. Even as you rotate the models dynamically, you need to take that into consideration because if I’m giving you a five year ahead forecast or view on how you should be positioned in Germany, you need to consider, the relative importance you’re attaching to a variable or a model may not be the same as it is short term.

And so ultimately what you have is this panel of weights, like a three dimensional type thing where the weight varies by horizon, by investment horizon or forecast horizon. And then it varies also as you move across time.

[00:16:47]Richard Laterman: Very interesting. And are you guys asset class agnostic? Are you looking across all the major asset classes or do they vary depending on the geography that you are focused on?

[00:16:56]Joaquín Kritz Lara: No. So

[00:16:56]Richard Laterman: I,

[00:16:57]Joaquín Kritz Lara: We do, so on the equity side, we’ll cover the 30 largest equity markets, I think in the world. So it’s 95% or something of the All Country World Index for the MSCI. The one difference is that for certain markets, the US in particular we’ll cover sectors as well, just because even if you look at the size of some ETFs for some US equity sectors, they’re bigger than entire countries.

[00:17:21]Richard Laterman: Yeah, for…

[00:17:22]Joaquín Kritz Lara: Yeah. Oh, absolutely. Like the largest ETFs for say energy or something, which is a tiny share of the S&P. It’s enormous, right? It’s huge. And so we do that. On the fixed income side, I would say there, we do sovereign and corporate debt for the US, sovereign debt only for other developed markets, and then hard and local currency debt, although we do a little more detail on hard currency debt for EMS currencies. Basically, any other asset class, any asset class that we’ll have a view on equities or fixed income will have a currency view on, obviously, because the FX risk is very important. And then commodities, we do mainly industrial commodities, so energy, metals, and we do gold as well, mainly because it’s a useful hedge in portfolios potentially. But we won’t do like really alternative stuff like crypto or like private equity that we, we don’t do that.

[00:18:15]Richard Laterman: Okay. So maybe let’s shift into the actual state of things as they stand right now. Obviously inflation continues to be one of the major themes occupying investors’ brains. And from that, the price of money or the cost of money, right? The interest rates and the path of interest rates.

Will they pivot? Will they ease? Will it be higher for longer? What is your current view on inflation? In the US it seems like we have two very hardened camps. For a local minimum, but it’s still structural higher inflation for a foreseeable future. And then some people really thinking that we’ve peaked and it’s all downhill from here. Where do you stand?

[00:18:55]Joaquín Kritz Lara: Yeah, I think it varies a lot. Even if you look at inflation expectation metrics, it, their average is obviously of what people think. But even there, if you look at how bond investors are on average thinking about the issue for the moment, you can basically, they believe it’s like a rear view mirror type situation.

The two year break even rate is 2.1%. So that’s basically telling you that the market, the bond market thinks that, essentially you’ll go back to target soon, right? Because you, that’s the average expected inflation rate over the next two years. Even long term, say the five to 10 year expectations, the five year, five year forward, that’s two, three or something.

So again, but obviously that’s an average. And you have people like Ackman that think no it’s 3, 4, 5%, or at least as Mike was saying, that’s what they claim to the public. But then look at Main Street. If you look at the one, even five year ahead, consumer inflation expectations, those are 3, 4%, right?

So on the ground, people think it’s a very different story and I think that matters hugely for the evolution of that inflation process. So I think, in thinking about whether we’ve peaked or whether actually, whether we’ll go back to 2% fast or not, and we’ll remain there, it’s, I, the first thing I would do is just simply remind ourselves as to why we’ve been able to drive down inflation from nine to three.

And really it’s two things. The first one is that, energy prices normalized, right? Or that they went down. And so that’s like something the Fed had really nothing to do with. And can we continue to bet on that with very tight oil supply? I don’t know. Probably not, but certainly you’re not going to get, and even crack spreads right on gasoline and stuff, they’re super wide. So I don’t know if you can continue to bet on that in the second half of the year. The other thing is that, goods ex-energy really benefited from a shift back in expenditure pattern towards services, which essentially eased up supply chains, right? So there was an improvement delivery times, which drove down prices.

But if you look at things like the ISM Delivery Index, and you mapped that against PPI inflation say, it tells you that you already peaked, you’ve already benefited fully from that tailwind. So going from three to two and then remaining at two, you got to turn to services, right? So it’s got to come from services, especially if energy becomes a headwind to you and no longer a tailwind.

So there you want to break it down in two, I think because it’s half of services would be shelter. The other half is like sticky service categories. Anything, I don’t know, like really any sector that will adjust prices maybe once or twice a year. So think of like insurance, healthcare, things of that nature, right?

That would be the, I think you have some potential benefits still. The important thing there is that housing crises lead shelter by about 12 months. Housing prices started falling. They’ve started coming back up in the April and May data, but from Case-Shiller, before that they did weaken.

And so that would suggest weaker shelter inflation the second half of the year, which is deflationary. On the other side of the spectrum though, you need to consider other core services. And there you have a problem for two reasons. The first one is that the biggest determinant of service ex-shelter inflation are consumer and business inflation expectations, and those are 3 to 4%.

And so what that means is that if you’re a business that is adjusting prices once per year, and you think that inflation will be 4% in the next 12 months, you’re going to want to raise your prices by 4% or more to shield yourself from potential profit losses over that adjustment period, right? Because at, you’re only going to, you only get to adjust your contract once per year.

So you’re going to raise by, try and at least to push 3, 4, 5%. And that becomes like a self-fulfilling type situation. The other thing is the job market, right? Nominal wage growth is not much of a big driver for goods inflation, but it matters a lot for labor intensive industries, retail, wholesale, that sort of thing.

And the big thing there is nominal wage worth still elevated. And while vacancy rates have diminished, the market is, the labor market is still very tight. And here, I think one point that is often missed has to do with the structure of the job market. It’s not the same thing as the structure of the economy.

And by the structure of GDP, so far this year, I think two thirds of all employment growth in the US, same thing I think in Canada and in European countries, comes from a couple of sectors. Healthcare, which is very labor intensive. Accommodation and leisure and education. There was a bit of a push from government, but those three sectors, if you actually look at the numbers, they represent twice the employment share in non-farm payrolls than they do of GDP.

So you could realistically be in a situation where you continue to get pent up demand for contact services, which obviously got hammered during the pandemic, and they’re still below pre-Covid levels, even as economic growth stalls. And what that basically means is that you could continue to see decently strong labor demand, even as consumption growth starts slowing down.

So in that context, probably you’re not going to see a sharp decline in wage growth, even as broad-based measures of activity that are not tied to the job market, start weakening like GDP, or production or whatever, right? And so when you map that into a probabilistic framework, what you get is something that I think is quite interesting.

We’re finding right now, I think it’s like a two and three chance that inflation remains, 70% something, that above target over the next 12 months. But the inflation risks, meaning the right tail of the distribution, are much lower than what they were a year ago, basically because the likelihood of the economy stagnating is now much higher than what it was a year ago.

So cyclical conditions will weaken. They contain the likelihood of sharp spikes in inflation, like a ‘70s type situation. But you really shouldn’t be betting on going back to 2% anytime soon because what you would need for that to happen is, goods and energy to continue collaborating the way they’ve done so far, which I don’t think they will.

And then you need service inflation and shelter to drop down sharply, which also seems unlikely if that. I don’t know if that made sense. It was when it…

[00:25:25]Richard Laterman: No, it does. And there’s also a component of the base effect, right? We had much easier base effects for the last…

[00:25:33]Joaquín Kritz Lara: Absolutely.

[00:25:34]Richard Laterman: …12 months, and they are now potentially going to serve as a tailwind for inflation, a headwind for investors in the sense that we are now once again going to be faced with a potential tough … for inflation to continue to come down.

And that’s what we’ve seen in the last couple of CPI prints. Maybe you can add, shed a little bit more light there, but we’ve seen a re-acceleration of some of the components that had served as a more benign influence lately and had given investors maybe some reason to be cheerful.

Now they’re once again displaying a little bit more of a more pernicious dynamic.

[00:26:07]Joaquín Kritz Lara: A hundred percent. So I think the biggest contributor to that dynamic would be gasoline and energy prices, right, where you had that big spike right after the war started, and then it started dropping down, going down. And so you had these very favorable base effects in the first half of this year.

Spot gasoline prices or conventional gasoline prices, they were falling 20% year on year type thing, right? And that it wasn’t because gasoline spot prices started, declined month over month this year, they were actually pretty flat. It’s more that you were comparing to a very strong 2022.

Our forecast for gasoline prices right now actually, if you look at the spread between gasoline and crude, it’s very large. It seems unsustainably large. There’s an inventory thing going on there. So we think that’ll go down, resulting in month over month potential declines in gasoline prices.

But because of that base effect, there’s like an 80% chance that gasoline inflation or energy inflation is positive and even rises double digits in the second half of this year, which is really purely base effect, right? And you can make, I think, a similar argument for other types of merchandise goods.

And you get that, it’s very straightforward I think, to envision a situation where you would get positive goods inflation going from, CPI year on year was declining 10, 15% I think in the first half of the year. And so that could easily turn on you. I think that’s going to get offset or mitigated by shelter turning negative year on year or decelerating very sharply.

But it, the base effect scenario, it really doesn’t help. The other thing to do with expectations is that, I think you can make a case maybe that bond investors are sophisticated and they’ll look at, a lot, a bunch of different dynamics and then make a decision as to why they think inflation will move the way they’ll do. Consumer inflation expectations, which matter a lot more for, making what actually happens for inflation, in policy makers. That’s really a consequence of prices at the pump. It’s really not more complicated than that, especially the 12 months ahead. So if the oil market remains tight and physical demand doesn’t really fall that much, you could be in a situation where people, continue to bet on 4%, 5% inflation.

I don’t know. And that again creates this self-fulfilling type dynamic, which will be, becomes really problematic for the Fed, right? Because at that point, what you do right now, you’re in this sort of Goldilocks type interlude. I don’t know if Goldilocks is the right situation. Technically I think it’s still overheating, but anyways, it’s like…

[00:28:45]Richard Laterman: A lot of people have described it as Goldilocks. So I think at least zeitgeist-wise you’re in the right direction there.

[00:28:50]Joaquín Kritz Lara: Yeah.

I think if you have inflation still one point above target I’d still call it overheating, but whatever, you can call it Goldilocks. I think that’s fine. But you know, what do you do as cyclical conditions start to weaken if you are Powell and suddenly you get, you were at 3% in inflation and all of a sudden you’re at 5 or 4, right?

That’s going back to what I’m not going to say, going back to what Volcker had to deal with, because he was dealing with 18% inflation. But anyways, it’s the same type of dynamic where you want to avoid that, that it, it makes forward guidance very difficult, that’s that, right? Because you suddenly, you become unsure whether you should be pointing to further hikes, re-maintaining a pause and that can potentially affect credibility. And that’s where I think they have this really big problem moving forward. I, if you were to ask me, if you listen to the FOMC meeting notes, what he said after the last conference, we’re basically, I think we’re towards the end of straightforward forward guidance. It’s, at this point, it’s we’ll see what the data tells us, type of thing.

[00:29:55]Richard Laterman: Yeah. Yeah. And what you’re referring to is a potential expectation jump risk, if you will. And what’s interesting is that the Fed and most other central banks, in recognizing that they have no influence over the headline, but much more on the core side of the equation, they’ll claim that they’re looking at Core and the Fed looks at Core PCE, but at the end of the day, if you have headline inflation creeping up to mid to high single digits, once again, it doesn’t matter if the core dynamics are a little bit healthier because he still is managing expectations for the broader economy. So it seems like he would not be able to ease off even in face of a potentially economic slowdown. Is that in the ballpark?

[00:30:32]Joaquín Kritz Lara: It is absolutely, which I think is, I don’t know how you guys see it, but I think that’s right now, one of the biggest underpriced risks of the market, right? This idea that suddenly people are in this soft landing optimism camp all the way. That’s really the biggest driving force behind at least US equities, I would say.

And also the improvement, at least partial improvement in market breadth we’ve seen in the last couple of months. Things like the bull/bear spread. They’re now really positive. And I think, a lot of that is, is tied to just believing that the worst has passed, right? That, oh, the first half was supposed to be really bad. It didn’t end up being really bad. The consumer saved the day type of thing. We’re good. I would blame a lot my profession for that, economists maybe not being that clear on lags in monetary policy. It becomes difficult to explain that, I think.

Oh, you start raising rates, but it doesn’t really hit the economy immediately. It takes some time. But even without that, one of the really puzzling things to me is that somehow people seem to be ignoring time-tested recession signals. Forget about theory, right? The yield curve is inverted. The yield curve hasn’t missed once in 50 years, once. The other one that I think is interesting, I think they reported unemployment claims yesterday or two days ago. We actually ran, we did an exercise last month. We said, okay, let’s look at any recession signal that the market usually likes to look at and test its predictive content on downtrends in terms of the number of times it gets it right. How many times it’s overly sensitive, right? It tells you there’s a recession coming and it doesn’t happen, and how many times an outbreak misses it. And what you find is that it varies quite a bit, right?

The ISM new orders, for instance, it always gets a recession. It’s just that there’s a whole bunch of times where it tells you’re going to get a downturn, it doesn’t end up happening. Say it dropped below 50 after the Asian crisis in 97. We didn’t really get a recession after that. 2014-15, the BRICS crisis, same thing. It dropped below 50. Didn’t happen. So sometimes I get it from housing permits and starts. Those are good, but they miss some recessions. They missed 2001, for instance, because it wasn’t linked to the housing market really. So really there’s two things that seem to work very well, and we actually build them into our models because they help improve the downside risk measures.

The first one is the term spread between, it’s the 10 year minus three month. Really, that works really well, from what we can tell. And then the other is bottoming out of unemployment claims. Turns out that the yield curve never, has never missed in the last five decades. Perfect track record. The unemployment claims they’ve missed a couple of times, I think, but it’s a very strong track record. And as it turns out, if you look at the lead time between both things, it takes about 12 months on average for the term spread from inversion. A recession, we’re at month nine or eight right now from the inversion last year.

It takes eight months for the unemployment claims to bottom out, and then you get a recession. We’re at month five now. I don’t like averages, obviously, because ideally, with uncertainty, but if you look at averages, that would tell you’re going to have a nice early fall. You’re going to believe that things are still really peachy.

And then all of a sudden, by the end of the year, the beginning of next year, you’re going to have situation where tight lending standards, elevated borrowing costs, start really hitting the economy, which is, again, consistent with these signals. And so that belief, I think is one that you need to really take into that idea. When constructing, when doing portfolio construction and asset allocation in particular, I would say it’s really important because it, it affects the timeline of your decisions right near term. You’re probably okay remaining in the bullish camp and optimism. You just need to be really wary about your six to 12 month or even longer positioning where, if you believe that the worst has passed, you might have some really unpleasant surprises.

[00:34:45]Mike Philbrick: Yeah I think I’d, I’d emphasize the idea of the lag being variable, right, on average it’s 12 months. I think in ‘07, ‘08 it was more 18 months, right? So you can have some pretty serious situations where the Fed is saying everything is fine, we’ve licked it, it’s okay. And it pays, I think it pays dividends to be mindful of the fact that you have had these signals. They do have a very good track record. The other thing I think is so important in this context and you covered it in your recent report, I think today on the asset allocation side and the idea, so when you think of having hedges in your portfolio, and I like the RMS framework, first responders, second responders, third responders, first responders, like a bond.

So bonds have done a great job over the last 40 years from ‘82 to ’22, of actually being very non-correlated in a disinflationary type environment, of providing a buoy to the portfolio. And as you point out, while we expect the Fed to pivot in late 2023, 10 year yields should remain above three.

One key reason is the growing possibility of wider risk premium as the supply of Treasuries expands to meet soaring interest payments, right? So the, you’ll have sort of a growth shock, then you’ve got all this debt, then you’ve got to have a bigger risk premium. So you may not get the juice out of your bond portfolio that you have gotten in the past because of the regime that we’re in. And so these are, how else do you hedge the portfolio? Long/short stuff comes into play and on all those types of scenarios. But, …

[00:36:15]Joaquín Kritz Lara: … and then

[00:36:16]Mike Philbrick: … maybe you can elaborate on that. Yeah,

[00:36:18]Joaquín Kritz Lara: …of thing.

[00:36:19]Mike Philbrick: precisely. And maybe you want to elaborate on a bit of that because, yeah, exactly.

[00:36:21]Joaquín Kritz Lara: So, I completely agree. I think the, in, in our asset allocation piece, which is standard, it’s the stock/bond framework. We will, we’ll give weights and recommendations by whether it’s long-term sovereign debt, short-term money market stuff, high yield investment grade, corporate.

So there’s a bit of diversification to get from there, but really what you find is that you shouldn’t turn overly conservative even at the six to 12 month horizon, even if you think that growth will stall, because you’re not going to get that juice, that defensive boost from treasuries. And as you pointed out, I think the, there are, there’s two things. One is if you get high inflation, positive inflation surprises, breakeven, inflation may rise. And with it long-term yields, the other thing is obviously the risk premium for that though. I would, it’s a very complex dynamic.

I’m not certainly, versus what Ackman was saying, I think he’s forgetting about, he’s saying, you’re going to get this massive risk premium, basically because of this idea behind the supply of Treasuries. The other thing that’s mentioned quite a bit is the Japan argument, right?

This idea that Japan is, the BOJ will likely end YCC. Japan is the biggest foreign holder of US treasuries. They may decide to dump those and shift to JBS. And if they do that, then basically demand for bonds in the secondary market will be lower, and that’s going to drive down prices, raise yields, increase the risk.

Premia QT is another one, right? So lower demand for Treasuries and so on. So I think all of that plays out. And so when you put that into a modeling framework, it tells you below 3%, chances are no. However, above 5%, which is what he’s saying, and a bunch of other people are saying also, maybe not because you’re forgetting flight to safety demand, which is huge, right?

So as macro conditions deteriorate, you would still have a large portion of the institutional and even retail space that would shift towards Treasuries as, for protection, which would limit the downward pressure. So I’m not saying completely discard Treasuries in that context. It if you are to play duration, I would say short-term debt is probably good because it’s much less likely to, it’s paying good coupons right now, the yield curve is inverted.

And if you face less than, certainly when making those decisions, like in the one year, right, you know what you’re going to get for 1 year. With a 10 year, you have no idea, right? It depends on how the price moves the return you’re going to get on that. So I would say, overweight, short term money market stuff, that’s probably good.

And then you’ve got to start thinking creatively, right? It’s, many people talk gold. Do I think that, the one issue with gold is, I think gold probably gives you more protection, that it, it’s effective in a portfolio long pure, long gold positions. They’re a bit tricky because the gold market, as it turns out, if you look at the future curve, it’s very steep. And so it’s going to be difficult for you to make money just on that future sphere. So if you go…

[00:39:29]Richard Laterman: Negative Carry?

[00:39:30]Joaquín Kritz Lara: …with options. Exactly. You have a problem with Carry. That’s right. So for that I don’t know, but certainly in, in adding an alternative that’s low, that has a lower correlation to stocks, then that probably works.

And then you’ve got to have a view on commodities. The one thing with commodities though is the left tail. If you get commodities wrong, you’re going to bleed. You may lose 30%. That’s not safe haven. The thing is it’s useful diversification from a different differentiation standpoint because if you, if what you think is the Fed is going to have a problem because inflation is higher, then commodities will do well.

And so that will give you a lot of protection in your portfolio. In the same way that if you had read 2022 correctly, you should have been long, overweight commodities, completely replaced bonds by some like standard plain vanilla commodity ETF or something. And you would’ve done fine. You, maybe you would’ve even made money right, in long-only portfolios if you were to do that.

But the one issue with that is that you’ve got to be really, we want to avoid the word confident, right, in this discussion. But you want to do your research properly, I would say, just to determine the likelihood of energy and say metals or something like that, having enough upside in an inflationary context to be able to offset any downside risk to earnings, let’s say on the equity side. But it’s certainly challenging, right? It’s, the 60/40 doesn’t work in this context. Yeah.

[00:40:58]Mike Philbrick: Yeah and to declare my conflict. I’m obviously talking a little bit of our book as being a managed futures manager that can go long and short. These asset classes and managing risk sizing bets, all of those types of things and those types of strategies tend to perform very well in this type of environment, where you have the expansion of dispersion, where you have different sort of correlations and you have these dynamic outlier events so that you can adapt to them. So, I’m I hand up, can I admit that I’m talking my book a little bit, that’s a little bit of what this is about too, is that those classic diversifiers that investors have counted on for the last 40 years in an inflationary environment, they change and they change very dramatically.

And this is in, this is a slightly different regime, so you have to be thinking about those things. I wonder if we could shift gears a little bit to talking about more in the commodity space and the EM space. because I know that’s a big focus as well for you. Richard, anything that you wanted to talk about before we jump that direction?

[00:41:55]Richard Laterman: No, I was just going to add, and I think this is going to jive with the direction that you’re going, but we’ve seen tons of research of how difficult it is to have buy and hold positions in commodities, but rather if you have a more tactical overlay, and then again, caveat empor on the whole talking one’s book, but whether it’s a trend overlay or some other form of tactical, a systematic, tactical way to hold those commodities and go long or even short and size them appropriately, helps a lot and can alleviate some of the pressures in a portfolio that is hinging on two legs instead of a third leg that has the ability to go into the commodity space during inflationary periods. The fact of the matter is investors haven’t had to think about that at all for the past 40 years.

So those types of frameworks, so those ideas have become stale in the minds of a lot of people, and they’re once again coming into prominence after 2022. But you wanted to jump into the commodity space. Joaquin, your

[00:42:52]Mike Philbrick: and underlined in 2022, they provided massive value.

[00:42:56]Joaquín Kritz Lara: Oh, absolutely.

[00:42:57]Mike Philbrick: Yeah.

[00:42:57]Richard Laterman: Yeah.

[00:42:58]Mike Philbrick: I don’t know if I was talking over you.

[00:42:59]Richard Laterman: No. Yeah. We got a little bit of a lag there. No, but Joaquin, Argentinian, Brazilian, we obviously have some rivalries on the football or soccer pitch. But there, there’s definitely a lot of overlap when it comes to the commodity space and interest there. So maybe you can tell us a little bit of what you’re seeing in the broader EM space.

You, if you want to start with China and maybe talk about India. And I’m always curious to know a little bit of one’s vision on demographics, particularly because you hear a lot. One of the things that captured my curiosity more recently was this idea that China had to republish their census and then all of a sudden a hundred million people vanished from their population, 1.4 to 1.3 billion.

I guess at that level, maybe it’s a rounding error, but when it comes to the working age population, it becomes a little bit more consequential. So maybe we can talk a little bit about the EMs, starting with China?

[00:43:50]Mike Philbrick: Yeah. Yeah. Can I jump in and just say too you’re from Argentina, that’s, I think, the best performing stock market almost in the world at this point over the last year.

[00:43:58]Richard Laterman: What?

[00:44:00]Joaquín Kritz Lara: Currency going from ridiculously low valuation

[00:44:03]Mike Philbrick: Right,

[00:44:04]Richard Laterman: Is that in US dollar terms though, Mike? And what dollar are we using?

[00:44:08]Joaquín Kritz Lara: …

[00:44:09]Mike Philbrick: In US dollars.

[00:44:10]Richard Laterman: But is it the official currency rate? Or are we talking what actually buys…

[00:44:14]Joaquín Kritz Lara: no, it would be Argentinian stocks traded in the States. So it would be in dollars. In actual dollars.

[00:44:21]Richard Laterman: ADRs. Yeah. Yeah.

[00:44:22]Mike Philbrick: Yep. So I just don’t want you to forget about South America in the…

[00:44:26]Joaquín Kritz Lara: I’ll talk about that. Yeah. We like EMS quite a bit now and that’s, that kind of view for the last five years has, it would’ve been controversial or disregarded. because the real, the truth of matter is with the exception of India and Taiwan, the EM space has done very poorly in the last, really since the BRICS crisis of 2014-15, since oil fell sharply.

You had the residential property crisis, the first one in China in 2015. After that, you haven’t gotten a lot of value out of EMs. Now I think you’re in a position where you can really start, paying more attention to the EM space, if anything. Obviously it depends on the investment horizon and so on.

The valuation aspect should, at the very least, pique your interest. Take a look at a place like Brazil. It’s a, it’s been doing really well, the MSCI Brazil in the last whatever, nine months or something. But even at the, even with that, any valuation measure, you pick forward piece, cyclical adjusted PS return, market caps, GDP, whatever, they’re like really low and you have this advantage – I’ll talk about China in a second, –  of central banks in South America, specifically in Latin America, I guess I would add Mexico, being much more aggressive in the inflation fight. They started hiking rates in early ‘21 and they’ve given themselves so much more space, right? That compressed valuations at the time.

That’s a big reason why valuations fell so much, but now you’re in, that they’ve already started pivoting, right? The Bank of Chile cut rates, the Central Bank of Chile, the BCB cut rates recently. They surprised, actually cutting more than what market’s expecting and that provided, and I think that’ll provide quite a bit of a boost.

The one caveat there if you are unhedged, is the currency aspect, right? I would argue that there’s, that helped the Real, the Chilean Peso appreciate. And so if that turns, you have to be a little careful there. But I do see certainly quite a bit of potential in that front.

The amount of potential will depend, basically on policy support in China. South America is very intrinsically linked to dynamics, to China’s business cycle and especially the policy cycle, right? So how much policy support you’re getting from Beijing. And there I would say we are not very optimist.

We’re actually bearish on China long term. We think the demographics as Richard was saying, are very bad. And it’s not just the demographics, right? They’re working … contracting, but in addition to that, they have excess housing supply. And that’s a problem because that was probably, the big, building construction was the biggest driver of growth for them, the last decade.

And it benefited copper, it benefited South America to some degree, I would say. And that, they’re going to tap out on that. And then they also, there’s the geopolitical risk, which matters mostly I would say in my view, because it dissuades capital transfer, like knowledge transfer, right?

So if firms don’t want to enter China, productivity growth is going to stall. And if you’re not getting investment growth and you’re not getting productivity growth, then you’re not getting earnings growth, right? Forget about it. And so at that point, it becomes an issue. I think there’s a six to 12 month window though that China’s very attractive because it’s very cheap.

And because I do think that the market is underestimating the potential of policy support, if anything, because Beijing really wants to make sure they’re going to hit 5% on growth. They missed last year. I don’t think they want to miss two years in a row. That’ll be disastrous. They have 20 something percent youth unemployment.

They’re trying to prop that up. And I think that would give them some cyclical upside, which should certainly benefit South America, like metal exporters in South America. They’d certainly benefit from that medium term and then longer term, the, I think India you mentioned that is, is a great, a great market to follow and track.

The one problem that you have with India right now is that it’s very expensive, right? Again, valuations aren’t everything. But the big issue you have is that with India, we’ve noticed that you have this delay. It’s about a 12 month delay between you get rate hikes and rising yields and a compression in valuations.

And we’re now entering that, the start of that cycle of valuations potentially starting to collapse. I, we find that the Rupee is also overvalued. And so that sort of makes near term bets in India not that great. And what you’d really need long term though, so in the last 5 years, or 10, even India outperformed basically because of multiples expansion.

And that is not I think, part of that has to do with like corporate policy. For example the Mumbai Stock Exchange, for instance, they started allowing almost startups to trade. They started allowing IPOs for startups, but for like growth techie type startups. And so you had this massive inflow influence of small firms that had really large PSs, enter the Indian Stock Exchange.

And that really inflated valuations and you really didn’t have that anywhere else in the world. And so that I think has benefited them quite a bit. I don’t know how sustainable that is. So long-term, you need earnings and you’re going to get that I think, from two things. One is if the formalization of their economy, if they can get digital payments right, grow their financial and banking system, banks, which are the biggest component of the MSCI India are, should do well in that context.

And so that should help. And then the other big thing is, it’s not just pure demographics by like straight, straight up population growth. It’s the rise of or the potential for India’s urban middle class. So India’s urbanization rates are really low versus those of any other emerging market. They’re like half of Brazil’s, for example, or something like that, right? They’re super low. And then per capita income in India is less than half that it would be in a lower middle income country in South America. So in Peru for instance, or Columbia or something like that, per capita incomes are double that what they are in India.

In India right now, you’re looking at basically at what China was in the early 2000s. I’m not saying that you’re going to hit per capita income growth in India anywhere as fast as China got it over the, between 2002 and 2007 or something. But even if they were to grow at half that speed in per capita income, they would contribute almost double what they do to global growth today than what they’ve been doing so far, which is essentially demographics driven, population growth driven, right?

And long-term bets on India, really I think, hinge on them being able to derive returns, not so much from valuations, but really driving up real earnings and, but they have two potentials, or three. Urbanization growth and per capita income, and formalization of the economy that really no other country in the emerging market space has. India by many measures, I would say is closer to a frontier market in the structure of the economy, but that’s good, that gives them so much more upside in earnings than you would get otherwise.

The only caveat is, just think like in portfolio construction. If you bet on India today, I think there’s better bets that you can make. South America, China tactically, or even six to 12 months, I think they’re better. In thinking long term, India has more potential than any of them by a long shot.

[00:51:42]Richard Laterman: And typically when we talk about emerging markets, China and India are the large, two largest economies in the emerging world. And they’re the first ones that people think about. Are there any ones that are surprising you recently, that are flying under the radar or that you expect can have, can start to punch above their weight or to move up

[00:52:01]Joaquín Kritz Lara: Yeah, so I like those in Southeast Asia. Southeast Asia is a region of the world that’s under, heavily underweighted in the equity space. Indonesia for example, is a big emerging economy, but they have a tiny weight in, it’s 2% I think of the MSCI EM Asia, right? So it’s really small. Thailand as well.

I think Indonesia, if you take that as an example, it has a similar structure to what India would have. They’re more developed, like their per capita income levels would be higher than those of India. But they probably are also big potential winners from this idea that companies want to decouple from China.

And that’s another one where I think you could see a benefit. I would also add Mexico to that list. The one thing with Mexico, again, as a big winner of deglobalization or nearshoring or whatever, that’s the, and really that’s the number one factor behind the peso appreciation.

It, what’s interesting is the Bank of Mexico has this survey where they track expectations around FDI inflows, not actual inflows. What people think will be future inflows, just plot that against the Mexican peso. It’s one for one, right? So it’s like there’s this belief that the Mexican peso that, that you’ll get these long-term flows into Mexico that is driving interest into Mexico.

So I, I think the Mexican peso, it’s probably punching above its weight right now. So again, you face FX risk. And you also face exposure to a potential US manufacturing downturn. So short term, maybe not so great, but long term, the cost structure of Mexico’s economy is phenomenal compared to that of other emerging markets.

If you look at the, if you compare output per work in Mexico relative to, like salaries, say compared to China, that ratio is very beneficial to Mexico, right? And then you have lower transportation costs. There’s a whole bunch of advantages that I think could certainly benefit, which is again, an economy that has been stagnant, right?

It doesn’t, it’s not an economy that grows particularly fast, I would say. But it has this potential to benefit from spillovers of rotation away from China. That’s what I would say are the ones that I would like the most. And then South America, if China does stall and you, you’re entering this sort of “ification” type situation with China. The biggest potential advantage I’d say for a metal exporter like Chile is energy transition, because if you were to get a situation, let’s say, where copper demand were to remain strong, even if residential construction China stalls because of growth in EVs, let’s say or solar energy or something, which is tiny, there’s a assure of copper demand today, then that could potentially offset that tailwind, because today, obviously their dynamics are very linked to China’s business cycle and you want to start decoupling from that. So South America, long term, I say if you want to go long or overweight, you probably want to bet on that energy transition more or if you’re looking at Columbia or Brazil, even for oil exporters.

No oil supply, right? What happens if OPEC and shale producers say we’re not going to invest anymore like they’ve been doing in the last couple of years? And maybe you’re looking at fair value of oil at 90 or a hundred, not at 50 or 40. And if you have that, then again, South America would benefit from that. You just have to be careful that if China does stagnate, there’s headwinds to that.

[00:55:27]Richard Laterman: If they do stagnate, you got to be a stock picker because you’re going to get on one side, you’re going to get a massive reduction in the demand for oil. All the soybeans that are being produced in Brazil and in Argentina. So there’s going to be a currency knock-on effect because the terms of trade have benefited Brazil and Argentina so much.

Argentina’s facing some other issues on the institutional side that have kept the currency spiraling downwards. But Brazil the real has appreciated quite a bit recently, and a lot of that has to do with the weakening dollar on a more global setting. But definitely a resurgence of commodity price, I’d say particularly the agricultural commodities have benefited. So I would say if you do have to bet on South America while hedging for a potential economic stalling in China, you want to do it a little bit more on the stock picking side. Buying the index might be a little trickier. Would you agree?

[00:56:16]Joaquín Kritz Lara: Yeah. I think so at the very least, play sectors, right? And again, like not every country has similar exposure. Columbia for example, their trade exposure is very US focused and they basically export oil. So it’s not the same type of dynamic. So you could do like some sort of overweight, long/short Columbia, Chile or something, let’s say you could do that. But I would agree with, I would certainly agree with that. I wouldn’t maybe mention it to my clients because we’re not stock pickers, but yeah.

[00:56:46]Richard Laterman: Fair enough. Yeah. I was curious, when you’re talking about Mexico, does the institutional backdrop give you much pause when you think about the cartels and the strength that they seem to have over certain sections? Of the country. Does that bleed into the analysis, not just for Mexico, but as you’re looking at countries in general where there is that additional component from a security standpoint and the potential for that to bleed in institutionally, is that a factor ever?

[00:57:13]Joaquín Kritz Lara: We, it’s certainly something that we’ll think about when we start our discussions around EMs. The one issue you have when you are building models is that it’s very difficult to quantify, right? So the way we will try and quantify these things is, there’s these, I don’t know if you’ve heard about them, like these policy uncertainty indices.

You have a whole bunch. You have some that are broad economic policy and uncertainty indices there, and there’s one particular that’s called the geopolitical policy uncertainty index or something like that, does take security into consideration. It’s one of its components that we will take into consideration.

It’s just that it, the signals that you get from that are sometimes useful and sometimes not very useful. Like for instance, it, in the last couple of years, we’ve found it most useful for Taiwan, for instance, where that sort of spike in tensions in between China and Taiwan have weighed on the Taiwanese dollar. But like, how do you model that? And you want to use something like that to give you a sense of whether the currency or the stock market in Taiwan is very geared towards semiconductors. It would be more the currency, whether the currency is trading at fair value, is it overvalued or not?

And so that’s the kind of thing that we would do for Mexico and for Latin America in general. We would use that same type of analysis qualitatively. If I were to just comment on that, I would say that it is a potential headwind I would say, mainly if it dissuades like infrastructure investment, right?

So if what Mexico needs to be able to actually attract large amounts of foreign capital is an improvement in their infrastructure, a reduction in corruption indices to be able to improve the ease of business, if they can’t achieve that, then even if, let’s say logistics costs are much better and wage costs are very good, firms may still prefer Southeast Asia to Mexico.

And so I do think that’s certainly something you want to factor in your analysis, but it’s more a structural view. I don’t know if it matters much for six month positions or something.

[00:59:21]Richard Laterman: That makes sense.

[00:59:22]Mike Philbrick: What about the maybe switching gears. So that was global EM, and then I don’t think we went, delved into the sectors as much in the US and I’m…

[00:59:31]Joaquín Kritz Lara: No, but we can do that.

[00:59:32]Mike Philbrick: Real estate. Yeah, real estate is something that’s top of mind at the moment. Any other particular, what’s your thoughts on real estate, commercial real estate?

[00:59:40]Richard Laterman: Banks, how that relates to banks. I think that would be also an interesting thing to talk about.

[00:59:45]Joaquín Kritz Lara: So for we’re like in, in US portfolios, we would be underweight real estate. Real estate as it compares to other segments of the equity space in the US is simple to model, in the sense that there’s a very strong long-term link with pro commercial property prices. Now the problem is that you’ve got to get the commercial property price call right. To be able to accurately assess whether you should be overweight or underweight in that sector. Right now, we’re underweight, we’re picking up. We’ve had a big drop in CRE prices in the last year. Much more than residential. I don’t think it’s bottomed out.

And with that, that would suggest still significant downside risks. I think the biggest problem that especially office REITs would face is you’re going into this period where you have to like, renegotiate your tenant agreements and you face potentially weaker demand for the actual space and you’re refinancing at much higher interest rates.

So you, there’s a liquidity problem that I don’t think we’ve seen so far, which I think creates significant downside. And I would say that applies not just for like REIT ETFs say, but also commercial mortgage-backed securities. So you’ve had this widening of spreads in CMBS relative to say, high yield debt or something, but I don’t think it’s nowhere near as much as you would if, I don’t think default rate risk is properly priced out there.

The other big and so there we, I think we’re a little hesitant to put on overweight positions there. We were much more defensive in that space. Where I think it’s much more interesting, as Richard was saying, is how you tie that into banks. It depends on the size enormously, right?

There’s huge differences in exposure between large, what’s called systemically important banks like your JP Morgans of the world type thing, and regional smaller regional banks. The vast majority of CRE loans, you may have seen this in CNBC or whatever, like some papers about it, is done by small banks. So a much larger share of the balance sheet of small banks is exposed to commercial real estate, and I think that represents a big downside risk. So when mapped into models, we’re picking up left tail risk on smaller banks, which is typically very high when you think that earnings will slow, Banks are, I think it’s the worst performing sector in recessions, in historically or if not, it’s like the second worst, but it’s really bad, right?

Because they’re very tied to with the credit cycle. When you map it to regionals, you get this very large downside now. But the thing is though, that at big banks following the SVB crisis in March, you had this big rotation in liquidity away from regional banks and towards larger banks, but also towards other sectors like mega-cap, tech, AI, that sort of thing. And that’s caused small banks to trade significantly below fair value. And so yes, there’s downside, but there’s enormous upside if you don’t get a deep recession, right? So the expected gain on a position on regional banks today is really very high. I think there’s very few sub-sectors in the US equity space that we are modeling such potential gains that we would for regionals.

But ultimately it matters on your risk tolerance, right? Because what I’m talking about really, think about it probabilistically, is the risk reward trade off, right? It’s you’re comparing upside to downside risk. What I’m saying is downside risk is high, but upside risk is also very high. So it depends on your amount of risk tolerance, whether you should be overweight or underweight it.

And so that’s for a neutral, for a balanced risk profile, it’s a neutral and it’s probably overweight against larger banks, which unlike small banks, are not trading below fair value and are also exposed to very large downside risk if the economy were to stall. So if you were to do a long/short position or something because they’re similarly exposed to standard recessions, forget about the CRE risk for a second. With a long/short, you’re basically killing that source of risk, right? You eliminate it because both sectors would be affected by that. And so what you’re left with is evaluation play for the most part. The one caveat is the CRE situation, but I would say, it’s not the segment of the equity space that we would be most concerned with, again, because it’s attractive relative to fair value.

We, I’d be more concerned with like deep cyclicals. So deep VA value cyclicals, consumer discretion did super well. It did super well in the second quarter. You met, I’m sure you tracked, you looked at the earnings there. They had super strong earnings from prices. I think they doubled analyst estimates or something. Yes. But a lot of that had to do with a normalization in supply chains improving costs. That’s basically done. And consumers burning through excess savings. That’s done too-ish. There you’re exposed certainly to expectations now being really strong and surprising on the downside.

Similarly capital goods, machinery, for example, they’re very interest sensitive, but with a delay. And so as, even if you think that the US economy will avoid a downturn overall, I don’t think it’s realistic to expect manufacturing to avoid a downturn. I think, you’re going to get a lot of weakness from goods which are much more interest sensitive, but also because you’re having an expenditure shift right from goods towards services.

Heavy industry is like very income sensitive, very rate sensitive. And so those are the, those spaces I think are the ones where we’re a little wary even there, like there are exceptions. It’s you’re saying Richard, you want to stock pick, but if you want to delve into the sub-sector level, I don’t know, like airlines for instance, they’re within industrials, but I like those because there’s upside, right?

There’s pent up demand upside for services. The, they basically, Asia was shut off for commercial airlines for two years, not just China, Japan, whatever.

[01:06:08]Richard Laterman: And supply reduction in the airline space, they’ve reduced quite a number of flights, at least anecdotally, a lot of the flights that we used to see. But the issue seems to be the availability of jet fuel.

[01:06:19]Joaquín Kritz Lara: Oh, 100%. I was very optimistic about airlines three weeks ago or four weeks ago, and then kerosene prices spiked and that burned my view on that. But that, they are incredibly sensitive to that. And I think like the biggest determinant of returns in airlines, even we build this explicitly in models is the spread between ticket prices and jet fuel.

[01:06:45]Richard Laterman: That is the two main variables. Yeah.

[01:06:47]Joaquín Kritz Lara: Yeah. Yeah. But the thing though is that usually air traffic or cargo capacity, there’s a term for it. I forgot what it is, but anyways, there’s a reported term that airlines give, which is basically, it’s how much they’re able to fill a plane and the amount of planes in the air type of thing.

So it’s like a volume capacity measure. They’ve been able, they’ve been very efficient in filling planes back, but as you said they took a lot of planes out and now they’re starting to bring them up to speed. And I, a lot of this I think had to do with Asian Pacific routes being out for a couple of years.

And if that comes back, then you have that demand potential for that space that you don’t really have in that many other sectors. That’s one angle we’re pushing. I think, in general, it’s not just airlines. If you think that the economy’s going to slow down you want to pick sectors that are robust to that overall slowdown in the demand standpoint.

And sectors that have pent up demand potential from the pandemic are obviously obvious choices. Airlines would be one. Healthcare services, I think is the other big one. Healthcare services is a, is the sector of the economy, with the exception of air traffic I guess, that has recovered the least. It has the biggest upside to get back to pre-Covid levels in terms of spending.

And that makes sense, right? Like during the pandemic there were a bunch of people that said I’m not going to go do my regular checkout with the doctor, and so you had this big drop in spending or as a share of overall consumption. It’s a defensive as well.

And so it does usually very well in downturns. So it’s more that, right? It’s like you want to find segments that are resilient to a broad adverse macro shock. And I think you can even extend that idea to tech, right, within tech, software is much more resilient than hardware. Hardware, investment in hardware does really poorly in downturns. You have this big drawdown in investment for computers, whatever phones, that sort of thing. Or spending during downturns, R&D and investment in software, not so much. And add the AI wave to that, look at, just focus on the Cloud revenues that you’re getting from software providers, just that portion of their businesses, the margins are very good, very good. And so that’s another one, right? You want to, again, you want to pick segments that are on an earnings, from an earnings side, that would be resilient to a slow down in broad-based activity, and then under-weight.

Those that would not be, or the risk would be magnified, like consumer discretionary like in-store retail, for example, things of that nature. Or machinery for example.

[01:09:21]Mike Philbrick: The other thing that you mentioned that I think is conceptually very important when we’re thinking about the regional banks and your probabilistic framework, the distribution of the probabilistic outcomes is different. I think that’s what you’re highlighting when we’re talking …

[01:09:35]Joaquín Kritz Lara: It is just really, that’s I think what I mean. Yeah.

[01:09:38]Mike Philbrick: Big fat tails squished down very wide. And so that has implications on how you would size that particular exposure in a portfolio. And that’s, that those are really important insights for portfolio managers when they’re thinking through these types of things. That’s why I really enjoy the framework that you provide.

It’s okay, here’s the undervaluation, here’s the investment case. But keep in mind, the upside has a fat tail, but so does the downside and the middle’s kind of squished. And so this is a different, this is a slightly different distribution within a normal type distribution if we’ll call, starting with a normal …

[01:10:15]Joaquín Kritz Lara: Yeah, absolutely. It actually, it looks very, it does look very different. And so at that point, it really depends on your risk tolerance or the risk tolerance that the fund has, if you’re a portfolio manager, right? If you are operating within a balanced fund, you’re going to size differently than if you’re in something that’s really aggressive.

[01:10:34]Mike Philbrick: Yeah.

[01:10:35]Richard Laterman: Mike, I like that you circled back to the regional banks. because I’m reminded, we had Eric Basmajian a couple weeks back from EPB Research here on Riffs. And he was talking about, he gave us an update on the regional banks, and he was talking about how there are signs that they have begun to retrench from lending, particularly because of the inverted yield curve, but also because of the hit that their balance sheets have taken and the fact that they can’t really lean on the guarantee of being systemically important to be rescued in the case of a more severe downturn.

So I’m wondering how that plays into your call for the regional banks as well as for the overall economy, because we know that without any growth in credit or net growth in credit it’s likely that the economy grinds to a halt.

[01:11:19]Joaquín Kritz Lara: I think it boils down to whether you get a deep downturn or more of a stagnation type situation, right? If the economy were to stagnate but avoid a deep downturn, then credit spreads and default risks, I don’t think would rise enough to trigger those mass bankruptcies that I think you’re alluding to.

If you do get a deep downtrend, like a 2009 type situation or 2020, then you have a problem. It, there, I would say that we, because you still have pent up demand for services because of the structure of employment, you should be protected by job creation, which is a huge driver of growth relative to what you would in past downtrends.

And so what I would expect, at least in the next 12 months, I would say is a significant slowdown in the economy, but not like a complete collapse as some people do believe will happen. If you were to look at patterns, let’s say real interest rates or the real interest rate gap, which is the difference between interest rates and some kind of neutral measure of rates in the economy, that gap right now is really wide. It’s the widest it’s been since, like the seventies, early, early seventies. That thing leads consumption by two years usually. And it would tell you that you’re going to slow first and that it’s going to become a real problem for you.

Right at, if you believe that, then the two year outlook, where it starts becoming really difficult for firms to start getting financing, credit card debt, becomes high. Anything that has a variable rate to it becomes high. People start really cutting back on spending.

You get that scenario, which is not impossible. And then you are, you’re in, that … And so just to be explicit about this, What I mean by regional banks having very, a fat left tail, that fat left tail is consistent with the fact that we cannot discard a situation where the economy were to contract 2% or more, let’s say.

So those scenarios are equivalent to each other. What I’m saying, there’s a difference between something being able to happen and the likelihood of it being high or low. So we’re…

[01:13:36]Richard Laterman: That’s why you’re referring to it as the tail.

[01:13:39]Joaquín Kritz Lara: Exactly, if you look at the distribution from growth, you find you can’t discard contractions of 2%, 3% of G D P, which are big. But the probability of that, and in normal cases you should be able to discard those events, but the probability of that happening is maybe not as high as what some investors may believe them to be. And again, I, you map that into regional banks, it tells you, you should know that if you invest in banks, they’ve already lost. How much are they down this year? 40 something percent. You’ve already lost 40. Maybe you could lose another 40. Just be aware of that. It’s just that if that doesn’t happen and there’s a big probability, it won’t happen, you could make double digits. You could be making 20, 30%, and there’s other sectors of the equity space, the more overvalued ones and so on that’s much less likely.

[01:14:30]Richard Laterman: I guess what I was alluding to and what I think a lot of people have been speculating around has been this idea that the banking system in the US has fundamentally changed, or given the signals that we’ve received that there are certain banks that will be rescued and others that might not. And because deposit rates are, deposits don’t yield anything in most banks, and you have money market funds offering you such a large Carry…

[01:14:57]Joaquín Kritz Lara: There’s this risk of deposits flowing out of these.

[01:15:00]Richard Laterman: Which began after SVB and then appears to have stalled to some degree. And you haven’t seen it, it’s mind boggling. But, behavioral science shows is that inertia is a very powerful force. And so a lot of people just maybe don’t want to deal with the idea of moving their money to money markets, but this seems to, this funding aspect of regional banks seems to be a real structural risk that they are facing in the coming years and that we might see a major consolidation.

[01:15:30]Joaquín Kritz Lara: Which is, which you didn’t get that many banks that went down, right? There were a handful, but what happened? They were absorbed by these much bigger institutions. And you, if that were to happen, then that would be the portion of the Taylor distribution that tells you that large banks will outperform the smaller banks.

And that’s absolutely not something that you can discard in any way, especially for small banks that have a large share of uninsured deposits plus a large share of office CRE loans. But SVB was, if you looked at the list, they were like clearly the most exposed to that. Not SV sorry, First Republic. So the other ones that they were very clearly exposed to, that SVB was different. It was more like they…

[01:16:21]Richard Laterman: Deposit flight from the tech companies.

[01:16:23]Joaquín Kritz Lara: The price of bonds in the secondary market falling. It was more that. But in fact, if you look at the share of uninsured deposits for the regional banking space as a whole, I can’t remember the statistic correctly, but it wasn’t, it’s not that high. It was like half the rate on average than those banks that did go under, something like that. So it was much, much lower. Is it a big risk? Yes, absolutely. You could you get deep consolidation? If you were to ask me, you guys are based in Toronto. The structure of the Canadian banking space is much more resilient in that regard, right?

Because you have these six banks that essentially, when even three that dominate the entire space, it’s very different from the United States in that regard. So it’s more the bear twin for your high, the, there’s market power there’s switching costs, there’s all these things that give them more resiliency than you would be getting in the US, where you have a lot less concentration in banks. And that translates into a lot of the ETF products that you have, having that downside exposure to what you’re describing.

[01:17:30]Richard Laterman: Yeah. No, that makes sense. I know we’re coming up on an hour and a half, so I guess I would just maybe ask you a final topic question topic, pivot into the currencies and pretty much the dollar. What is your take? The dollar has shown a little bit of weakness recently, obviously that has helped the commodity case, right?

We’ve seen precious metals in the last couple of months recover. And commodities as a whole, that has played a role. Do you have any strong opinions, strong convictions on the dollar?

[01:17:59]Joaquín Kritz Lara: Yeah. In the coming months, I think as long as global risk appetite remains, there’s going to be downward pressure on the dollar. So basically, as long as you keep getting positive economic surprises in the US or elsewhere, meaning that growth numbers come in stronger than people were expecting, inflation number comes in lower, then that certainly puts downward pressure on the US dollar, especially because especially in G7 countries.

There is, I would say, an equal to bigger pressure by central banks outside of the Fed from maintaining a hawkish stance, the ECB.

[01:18:38]Richard Laterman: Bank of England?

[01:18:40]Joaquín Kritz Lara: I mean in the case of the Eurozone one of the big problems that ECB has is that core inflation is very exposed to these sort of wage/price spiral type situations because of collective bargaining, right?

So in, in Europe, I think it’s 80% of the workforce is under collective bargaining agreements. And what that means is that inflation actually leads wage growth by about five months or six months, something that, and so if you get high inflation, you get higher wages and then higher inflation, and then higher wages and so on, right?

So they, if you look at what Lagarde has been saying, she’s, we’re going to, they’re very hawkish right now, and so that I think tells you the dollar will probably remain weak near term. We do think that the global economy will stall towards the end of the year and the beginning of ‘24.

At that point. I think things could start changing. We see a higher probability of the Euro’s  even depreciating 12 months into the future. Does that, and even if we continue to see this slide on the dollar one of the things that I’m often asked is this idea of the dollar being, losing its status as the preeminent global currency type of thing. That always happens every time the dollar falls for more than three or four months.

I don’t think that’s something that people should factor in their thoughts at least. Cyclically, it’s very natural for the dollar to depreciate as a floating currency, even fall sharply as it did in some periods in the early 2000s, without it actually losing its status as a global currency.

So basically what I’m saying is, if global activity slows down and safe haven demand kicks in, the dollar will strengthen. Chances are, right, regardless of whether there’s fears around its reserve currency status or any of that stuff, which I mean, fair enough. But the safe haven aspect is usually not mentioned in these discussions, and I think it’s huge.

[01:20:32]Mike Philbrick: Yeah. So along the lines of the bond side of things. Flight, a flight to…

[01:20:36]Richard Laterman: It’s more the reserve asset than it is the reserve currency. And the fact that you…

[01:20:40]Joaquín Kritz Lara: Yeah. That’s it. The store of value aspect of it is so important. It’s not, and of assets that are traded in dollars like bonds.

[01:20:49]Richard Laterman: I hear a lot of people s speculating around since the sanctions that were imposed on Russia and the weaponization of the dollar. That the marginal appetite to hold dollar assets would be diminished. Then the natural next question is what is the alternative? And it’s the whole cleaner’s dirty shirt argument that I think is so compelling, because you don’t have anywhere near the depth of market that you have in the US, anywhere else.

But I always questioned myself because at one point, I’m sure no one could imagine the pound sterling ceasing to be the reserve asset. And I wonder if we’re getting out of a gold standard, right? Leaving the gold standard. So I wonder if we’re lacking imagination. When we have these discussions in this understanding that these changes would happen really marginally, really in a very incremental way, and then all of a sudden it would build momentum and you might have some form of face shift, especially when you consider this potentiality for a global decoupling and deglobalization happening.

And you start hearing about these emerging markets trying to at least trade in their own currencies. That’s how it starts, right? So I guess it’s hard to imagine these things because they would be such a monumental shift from the world that we know today. But I guess it’s inherently…

[01:22:09]Joaquín Kritz Lara: I think it would take a, I think it would take a lot. It, I’m not saying it’s impossible, it would take a lot. I was looking at the numbers the other day. There’s this short research piece by the, since the Bank of International Settlements, it may be from last year or two years ago.

They look at the role of the dollar. Typically, these exercises are like the role of the dollar in global trade. But no they look at the dollar in any kind of foreign exchange transaction worldwide, where the dollar is one of two pairs, right? So it’s the dollar against the euro or the dollar against the Australian dollar or whatever, right?

The share of foreign exchange transactions in spot markets, forward markets or swap markets that is accounted for by the dollar is 90%. 90. That’s insane. Now, why is that? Yes, there’s this marginal appetite for the dollar as a reserve current asset, like for foreign currency sellers, for central banks.

That, to be fair, has been declining, that share, right? It used to be 70% 20 years ago. Now it’s 60, it’s dropped 10 points. Can BRICS bring it down to 50 or 40? Probably, it could happen. Not maybe, not probably, but possibly. But there’s a bunch of other uses for this that are, that would have to get displaced.

The first one, which is sounds stupid, but it’s a big portion of liquidity is, it’s a vehicle currency, right? So let’s say you want to exchange lira for real. What do you do? There’s no market for lira to real, so you’ve got to use the dollar as that exchange medium.

[01:23:40]Richard Laterman: It is like water. It’s the medium, it’s the medium through which everything navigates through.

[01:23:45]Joaquín Kritz Lara: Yes, exactly. The other thing is on the good side, 50% of invoices worldwide are done in US dollars, including literally 100% of commodities. So that would have to be displaced as well. And then we have to remember that foreign funding we’re used to like, we use the term hard currency and dollar denominated debt interchangeably.

If you’re a fixed income trader or whatever you would use it interchangeably. And that’s because I think it’s, again, 90% of all debt that’s non-local currency denominated, which is often issued by emerging markets. But you could also have some developed market debt in foreign currency, maybe less but yes it’s in dollars.

For loans it’s 60, 70%. And then you have the dollar as a safe haven asset, right? So what you would need to displace it is something that is liquid, to act as a bit of exchange. Imagine having to transact invoicing. Let’s say you’re buying machinery from Spain or something into Mexico, and you’re using bullion to do that.

Imagine, that just seems like a complete hassle. So it, that becomes an issue and that’s a big portion of the movement in, or the demand for dollars. And then you need it to act as a store of value. And it, like the digital payment space, for instance, is one potential alternative, but is it, do people really view it as a store of value? I don’t know. It’s quite risky so far. If you’re in a country that faces institutional problems, like in, I don’t know say in Argentina, crypto is really popular. In Turkey, in El Salvador, It’s like official, for the most part, not really. It’s not that used as a share of overall transactions.

And so it it’s almost like you, you remember like when you go to Macro 101 in undergrad and they, no, it would be like Money and Banking 101 and they tell you about money, what makes something a currency and it’s like it has to…

[01:25:44]Richard Laterman: Fungible store, valuable.

[01:25:46]Joaquín Kritz Lara: Yeah, it’s that. It’s like it’s got to be liquid and it’s got to act as a store of value.

And we have to think of things that do both for all of these different uses that I’m describing. So what you would have to get is EMs being a big portion of the world economy saying, we’re not going to borrow anymore in dollars. We’re not going to transact in dollars, meaning I’m not going to buy oil in dollars. I’m going to buy it in Yuan and I’m no longer going to store reserves in dollars, but I’m going to use something else. So it’s like there’s layers.

[01:26:20]Richard Laterman: Process, if at all. And so for the purposes yeah, and you would need to have several major ruptures in the global order as we know it today for this to even be conceivable. And it would still have to be something that would take place over at least a decade, probably.

[01:26:36]Joaquín Kritz Lara: Not to say that you can’t have the dollar slide 10 or 20%. That would still not make it the end of the dollar as king dollar. It wouldn’t be the case. It’s an asset price. It can drop.

[01:26:50]Richard Laterman: No, but I appreciate that you actually entertained the thought and you took us on a little bit of an imagination, a little bit on, on a ride to contemplate what that might look like. So that’s very much appreciated. I know we’ve gone quite long here. We’re an hour and 40 minutes almost.

Mike, any final thoughts?

[01:27:07]Mike Philbrick: No, it’s been a great conversation. I think I’d love Joaquin to tell everybody where they can find you, where they can find Numera, Twitter, webpages, all that sort of stuff.

[01:27:16]Richard Laterman: All the plugs, now’s the time.

[01:27:19]Joaquín Kritz Lara: That’s right. So if you want to follow our research, we’re on Twitter. On LinkedIn, same thing. You can follow me on LinkedIn. I do a little bit of Twitter, but I would say on LinkedIn. I’m doing daily posts on our research. And obviously if you are interested by what you heard and want to entertain the possibility of becoming a client of ours, do reach out. The stuff we do is interesting and I think should help you as an institutional investor.

[01:27:46]Richard Laterman: And high quality caliber, without a doubt from what we’ve seen. So yeah, we really appreciate you coming today, Joaquin. It’s been a pleasure.

[01:27:53]Joaquín Kritz Lara: Absolutely.

[01:27:53]Richard Laterman: And have a good evening, everyone.

[01:27:55]Mike Philbrick: Yeah.

[01:27:56]Joaquín Kritz Lara: Bye bye.