[00:01:31]Alfonso Peccatiello: Guys, always a pleasure to be here. One of the three podcasts I listen to religiously every time. So I love you guys and the work you do. What’s up on my mind today is that this morning, I ran up a quick search on Bloomberg. Just go on Bloomberg News and type in soft landing and you’ll get, I personally got 26 results and those 26 don’t seem too high, but those were 26 articles mentioning soft landing in the last 48 hours. What the heck? And then I thought, okay, this feels like when everybody was talking about the recession and many media outlets were pushing one day in, day out, recessionary articles, late 2022 and turned out to be a contrarian signal. We haven’t seen a recession this year. So I had myself thinking, now that it seems like the only obvious outcome of all of this is soft landing, does it work as a contrarian indicator as well? That’s what woke me up this morning. And I’m going to share the screen to show a chart now that my friend Dario Perkins has put up. Dario is a very good macro strategist and he has been basically quantifying this contrarian signal.

And he has looked at the percentage of all Bloomberg stories that mentioned soft landing, because the absolute number is a bit skewed by the fact that today we’re much more digitalized, right? So you’ll have a lot more new stories today than the eighties. Why don’t we take the percentage instead to standardize that?

It was a great, great idea from Dario. And then he looked at, you know, soft landing mentions against recessions, which you see shaded here in gray. And you’ll see that in the nineties, 25 percent of the stories were talking about a soft landing right before the recession. I’m going to skip here, 1995 for a second only, but then 1999, 80 percent of the stories were soft landing and we got a recession.

2008 took a little bit longer, but still same story. And today 45 percent of  articles mention soft landing somehow. It seems to be a relatively decent indicator with a sample size of five, obviously. So take it with a pinch of salt. This is all anecdotical, but 1995 is interesting because also there we had 40 percent of the stories mentioning soft landing and we did get one. 1995 was the only episode in US history where the Fed hiked rates in 1994 from three to six. Everybody got very scared and yet we got in 1995, a soft landing.

[00:04:06]Mike Philbrick: Also the bond massacre, right?

[00:04:09]Richard Laterman: Yeah, I was about to say, so the massacre we saw in financial assets did not quite reflect what was going on in the underlying economic fundamentals and what actually took place going forward. Is that what you’re saying?

[00:04:22]Alfonso Peccatiello: Yeah, it’s pretty much true. And, I think this is a very interesting discussion to have because now we’re discussing whether 1995 is going to happen again.  I sent a note a few days ago, which was called Party Like It’s 1995 because that’s basically what markets are trying to push through as a narrative, especially as the latest inflation prints have been particularly friendly. And you have Powell, which is basically splitting inflation in three, goods, housing, services ex-housing. This is the split that the game master is using. So let’s use the same, I figure. And goods inflation is stuck at around zero to two, which is pretty much the pre pandemic range. You know, the supply chains have healed and all of that, and China is slowing down.

The manufacturing cycle looks horrible all over the world. So fine, goods inflation, not a problem. Then you have housing, but goods inflation represents 25 percent of core inflation. So you have another 75 percent to look through to get there. And you have housing, which is about 45 to 50 percent of the core CPI basket, which is pretty big. And housing inflation is still running at five, annualized, but it has been coming down and the Fed knows that it will be coming down because it just lags what’s happening on the ground. And Zillow or Apartment List or other more timely indicators of rent growth are running at about, so again, friendly numbers, which we should see reflected as well somewhere next year. That leaves only the last sticky part, services ex-housing inflation, and that’s annualizing at five. It’s a bit like wage growth, which growth is annualizing at four, four and a half. I mean, those aren’t yet numbers that will make the Fed feel comfortable. But hey, if the labor market keeps slowing down and if wage growth keeps sequentially weakening, then at some point you’ll have a confidence that also that part of the basket is coming back in line with 2 percent core inflation. And that’s what markets are trying to extrapolate, I think. And you have equity markets that are buoyant, which makes sense because when, once you remove uncertainty from where you’re going next with inflation, then generally speaking, a removal of uncertainty is friendly for risk premium. So equity markets do well. And I think 40 days ago, I had people that didn’t know what term premium was a year and a half ago. Tell me that term premium had to go 300 basis points higher. So there was probably the peak, I think of fear in bond markets.

Everybody was trying to attach an exposed narrative to the selloff in bonds. Was it supply? Was it term premium? Was it whatever? And look, now I think you are getting a bit more of a predictable path ahead out there. And markets like predictable. They love it. They squeeze out any risk premium that’s available out there. And it’s Party Like It’s 1995. And that’s the strong market consensus as we speak. But we invest against market consensus the whole time to make money. You either have to surprise either on growth, inflation, or the Fed reaction function against the expectations, or you have to make sure that the valuations at which you buy leave you enough risk premium to squeeze out, even if consensus comes true. Those are the two ways to basically make money in an asset class or in multiple asset classes. And, I’m here debating with myself where to go next.

[00:08:08]Adam Butler: Well debate with us. So, what do you think the, what do you think the roaches are in the peanut butter here for, for investors, or do you sort of see a clear landing strip that might, to facilitate the soft landing that the market seems to be pricing.

[00:08:28]Alfonso Peccatiello: So there are three angles here to debate when it comes to the perfect soft landing. So the perfect soft landing sees this inflation growth below Trend, but not recessionary and the central bank proactively accommodating, okay. That’s basically, those are the three ingredients necessary. Closest example in time is 2019. So in 2018, the Fed hiked rates following Trump’s fiscal stimulus at some point that broke credit markets. Basically we froze out the credit markets in late 2018. The equity markets drew down aggressively. In the, if you remember, April was down 20 percent in six weeks or something and Powell showed up in January and said, sorry guys, that was too much. I’m not going to do that anymore. We are going to loosen financial conditions. Inflation was already 2 percent by the way. So it was pretty easy for Powell to show up and say, Hey, I’m going to lose. And he did. So you got all the three ingredients in 2019. Growth was weak, non-farm payrolls were on average a hundred, 120,000. So subpar, but not recessionary. And, inflation ended up below 2%. So great. The NASDAQ rallied 35%, if not, if I’m not mistaken that year and bonds also delivered a 20 percent return. So risk parity in nirvana. Everybody happy and all that.

So where are we on these three angles? Growth, inflation, and the central bank reaction function.  Now, the first one on growth, and I’m going to share a chart of mine again here. I don’t like GDP. I don’t like earnings as a single indicator of growth. I’d rather take a gauge, a broad gauge of indication of where US real growth is.  And I’m not going to make up the basket myself because I will be biased towards an item or another, but I’m going to be using the NBER gauge of real growth. So the NBER is the institute supposedly calling whether the U. S. is in a recession or not. So I wonder, what are they looking at, you know, when they call whether the recession is happening or not. And it comes down to the fact that they’re looking at seven indicators.

So you can build an index out of that and basically mimic and replicate live what these guys at the NBR are looking at. And this indicator is interesting because it takes into account labor, growth, and consumer spending. So it’s pretty wide ranging and also towards services, consumers, and manufacturing, relatively well distributed. US real growth, according to this indicator, is annualizing at about one and a half percent. How does that feel? Slightly below Trend. Trend growth in the U. S. over the last 10 to 20 years has been 8 in real terms. 1. 5 isn’t too bad actually. Interestingly, in December last year, it’s true we were mocking the fact that everybody was calling for a recession, but this indicator was at 0.1 percent, was flirting pretty much with zero.

We had weakened pretty aggressively on a trending basis back then. The fiscal stimulus from Biden, I think has done quite a lot of the heavy lifting here as basically between October 22 and October 23, 1.7 trillion have been spent into the economy. And clearly that has helped, I think, this indicator to pick up again.

So that’s where you stand today. That’s a check for soft landing because you start from a level which is just below Trend, which is one and a half. And even if we keep weakening further, you know, there is some room between one and a half and zero. So over the next three to six months, I think the market might still interpret bad news as good news. That’s the setup where you have growth at one and a half and then growth comes down at one. But it’s still not zero. So it’s good news because it will encourage the Fed to actually loosen. That’s the interpretation.

[00:12:23]Adam Butler: And I think you’re still, for those at home, too, I just want to point out, who may not be able to see, this chart shows obviously a major drop during the COVID crisis before the stimulus was unleashed. Then a massive recovery well above Trend. And then a slow kind of decline back toward Trend. And it looks like, as you mentioned in December last year, you almost want to point that out as, have we already seen the soft landing and we’re actually, you know, rising back up to cruising altitude?

[00:12:52]Alfonso Peccatiello: This has been quite a bullwhip cycle, right?

I mean, look at this massive V-shape thing during the pandemic. So it’s very, very hard to interpret this cycle, but you can make an argument that basically 2022 has been the reflection of the tightening, which has started six to nine months earlier. So you add a slowdown, probably the slowdown without the fiscal stimulus would have led the economy into a mild recession, at least in 2023.

But Biden came in with 1.7 trillion of fiscal stimulus. So you were able to pick up some momentum again. Now, obviously we go to the point of what happens next, and growth over the next six to nine months is generally a reflection of credit and monetary conditions six to 12 months earlier. So it all works with a lag, right? You tighten, or you’re losing monetary and credit conditions. And six to 12 months later, you’re going to see some impact on economic growth. So the famous macro lags. We’re back to discussing the macro lags, and you know, I’m going to just use one, one simple indication here, which is the yield curve slope. Yes, it has a great track record in predicting recessions, and the chart here shows simply two to 10 year against recessions. And you know, every time it has inverted, generally speaking, it has anticipated the recession.

Interestingly, the steepening after the inversion has often been the harbinger that the recession was really coming close. And that makes sense. That makes sense because it, when the curve steepens after an inversion, it can do it two ways. It can bear steepen, or it can bull steepen. So if it bear steepens, it means that you are pricing in term premium. So you’re basically saying, look, we have been inverted, conditions are tight, but it isn’t working.

The economy isn’t falling in a recession. Is this time different? The market starts asking themselves, should we price more uncertainty for growth and inflation? Maybe the economy can handle these higher rates for much longer than we thought. And so the curve steepens, bear steepens, longer interest rates move higher.

And that’s generally a lot of tightening, more because long end rates moving higher have a much more strong impact on mark to market businesses, on mortgage rates, for example, and so on and so forth. And at some point that generates a recession, or you can have bull steepening. Bull steepening happens more often, I would say. And that’s the moment when front end deals need to drop to accommodate some weakening in the labor markets or somewhere else.

[00:15:30]Adam Butler: It’s the Fed and the markets recognizing that the Fed has maybe overdone it a little bit on their tightening cycle. And we’re starting to see a creeping weakness that the market, that is at a higher magnitude or a higher velocity than the market had anticipated. And…

[00:15:47]Alfonso Peccatiello: That’s true. And the other thing is how long does it take, right? I mean, and history says that it’s pretty variable, you know, it takes anywhere between 12 and 24 months. It’s a whole year of difference when it comes to how long is the yield curve inversion going to take to feed into recessionary conditions.

So I went back to the 80s, looked a little bit at inversions and recessions, and 16 months is kind of the median outcome here. It’s very variable. Also, three times you had bear steepening just before the recession and three times you had bull steepening just before the recession. Only that bear steepening happened in the eighties.

So people don’t tend to remember that, but it actually happened before recessions and bull steepening instead in the nineties, 2001 and 2008. Today we’re at month number 16 after the yield curve inversion. So, right at median would argue for the fact that over the next six to nine months, the probability that something goes wrong is higher, rather than lower.

Let’s say that these, unless you are in a soft landing. So all this sample gets denied by the fact that you are going to achieve another soft landing, a rare episode in history. If you aren’t, then the next six to nine months are more likely to see some recessionary backdrop, interestingly.

Why do lags take longer this time? I think in the US, so if you look at the UK or Europe, you are already flirting with the recession as we speak. Real Trend growth, real consumer spending, real retail sales in the UK and in Europe are already zero or negative. So why is that? Well, every central bank in the world has tightened, including ECB, including the Bank of England, pretty aggressively following the footsteps of the Federal Reserve, but their private sector isn’t nearly as insulated from tightening as the US private sector is. I mean, the US private sector is locked in low interest rates for a very long period of time, and you can’t say the same or to the same extent about Europe or the UK. For instance, in the UK, mortgages are reset on average, every five years. Every five years, that’s pretty short. It means the lags start to kick in aggressively. In Italy or in Spain, 40 percent of the mortgage market is variable. In the US that’s 8%. Now 40 percent means that immediately you’d have to allocate your wage more towards mortgage service payments, installments, basically, because the ECB is hiking rates and it’s impacting your mortgage payments straight away. And you can’t say the same for the US. So…

[00:18:23]Adam Butler: Just a quick pause there, because in Canada, which, you know, Richard’s there. We’re all from there. They have a similar situation. The banks in Canada have been bending over backwards to find ways to not have to raise the cash flow burden on households. Right? So, they’ve resorted to accruing larger amounts of the liability on the bank balance sheet. So, you know, people continue to pay their mortgages, but in fact, the size of their mortgage is growing because the excess payments that they would otherwise have to make just continue to accrue. Are you seeing the same kind of shenanigans occurring in Europe?

[00:19:06]Alfonso Peccatiello: No, not really. In general, Europe is relatively strict about regulation and financial regulation. So, it’s much more difficult to bend existing rules, let’s say. But it’s a good point, I think, to remind people that not all private sectors are structured the same way. So, you mentioned Canada as well, but I was looking for instance into several private sectors. And let’s see if I can pull the chart on that as well. I’m going to give it a try. It’s one of the many that I publish here.

Maybe yes, maybe no. No, I can’t, but the story was, I was looking at different private sectors from the UK to Europe to Sweden, and you have to look at vulnerabilities through three dimensions there. How many refinancing cliffs are coming, because that is the most immediate way you’re going to see tightening of financial conditions being broadly reflected. How many corporates and how many households have to refinance the entire notional at much higher interest rates at 300 basis point higher than they’re used to. And the US is very slow at kicking in because again, corporates and households have turned out their liabilities very aggressively. Europe is looking pretty bad on that angle, for example. By my calculations, 24 percent of corporate loans and bonds in Europe need to be refinanced straight away next year. That’s a lot. It’s a quarter of your entire liabilities to be refinanced straight away.

And mind you, in Europe in 2015, 2016, you could borrow for 10 years as a triple B rated corporate at one and a half percent. One and a half percent, all in, borrowing costs. Any business model works pretty much at those borrowing rates. And now, try now. Now it’s around five, five to 6%. So we’re talking about a completely different setup.

[00:20:55]Adam Butler: You know, what is interesting too in the US of course, where are we seeing weakness typically in past cycles? Even in the US you did see the interest sensitive sectors, mostly housing, housing would lead. As a sector that would roll over in response to a major tightening, we’re not seeing that now.

We’re also not seeing a major response in labor markets because the large cap corporate sector, especially did a massive refinancing at added term in 2021, because they read the signal from the Fed that they were going to start raising rates eventually, right? So the corporate sector is well capitalized.

The housing sector is well capitalized. There’s no refunding cliff. Where are we seeing revolving credit where those rising rates are hitting? Auto loans. And look what was one of the major items leading to the downside in the inflation gauge, was obviously new and used car sales, right? So even in the US, sectors that are vulnerable to rising rates are rolling over as expected.

[00:22:06]Richard Laterman: Alf, what did you make of the last print in US GDP, notwithstanding the fact that it was a, and these tend to be revised in the coming months, but that doesn’t seem to quite jive with the scenario. And it’s, it probably plays into the reason why so many people have been confounded. The strength of the US economy and everybody was expecting some form of landing, whether soft or hard in the second half of 2023, and that hasn’t taken place. So what did you make of that number? How does that play into the scenario that  you’re picturing?

[00:22:39]Alfonso Peccatiello: So Richard, that goes basically to explain why I don’t use a single data point like GDP to extrapolate. GDP is basically built through looking at serious, several things like consumption, but also government expenditures and net exports. So things that are generally more volatile in nature, let’s say.

So if you look even at the core components of GDP, there is a thing called real final sales. So you’re literally trying to zoom in into more of the consumer side of things. But even that one was actually relatively strong, 2.5 percent annualized.

So you’re looking at a pickup in the third quarter. But if you smooth that out by the entire year, GDP growth this year is likely to come in north of 2%. in real terms, year over year compared to 2022. And again, it goes to show that there has been a pickup in economic momentum. And I attribute that mostly to the fiscal stimulus. I mean, you have to think of fiscal stimulus, like the government is effectively handing over resources to the private sector. It’s a bit like saying, I think people don’t get this part correctly when they say interest rates at 5%, so that must be restrictive straight away. And the answer is yes, they will be restrictive over time, as long as more liabilities from the private sector need to be refinanced at those rates, because that’s the mechanism by which you tighten conditions. You make borrowing more expensive. But there are time lags for that to happen. And in certain economies, their time, those time lags are really, really short. Like Sweden or the UK, or Canada, or Europe for certain reasons. But in the US those legs this time are not short, while I have clients that are effectively, let’s say, Treasuries of mega-cap tech stocks, okay, and, and these guys are sitting on hundreds of billions of cash. They can’t seem to find good CapEx which beats hurdle rate for rate of return. So they rather just sit on the cash and try to invest it in a portfolio. And they told me, well, if everybody is complaining about higher rates, we aren’t. We aren’t because we don’t have much liabilities to refinance in the first place. And we are getting paid 5 percent to do absolutely nothing on billions of cash. So that’s a bit the irony, I think, of what’s been happening so far.

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[00:26:03]Alfonso Peccatiello: Interestingly though, generally late in the cycle, once all these things are surprising to people, people start to extrapolate that this time is different and therefore hiking interest rates won’t matter, and this trend will be extrapolated forever. And I think that’s a bit where the consensus is today. Not so much about, let’s say that growth is going to come in very strong, but that we have avoided the recession a hundred percent. If you look at different option markets, which I tend to do to get an idea of the probabilities of different outcomes being priced. So is it soft landing, is it strong growth, or is it a recession? You can look at commodities optionality, bond optionality, equity optionality, blend it together, all the signals that you get from options and try to get yourself a regime for where are we going to land next. And the recession right now across assets over the next 18 months, according to my models is priced at about 17%. You know, you might want to argue that, 16 months after the yield curve inversion, and after such a tightening from the Federal Reserve, 17 percent is a low probability to be priced or a very conservative…

[00:27:16]Mike Philbrick: Yeah, I think it’s critical now to really hone in on that. It’s not what’s going to happen. It’s what are the expectations around what’s going to happen and how might they be mispriced. So in this, just to try and simplify it a little bit, you do all these calculations of these various markets who have opinions. And commodity markets, you know, they’re hedging real growth. They’re hedging actual delivery of stuff that would have to be used to create economic growth. And so that’s, they’re not doing that. They’re suggesting that it’s a little slower. And, and so when you calculate these things altogether, 17 percent chance of this happening in a probabilistic framework, you know, as good as any, it, the question is, is that too low? Is that adequate? Is it too high? And how are markets reflecting that? I think that’s a really key point that gets missed often. And so continue on. But I think it feels to me like 17 percent of the moment might be a little on the light side.

[00:28:25]Alfonso Peccatiello: Yeah, and again, you don’t need to, again, we said it at the beginning and I think it’s important to make money in markets. You don’t need to be right because people think you need to be right. So that means a hundred percent realization of your base case. You don’t necessarily need to be right. You need to be investing in assets that either benefit from a surprise against consensus of one of the three elements, growth, inflation, or the reaction function of the Federal Reserve, to conditions. So you have consensus that you need to surprise markets somehow, and invest in assets that benefit from this surprise. So as these probabilities get reassessed, let’s make the example of a recession right now. If you would buy some assets that do well in a recession, for example, or make up a structure like that, you don’t actually need to see a recession to make money. You just need the probabilities to move from 17 percent to 30 percent and you’ll have, you’ll be in the money. You’ll have a positive expected value by your investment effectively.

So that’s one way to do it. Or the other one is to say, well, soft landing, according to my models, is priced. There is about 75 percent model probability over the next 18 months. It’s a very strong consensus. And again, it could still happen. That doesn’t mean it’s wrong by definition. I don’t want to be this contrarian guy that has to say something wild.

It might be we get there, but then to make money in that environment, you need to find betas. You need to find asset classes that are still appropriately priced in a probabilistic way so that you can squeeze out some risk premia out of these assets. Those are really the two ways that you can try to make money.

The best thing ever is to find something the markets are dramatically underpricing as an outcome. So the surprise element is there. And on top of it, assets were also particularly cheap. So risk premia were very, very large to squeeze out. That’s the best possible setup you can get in markets. Also a pretty rare one, if you ask me. And, if I look…

[00:30:29]Richard Laterman: I wanted to ask you, I know that we’re going to be talking about a little bit of the project that you’ve been working on, which is your Forever Portfolio. And I’m keen to pivot towards that. But I did want to ask you before we do, to what extent do you attribute the signaling that we’re getting from the bond market that has confounded a lot of investors, that seem to not quite match what the fundamentals are displaying to the fact, to the choices that the Treasury has made in its bond issuance, front-ending a lot of Bills, which typically suggests that they’re going to have to issue more bonds later on, and how that plays into the market dynamics and liquidity.

[00:31:14]Alfonso Peccatiello: So I think supply is clearly an element when it comes to the short run. So the story is pretty simple. If you supply more duration to the market, the market is trying to rebalance their appetite for that duration against their appetite for other risk assets. So say equities or credit, et cetera. Especially if you, again, if you surprise, Richard, that’s the key word. If you surprise markets by telling them they’ll need to allocate more of their balance sheet, more of the risk capacity, to absorb Treasuries rather than anything else, that might be a short term surprise to markets. Personally, I measure that not by bond yields, but by something a bit more, that sounds a bit more complex, but it isn’t, but the difference between bond yields and swap rates, also known as Swap Spreads. So there the idea is, if you are going to supply a lot of bonds to market makers because these are the primary dealers, are the guys that are supposedly getting on the Treasuries at issuance, so the story is, the Treasury issues more thirty year bonds, primary dealers show up at the auctions, buy these thirty year bonds, and then they’ll have to allocate it, to end clients.

That’s mostly the channel through which Treasury issuances work. If you’re going to issue a lot of these bonds to primary dealers, then they have effectively to make room in their balance sheet. They have to have a larger inventory of bonds on their balance sheet. And suppose it’s going to take a little bit longer or a cheaper price for these bonds to be sold to pension funds or insurance companies, et cetera, et cetera. How is that going to be reflected? You can really zoom in that by looking at how bond yields do against Swap yields. And why Swaps? Because Swaps are another way to get on that duration risk without having to spend a ton of cash to buy the bonds. Swaps require just a little bit of initial margin to get in and some maintenance margin, obviously, but they are a much more cash light instrument to achieve the same objective, which is to get duration on board. So if there is a bond avalanche and a supply indigestion, you should see this reflected in bond yields going much higher than Swap yields. And I have looked at that, and to be honest, the reaction has been there. A few basis points, especially on the surprise of the quarterly re-funding announcement that led to all this narrative-driven bond deals are going higher because of supply. But it was much smaller as an impact that people want to make it to be. So I think it’s something you need to look at, but there is a lot of storytelling and narratives that are built, exposed around this topic that are really not quantifiable in the nuances of bond markets that I look at. It’s more of a good story and an easy one to understand than it is a quantum of driving asset prices, I would say over the medium term.

[00:34:26]Adam Butler: So, before we move on to the meat of the conversation which I think we’re all anxious to get to, as well, are there any obvious mis-pricings here? Or do you think, I mean, I think I heard you say there’s a, the market’s pricing a 17 percent chance, or like an 83 percent chance of a soft landing, and according to your economic models, the probability is close to 25%. I may have misread that or misheard that, but that doesn’t sound like a major mis-pricing. Are there any major mis-pricings out there that you think represent compelling opportunities?

[00:35:08]Alfonso Peccatiello: So Adam, the story is that markets are pricing a 17 percent chance of a recession over the next 18 months. I think that’s particularly low. So those deals are interesting to explore, to check whether there are assets that could benefit from that. And if you are a medium-term asset allocator, then I think there are two interesting things.

One has to do with the risk premium and the valuations. And in this case, the recessionary deal is a bit underpriced, I would say over the next 18 months. That’s the starting point. And the second is that the median expectation for core inflation by the end of next year is 2.7%. So the Fed expects it to be around about there and economists also expect it to be at around 2.7%. Now I’m going to share the screen and show a very simple but effective model for predicting where inflation is going to go.

And it’s a monetary model. Because an economist a bit more famous than me once said that inflation is always and everywhere a monetary phenomenon. And I think he’s right, especially if you measure inflationary money and leave aside all the machinery of bank reserves and QE and QT, because those are interbank monetary plumbing operations, let’s say. While if you focus on the amount of money the real economy can spend, that is deriving from credit and fiscal stimulus, in other words, and if you pack them up effectively in one index, which is the credit impulse, the orange one you can see on the screen, you tend to get a decent lead, especially against rapid changes in inflation. So if basically, you are printing the standard amount of deficits and the standard amount of credit each year within a range of interval in the US, so you are doing real credit creation of about plus three to plus 5 percent each year, you are not going to get much swings in inflation, or this model isn’t really useful to predict whether inflation is going to be one and a half or two and a half.

It doesn’t really help there. What it does well is if you are going to print a ton of money all at once and you can measure it correctly, and again, this is inflationary money, so fiscal deficits and credit creation, exactly what we got in 2020 and 2021 in other words, and you apply a lead time or a lag of 18 months, then you should get a heads up on whether inflation will pick up or not. The model did well indeed to anticipate inflation in 2022, but that Trend of money printing has been reversing really aggressively, obviously, on a rate-of-change terms, right?

Especially, private credit has dried up aggressively. Mortgage applications are the lowest since 1995, for example. So you aren’t getting new credit really printed for the private sector. Corporates are staying away, first because they have already locked in funding, second because small cap interest rates are eight to 10 percent today. So it’s really prohibitive for small companies to access credit in the first place. So they have stopped the credit machine. Now, inflation has been coming down, and this model has been calling for it to come down since December, 2022. So far, so good. But if you look forward, the model doesn’t stop. It tells you that by the first half of next year, headline inflation should annualize at about 1%. That’s really low. And core, which is not in the chart, but core should annualize at about two. So if you are getting to the point where mid of next year the Fed can pretty much say, that job is done. I think that while markets are in the base case, that this inflationary soft landing is going to happen, which also means inflation is going to slow down. It’s in the expectations, the pace of this slowdown might actually still keep surprising markets on the downside. So if you get an inflation which slows down faster than expectations, and you also get a recessionary tail, which is underpriced, then if you put it all together, ideally, what I try to do here is to buy more two year bonds. when they get closer to 5%. So when you get a 5 percent rate, which means you’re pricing out some cuts from 2024 and 2025, that’s when I like to get a position on which can benefit both from the inflation downside surprise or from the recession retail being underpriced. So two year interest rates I think are an interesting addition to portfolios with a good positive expected value over the next 18 months.

[00:39:50]Mike Philbrick: And if you’re wrong, you collect the two, two year and you get to your money back in a couple of years. So do something else with it.

[00:39:56]Alfonso Peccatiello: Yes. The other interesting thing here is to look at commodities. Obviously, I mean, oil prices now have dramatically undershot, but obviously if you get the recessionary tail being underpriced and inflationary prospects being as well, more negative than people expect, then obviously inflation, commodities don’t do particularly well in this environment. That’s particularly industrial, and more inflation cyclical driven commodities, which brings us, I think it’s a nice bridge to the portfolio construction process, because there are also orthogonal ways to do this. If you get the next three to six months, where it’s still predictable, this inflation growth slows down from one and a half to half a percent over the next three to six months.

It doesn’t look recessionary yet. You think, okay, let me go and squeeze risk premium somewhere. This looks a lot like 2019. So I’m going to go and buy risk beta. Okay. And then you look at valuations and you’re like, holy moly, look at the NASDAQ. Look at other things that I would like to have as a beta expression of this environment.

[00:41:04]Adam Butler: Scale.

[00:41:05]Alfonso Peccatiello: Expensive. So what other orthogonal things can I get? One answer is Carry, for example. So Carry tends to do really well in environments where realized and implied volatility are coming down. Everything is very predictable. And Carry is nothing else than pocketing either interest rate differentials or a version of interest rate differentials. You can do it across asset classes, pocketing it and hoping that nothing happens in the meanwhile. And Carry is one of the risk premia that exist in markets, have existed through centuries pretty much and through regimes, be extracted. And this could be an interesting addition to portfolios for next year.

[00:41:53]Adam Butler: I like to sing from time to time. And I think your main point, too, is that that Carry would be a strategy that you would add on top of a more balanced, resilient, strategic asset allocation that is prepared for, you know, all of the major economic dynamics that you might experience, right?

So why don’t we sort of pivot to an exploration of how we might start to think about the construction of a portfolio? I mean, this is obviously a topic that is near and dear to the hearts of everyone on this call, and probably many listeners to this call who’ve been listening to us for a long while. So, we all love this.

Let’s pivot to the bread and butter, and then we can begin to add some preserves on top to sweeten the sandwich. So let’s start with, what are the dynamics that typically drive asset prices over the intermediate and long term? And then, let’s touch on how we might be able to construct a portfolio to be robust to those.

[00:43:05]Alfonso Peccatiello: Yes. So, I embarked on a project a few months ago, which was to try and design a portfolio which extracted risk premium in a reasonable way from markets in all possible macro environments. which is quite an effort and a very nice intellectual debate, but I think it’s what people should look at. And that’s where I want to start, because I think they start from the wrong angle.

The wrong angle is the 60/40 mantra, which has been predicated for the last 15 to 20 years, particularly, and the returns have enforced it. Unfortunately, 60/40 portfolio is an 85/15 portfolio if measured correctly, which basically derives 85 percent of its volatility from the S&P 500 and only 15 percent from bonds. So it’s not balanced. It’s a very unbalanced portfolio, which does extremely well in one of the eight macro environments, at least eight macro environments that you can consider. So does it mean it’s a bad portfolio or a bad tilt? Not at all. It can be a great tilt for the right macro environment. Does it mean it’s the best portfolio to sit and hold for the next 40 years? No, it’s not. And for a couple of reasons – the first is it’s not balanced. The second is that by being not balanced, it has faced drawdowns of 35 to 50, 60 percent in its history, which is I think, a sufficient hurdle for many people to make bad investment decisions, like leaving markets altogether and not pursuing any more the extraction of risk premia, because they get spooked by the drawdowns. And that’s the worst thing you can do. The worst thing you can do is not participate into the risk premium extraction game at all because you get scared by drawdowns. And the third thing is, by being 85 percent correlated effectively with the S&P 500, that also means the 60/40 return stream is very correlated to your own personal return stream.

And your own personal return stream is your job or your company or whatever you do for a living. Ask yourself, when is the chance higher you’re going to get fired or your business is going to go poorly, when the S&P is going up or when the S&P is going down 20 to 25%. In other words, you’re adding correlation to your existing cash flows, which is your job or your business, by investing in a portfolio which is highly correlated to the equity market in general, to the S&P 500. So I don’t think the 60/40 serves the purpose very well when the purpose is extracting risk premia for different macro environments without having the need of having the crystal ball to know whether it’s this inflation or it’s emerging market driven growth, or it’s US growth or it’s a trending moment or it’s scary, that leads the way. And I think that should be the aim of investors. That’s where I started. And the last thing that I considered is can we achieve this outcome only using ETFs?

[00:46:20]Richard Laterman: And before you move any forward, even more critically, I think it’s important to note the fact that for a large portion of investors out today, and for a large portion of the pool of capital that is allocated to capital markets, this is money that is going towards people that do not have, or will soon not have a salary from which to draw from.

So this is going to be the primary source of income and livelihood for a large portion of people, which are the ones that can least withstand these very large round-outs into, when they’re about to start to withdraw from those portfolios. So obviously we’re talking about retirees. And when we think about demographics, that becomes an even more critical component of this conversation, because so many people are on this glide path of 60/40, maybe starting to tilt towards 40/60, 20/80, whatever, they’re starting to allocate more towards bonds and keeping some of their equities, but still very much levered into a particular macro scenario and ill-equipped to deal with any shifts in those.

[00:47:25]Mike Philbrick: Let me add a couple more layers on top of that being a very important time to think this through. If you sat in 60/40 for the last decade, have a glass of wine, congratulate yourself. You’ve done really well. You now have a recency bias, which is informing an overconfidence bias, which is encouraging you to stick with this allocation. And if we think back through the last four periods where the S&P has compounded at 15 percent plus for 10 years, they ended in 1929, 1968, at the end of the nifty fifties. And 2000 right before the financial crisis and the GFC. And finally, the fourth time, just right now. So you have this very strange set of circumstances that has accentuated the confidence of people. It’s, the old story. Maybe Thanksgiving is coming and the turkey doesn’t really know that the farmer’s not his friend.

[00:48:31]Adam Butler: Are you kidding? The farmer’s been there with more food than ever. He comes every morning. The serving sizes are getting larger.

[00:48:41]Mike Philbrick: Right.

[00:48:42]Adam Butler: And clucking and petting and making sure they feel fat and happy. They’re not stressed. So their stress hormones are low.

[00:48:50]Mike Philbrick: Agreed. And so Thanksgiving is next week. And, but just to say that there’s a lot going on here behaviorally. And I think one of the things we’ll touch on in the Forever Portfolio, is, is there’s a tracking error issue too, right?

So, the advisor, the allocator, the person who’s in charge of the endowment, is managing both the behavioral issues and challenges that, you know, Peter Bernstein talks about in Against the Gods. Like, these are hard to manage.

[00:49:24]Alfonso Peccatiello: Very, very hard.

[00:49:25]Mike Philbrick: And now you have to balance them with all of the other areas, the other domains and inputs for investing that create the other regimes that aren’t quite as kind to this portfolio, that is a disinflationary growth portfolio. But just to set the stage, like this is important. This is a calling. Preparation over prediction, always take the first step, think about these things. And then back over to you, Alf to kind of set the stage for, okay, you know, we’ve been pretty lucky over here. How do we think about the problem now in that base case of assets?

[00:50:00]Alfonso Peccatiello: Yes. So look, the next decade, not necessarily looks like the previous one. I think that’s the first starting point and sharing the screen, I think a good chart comes from Goldman Sachs here, and look, the 60/40 loves a predictable environment of predictable growth and inflation being predictably around 2%.

What the chart is about, I mean, this is the rolling volatility, 10 year volatility of GDP and 10 year volatility of inflation. Right. And it goes back to basically the beginning of the last century. And look, it’s, the last 10 to 15 years have been amazing.

The volatility of inflation and growth has been extremely low, all super predictable, which is the heaven of a 60/40 portfolio. But there have been periods where either inflation was particularly volatile or growth was particularly volatile. And in these environments, you have inflation adjusted returns for decades that tend to be zero or negative in a 60/40 portfolio. Now how do I know that the next decade is going to be different? Nobody knows. Nobody knows, but… there are a couple of things that could make it different. I mean, we have seen, for example, uh, demographics is shifting under the hood. So we have seen the Chinese labor force putting up, you know, from 400 million to, for 400,000 to almost a million. Sorry, I’m missing the magnitude here, 400 million to almost a billion Chinese workers in a few decades. They have been basically a great source of cheap labor supply for the world. And now over the next 20 year, the opposite is going to happen. China is going to lose part of their workforce. So you can’t really count on this new influx by 2028. Gen Z and Millennials are going to account for more than half of the voting share in the United States. So probably Gen Z and Millennials are going to have a different incentive scheme than boomers. For example, they might want to demand a different allocation of resources, more use of fiscal, more reallocation of resources that might be inflationary.

For example, fiscal deficits are being used more aggressively. That means the pendulum of growth and inflation might swing more aggressively than indeed over the last decade. It doesn’t necessarily mean inflation has to print on average at 5%, but it might move more viciously between minus two and plus four, for instance, which means more volatility ahead and therefore, at least we have to entertain the thought that we need something a bit more diverse than the 60/40 to achieve our objectives in every macro environment. So what are, what is every macro environment? I think you need three angles. One is growth, one is inflation, and the other one is the monetary policy stance. And I put them all in a NASTA location model that looks like a compass.

It has basically four big quadrants and a depth dimension that is driven by inflation. So think of it like a cube or like a quadrant with a depth dimension, a full quadrant with a depth dimension in it. For people who aren’t seeing this must be difficult to picture, but basically the story is you have growth on one axis. You have monetary policy stance on the other axis, and then you have inflation, which serves us the depth of your picture.

[00:53:21]Mike Philbrick: Think of it as a two by two Rubik’s Cube.

[00:53:24]Alfonso Peccatiello: Yeah, pretty much. So look, the story is pretty simple. The 60/40 works really well in one of the eight environments when growth is decelerating below trend and predictably. So inflation, you are in the blue area of the quadrant. So inflation is low, decelerating and predictably so, and the monetary policy stance is also supported.

So central banks are endorsing basically a loosening of financial conditions. If you get all of this, which has been by the way, the dominant regime for the last 10 years, the whole time, then great, 60/40 works effectively. Growth stocks and Treasury bonds tend to be the best performing betas you can add to your portfolio. There are seven other circumstances though, where for instance, growth is accelerating particularly and it’s also inflation is coming up. So nominal growth is surprising on the upside, for instance. But then let’s assume that the monetary policy authorities are saying, I want to run my economy hot. I am fine with having inflation accelerating and growth accelerating. For instance, this happened early in 2021. In early 2021, you had reopening, fiscal stimulus. Nominal growth was really, really fast, but the Federal Reserve wasn’t reacting. The Federal Reserve was saying, look, we are coming from the pandemic. I’m very happy to let the economy run hot and to recover rather than immediately tighten financial conditions. So what happens there? Well, rather than growth stocks, small cap tends to do pretty well because not only growth is picking up, but financing conditions are very loose. Assets like Bitcoin tend to have a very good performance in that environment because real interest rates are very low. Monetary policy is very, a commodity. Animal spirits are building up because growth is very strong. So you might consider having some beta in your portfolio that can benefit from an environment like this. You can also have environments where growth is accelerating, inflation is high, but the central bank is saying, fair enough, we’re going to raise interest rates. In that environment, it’s not growth stocks that do particularly well, but it’s assets that are benefiting from nominal growth and they are not hit by higher interest rates when it comes to valuations. The good old economy. So you’re looking at value stocks. You’re looking at brick and mortar shops.

You’re looking at the Dow Jones in other words. Okay, so, and you’re also looking at emerging markets in that environment, for instance. Again, maybe the world grows, but who tells you that you are not going to have a 2003, 2006 regimes where emerging markets crushed everything else, including the United States. We are so focused on what happened over the last 10 years that we basically exclude all other possibilities from, you know, just the realm of what can happen. And so you need to look at all these assets. And when you come up with, okay, what do I need? What are the betas I need in the portfolio to be equipped for all the circumstances?

There are four to five main principles I would say to respect. So you obviously need an equity beta. And let’s start from there because it’s, it’s pretty simple. So if you start from an equity beta, then let me see if I can get, it’s fine. I can explain that. So if you start from the equity beta. The first thing you want to do is not depend on a certain market cap tilt. So you don’t want to suffer from recency bias. You don’t want to over allocate to the asset class that Momentum wise has performed the best, because that will be the one that has the most weight in the basket of market cap weighted. In this case, it’s tech. It could be something else, by the way, but if tech does well for 20 years, then tech gets more weight in the market cap weighted index.

And you want to stay away from that recency bias. You don’t want a Momentum beta built into your equity exposure in the first place. So the first thing to do is, if I’m looking at the US, equal weight generally is a better way to get equity beta exposure, or not a better way, but a more balanced way to get equity exposure. The second is, the United States is not a hundred percent of the world growth or the world earnings and valuations in the US are much higher than anywhere else. So why don’t I diversify internationally? So those are the two principles. Do you have Japanese equities in your portfolio? Do you have Brazilian equities in your portfolio? Are you correctly exposed to all possible sectors? Do you have some small caps, not only large cap stocks in your portfolio? So think about your equity beta in a much broader sense than just the S&P 500, which is US only and market cap. And I’m going to pause here for a second.

[00:58:13]Mike Philbrick: You’re singing to the choir there.

[00:58:16]Adam Butler: Well, I like, you raised this in a previous chat that we had Alf. I think something novel that you bring to this framework, one of the novel things that you bring to this framework is a adding this dimension of monetary policy. Right? And I agree. This is a really important dimension from a diversification standpoint.

I’m wondering for those who are interested in watching the evolution of the economic state, what do you look for specifically? What sort of quantitative signals do you look for to signal net easing, versus net tightening? Is it literally just, you know, the most recent Fed move was to hike or to lower, or, you know, what else are you watching?

[00:59:12]Alfonso Pecatiello: So the first easy thing you can look at is the level and the direction of real policy rates against a reasonable expectation of where equilibrium rates might be. They’re unobservable, but you can have a reasonable confidence interval. And if you’re getting real policy rates way below, way higher than this equilibrium rate, you know that you are potentially easing or loosening from a monetary policy perspective. The second thing you can look at is the term structure of real interest rates. So again, real interest rates really, really matter from a monetary policy stance, but you can look at them very mechanically. So you can look at them on the short end. You can look at them on the long end. So long end real interest rates and the term structure of those is also an important signal because that collects not only what the Fed is doing now, but what the Fed is trying to message to markets it is going to do about real rates and what the market is absorbing out of that messaging. And the third thing you can do is listen to the game masters. That’s a less quantitative way but, Powell, for example, in November, 2021 started pretty clearly talking about the fact that, well, core inflation is starting to pick up.

We are more worried. We are going to have to tighten. So today you can even train some language models. So you can do this a bit more quantitatively. There are some Clouds of Feds. For example, you can use artificial intelligence in certain ways and train it to basically screen through the speeches from central banks and trying to understand whether you’re leaning more hawkish, you’re leaning more dovish. You’re trying to add the quantitative layer to the central bank observing job effectively, but those are basically real interest rates. The balance sheet of a central bank can also be one of the things you want to observe along this axis. So effectively the monetary plumbing, story, and additionally, the rhetoric from the central bank. Those are the three elements that you want to bring, uh, to the, to the equation.

[01:01:23]Mike Philbrick: Some nice alternative data in there too.

[01:01:25]Alfonso Peccatiello: Yeah, it’s really interesting. I used to do this just by basically listening to every speech of these guys. And it’s a very tedious job to be very frank. So if you can have artificial intelligence do that instead of you, it’s not too bad. So on the equity sliver, you can achieve that, as we said, through international diversification and equal weight exposure rather than market cap weight exposure.

On top of it, of course, you can try and be smarter. So you can try, for example, to test for some factors that tend to add excess returns over time. So what are those? For example, I mean, Quality is one factor. Quality can be defined in 2000 ways, but one of the exercises you can do there is try to screen for companies that reward shareholders without incurring in too much unproductive leverage to do that. My friend Matt Faber has this famous shareholder yield approach, which I think is very smart and it’s a very intuitive way of doing that, but basically you can build on this.

The principles remain, try to look for internationally diversified companies. Get an exposure, which is internationally diversified, equal weight, and look out for factors that you can overlay on top of this to try and generate some excess returns. The thing about a Forever Portfolio, though, is that if you want to look at equity beta and then bond beta and then commodity beta and then FX, which I’m also going to talk about and then Carry and Trend and all these betas you want to put up together, one of the most important things of them all is to size them correctly.

[01:03:03]Adam Butler: Um hum.

[01:03:05]Alfonso Peccatiello: People size their attackers in a very offensive way, and they forget to size their defenders in a way that their defenders matter enough to shallow the drawdowns and achieve this objective in their portfolio.

So you have some, so you have some attackers, right? I mean, like equities are obviously an attacker in your portfolio because the distribution of returns of equities over time is skewed to the right.

That means the world grows. Earnings tend to grow over time and unless you’re buying at ridiculous valuations, you have a good chance that over a 5-10 year rolling period, your return will be not zero, but skewed to the right. It will be something in the positive arena, okay? And if you have that, you know that by investing in this asset class, you’re likely to get rewarded with some risk premium over time. Or in other words, what I’m saying is that internationally diversified equities tend to return cash plus four to five percent over 10 year rolling periods, going back 200 years. Now, if you buy them at 35 times earnings and probably you, you don’t get there, but if you are relatively conservative when it comes to your framework for valuations, you should get there. So that’s an attacker. It’s something you can own in your portfolio that delivers a drift to the right to your return profile. Great. But you can’t have 80 percent in that because the volatility and the drawdowns are also commensurate, obviously. So there is no free lunch in markets, right?

If you get a return to the right, probably you’re going to get quite some drawdowns. So then you want to size your defenders in a way that they make sense. Bonds are an obvious defender. If you are in a disinflationary environment, then they do work, right? That’s the typical negative correlation that people are aware of. And when it comes to bonds, also there, you’ve got to think, what do you do? Because bonds can be a bunch of stuff. You have risk free, you have corporate, you have emerging market bonds. You have a lot of stuff going on. If you want a defender, then you’ll have to look at risk free. So you’ll have to look at government bonds.

You don’t want to overlay a credit spread component on top of it effectively. But Treasuries can be a lot of things. They can be two year, they can be 10 year, they can be 30 year. What do you buy? Which part of the curve do you buy? If you can use leverage, there are a lot of things you can do there.

But if you can’t, and you are an ETF investor, then what you want to look at is something that has enough duration so that when interest rates drop, you can get enough of the benefit from interest rates dropping into your price return in other words. And yes, the curve might steepen. So from a basis point perspective, it might’ve been better to buy a two year bond ETF, but the duration is so, so low that unless you can access leverage, you are better off buying a higher duration bond ETF. In other words, if the volatility of an equities lever is about 18% annualized or 20% analyzed, you want to have a bond component into your portfolio that has pretty much the same annualized volatility so that you can size it in a way that your defender matters. Your defender is really able to shallow your drawdown if your drawdown happens in this inflation, by the way, because then, instead, another defender that people completely forget about is defenders during inflationary periods. And defenders during inflationary periods can be found in the orange part of the quadrant.

But in the orange part. of the quadrant, you’ll find moments when inflation is high or accelerating. And there are attackers for that small cap or commodities, or let’s say small cap for the time being. And then there are assets that are a bit more hybrid and they can defend you during inflation as well. So commodities tend to be that, for example. Commodities can be an attacker, but they can also be defenders. For instance, the first half of 2022 is a good example where commodities were basically one of the few asset classes able to offset the joint negative returns of bonds and stocks back then. And commodities can do well during inflationary periods so they can act both as an attacker and as a defender.

Again, there you need to choose which commodities and I suggest that you diversify them. You have industrial commodities like copper, or you have oil, for instance. Those are inflationary sensitive commodities that you want to have in your portfolio because they are the only ones that are likely to shallow your drawdown in moments where core inflation is above 3 percent, or rising above 3 percent, and bonds will not be able to shallow your drawdowns. So if you draw a chart of the correlations between bonds and stocks, you’ll see it turns positive when core inflation is north of two and a half to 3%. That’s because the central bank can’t ease at that moment. And therefore the only thing that is going to save your portfolio and offer a diversified stream of returns in that case is commodities. So you want to have them as well as a layer into your portfolio. And finally, something else you might want to have as basic beta. So remember you have equities, you have risk free rates, you have commodities, and then you have the dollar.

Now the Dollar is another interesting beta that I added into my approach, and, look, the Dollar is the only asset that works during the leveraging. That’s because the global monetary system is built around the Dollar being the global reserve currency of the world, which means right today, there are 12 trillion of foreign, sorry, of Dollar denominated. So this is Brazilian corporates, Chinese corporates, other companies around the world that have borrowed in Dollars, despite not being able to access Dollars unless in organic ways, like trade flows, for example. So if the economy is growing and Brazil is selling more soybeans, they’re fine paying their Dollar liabilities because they’re getting an organic access to Dollar flows. And the moment that stops, Brazil still needs to access dollars to pay their Dollar liabilities, their 12 trillion Dollar denominated debt. But the Dollar flow has stopped and they can’t call up the Fed and say, hey, I need some Dollars. Yes, maybe some countries can, but it’s not an immediate mechanism because those Dollars enter the banking system, not necessarily rich corporate straight away. So what I am describing is a situation where the world is leveraged in dollars and the entire system is built as such that we lever up basically the Dollar status. That works great when the economy is growing. Also the reason why the Dollar depreciates when the world growth tends to do great, but the opposite happens when you’re deleveraging, so when you’re deleveraging, the Dollar appreciates, and it’s one of the few assets that actually delivers positive returns.

And it does so if growth is decelerating. The central bank is very stubborn. For example, in that combination, you increase the chances of deleveraging. Or for example, as well, when inflation is accelerating very rapidly and it’s generating pain through the global economy and you will have the commodities and Dollars rallying together.

We have seen that, for example, a couple of times this year, but the Dollar tends to have to guarantee another diversified stream of returns against deleveraging moments, which are rare. That’s correct. They don’t happen very often, but when they do happen, late 2018, the great financial crisis, and other episodes, the Dollar can offer diversification abilities which are not easily found elsewhere.

[01:10:50]Adam Butler: That’s a great review. We often say that diversification is two things. It’s having diversity of exposures. You just named four, that are well suited for different macroeconomic regimes. And you also hinted at the other, which is balance, right? Because if you hold 50 percent equities in the portfolio and 50% Dollars, or 50 percent to your Treasuries, then obviously your offense is completely dominating the field and you’re, if the economy breaks through your offense, there’s no defense there to act as a buffer.

So can you walk us through how to think about allocating to these different regimes and regime related assets in a portfolio to achieve diversity and balance?

[01:11:46]Alfonso Peccatiello: Yes, so the diversification part is through the four main asset classes we discussed. Again, guys, this is a retail friendly ETF only exposure, and it’s the reason why so far, I haven’t spoken about uncorrelated risk premia strategies, because you can try and add on top of these different layers of returns which do well in different macro environments, that are not necessarily correlated with one of these four. So this is another exercise you can do later on. But first you start from building a portfolio that is well distributed across equities, interest rates, commodities, and the Dollar. That’s what you want to do. Now to achieve that, you need to have all assets weighted the same, not by notional, but by what I would call a volatility contribution weighting. So that’s a very simple concept where you basically say okay, what is the standard typical volatility of an asset class? And I want to weight them all so that they all contribute in the same way to the volatility of returns of the portfolio. So that is not achieved by doing 25, 25, 25 and 25 because the Dollar is a much less volatile asset class than, equities or commodities can be very volatile, while bonds can be less volatile.

So what you want to do is to say, look, I want all these four assets to roughly explain an equal portion of my total portfolio volatility of returns. That’s what you want to try and achieve as your objective. Now to do that, you will need to use some leverage because to bring up the Dollar to the same level of volatility contribution to other asset classes, for example, you might need to have a leveraged Dollar position. So basically, you need to be able to bump up this Dollar contribution to the volatility of returns. Again, we’re trying to do this only with ETFs. When I talk about leverage, then people generally freak out because they attribute negative connotations to leverage. But the reality is that leverage can work really well in achieving this equal volatility contribution of different betas to your portfolio as long as correlations and the true macro drivers of each beta are considered carefully. Now, unfortunately, I can’t find a Dollar leveraged position as an ETF out there. So maybe I should make one. I don’t know, but I can’t find one, which then means that being the Dollar has only about an 8 percent annualized volatility as an asset class, it’s FX after all, so it’s less volatile than anywhere else. You need to start by allocating a decent chunk of your portfolio to the Dollar. That means your portfolio will be long Dollar and short Japanese Yen, long Dollar and short Euro, long Dollar and short Sterling. So the DXY basket effectively. Okay.

Good thing about that is that in most of history, this tends to Carry positive. So you own this in your portfolio and it’s a protection effectively against the leveraging events. But in the meantime, you are getting paid some Carry to own it because Dollar interest rates tend to be higher than Japanese and European interest rates. In other words, so that’s where you start. Then you have used about 25 percent of your cash if you do this, and you have 75 percent to allocate. And at that point, you’re looking at assets like equities, interest rates, and commodities. And those have annualized volatilities. Let’s say that range between 20 and something like maybe 35 to 40 percent before leverage. Okay, so you have assets that are quite volatile and you can also allocate accordingly.

So if you start from equities, you say, okay, I want to have equal weight US equities. I want to have developed markets ex-US. So I want to have Japan and Canada and Australia and all the other international diversifications out there. I want to have emerging markets. I don’t want China to be my emerging market because that’s the problem with most of these emerging markets baskets out there. They’re 40 percent China. I don’t want that. I want emerging markets. That means you’ll have to split the Chinese exposure and the emerging market ex-Chinese exposure. Once you get an allocation done that way, you have an equal weight, relatively equal weight, well distributed, internationally diversified equity exposure. And now you say, okay, I want this to contribute a decent amount of volatility to my portfolio because I want to extract risk premium out of it. And let’s say this should account between 25 and 30% of the volatility of the returns of the entire portfolio. Therefore you can allocate a certain notional.

And let’s say you’re going to start from about 30%. This is an optimization exercise at the end of the day, right? You want to balance out all the assets. So once you have used all the cash, you get more or less the same amount of volatility contribution from each asset. So you do 30% in equities times 20 percent volatility contribution, and you get your output.

At the end of the day, you want all these final outputs to be more or less the same in your portfolio. With bonds, the look with bonds, the situation is you want high duration exposure. So you want something that has an analyzed volatility that is high enough to offset your downside in equities. Long end Treasuries are the obvious way to do that. But the problem is that you have to start using leverage at some point. Otherwise you have done 25 percent on the Dollar, 30 percent on equities. You have already used 55 percent of your cash. And at some point you’re going to start feeling a bit light when it comes to your cash exposure, and how do you allocate that? So in other words, if you want to do Treasuries without leverage and you want to achieve the same amount of volatility of equities, you should buy about 35 percent in long end Treasuries. Now that gets you very close to a hundred. You have used 25 on the Dollar, maybe 30%. You have used 30 percent in equities and now you’re looking to do 35 percent on bonds. You can see you can’t sum up what are commodities, you still haven’t added them to your portfolio. That makes you understand that instead of having equal notional exposure, you want to have equal volatility contribution to your portfolios. So at this point, you need to use leverage somehow. And in the bond space, there are some leveraged ETFs you can use. So there is 3X long end Treasuries, for example, right? That gets you not only the duration of TLT, which is about 17, 18 years. So it’s a relatively high duration ETF, but it gets you three times leverage on that. Now, leveraged ETFs are not ideal, okay? Not ideal by the way they’re built and by the way they try to achieve their leverage, mostly because of, I would say, daily rebalancing and hidden costs that come with that, but it’s the only immediate retail friendly ETF. The only way that you can think of in trying to achieve a return exposure that is commensurate to what you want to achieve, is by doing 3X TLT, that ETF, which is three times leverage.

You can only allocate 12 percent to that, and you can achieve the same amount of volatility contribution from that single bond ETF to match your equity beta, basically.

[01:19:28]Adam Butler: I know you’re a credit/fixed income guy. From your perspective, are there any trade offs to exclusively allocating to the long end of the Treasury market?

[01:19:42]Alfonso Peccatiello: Yeah, there are because there could be situations where the two to five year part of the curve dramatically overperforms the long end of the curve. And we have seen that happening a couple of times when the Federal Reserve reaction was extremely acute, so that markets thought, okay, you guys are easing so much now that I’m going to reflect some term premium now back into the curve because this is too much what you’re doing.

And 2009 is a good example, 2010, the curve steepened extremely aggressively. So by getting the exposure down in the long end, you really didn’t get much bang for your bucks. And instead, by doing two to five years, you are really solely focusing on the Federal Reserve reaction function. You are saying if things go bad, the Federal Reserve will have to cut rates more aggressively than when forwards are pricing. And that’s the beta I want. That’s the emergency bond disinflationary rescue that I need in that particularly recessionary environment, for example, right? So yes, there are trade offs, and that’s why if you can use futures, if you can use leverage, not through ETFs only, obviously you have way more options, but if you’re trying to achieve diversification in a proper way, then you not only need the high duration through ETFs, but you need it even leveraged to try to even match your bond beta with your equity beta.

That’s the only solution you can find in an ETF only way. And it still will work, Adam, but sometimes it won’t work as effectively as if you could have done it via futures in two years and in five years. But for people investing in ETFs only, I think that’s the only solution you can find is to do a three times leverage long end bond ETF, and to size it. And only 12 percent of your entire portfolio, which is a small notional size because of the leverage and the abandoned duration. It’s more than enough to provide you with a reasonable bond beta for when you need it.

[01:21:52]Adam Butler: Yeah.

[01:21:52]Richard Laterman: I might actually have a solution for that, Alf.

[01:21:56]Alfonso Peccatiello: Tell me.

[01:21:57]Richard Laterman: There’s a Return Stacking ecosystem of ETFs that we have been working on. And, we might…

[01:22:04]Mike Philbrick: Yeah, but, that we can’t talk about…

[01:22:06]Richard Laterman: Right now.

[01:22:07]Mike Philbrick: But, talk about those, take that offline.

[01:22:08]Richard Laterman: Yeah.

[01:22:10]Alfonso Peccatiello: But you can see how useful these products would be, right? Because for an ETF-limited investor today, that is not possible. There is no way that you can get a leveraged exposure to the exact factor you want, which is the Fed is going to cut rates because we are in this inflationary recession. That’s what you’re trying to get here.

Okay. And that is not thirty year bonds. That’s two year rates. That’s five year rates. That’s what you’re looking for here. But because of the low duration of those, you need leverage to get the right amount of volatility contribution you need. Okay. So if you can structure a product that helps investors doing that, that’s amazing. In the meantime, if you only want to use beta ETFs, let’s say, so an equity ETF, a bond ETF, your best proxy is to do long end bonds, and to do it leveraged. At this point, you still have, so you have spent about 30 percent notional in equities. Remember 25 to 30 percent in the Dollar, about 10 to 12 percent in bonds. So you are still left with about 30 percent of cash that you need to use somewhere else. Okay. So here, I chose personally to do emerging markets and emerging market bonds in this case, which are, which is my way to express Carry through, so it gets you more exposure to the emerging market world in case growth would be coming from there rather than from the US or from Europe, for example. And on top of it, because emerging market bonds trade at high risk premia and interest rates in emerging markets tend to be also higher than in developed markets, you get an exposure of Carry. Finally, commodities, and commodities are very volatile. That’s great because to achieve a volatility exposure there, you don’t need much notional.

So you can use basically your 15, 20 percent left in commodities. And there are also two times leveraged commodities on gold ETFs, on gold and on oil, that you can try and use to basically achieve your objective of volatility contribution being the same through asset classes. And in commodities, importantly, you want to get the inflation sensitive commodities done in a balanced way.

So that’s agricultural, industrial, and oil. Not only one of those, but all of three together, because you don’t know where you are. Inflationary sensitive commodity rally is going to come from, it might be oil, or it might be agricultural commodities. So get exposure to all of them and also to gold, obviously. So gold in the portfolio needs to have a space because it’s an asset class that does particularly well in one or two rare and isolated macro environments, but it’s a bit like the Dollar. When they come to fruition, the complexity of returns is extremely large and also the uncorrelated, the non-correlation to other streams of returns tends to be very high. And once you have packaged this only with ETFs, you get to a quite interesting setup. So let me share with you a chart here.

Now this is a 20 year look-through for this portfolio. And I put it against the 60/40, not because it’s a reasonable benchmark, but because everybody likes 60/40.

So why not, first point Alf, why only 20 years? And my answer is, get me the data please to do it longer in a reasonable way, and I’ll be happy to back-test it longer. But for emerging market bonds, for instance, it’s really hard to trust me to find good data sets to back-test it. The secondary reason I have is that the last 20 years, including 2002 and 2003, and that period have been interesting because you have had periods where emerging markets did particularly well, 2002 to 2006. You have had a Great Financial Crisis with deleveraging attached. You have 10 years of 60/40 heaven, but then you have COVID and then you have fiscal dominance. And then you have 2022, where no assets worked, apparently. So it’s a relatively diverse set, I would say, of macro conditions. It maybe doesn’t have them all, but it has a reasonable diversity of macro conditions.

[01:26:25]Richard Laterman: And just to clarify, when we speak about the 60/40 here, we do mean US 60/40, not global, right?

[01:26:31]Alfonso Peccatiello: Yeah, we need, we mean US 60/40. So I’m basically benchmarked against VBINX, the Vanguard Balanced 60/40 Index. What I did here is basically try and look at various metrics for doing this and rebalancing it quarterly in a very lazy way, just the rebalancing at the end of each quarter. No active macro tilts applied whatsoever.

Just literally keep doing this all over again, only through ETFs, by the way. So no need to find fancy structures and also back-test over the last 20 years and 10 of these a year. So half of the sample is dominated by a macro environment, which favors 60/40. So I want people to keep that in mind.

Okay. And nevertheless. You get annual returns of 8 percent for this Forever Portfolio implementation, and you get a cumulative return of 382 percent with an annualized volatility of 7.8. So in sample, the Sharpe ratio of this portfolio is about one, which is quite interesting. If you ask me, it’s pretty high. LY volatility is relatively low. The 60/40 portfolio in the same period has delivered pretty much the same returns, about 8% a year in total return basis between 2002 and 2023. If you think that’s low 8%, it’s because you had a couple of interesting drawdowns. The first in 2008, 26, 60/40 went down 36%, and it takes a lot of time to recover from these drawdowns.

Okay? So 8% was the same return, but the level of volatility was 11%. The 60/40 portfolio with a maximum drawdown of 36 percent against a maximum drawdown of 24 percent in this portfolio. So, you know, the Sharpe ratio is higher, the … is higher, the beta of the Forever Portfolio to the 60/40 is 0.35, positive beta.

So this is still a portfolio that is correlated somehow to the 60/40, but remember where you’re starting from. You only want to use ETFs and you want to make it so that every retail investor in principle can get access to this. And you have achieved a better structure of a portfolio, more equipped for different environments that delivers ex ante the same amount of annual returns, with way less volatility, and a maximum drawdown of 12 percentage point less than the 60/40 in this environment. So it can, and it should be done. It’s an achievable objective to have a more balanced portfolio than the 60/40 without having to sacrifice a ton of returns. Additionally, if you are happy to get a 12 percent analyzed volatility, you could clearly lever up a Forever Portfolio version to bring up also your returns accordingly. And you can also add uncorrelated strategies if you use futures and leverage to even compel this portfolio construction further.

[01:29:39]Mike Philbrick: Yeah, I think that you’ve really addressed the three main questions, right? Has someone exploited fully the opportunity for asset allocation? Have you thought about the risk premiums being harnessed and are they well balanced? And lastly, are you allowing any market and market structure to dictate the structural characteristics of the portfolio? And if you think through those three questions with the 60/40 portfolio, have you fully exploited asset allocation? No. Are you balanced in the way you’re harnessing the risk premiums of stocks and bonds? No. Are you allowing the market structure to dictate the structural characteristics of your portfolio? Yes.

That’s the precise wrong three answers. And these really boil down to three main points is diversification, balance and risk management. And so you’ve thought through very well, I think, and certainly congruent with many of the things that we think about how you should address these three questions.

And I do sort of harp on these three questions. And this is what I mean when I ask these three questions of people who are looking at their portfolio, but also realizing on the behavioral side of that, you do have tracking error issues to deal with and think about in a portfolio. So again, not all or nothing.

If you have a group of clients who are in Texas and like oil, or in San Francisco and like tech, you’ve got to put this in alongside those portfolios in order to enhance their overall experience. Well, I’ll throw it back to you for some, some more thoughts.

[01:31:17]Alfonso Peccatiello: Yeah, I mean, for me, one other important table is that to talk about tracking error. And that’s really important because when your neighbor is getting rich out of a 60/40, it is very hard for you to justify that you are doing these commodities and that you have Brazilian equities and whatever you have in your portfolio. It starts to get hard because, you know, your neighbor is getting richer, so that doesn’t work for you. The other, the flip side is that your neighbor went to a 36 percent drawdown between October 07 and March 09, which took 802 days to recover, while if you allocated to this, again, pretty simple framework only with ETFs, which can be improved massively through the use of futures and other uncorrelated strategies, you took half the time to recover from your drawdown. Half the time. So your neighbor was miserable for 400 days more than you were, in other words. So it’s, you know, there are flip side as well. There is tracking error and there is recovery time from drawdowns and the 60/40 hasn’t had a major drawdown since the great financial crisis.

So people have forgotten that it will, because an asset portfolio allocated 85% effectively in both terms to the S&P will have drawdowns which are larger. It’s the nature of the distribution of equity returns, which you’re getting 85 percent correlated to. And so your neighbor might feel happy, but it will also take sometimes a lot longer to recover from when …

[01:32:44]Adam Butler: …

[01:32:45]Mike Philbrick: The only solace that’s taken is that when they’re down and hurting, so are their buddies.

[01:32:52]Alfonso Peccatiello: And…

[01:32:52]Mike Philbrick: We could all commiserate with each other. So I do want to, we have been at this for almost an hour and a half. So we, I think we want to start wrapping up in the next five minutes, if we can Alf, just to respect everybody’s time and make sure this is high energy. So as we come into these final thoughts, you have a slide there. If you want to go through that behavioral slide on losses and whatnot, I absolutely think that would be…

[01:33:13]Alfonso Peccatiello: No, it was a Daniel Kahneman chart, which showed the psychology of losses and he tried to measure, and he came up with a multiple of the negative impact that you feel by having losses rather than by having gains. So effectively the pain felt by a hundred dollars loss is way larger than the excitement you feel by a hundred dollars gain.

That’s important because when your drawdowns exceed in general, 20%, you have a higher chance of having a negatively convex reaction. So basically, dumping everything and running for the hills, which means not participating in the risk premium extraction game right when more likely risk premia are abundantly available.

[01:34:03]Richard Laterman: Precisely the wrong time, you would sell everything and cry Uncle.

[01:34:07]Alfonso Peccatiello: So it is paramount important to have portfolios that don’t have drawdowns of 36%. That’s pretty much what I’m saying, at 36 is actually on the low side. So if you go back in time, the 60/40 will have larger drawdowns than that will.

[01:34:20]Mike Philbrick: And then you want to start thinking about them in real terms, like the seventies, in real terms of what the drawdown was in purchasing power. It’s incredible, the sizing that happens.

[01:34:29]Alfonso Peccatiello: So for me, the key messages for investors here are the following. Following people like you, because you have a framework that allows people to construct portfolios that are equipped for different macro environments. There are professional ways to do this. I shared with people a framework to do this only with ETFs, which has limitations, but it is always very practical. And if you look at the last 20 years, you would have done still pretty well for yourself and your neighbor. Can’t say much to you while for 400 days, your neighbor would have been pretty miserable much longer than you were. So you can still achieve this only with ETFs, but there are ways to do this even more effectively than only with ETFs, through the use of leverage and uncorrelated strategies, which is exactly what I plan to do, somewhere next year, through launching my own fund, that will allow basically, people to get access to a professional implementation of the strategies we have discussed. And you guys are pretty much in the same game, so we might become peers, which makes me very happy.

[01:35:38]Mike Philbrick: Yeah, that’s, that’s amazing. So I’d like to thank you MacroAlf. For those who want to find Alf,  Alf on Twitter now X, I guess it’s @MacroAlf and then on Substack, The Macro Compass, and he’s a prolific writer, constantly talking about this, and in this field. I would also encourage those who are listening to look up From All-Weather to All-Terrain, which is a portfolio, an article we did just thinking about this type of strategy and then layering on the next step, which Alf has kind of alluded to. You know, you can do some active tilts, you can do some active things and maybe next time Alf we’ll get you on and talk about that next layer.

So now that you’ve got a good balanced portfolio and you are doing no harm, from the doctor’s oath, how might you think about those active tilts? How might you think about imparting some extra return that’s non correlated to enhancing what you’ve developed with the Forever Portfolio? And I think that’s a great place to stop off, but also think about where we’re going to talk about, what we’re going to talk about next.

[01:36:50]Alfonso Peccatiello: Yeah, I think that’s a great idea. And the other, the part that people are not very familiar with is strategies that do well with inflation. And of course, Trend has gained a lot of relevance of late, but there are also others that can do well during inflation. People are not very familiar with uncorrelated risk premia. We talked about Carry, but there are others out there. And all these discussions are great because you guys are putting them in the open air for listeners to benefit from. And you’re doing great. Keep up the good work.

[01:37:27]Mike Philbrick: Thank you. Thank you for taking so much time. Any closing thoughts, Richard, Adam?

[01:37:32]Richard Laterman: No, this is great. It’s remarkable what we can do with just a few ETFs in a period where the 60/40 had some of its best returns ever, and then when we start thinking about Stacking or layering some additional tilts, the sky’s the limit and you create a lot more robustness to different kinds of economic regimes.

So excited for next time that you’re going to come on and we’ll continue this conversation.

[01:37:58]Alfonso Peccatiello: Yeah. I would love to be back guys. Thanks again.

[01:38:01]Adam Butler: Thanks, Alf. Enjoy your pizza.

[01:38:02]Richard Laterman: Thanks, guys. Sorry to interrupt, but I did want to take a quick second to remind our listeners that, the team works really hard on these podcasts. We spend a lot of hours trying to get the right guests and we do a lot of prep work to make sure that we’re asking the right questions. So if you do have a second, just do hit that Subscribe button, hit that Like button and Share with friends if you find what we’re doing useful.