ReSolve Riffs with Prometheus Research on Navigating a Potential 2023 Global Recession
For the opening episode of the new year we had the pleasure of speaking with Aahan Menon, founder and CEO of Prometheus Research, which seeks to democratize access to elite financial research to the general public. This great conversation covered several topics, including:
- A macro framework focused on the interplay between the real and financial economies, and the business cycle
- The main driving forces in markets and the economy: growth, inflation and liquidity
- Key variables for measuring liquidity
- Creating the condition for potential asymmetric returns
- How the increase in the stock of assets facilitates other activities
- The original aim of quantitative easing
- The contest between the ‘Dot Plot’ and the yield curve
- The signaling mechanism of price levels
- The biases and shortcomings of the CPI
- Cyclical vs secular inflation
- How economies have evolved in the last few decades
- Why inflation volatility may be asymmetric
- The false diversification of the 60/40
- Why increased uncertainty usually signals a turning point
- Updating priors – a ‘burden of evidence’ approach
- Fluctuating edges and the challenges of volatility targeting
- And much more
This is “ReSolve’s 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.
Founder, Prometheus Research
Aahan Menon is the Founder of Prometheus Research. Prometheus provided elite quantitative macroeconomic research to the public. Using a data-driven process, Prometheus offers real-time insights into the evolution of markets & economy and combines these insights algorithmically to create rules-based portfolios to help guide investors to achieve equity-like returns with much lower risk. Prior to founding Prometheus, Aahan worked both in the retail research business at FXDD and on the buy-side at Light Sky Macro- bringing a well-rounded perspective to markets. Aahan has an undergraduate degree in Finance from NYU’s Stern School of Business.
Rodrigo:00:01:51All right, all right.
Mike:00:01:51Hey. All right, all right. Welcome to 2023 and Fridays. I love it.
Aahan:00:01:56Happy New Year, guys.
Rodrigo:00:01:57Happy New Year, Aahan.
Mike:00:01:57Happy New Year, Aahan. Great to have you on and get to meet you screen to screen.
Aahan:00:02:04Yeah, likewise. I’ve been an avid consumer of your guy’s content for a while, so I’m very happy to be here and be able to contribute.
Mike:00:02:13Yeah. And we found Prometheus very quickly too, come out of the gate. And then we’ve had a couple of people actually request that we have you on, because I think your global macro mind framework jives a little bit with what we’re doing. And so why don’t you give us a little bit of your background and Prometheus, where you came from, what the genesis of the idea was and where you’re headed. Before you do that, I will remind everybody, this is just three dudes talking on YouTube on a Friday afternoon. This is not investment advice. So, don’t take it as such. So, now we can have a nice wide ranging conversation. And that is my disclaimer for that. Back over to you.
Aahan:00:02:54Probably not the best idea to get your investment advice on YouTube as a general note. Yeah. So, to give you my background. So, my name is Aahan Menon, and I’m the founder and CEO of Prometheus research. Prometheus is a systematic macro research firm dedicated to the democratization of finance. So, what we do that’s pretty unique at Prometheus is we spend our time trying to understand how the economy works and what’s going on. And then we codify that understanding into a systematic rules based framework to create dynamic portfolios. The purpose of the portfolios is to create durable return streams that can survive and potentially thrive in all environments.
Now, alongside the systematic portfolios, we also offer a host of written research ranging from one page topical notes to extremely in depth 30 page research reports on the macro outlook, right. And the objective and the overarching goal is to create a holistic suite of products that can help investors of any size navigate macro-economic cycles.
Quick note on myself, prior to starting Prometheus, I have a background from the institutional buy side and the retail sell side. So, I started my career in macro and econ research at a hedge fund called Light Sky Macro. I followed and continued that macro research career in a different setting at a retail broker called FXDD. And 2022, the stars kind of aligned and you know, I think it was an opportune time to start Prometheus, which is when we did. And we’re a two person research team and still growing. And it was an interesting time to start, given the approach that we have, and I think that there’ll be a lot of overlap and kind of how we think about things as we go through this discussion. And I’m looking forward to trying to help you know, our subscribers navigate 2023, and that brings us to our conversation today, right?
Mike:00:04:52Yeah, yeah. And everyone check out Aahan on Prometheus Research. I think it’s Prometheus at Substack as well, if you want to get — follow your commentary and sort of … Let’s get that at the beginning where people can find you. We always wait till the end. But let me, let’s do it at the beginning, we’ll do it at the end as well. But just so people can start to scroll through your Twitter profile, and subscribe on Substack as we’re going. Let’s get them doing that first.
Aahan:00:05:18Awesome, I appreciate that. So, you can find us on three different places. You can find us @PrometheusMacro on Twitter, you can find us on Prometheus-Substack, or Prometheus Research at Substack. And then we have the new website, which launched a couple of days ago that’s Prometheus-research.com.
The CIO Dilemma in 2023
Mike:00:05:39That’s awesome. So, I want to kick this off, Rod, if you don’t mind, and just give you a kind of a big broad question to start, Aahan. What is the CIO dilemma in 2023?
Aahan:00:05:55I think the hardest thing for most people is going to be to figure out whether you are going to have what has been a fairly anomalous year in 2022, continue to play out. And so I think the big challenge is we’ve been in an environment. And we’ll explain more about the characterization of this environment, but what we’ve called stagflationary nominal growth with tightening liquidity conditions. Right. And that has been an extremely tough environment for any kind of traditional asset allocation. Now, I think the question for 23 is whether we remain in said environment, or we have an interim period where we transition into something a little bit more different and perhaps more familiar.
Three Frameworks, Two Economies
Mike:00:06:40I like that. I like that. So, walk us through your framework with trying to figure that navigation out. And also where you’re seeing sort of contrary evidence in different asset classes. Are you seeing sort of the bond market, even within itself, is saying a couple of different things, the equity market saying some things, the commodity market is saying some different things. So, how are you processing all of that through your macro framework at Prometheus to try and come to some conclusions? And at the moment, are you seeing big bets, small bets, kind of be more conservative? How are you seeing all that come through your lens?
Aahan:00:07:21Yeah. So, I think maybe we can take the framework aspect first, and then kind of delve into the current context, because I think you guys will appreciate this. We have a good deal of work that we’ve done and time that we spent in kind of developing how we think about things. And I think that’s usually much more value than what we think at any given point in time. Right. So, when it comes to framework, they’re three separate things. And so the first is the macro framework. The next is the investment framework, which is like how you weaponize that macro framework, right. And then the third is, you know, how you kind of reiterate your research process. And so maybe we start with the macro framework, because I think that’s probably most relevant.
The way the macro framework and the way we think about the world is that the economy is the sum of two parts, right. And it’s the real economy and the financial economy. So, the real economy is just the sum of the factors of production, just labor and capital, right. And these are just very real tangible things; they’re your and my skills, they’re things that we make. And on top of this real economies, is a financial economy, which is just a sum of money, credit — money, and credit, which is just assets and liabilities. And these two things, while interrelated from time to time, can get really out of whack. Because the ability of the financial economy to expand and contract is much stronger than the real economy, because it’s just a bunch of contractual payments between participants.
And this — and now while these things can get really out of whack for a while, there tends to be a snapback effect, which usually happens as the financial economy kind of contracts and comes back to some kind of equilibrium with the real economy. So, you can imagine them kind of in dynamic equilibrium. And that snapback effect and that expansion away from each other is the business cycle. And as investors and economic participants, what we’re trying to do is we’re trying to manage risks surrounding that — that business cycle. And so the way we think of understanding the business cycle is that it is characterized by three major components, right? If you can get a handle of these three things, you probably have a good idea of what’s happening with the business cycle.
These three things are growth, inflation, and liquidity. So, growth is just real output. It’s the output of goods and services in the economy. And these are tangible things so they are different from inflation, which is really just a movement in the price level, right? Finally, liquidity, a little bit more esoteric, but when we’re talking about liquidity, we’re talking about funding liquidity, which just refers to the price and quantity of money and cash-like assets in the system. And so if you can stack all these things together and understand how they’re going to evolve over, say, the next six to 12 months, you have a really good chance of understanding how the cycle is going to evolve, which means you have a good understanding of how capital is likely to flow. And that’s what we’re trying to do, really.
So, the idea is to have some sense of how these conditions, these macroeconomic conditions are going to develop. And we want to allocate pro-cyclically with these conditions, right? And I think that the benefit of thinking like that is twofold. One, if you — now this is obviously conditional upon you being right. Now, if you do happen to be right, one, it minimizes your chances of being in massive drawdowns in any particular asset. Right. And the second is, if you happen to be on the right side of bets, while a lot of market participants are on the wrong side of bets, you can have asymmetrical payoffs. And I think the combination of those two things is really what sets up a good and durable sort of return stream. And so that’s kind of how we think about macro broadly and investment in that context. And we can get into other parts of like how we think about — yeah.
Rodrigo:00:11:16Aahan, can I double click on that liquidity? I think you mentioned something very interesting which is, it is a very esoteric area. It certainly is, for me, this is it, those three. We talk a lot about growth and inflation at ReSolve, but liquidity has always been… excuse me. Just inhaled a little bit of water there. Liquidity has always been fascinating to me, it is an important aspect of what we do as well. But how do you differentiate sentiment liquidity? How do you guys look at liquidity? What metrics do you need to really understand in order to understand what I guess is just a flux, right? Are we in positive flux, are we negative flux, are we in neutral flux? Broadly speaking in the broad market, right? And is that quantitative tightening and quantitative easing? What does that mean? What do you — tell us about your view of liquidity and how you view it and how you measure it, and how you take, I don’t know, take any sort of metrics from it?
Aahan:00:12:19Got it. So, I think that there are many different types of liquidity. And generally, what’s more typical is to focus on market liquidity, right? So, you look at various measures of what’s happening with markets. The way we kind of try to look at it is we try to take it to a fundamental place where we’re trying to think of, what is the dry powder that facilitates future economic and market activity, right. And so you can think of it as the stock and as a flow, and then there’s the flux, right, of cash-like assets in the economy.
So, what traditionally has been a very good metric for liquidity has been the price of money, because that’s been the primary level that central banks have pulled to increase the availability of credit in the economy, right. And so if we decrease interest rates, we’ve typically had better liquidity conditions, which facilitates economic expansion. And when we do the inverse, we have a contraction. But when you run out of kind of the ability to move interest rates up and down, there still remains the ability and which always existed, it’s not that it only exists, once you get to the zero lower bound, you have the ability to inject cash and cash-like assets. Now, I think when you start thinking of, okay, we understand the intuition. How do I actually look at this, right?
The way we do it is as follows. We look at the two major liquidity creators. There is the US sovereign, which is basically the sum of the Federal Reserve and the fiscal authorities. And then you have commercial banks. And between these two parties, you have the highest and most liquid form of assets. And so when you track conditions and how they evolve in that ecosystem, that’s really how you understand what’s happening with liquidity conditions.
Rodrigo:00:14:23So, are you going into how much the Fed is printing, how much the central banks are buying, what the repo markets are doing, and adding all these things up to come up with a positive, neutral, negative flux? This is just my lingo. You can use whatever lingo you want. But is that — are those the places you’re looking at for that liquidity?
Aahan:00:14:43Essentially, yeah. So, I think an important fact here or an important nuance is kind of that what ends up happening with this liquidity analysis is like people end up siloed in one part, right? So, either you look at the Fed or you look at the Treasury, or like I’m a commercial bank guy. You know, you ended up looking at one of these things. But what probably matters is the sum of all of these put together. And so maybe if we talk a little bit, so the most important player, obviously, in all of this is the US government, right? And the reason that it is, is because you know, it’s liabilities, the US government’s liabilities are the most pristine assets that we have in the financial system.
So, now, when I want to look at, what we try to do is we net our holdings between the central bank and US fiscal authorities to come up with what an estimation of the aggregate US government balance sheet is, which is like, we’re looking at the aggregate liabilities of the government, which are the aggregate assets of the private sector. And so then if we go down and we look at the more — the lower maturities which have less price variation, because they’re less exposed to duration, we’re essentially looking at the stock of the most pristine assets in the economy. And what we find over time is as the stock of assets is increased, it facilitates activity in other places. Now, the problem with liquidity generally is that it’s fungible. Right. So, you know, I can sell my T bills, and I can buy a car. I can sell my T bills, and I can buy, I can buy equities. And so what we do know, though, about liquidity is that if there is an immense amount of it, the potential for economic activity is quite large. And vice versa.
Rodrigo:00:16:35Okay. So, I understand broadly. I also have seen, and more read, decade’s worth of liquidity injection into a central bank, i.e. Japan, with very little impact on those financial markets. And then the last few years, we’ve seen a large amount of liquidity injection that actually worked to create inflation. So, how do you differentiate kind of monetary, just printing the money, putting money in banks — bank accounts? And how do you differentiate the liquidity that’s actually going to impact the real economy and bump prices up?
Aahan:00:17:13Yeah. So, I think that’s a really good question. So, if you think about QE at its core, by itself, it’s just maturity transformation. So, we have, let’s forget the real economy for a second, all you’re doing, really, is you’re coming in and you’re creating liquid reserve balances, and you’re trading out longer duration assets. And so that mechanism, if you actually think about it, or look through economic accounts, it has no reflection in economic activity. Now, what is a potent mix is having very large deficits, and using QE to, air quotes, monetize these deficits. And these deficits actually have an impact on economic activity that are literally there in the account. So, I think that it’s fairly straightforward in an accounting sense. But in a broader sense, I think what the hope was with QE, was that we could create financial conditions that were so conducive that it would generate activity. But the problem was that the outlook for activity of economic participants wasn’t adequate to just create this massive levering in the system and create this robust expansion.
So, now, when we’re thinking about what happened in 2020, right, as opposed to what happened with QE and the opposite QT, what you had was you actually had fiscal authorities come in and inject income, live and into the economy. And so once that money makes its way into the economy for a period of time, it may be saved, right. But as we — so, maybe we actually go through the example because I think that’s the best way to probably do this. So, we had the pandemic lock downs, right. And in the pandemic lock downs, you basically had output disappear almost overnight. And in response to that, the Fed and Treasury came together. The Fed said we’re going to buy an unlimited amount of bonds, and the Treasury came in and said we’re going to send you a lot of money.
Now, output still didn’t increase but income increased. And number one, we want to register, that’s an anomalous thing, output and income usually tend to coincide and rise together. Now, when you have these income injections for a small time period, you actually had the money saved, so profits still suffered, activity still suffered. We were in a deflationary kind of situation. But as we reopened, more and more of this money got spent into the economy, which resulted in profits being higher, and the ability to reinvest became strong once again. And once we began to really reopen, you had a demand to increase output, and you started having this money turn over and be spent into the economy. And so that’s the real difference. The difference is that fiscal authorities can actually inject economy — can inject liquidity into economic activity, but quantitative easing tends to be relegated to financial markets.
Rodrigo:00:20:15Okay. And so that latter one helps us with understanding inflation, and the former one helps us maybe understand financial markets.
Aahan:00:20:26And you could argue that they’re both kind of inflation, they’re just different types. Right? So, if you think — …
Rodrigo:00:20:32One feels more growthy than the other, right.
Aahan:00:20:35One feels more growthy than the other, and I think that that’s just a distributional effect, right. So, you have a lot of people that buy stuff, buy day to day objects, but you don’t have everyone trying to buy equities every day. And the concentration of people that own and buy equities is a small fraction of the population. So, if everyone owned equities, we’d hate it when they go up.
Mike:00:20:58I suppose it’s been a bit of a Keynesian affair with the fiscal side. Right? So, you have a shock, you inject a bunch of money, and then it’s got to flow through the system, which takes a while.
Aahan:00:21:10Sure. And I think that that’s the problem that we’re having, right? So, you have the problem — so, you know, this is kind of getting into the inflation issue, which is that the Fed and Treasury came together to do something, right. And the Fed and Treasury came together, create a lot of liquidity, so they injected money and credit into the system. But now you have the Fed alone trying to reverse these conditions. So, if you think about the mechanism that would be needed to actually tamp down on this inflation really quick, it will be taxation, right. So, if I inject $100 into a closed system, and I say, or the only way to really erode the value of it, is to, one, reduce the number of dollars, right? So, we have less money, or we have inflation, which is basically just a reduction in the value of it.
And so I think the problem that we’re facing is that the Fed doesn’t actually have the adequate tools to combat this effectively. And so they have to really lean on the tools that they have very aggressively. So, what are the tools that they really have, they can work through financial conditions. So, they have to — the problem we have today is not a credit problem. The problem we have today is a money problem. And the Fed isn’t well equipped to deal with a money problem, fiscal authorities are. So, the Fed has to lean so hard on financial conditions to bring us back to some sort of equilibrium that it’s causing all the issues that we’re seeing today.
Mike:00:22:35The fiscal side is also complicated by votes. Right? The fiscal side is not a pure — and not that the monetary side is pure either. But from the perspective of not being polluted by the prevailing sort of Zeitgeist or vote getting. So, there’s going to have to be, or there will be some fiscal stimulus that’s going to be sort of pointed and directed at certain, I think you reference this sort of different strata within the populace. And so that also has to be factored in by the monetary side of the equation. You’re going to have to do targeted sort of fiscal spending in order to help those groups that are impacted at a larger level. And meanwhile, you’ve got this sort of blanket, monetary policy happening.
Aahan:00:23:35Right. And I think that that’s, I think, more often than not monetary policy and policymakers, they kind of assume nothing is going to happen with fiscal policy in a meaningful way on the timeline that they want. So, they really have to lean on the tools that they have and they have pretty blunt tools. And if you really put what’s happening today into that context, right, we have high inflation, wages getting squeezed, real output, real income getting squeezed. And in that environment, it’s not going to be a popular thing to tax people.
Mike:00:24:09Oh God, no. Well, this is part of the equation.
Rodrigo:00:24:11Right. This is the problem. This is why the Fed alone couldn’t get inflation up when they wanted to. They needed a massive disaster for fiscal spending to actually come into play. And of course, they did too much of it. They were — and it was going to be much worse if they didn’t get clawed back once negotiations began. So, it’s an interesting thing, the politics side of things and what the Fed has to do in an aggressive way to control the situation. So, now the Fed has done something very aggressive.
A lot of people we’ve had on our podcast, consider it to be outrageously aggressive. You have interesting discussions between the two co-CIOs of Bridgewater as to what their view of what the Fed is likely to have done and continue to have to do between — they have done too much and it’s going to break the system in an utter recession, to they’re going to pull back way too early and are going to have to do this over and over again a few times. So, this is, and both lead to recession. The question is how, how badly have their aggressive policies for — because of what you explained, how badly are they going to impact the economy? So, what are your thoughts on recession here going forward?
Mike:00:25:19Oh, yeah, who wins, dot plot or yield curve?
Aahan:00:25:23So, I think that the way to think through what the recession or whether or not. I think it’s probably more meaningful to talk through how we get to recession relative to whether we get there or not. And obviously, we’ll end up at whether I think that we’re going to get there.
Mike:00:25:42Yeah, well — Right. Let’s go through — we’ve talked a little bit about the liquidity side. So, I guess now what Rodrigo is leading us to is, let’s talk about the growth and inflation side. Rod, is that where you’re headed?
Rodrigo:00:25:56Yeah, I’m happy for Aahan to lead us down the path. I want to know, I’m dying to know what he thinks. Let’s go.
Aahan:00:26:01Okay. So, I think when it comes to recession, maybe — so we started with the context in terms of what happened and how we got to inflationary conditions. And last year, we had the situation of stagflationary, nominal growth and tightening liquidity. And what we’ve typically seen is that this environment of stagflationary and nominal growth is usually one that precedes a transition to stagflation. And the way that usually happens is through the following chain. So, you tend to have profits and real profits contract or come under pressure. And as a result, when — so, if you think about the purpose of profits, it is to reduce your cost of capital, right. So, when I redeploy, but in an inflationary environment, when I redeploy my capital, I actually get less and less per unit.
So, as a result, there is an increasing amount of pressure on my ability to produce more, right. And even on the consumer side, you experienced the same thing. So, over time, you end up in a situation where production and output begins to suffer, right. And the only level that businesses have to maintain their nominal activity is prices. And they will push that as much as they can. So, as a result, you end up in a situation where you have kind of a shrinking nominal pie with a faster shrinking real pie, right. And you end up in a situation where profits can begin to contract. And that’s kind of where we are now. We’re at a situation where profits may or may not contract, and that’s what everyone’s really focused on. And when you have this profit contraction, businesses do what they need to do to maintain or sustain profits or have try to claw them back, which is they go out, and first, they begin by adjusting the number of hours their workers work, right. Or they will try to adjust the number of — the amount of wages. That’s a lot harder, right. And then the last thing that they will do is they’ll start firing people.
Now what the issue is, is that while on a per business basis that might be the most logical thing to do, when you do that, at the economy wide level, you suddenly take out employees, right. And employees are probably the most vital part of income and spending in the economy because they both generate income and they generate spending. So, when I take out employees, when a business tries to protect its profits and when business in aggregate try to claw back their profits by reducing labor, you actually end up in a situation where they end up exacerbating conditions, income and top line disappear, and you transition into a recession. So, where are we in kind of this template of things happening, right?
In 2022, we had the first leg where real profits kind of contracted in Q1 and Q2, and so did nominal profits. Q3, they got a little bit better. And as a result, initially as we went into Q1, Q2, we actually had production extremely strong. But these dynamics that we discussed, started to play out. And over Q3, Q4, we’ve actually seen production and output drop precipitously. Now the question ahead of us is, one, when and if profits are going to begin to contract meaningfully? And from there, will that contraction be adequate to catalyze firing, right? And once we hit that point, that’s when we really start talking about a real recession. Right? And what’s important to contextualize here is that you don’t actually need an outright contraction of the labor market to generate a recession. You need a softening of the labor market.
And why that is, is if you think about aggregate incomes, right? It’s just a function of the null more people employed or the growth of employment plus the growth of wages, real wages and the number of hours that people are working for those wages. And so if you look at two and three, which are the hours worked and the wages, they’re actually already in contraction. And the only thing that we need now is we need employment to soften a little bit, and the aggregate goes into contraction. And that’s kind of the trajectory. What we have to figure out in 2023 is how fast and how long is it going to take us to move through this process?
Mike:00:30:34And do we get the immaculate disinflation that I keep hearing about, right, this idea that employment rates stay steady, but job openings, they contract. But you know, nothing else happens. And it’s, I guess it’s appropriately named. It is a crazy thing.
Aahan:00:30:54I think when it comes to inflation, a lot of the inflation discussion can be kind of couched in a similar type of setting, right. And so when we’re thinking about future inflation, what we need to think about is how nominal activity is going to move over the next six months, and whether it can sustain itself at the current pace and if it cannot, right. And I think that when it comes to thinking about how inflation is going to evolve over, say, the next six or 12 months, what we need to do is we need to look into the components of inflation to understand how those things are going to evolve. So, there is typically this kind of on, and we will probably touch a little bit on the inflation print that’s coming up next week. That’s always an exciting topic, right?
So, when we’re thinking about inflation, what we want to think about is the broad categories, right? So, there are four categories that you really want to look at. That’s housing, there are services, ex-housing, housing is usually counted as a service, because people pay rent for the most part. So, they’re services, ex-housing, housing is the biggest component of inflation. And then you have goods, right, which are divided into durable and non-durable goods. Now, the combined trajectories of these two things is going to determine where you land, right. And so when we think about housing, housing is largely a function of just what’s happening with home prices. And so to get a little bit into the weeds of this, the way that housing inflation is calculated, is that what we do is we go out, and we look at what is happening to housing prices, right?
So, the way that it’s imputed in CPI, is that you take a sample of households that rotates every six months, right? And what you do is you go and ask them, hey, like, have your rents changed? Or have they not? Right? So, first off, there’s an anchoring bias, you only report — you look at your last rent, your last survey reading, and you’ll say yeah, it was about there, somewhere in and around that number. And so if you think about what is required to cause people to actually report massive changes on a — between every six months, you need to have a precipitous decline in housing. And you know, that needs to be front of newspapers, because this number isn’t an actual number. It’s based on what owner’s equivalent rent is, which is basically, if I have a house, what I would charge for it.
So, the problem is that the sample, right, because of this six month rotation period doesn’t fully rotate for an entire year. So, as a result, what you see in housing prices, doesn’t actually make its way into the index for, let’s call it about 12 months to 18 months, it depends on how big the changes are in the smoothing process. So, what we know off the cuff is that we’re likely in a situation where there’s still a little bit of housing inflation ahead of us, right. And that will taper off but it’ll take a long time for that to sort of come down.
The next component is medical services. And now this is a bit — well, not medical services, services at large and then the largest component of that is medical services. Now, what has happened, which has created a big deflationary pause is that last year, so we have services spending, and sorry, services inflation. Within that we have medical services, which is the biggest part, you had a change in the computation of insurance premiums, right, medical insurance premiums, and as a result, you had this big, this massive, like completely unusual drop in medical inflation. Right? And now the question is, how much is that drop going to continue to weigh on services inflation? What I will say is that it’s not as clear cut.
What we do know is that — large, we’re probably going to see a stable and steady kind of undercurrent in services inflation, but the problem is that there is a smoothing process applied even here, which means that this one big drop in November is probably going to permeate through the entire series for the next 12 months. So, net, net, probably a little bit of moderation there.
Now, when we go and start looking at goods, it’s a little bit more of an interesting story. Because when we look at the goods economy, there are durable goods and non-durable goods. And when we look at non-durable goods, they largely reflect commodity prices, that I know that you guys are all too familiar with, right? And the pass-through from those is relatively quick. So, what ends up happening is what happens from goods, what ends up happening with commodity inflation or commodity prices ends up passing through to these non-durable areas in a period of three to six months. So, if we have basically aggregate commodities so we look at ags, we look at industrials, we look at energy commodities, and we stack those together and try to figure out, which are the most relevant to non-durables, what we find is that within about three months, you tend to have some sort of pass-through, and that is mixed again.
And the last one is probably where we see the most decline, which is durable goods, right. And the main items in in that basket are things like furnishings and cars, right? Those are transported at large. And those areas. So, when you think about the Fed’s tightening, right, the Fed’s tightening has the most impact on this part of the economy, right? The reason is, because these parts of the economy tend to be the most levered both in terms of their purchases and their creation, right. So, if I have to start an auto plant, I probably need to borrow some money, which means that if rates are rising, I’m not going to be able to finance a big plant.
So, what ends up happening is that these are the most cyclically sensitive. So, when people talk about cyclical and a-cyclical, like, these tend to be the most cyclically sensitive areas. And we’ve seen in these kind of durable goods segments, and you also had COVID-19 specific effects, which we can talk about. But when you look at what is the most affected by the Fed’s policies, it’s this area, and that’s where we’re seeing disinflation, that’s where we’re seeing deflation in a lot of places. And so the combination of these things, nets out to an inflation trajectory, that is not crazy like 2023, but it’s also not a good one, right? So, the way we’re looking at it is we’re probably going to have a stabilization of inflation in a band. That band is a pretty big one. It’s probably between four and 5%. But what’s important to realize is that that’s still double of the Fed’s target.
Rodrigo:00:37:53Yeah, it’s an interesting thing. It’s the difference between cyclical and secular inflation, right? And I think there’s good arguments to be made, that we’re in a different secular inflation period, but probably peaked on a cyclical basis a couple of months ago. And we’re going to see how that’s going to play out over time. But Mike and I talked about the inflation volatility prior to 1981. What was it, four — Like, it’s over 4%, standard deviation, and …
Mike:00:38:24‘91. But yeah, it’s five — … Yeah, ‘91. It’s like 5%, call it 4.8 or something like that.
Rodrigo:00:38:30And then you’re looking at like, 1.6 up to 2020. Right. So, we’re likely going to see a lot more volatility around that number as we see more …
Aahan:00:38:39You know, one thing I would add to that, though, is that for context, you also, prior to that period, you actually had a larger contribution from industrial components of the economy, relative to services components of the economy. And so if you think about how inflation passes through the supply chain of the economy, right, it starts with, like, the most volatile components of inflation are these energy kind of areas, right? These energy/commodity kind of areas, because they’re contractual agreements, like a mark to market every single day. Right? But as you start making your way up the complexity chain, so as you start getting towards services, right, we basically take every other cost as inputs, and then we charge prices, right, as the service providers.
And so I think the stability of inflation also kind of reflects the kind of change in that kind of structural feature. But no, I do agree with you when it comes to general like, experiencing more inflation instability just as a function of larger monetary and fiscal volatility, right. And if you think about the way the cycle has worked, we’ve seen like a cycle and a half in three years. So, I am definitely partial also to the inflation volatility argument.
Mike:00:39:56That’s a really great point though, really nuanced point in that the economies of the world have changed dramatically from that period of you know, pre 1991, going back 50 years. And then thinking about the way economies have evolved with technology, taking something from nothing, right, and then producing content, Google Maps, a number of items that we’ve had in technological revolution that are actually not in — they’re deflationary. And they don’t actually require any sort of stuff, if you will. The stuff that they require is innovation. And the innovation leads to some sort of profit margin, which is a really interesting impact or effect that would — and 1991 is interesting timeframe as the internet evolves into that period of time, and you have this period of innovation that actually doesn’t require stuff to create profits.
Rodrigo:00:40:59I’ll push back, I’ll push back on that. I mean, once you start having to deal with inflation, or disinflation or deflation, you will see how quickly service prices go down and become volatile. Now, I’ll tell you this from just being in Latin America, it really is about the rate of change. And it doesn’t matter whether you’re a commodity producer or a doctor. I’ve seen changes in health services in Latin America go up and down wildly, depending on whether we’re in a deflationary or inflationary environment. So, I think the 1991, I think that’s the beginning of the Great Moderation. It has a lot more to do with throwing bodies at the problem, demographics. Yes, everything that has to do with the internet and kind of readjusting to that, having a big deflationary push. But once we have demographics change, which is what we’re seeing, we’re having nationalization of a lot of industries. You know, I’m talking to a lot of guys on island here that used to produce in China, and now we’re going to the US and Mexico to get equal amount of pricing, maybe a little bit higher, right, that it’s just going to be a different world, and it might affect services as well. I mean, services meaning, we all have all of our — we’re a 100% of service industry, Mike, and we have gotten, everybody raised their prices on us really aggressively this year, right, over 10%.
Mike:00:42:30Rod, as I said, it’s a bit — it’s a nuanced. It’s a really interesting angle that Aahan brings up, which I think has some factor in it.
Rodrigo:00:42:38That’s why we’re charging four and 40 next year, right.
Mike:00:42:42Yeah, yeah. I also think it’s interesting how if you’re thinking of a businesses to buy, subscription businesses that have a — almost a no cost of capital, are an interesting thing to buy, like a music subscription, right? Obviously, that can be ratcheted up, and you’ve got new music to produce, okay, that costs some amount of money. I don’t know what it costs. But when you think about all the old catalogs, that’s all built, so a very easy way to hedge inflation in a pricing mechanism would be to buy businesses that don’t really have a cost of increasing — the cost of their goods sold, doesn’t really increase, right. They just mark it up with inflation, because everybody’s used to inflation. Anyway, it’s a bit of a spur on this topic, so I don’t want to get too far off of it. I apologize. But it’s an interesting — …
Aahan:00:43:32No, it’s an interesting thing. You know, just to go back to what you were saying, we actually did a little bit of work to try and understand this. And I think that there is something to the fact that the price decreases that you see in technology do not adequately reflect the computational efficiencies that you’ve generated. So, you know, talking about that ‘91 period. So, I think that one thing that everyone that was focused on inflation, during, like the 2010s, was really fixated on was like, what are the statistics missing? Right. And this was really something that was kind of at the forefront, that we probably are gaining computational efficiencies that just don’t get captured in traditional statistics in terms of how much cheaper a computer has become, and that probably has some degree. When it comes to the inflation volatility. I think that it’s harder for services to have…
Like, I think the volatility is asymmetric, right. So, I think that you are able to, prices tend to be sticky and inflation tends to be sticky. And you can have service prices rise dramatically, right. But it’s very hard for people to demand less. And so I think that that kind of balance of things is also important when you think about the goods versus services economy where you can actually mark down goods easier than you can probably mark down a service. And so when you’re thinking about inflation volatility in like a period like the ‘70s, where you have an industrial economy versus now where you have a services oriented economy, you probably have more upside volatility relative to like a contractionary. So, you probably have higher stable inflation, with some shocks to the upside relative to sea-sawing of inflation, if that makes sense.
Rodrigo:00:45:27It does. We’ll see how it goes, Aahan. We’ll put a penny on that. And — you just said something very interesting. When it comes to services it’s easy to increase but tough to reduce without giving them more, right, they’re going to demand more services. And here we are — Let’s look at the streamers, right. Has Netflix gotten better for us or worse for us? Do we now — I used to pay $7.99 to get Netflix. Now I pay 16 bucks for Disney for — …
Mike:00:45:59It’s a slightly different … conversation, though. Because the production of movies has a cost. Keep going.
Rodrigo:00:46:09There’s competition and there’s competition, we’re getting less in a lot of services. And I think that you’ll see if there is a deflationary bust that those services will come down drastically as well, if what I’ve seen in Latin America is true. But it’ll be interesting, I don’t know. I’m not 100%. Sure. But I’m leaning toward that the volatility on the downside at times will be drastic, even in the services area, we’ll have to …
Aahan:00:46:40Sure. I mean, I don’t think any of us are in the business of figuring out what’s going to happen over the next 10 years. Right. We have ideas, but I don’t think we can do much with it.
Rodrigo:00:46:47So, let’s talk more short term then. We are …
Mike:00:46:51Did we cover growth? Did we cover the growth pillar yet?
Aahan:00:46:54Yeah, I think so.
Mike:00:46:56— inflation. We’ve got growth. There is none. It’s all a burning heap of trash. Yeah. Okay. Got it.
Rodrigo:00:47:00Well, with all — with everything that we’ve laid out, it’s been an interesting year last year, where many people, unfortunately, came to the conclusion that stocks and bonds correlating was completely unforeseen. That’s never happened before in history. And obviously, it just hasn’t happened in their investment lifetime, right? There’s some mechanisms that we can look at in order to understand why equities and bonds went down together. And the question is, where do we go from here? How do we think the bond complex is going to act going forward given what we experienced recently?
Mike:00:47:34Can I add one little thing on this before, just because this has happened before, right? Having bonds and stocks go down together has happened in 1969, in 1931. And both of these events preceded significant change in the value of money, right? ‘69 preceded 1971, where we went off the gold standard. And 1931 was followed by 1939 and the involvement in 1933, and the US confiscation of gold to back its currency. So, each time we’ve had a significant dislocation like this, within a couple of years, there has been pretty — one was to confiscate gold and go to the gold standard, and the other was to go off the gold standard.
So, it’s — I mean, I’m not sure that — like that’s a sample size of two. And I’m not saying that we’re going to have that certain thing happen. But it’s happened twice and when it has happened, it’s not been the harbinger of great news. Well, depending on who you are, right? So, if you’re a passive investor, it’s probably not great. If you’re a more active investor and are positioning yourself for these types of outcomes, yeah, you’ve got dispersion, you’ve got a lot of different outcomes, and you’ve got a lot of opportunity in front of you. So, with that, that’s the set up I’ll — …
Rodrigo:00:49:00No doubt that Shiba Inu is the next monetary base which is a great shift to Elon monetization.
Mike:00:49:07Hey, hey. Don’t knock my Shiba.
Aahan:00:49:13So, yeah, I think we — if we think kind of about bonds and the bond complex at large, obviously, well, maybe not obvious to some right. I think that this 2022’s performance of stocks and bonds going down at the same time was something very unforeseen in the industry, but I think that it was just a function of the fact that bonds and stocks have a very similar inflation bias, right? And so if you think through kind of the original, all-weather framework that Bridgewater had put out, within that complex, right, of those different outcomes that you could have of growth and inflation, you just had a situation which was completely negative for both. So, if you think about stocks, stocks like falling inflation, and so do bonds. And when you put them together, you have something that’s neutral to growth, it doesn’t matter what’s happening to growth.
So, as long as inflation is stable, right, and you don’t have a high amount of inflation volatility, which is usually, which results in inflation being the primary driver of asset markets and asset market pricing, you kind of make it out okay no matter what. But I think that what most people don’t realize is that having that 60/40 bias portfolio was just this one big bet, right? It was this one big bet that for a really long time, inflation is just going to keep coming down lower and lower and lower. And maybe it’s just volatility of inflation, like you noted keeps compressing. And so if you have a situation like 2023, where you had inflation volatility just off the charts, right, I believe in March, we had a 1.2% month over month inflation rate, you just haven’t seen anything like that in a long time. So, as a result, you just have a very difficult environment for traditional assets.
And also, if you think about from a flow kind of perspective, right, if a very large section of the population, the investment population owns the 60/40, right, and they are explicitly or implicitly targeting some level of volatility, or drawdown, as these assets kind of get hurt together, for me to maintain my target volatility or drawdown, I actually need to sell down both assets at the same time. And so you have this self-reinforcing, really bad situation, inflation keeps surprising to the upside. And I guess the question is, is that going to continue. And so what we’re seeing based our all tracking of economic conditions is that we expect inflation to stabilize in a smaller band, relative to where it was in — relative to the variation we saw in 2022.
But what we’re also expecting to see is we’re expecting these dominoes that we laid out for growth, which start with profits, goes to production, and then goes to labor, and then which eventually results in a recession, we expect these dominoes to cause a contraction in real activity. And so what we’re likely to see over the course of ‘23, is that we will go from a year where inflation volatility was the primary driver of asset moves to one where growth volatility is likely the primary driver of asset moves. And as a result, you are more likely to catch an interim bond bid than you were in 2022.
Now, this isn’t me coming out and saying, oh, yeah, from now, bonds are back to normal. That’s really not the case, because we could continue to sustain inflation at a much higher level. And also, it largely depends on how the Fed will react in the event that we actually do have a recession. Because if you think about the kind of recession we’re going to have, it’s going to be a stagflationary one. Right? Because it’s unlikely that given current conditions, and given current conditions in the services sector, you’re going to see just this immaculate disinflation, right. So, as a result, you probably have positive inflation and strongly positive inflation as you go into a growth contraction. And navigating that, navigating those dynamics is going to be what determines what happens to bonds. But as we see it right now, the initial conditions are in place for bonds to have a better year given, we go into an actual recession.
Rodrigo:00:53:48Yeah, I mean that’s –
Mike:00:53:50That’s such an interesting point. Like, this is such a difficult period to try to make predictions, if you will, because it’s so path dependent. We’re not –. You guys have frozen on me, am I still here?
Rodrigo:00:54:06No, no, no. I’m here.
Mike:00:54:07So, have we lost Aahan?
Rodrigo:00:54:11I don’t know but you’re talking to me, baby. Keep going. I like where you’re going.
Mike:00:54:14Yeah, I hope I — But I mean, it’s just so path dependent that depending on how things actually work out, and then depending on how the Fed views those items through whatever lens they tend to want to look through. And then you’ve got some sort of fiscal overlay. It’s just — it’s almost impossible to try and say with any kind of certainty, this is the path we’re on because the path is dependent on actions. But, yeah.
Rodrigo:00:54:45Mechanistically you can understand what happened in the beginning of last year, right? Mechanistically it was rates, the rate of change of rates, which is kind of the most important aspect here went higher, they raised rates higher than we’ve seen since 1994. Right? So, when you see that aggressive change in rates, the contraction or the reduction in returns for equities and bonds together comes at the discount rate. Right? That’s step one, both of them come down together. Present value discount mechanism tell us that the prices should — of both things should be down. For the previous 40 years, we’ve seen a slow mechanistically- like secular reduction in interest rates, which, again, fixed income, it is a fixed amount of income. A new set of income comes in a lower price, then your old income is worth more, right.
From the 8% volatility inflation, if that is indeed the interim peak, and we’re starting to go down, you might actually see from a present value discount mechanism bonds begin to be more attractive right now. Right? But I’m going to get to your point about path dependency, right. So, again, I think short term, what we may be saying, is a peak inflation, a reduction of inflation possibly means a reduction of rates, but how much can we go down? Can bonds offset growth shocks, because now we’ve gone from inflation shock or a rate shock to now maybe we’re dealing with a growth shock. And in a growth shock, you would expect people, you expect people to move away from equities, to get the higher yields on bonds, and begin to act as an offset assuming that rates remain the same here, that inflation remains the same here, sorry.
And so you might see mechanistically bonds and equities be non-correlated momentarily. The question really becomes, how low can we take rates, bond rates, if inflation remains stubbornly high? Right. So, there is — there might be a limit as to the — or a floor.
Mike:00:56:39So, this is part of the — my quip about what’s right? Is the dot plot right or the yield curve right. So, you have Fed governor saying five plus long time. Then you have the yield curve saying two years, four something, but going out further, it’s less. So, that has implications and somebody’s right, and somebody’s wrong. So, in a world where the — in a world where they say, well, you know what, we can’t achieve 2% inflation, we’re going to target three or four, that has significant implications for bond valuations, obviously. But if they do that, equities probably are fine, because you’re getting more liquidity in the system for those other assets. If in fact, you do keep it at five, and you say, we’re going to get to two, that has significant implications for growth, and a growth trajectory and an earnings contraction as well as a multiple contraction on top of the earnings contraction. And that leads, I think, to a more or less sort of traditional bond stock relationship.
Rodrigo:00:57:51I think if you look at the 70s, you mentioned a few key periods, a few key years. But if you actually look at the correlation between bonds and equities for that whole decade, it was quite tight. Right. It had they — they moved in tandem, just in different levels of risk if you’re comparing the 10 year Treasury with equity markets, and you know, a lot of it probably has to do with the inflation issues and how high rates went during that decade. And so it’s not out of the question that we’re going to see a long period of general high correlation. But even in the ‘70s, even in the ‘70s– …
Rodrigo:00:58:29Right. Hey, man, welcome back.
Aahan:00:58:31Sorry about that. Yeah.
Rodrigo:00:58:32Even in the ‘70s you saw periods when there was big, abrupt growth shocks, negative growth shocks, where Treasuries acted as an offset, and then went back to this high correlation number that we haven’t seen ourselves in 40 years, right. So, I think there’s going to be, if history is any indication, it’s going to come — the correlation between bonds and equities is going to come and go. But probably if inflation is stubborn, it’s going to lean towards higher correlation than we’ve seen from a secular perspective.
Mike:00:59:03I guess my point is simply that it depends on how the Fed views these and how those 19 professionals decide to process this data or process this data and then decide to take action. And I actually find it hard to make a bet on that, not knowing the data. And then also there’s some randomness to their positioning. And their positioning is a bit hard line right now. Anyway..
Rodrigo:00:59:31Well, look, this is what — …
Mike:00:59:33I want to hear what Aahan has to say about all the stuff we’ve been talking about while he hasn’t been here.
Rodrigo:00:59:42I’ll sit back then. Go ahead, Aahan.
Aahan:00:59:45Well, why don’t you catch me up a little bit.
Mike:00:59:48Well, we’re just — As I was saying, it’s really difficult to make a lot of predictions with — So, I think that the distribution has some fat tails right now, and the middle is a little bit emptier. And so just on everything because we really — we don’t know this path. And the path has a lot of dependent items which are strange and different and can have kind of outliers. And then we have the reaction function of those. And so it’s just — I feel like it’s harder now than it’s been previously. But I would love your insight and thoughts on that. I’m happy for you to tell me no, it’s not Mike, this is butter.
Aahan:01:00:25I wish but I think that what is particularly hard is that we are at a point where data is conflicting, right. And I think that that is the hallmark of a potential turning point, right. So, we are at a potential turning point for growth data and labor data, we are at a potential turning point for inflation data in the sense that the impulse and inflation data is probably, you know, less. And we are maybe at a turning point for the condition for bonds. Right? And so when we’re looking at these things, I think that what we have to recognize is that what we’re seeing is all the initial conditions for turning point are being met. And so you know, some people might couch this in sort of leading indicator terms. But you know, the way I like to think about leading indicators, so to speak, is that they are things that create the initial conditions and the pass-through is not always entirely sure. So, if we’re thinking about sales pressures on businesses, resulting in employment falling, we’re not sure about what that pass-through is going to be.
And so once we receive the initial trigger for our expectations, we need to wait. And we’re kind of in this wait and watch situation of are conditions going to develop as we expect them to and as we’ve kind of tested and understood over time, or are we going to be in that outlier situation. And that aspect of it all is where the uncertainty is. It’s that we have really heightened nominal economic data. But we have really bad real economic data. We have terrible surveys. But we have really good employment data. We have some components of inflation really high, some components really low. And we have people that are undecided about what the Fed is going to do.
One guy says that Powell is going to be Paul Volcker. The other one says that he’s going to be Arthur Burns. And we don’t know. And the reason we probably don’t know is because we are undecided about where exactly we are in the cycle, which just tells me that it’s more likely than not, we are navigating a turning point.
Rodrigo:01:02:35Yeah, I think the — Bob Prince in his argument was talking about how the Fed is going to have a hard time understanding when they’ve actually succeeded, right? Because of the lag, discuss how — the moment you start tightening, it takes around nine to 12 months to see it in growth numbers. But what you really need to happen is to see it in the labor market, and that takes 18 months, right? The problem is if growth numbers fall off a cliff, right, they might feel the need to act and realize that, okay, well, we’ve fixed the growth situation for a second. But here we are with inflation again, because we never got to kill the labor market enough in order to manage inflation. And so this lead lag, this kind of asymmetric or a synchronous areas that they’re looking at is going to be one of the toughest things they’ve had to navigate in modern times.
Aahan:01:03:34Right. And I think that that’s the disagreement you highlighted right between the co-CIOs at Bridgewater. I think what we’re going to have to figure out is the Fed has done the tough talking part, right, but now it’s time to walk the walk. And I don’t mean this in any way to be disrespectful of the people at the Fed. I actually think they have really hard jobs, and they just try to do the best they can in a given situation. But we’re likely to be in a situation where growth is already based off our tracking, we have growth in and around less than 1% real, right? So, we’re very close to a potential contraction, right?
And as that contraction gets deeper, you could still have inflationary pressures. And they’re going to have to make a choice between which one they’re going to want to support. Are they’re going to say, yeah, it’s okay to let the labor market soften. And if that’s the case, we probably have a situation where oh, yeah, bonds could catch that bid. But if you have a situation where the Fed comes in and says that, oh, no, we can’t tolerate the labor market being weak at all. We’re going to welch on this inflation thing. We have a new inflation target. It’s now 4%. We’re in a different world. Right.
In that situation, you probably don’t have that bond bid. And just coming — circling back to the bond question, right, I think that’s a really like, as we said at the outset, that’s the CIO question, right, of the year. I think that a major thing, what we’re seeing from data is that it’s likely to evolve to be conducive towards bonds. But the hard thing is going to be two things. It’s going to be what you need to have a durable bond bid relative to an interim bond bid, is you need to have an upward sloping curve. Right? The reason you need to have that upward sloping curve is because you need large depository institutions to be able to securely and safely underwrite long term bonds and make carry. But in the environment we’re in, those conditions just don’t exist.
So, when we’re actually thinking about, is this going to be a bond trade or a bond investment, air quotes, what we probably need to see is a curve which is steep. And that’s exactly what happened in the ‘70s. So, if you go back and you look at the transaction data that was available, you can actually see that the underwriters of the bond bid in the ‘70s were large commercial banks. And they did that, only once you had two things that were amply clear. One, the Fed was done, they were absolutely done, they knew they were done. And we might be in and around that point. But what we don’t have is, we don’t have that steepness in the curve. Now they’re two ways you can have that steepness in the curve, right? You can either have — you can have the long end shoot up, which would be terrible, right, for anyone trying to buy bonds right now. Or it would be a situation where you actually have a bull steepener, right, where you actually have those recession probabilities being priced really aggressively. And because of that, you could actually find your bond bid and that would be a very good situation.
And so I think that when it comes to thinking about bonds, as you know, investment in ‘23, I think the preconditions that need to be met are these, that first you need to have a Fed that is for sure done on their hiking path, and what they are going to lean on is the duration of holding financial conditions tight. They can keep doing QT, which is probably not a good thing. But what they need to be done with is they need to be done hiking completely, and they need to be focused on holding conditions tight. The second thing that you need is you need some form of steepness in the curve. And those two things put together plus whatever economic environment we’re in from a growth, inflation, and liquidity standpoint, is what will determine whether we have a longer term bond bid, or it’s just going to be a short window before we have a real acceleration of inflation or something like that.
Mike:01:07:32A lot of conditionality there. That was awesome.
The Three Step Process
Rodrigo:01:07:34Yeah. So, that, because of all that, right, Aahan, you have like we have all these global macro conversations, all these different path dependencies. Ultimately, what I imagine your readers are looking for is when the rubber meets the road, like how do you make decisions, and you know, what timeframes are you going to use in order to invest? How do you think about that investing problem, and actually extracting some profit from all these metrics?
Aahan:01:08:03I think that’s a really important part of the conversation, right? Because I think macro in particular, is siloed to this very intellectual thing. And we can all argue and have views and stuff like that. But at the end of the day, we are trying to figure out how to navigate cycles, right? So, I think I’ll come back to that framework conversation. And what I’ll say is that how we kind of weaponize all of these things is that we go through a three step process, right? So, we have a fundamental forecast. And then we have what we call market regime configuration, and then we have timing overlays. Right?
So, the fundamental forecast is basically a quantified way of this entire conversation that we’ve had, right? It’s us trying to get a picture of what we think about growth, inflation, and liquidity and how they’re going to evolve over the next six to 12 months. And that can give us you know, based off kind of the all-weather template, we kind of know which assets we like, and which access we don’t like. In a stagflationary world we probably don’t like bonds, and we don’t like equities, that is one. But what we have to be very cognizant of, is the fact that as fundamental forecasters were really wrong, very often, right? And no matter how good you are, your hit rate is at best if you’re exceptionally good 60% on fundamental forecasting of any kind, right? Yeah, it’s a lot, if you’re the very best, right.
So, I think that, that and that’s why we built out this market regime confirmation. And what that means is that we go and we look at markets to see whether they are beginning to price the initial stages of what we expect from a fundamental perspective. So, just to put that in an example, if we going into 2023 expect deflation, what we want to see is we want to see markets to some extent begin to price that in cross asset pricing, so we want to see things like we want to see bonds bid, we want to see break-evens come down, we want to see equities do poorly. We want to see maybe curves invert. We want to see this whole constellation– we want to see $1 bid. We want to see this constellation of things, which has a lot of conditionality kind of come together to tell you, okay, we may be in a deflationary environment, which is really just a way of refining your signal, right?
And then from there, we go into timing overlays, which is really just our way of trying to pick our spots within a market regime and within a macroeconomic environment. We want to have a good amount of precision in terms of when we’re applying these views. So, again, using an example, if we think that we are in a dry — if we’re in a stagflationary environment, markets are conforming, we probably don’t want to be buying bear market rallies, right. Like, that’s probably not something that we want to be in. So, that’s kind of how we think through it. And what we do is we have a Prometheus ETF portfolio, which goes out every week and positions turnover every week. And we do that for a balanced mix of assets of 37 different ETFs, and every single asset passes through this filter, right. And then we sum those together and then we apply portfolio risk control, once we’ve stacked these all together. And that’s kind of how we think about weaponizing the macro framework.
Mike:01:11:19Can you give a little taste of where they — Oh, go ahead, Rod.
Rodrigo:01:11:22So, I just want to go back to the — first your fundamental framework. The signals that you get, how often are they updated? Like, how often do you actually get inflation — So, on a weekly basis, you get enough data on liquidity on growth and inflation in order to update your forecasts?
Aahan:01:11:41So, the way we do it is I mean and it varies by indicator, right? So, what we try to do is, it’s a burden of evidence approach, right? So, we’re looking across — So, if we’re looking at growth, right, we can use north of 30 different releases that come out over the course of the month. And we’re basically updating based on every release, right? So, say, we get personal consumption data, even though it’s lagged, we can make estimates for the future and things like that. But every day, we’re getting a new piece of incremental information, and I guess it’s kind of like a Schrodinger’s cat situation where we only know once it exists, so we kind of treat it like that. And so as we get this new information, we’re incrementally every day, technically, but we consolidate it down to every week, we’re getting new information. And we’re saying how has the outlook changed?
So, we’re very much trying to keep a pulse at all times, on how economic conditions are evolving all these different things? And that’s how we kind of go about our forecasting process. So, I think that it’s also really helpful because it increases your sample size massively. Right? So, if you constantly have this, every day, we’re getting a new data point, new piece of data points, and we’re adding them together, as opposed to oh, yeah, we have a quarterly outlook, or we have a monthly outlook, it just avoids the pitfalls of that sudden jump risk in your signals.
Rodrigo:01:13:05Exactly right. That’s why I was asking. It’s really tough in macro, fundamental macro, if you’re getting monthly signals to actually ever know whether you have an edge or whether you just got lucky for your lifetime. Right?
Rodrigo:01:13:19So, it’s important to get those multiple signals and get more of the law of large numbers on your side. Sorry, Mike, you had a question.
Mike:01:13:27Oh, yeah. I was just wondering, just generally, what’s the positioning, like at the moment? Is it largely, I’m sure you’re long RDFs or something, not advice, not advice. I’m just kidding.
Aahan:01:13:42That’s our biggest portfolio holding. So, well, so like we said, we tend to, I think that, broadly, what we’ve been expecting is all kinds of slowdown in this inflation volatility. And we expect on a cyclical basis, a bit of a slowdown. And so the positions we have on this week and our positions turn over weekly, are a little bit inconsistent with what you would think has a thematic kind of view, but we actually have stocks and bonds on together as a bet on a mild bit of disinflation, which would have been great this week. But we’ll see how that kind of pans out. More broadly, I think the way we’re looking at things is that the environment is probably less conducive to stocks, more conducive to bonds, and pretty neutral on a fundamental basis for commodities going forward. And so that’s kind of how we’re thinking about asset class kind of positioning. But yeah, for the next week, we’re looking at — …
Mike:01:14:52So, how are you seeing sort of the cash component given you’re seeing, I guess, obviously, some attenuation of the correlation of stocks and bonds, so you’re pairing them together to likely get — or are you seeing correlation blowing up? So, you’re positioned in that way. So, I guess, given your earlier comments about how correlations are changing, and just on a stock/bond portfolio, by definition, you would have some cash, given the correlation of these two assets. So, how are you feeling about the overall positioning of the portfolio? Is it sort of large in the context of historic exposures? Or is it a little bit smaller sort of confidence interval, if you will?
Aahan:01:15:32Right. So, I think the cash thing is very important. And you know, like, as research providers, you kind of start from a place of you want to do no harm and give people options, right. So, I think that when it comes to the environment that we’re in, right, the potential for jump risk in correlations is extremely high. Right. So, when you think about the environment that we’re in, one of tightening liquidity, cross asset correlations can go to one really quickly, right, because you have that balance mix of assets, which is supposed to be working in line with the economic cycle, is suddenly shocked by these tightening liquidity policies. And as a result, the correlation benefit that you’re expecting doesn’t actually pan out.
So, the approach we take, given that we can be at times very concentrated, like sometimes we can have only commodity positions on, right, we can deviate from balance quite a bit, is we focus on kind of what is our drawdown, and what is our max vol, right? So, what we’re trying to basically manage for is a condition where, okay, what if we have no correlation benefit in the portfolio at all, what would be our loss, and what kind of drawdowns would we sustain then? And in this kind of environment, what we’ve seen is that, typically, on an individual asset basis also, you actually need less risk exposure to achieve your vol targets, right? Because you have so much dispersion in these assets, you tend to actually need way less exposure in this environment.
So, we’ve actually, probably over the last four months or so, we’ve had between 15 and 30% cash. And that actually gets us to like a realized vol of approximately eight annualized. We try to do a max vol of 10, right. And that’s really, I think, just a hallmark of the time. You’re going to end up having cash, if you’re trying to manage this kind of jump risk in correlations.
Mike:01:17:40That’s well said. I think that’s just so important. Those are great words. Whoever’s listening to that should…
Rodrigo:01:17:48We’ve come to the same conclusion, provide a low/medium volatility portfolio, because that’s what everybody will want. And I just — this is just a side note on just portfolio construction, and model generation for retail and even institutional investors. It’s so funny to me how we all landed that vol target, right, that eight to 10. And we just minimize the drawdown and blah, blah, blah. But the vast majority of assets today, I would say the average portfolio construction is not 60/40. I’d say the average portfolio construction is 80/20. And that 20 is not government bonds, right? That 20 is some sort of obscure income product that really ends up being 100% growth driven assets in people’s portfolios. And when you’re competing against that as a model provider of eight vol, it’s just really tough. Like you could have, if the volatility of that portfolio is 16-20 vol, right, you’re eight, they could have half the Sharpe ratio that you do and perform just as well as you do. But somehow — …
Aahan:01:18:54You know, and that’s kind of how it works.
Rodrigo:01:18:55People are okay with 30 to 40% drawdowns are not okay with a 20% drawdown in low volatility portfolio. It’s one of those like … It’s really, really tough.
Aahan:01:19:06I think that actually they’re not okay actually living through the drawdown. So, they think they’re okay living through a 30% drawdown but then they have to live through the 30% drawdown and then they’re running around with their hairs on fire, right. And I think that so when it comes to vol– and this is actually something we’re developing and working on, which is I think that managing for this max vol kind of expectation, which is kind of consistent with managing drawdown, right. There is like an asymmetry to it, right?
Because if you think about it, I know that you guys have probably live this experience of running a moderate vol portfolio in a time where equities are roofing and you’re just going well, we have really great Sharpe ratios. Right? And it’s tough. I have experience working with people in a similar kind of situation that originated the … ETF, right? Oh, yeah, you’re familiar — you’re quite familiar with them.
Rodrigo:01:19:59For sure. Alex …
Aahan:01:20:01Yeah. Alex and Damion, my first boss. I interned for them a long time ago. Yeah. So, yeah. And basically, they had a similar situation where they were generating very good risk adjusted returns. But the problem is that you don’t look that good when you are generating a good ratio, because people on an absolute basis are just performing so well. But I think that the thing that we’re trying to work through is that this achievement of max vol usually comes during certain economic conditions. And so what we’re trying to move towards now is kind of expanding a band of max vol relative to just consistently managing for the same max vol. I don’t know what you guys experience is. I see Rodrigo nodding, so I feel like …
Rodrigo:01:20:50Lots to say about that. I mean, we went through a long period of, because when you think about systematic investing, like we do, right, you go through many stages. In the beginning, you start with, okay, there’s a bunch of factors that we could invest in. And the old empirical finance approach is one of, we don’t know whether the edge changes through time, right. And so if we don’t know, we’re just going to assume that we’re going to get it right. Like, we’re going to have a 54% win rate every single time we place a bet. And if that’s true, then having a volatility target is perfectly fine, right, because you’re getting consistent bets, and you’re assuming your Sharpe ratio is the same over time. And you can hit that volatility target all the time and get a consistent return.
But the reality is that, as we have evolved, we find that no, indeed, the edge changes over time. And the problem there is if you have a very small edge, and you’re leaving it up to your volatility target, that’s a problem. And if you have a very large edge, and you can measure that and you’re limiting your upside because you capped out your volatility target, right. So, I think the evolution of thought on our end is, when there’s a good bet, put the pedal to the metal within bounds. And when there’s a poor bet, bring down the volatility. You can actually, you’ll do much better that way and maybe compete with an equity market at a lower volatility. So, I’m with you on that. I think we all are in our evolution of thinking there.
Aahan:01:22:23Yeah. Actually, I think that one thing when it comes to specifically like volatility targeting as opposed to being like, in sort of a volatility band, is that the thing that I’ve often wrestled with, is that, that volatility targeting is implicitly a bet in itself, right, that you’re able to optimally estimate what your X post, or your T plus one vol is going to be. And that’s actually pretty hard, right, when you have a lot of assets in a portfolio, you don’t know the correlations are going to move. So, I think that the thing that we, you know, our edge is definitely not in doing that, right. Like our edge is in understanding what kind of environment we’re in and managing responsibly within that kind of environment. And so the way that we’re looking at it is to look at, okay, what kind of situation would we be okay, exposing ourselves to move vol in if we have a good understanding that when a certain economic environment which is conducive to move vol in these jump conditions.
Rodrigo:01:23:28Right, no. Yeah, I like that. I like that framework. I mean, one of my biggest pet peeves is the whole bet between, this is on vol sizing, the bet between Warren Buffett and Ted Seides of I can’t remember what the company was. But we had Ted Seides long ago on the podcast and the Sharpe ratio was outstanding during that 10-year bet. But the volatility…
Aahan:01:23:49I’m actually not familiar with this.
Rodrigo:01:23:51Oh, it was a bet between a fund-of-funds manager and Warren Buffett, a million dollar bet that would go to charity. And the fund-of-funds manager said that fund-of-funds and hedge fund … said absolutely not, the S&P is going to win. So, bet goes on, money’s in escrow,10 years go by, on the ninth year, I think it was the ninth year the fund-of-funds is winning because it’s ‘08 but — or ‘09. And then ‘09 and 2010 happened and the S&P comes roaring back and Warren Buffett wins the bet. Now, what’s the volatility of the fund-of-funds portfolio is five, volatility of the S&P is 16 to 20 during that period. Had you vol sized the fund-of-funds to the same volatility as equities it would have crushed it, right.
So, these are the things that bothered me about the S&P being such a dominant asset class; low Sharpe ratio, high volatility, many people are willing to bet their life savings on it, and maybe 20% make the wrong decision at the wrong time. But a lot of them stick around to realize it. But again, you’re not getting paid for the rest you’re taking on that concentrated bet. Whereas more thoughtful portfolio construction you can have a great Sharpe ratio, but you’re kind of not allowed as an industry to offer this at 18 vol, 20 vol. It’s just not palatable because that’ll lead to big drawdowns. And there’ll be drawdowns that are non-asynchronous to the equity market. So, how can you be losing 20% when the markets are up 40? Well, that’s what non-correlation’s like. Anyway, that’s my rant for the day. I don’t know if anything’s going to change, so we’re going to have to keep on trying to provide that four Sharpe at eight vol, right, Aahan?
Aahan:01:25:43Always aspiring for the four sharp. Everyone is, right?
Mike:01:25:48Awesome. Okay. Well, we’ve been here for an hour and 25 minutes. And it’s been very gracious of you, Aahan. I wonder, let’s wrap with you letting everybody know where they can find you, again, making sure that they can look at signing up and getting in touch with you and Prometheus, for your research, etc. And we’ll wrap from there.
Aahan:01:26:09Yeah. Well, I just want to thank you guys, again, for having me on. It’s been a real pleasure. Like I said, I have always appreciated your guy’s approach and content. So, it’s really been great to chat with you guys live. For those that are looking for more stuff on Prometheus, you can find us @PrometheusMacro on Twitter, you can find us at Prometheus Research on Substack, and you can find us on our website at Prometheus-research.com.
Rodrigo:01:26:37And Aahan, just quickly who’s your target audience for your research?
Aahan:01:26:42We are primarily aimed at retail audiences. But the way we’ve constructed things is it should be scalable to almost all investors, right? Like we’re trying to reach the broadest possible audience that we can, and trying to basically play for a little bit of a leveling of the field in terms of providing institutional quality macro resources to the general public.
Rodrigo:01:27:07And the ETF, the fact that you mentioned that it was an ETF framework, that probably means it’s a long only or long, flat type of strategy, right?
Aahan:01:27:15We’re very tactical, on the short side, extremely. It’s not an — it’s definitely not the optimal framework to have shorts on but in years like this, it can be value additive to have shorts on just from a diversification perspective. So, we — it’s kind of asymmetrical in the sense that we are more accepting of long exposures and just very tactical and if we only expect good payoffs on the short side that, you know, those positions are entered. So, it’s long/short, but for the most part, you will be long. Yeah.
Rodrigo:01:27:44Understood. All right. Beautiful. Thanks, Aahan, for your time. Have an awesome weekend.
Rodrigo:01:27:49And we’ll be back here again in a few months, I’m sure
Aahan:01:27:52Absolutely. Take care guys.
Mike:01:27:57Cue the music, Ani.
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