TMC #11! Real yields were stubbornly low in the 1940s, and I expect the same in the 2020s. That's about it with the similarities though: watch out for the material differences.
Thanks for other fine article. Three more differences between the 1940’s and today: 1) YCC was paired with austerity. Everything valuable to the war effort was rationed. 2) In the US, Medicare and Medicaid did not exist. Social Security was new, small, fully funded and not considered an entitlement. 3) The war effort took Americans to their highest peak of social cohesion. It’s at the second lowest point today. Only the American Civil War was lower. Try austerity today and you’ll see social unrest that makes 2020 look like a Girl Scout picnic.
Hi Alfonso, Thanks as always for helping me understand and tie the pieces together. It's been a couple of months since this update--are we still in Quadrant 1 and/or where do you see us now? Would Fed tapering push us down to Quadrant 4?
If: we attempt to achieve "[poor] structural growth" by "expanding credit" but the "private sector does not want to borrow more, and banks don’t lend";
Then: I understand the short leg of the trade.
But: how does it make one confident on the long leg of the trade? Is it because of the short maturity of it (1 to 2 months), relying on the lagging effect from the previous quadrant we were sitting on?
I am very grateful for your work, please keep up on the high value content, I feel it getting from good to better with each article.
The long leg of the trade is useful for two reasons.
1. If we remain in the secular quadrant 1, Nasdaq will outperform European Banks on a relative basis - the trade will make money. Even if Nasdaq drops, as long as European Banks drop more I am ok with it. The secular trends are clearly favoring long-duration, high quality cash flows from the here-to-stay tech sector versus the highly cyclical, steeper yield curve-linked cash flows from European Banks.
2. If we peek into the scary quadrant 4, the EUR/USD embedded short should make money and also long duration Nasdaq should hold on better than European Banks on a relative basis.
If I go only with short European Banks, I am hoping into Quadrant 4 only. If we stay in secular quadrant 1, European Banks can also trade sideways without providing any P&L to the trade. Adding the long Nasdaq improves the risk/return of the trade, imho.
I don't quite get point 2 though as I must be missing something. In quadrant 4 isn't that going to be a 'classic' risk-off event and in fact all get hammered also the Nasdaq. And in risk-iff wouldn't the banks do better as they are a flight to relative quality and do better? Clearly that's not your analysis. It it something to do with a flattening of the curve then which is painful for banks specifically?
In a risk-off environment, I expect the relative value performance between Nasdaq and more value driven indexes like Euro Stoxx Banks or Russell to be positive, i.e. tech to outperform value/cyclical.
This is because banks or companies in the Russell need earnings and a steeper curve to do well, while companies in the Nasdaq are seen as high-quality, long duration bond proxies.
Good article. The public sector debt can be sustained indefinitely and eroded by keeping rates below inflation. Don't think you mentioned the extent of the private debt but agree private section will pay off or save public deficits.
The ageing workforce should be offset by technology / AI / machine learning ... etc plus medical service job growth.
Given this - is it not business as usual expect perhaps now we move into greater public deficit spending / MMT with a monitory issue down the line.
Euro banks are in a downtrend on daily but not on weekly timeframe (would need to close below low of week April 19 2021. Source : SPDR® MSCI Europe Financials UCITS ETF
The NQ is up on NQ100 cash immediate target is 16051.
So I think reasonable trades - yes if one has access to market to short EFT/CFD
Hi Alfonso, thanks for sharing your analysis. A question about the trade. Does the monetary quantity on both nasdaq and bank futures have to be equal? So about 66 bank futures? Correct? Thanks
Hi Giulio. I did it equally weighted, but in theory the trade can also be done beta weighted for the volatility. In that case you should sell approx 0.7x quantities of Euro Stoxx Banks future for every 1.0x Nasdaq future you buy.
- timing to switch quadrants, especially if your performance is judged on a monthly basis as The Macro Compass is not that accurate in the exact timing but very much on the medium term direction
Hi JM! Observed real rates are a blend of Fed Funds adjusted for the Fed long-term inflation target (at the moment: -2%) and 5y forward 5y real interest rates based on swaps and inflation expectations (also pretty negative at the moment).
I agree that demographics are totally different in the 1940s vs the 2020s: it was inflationary back then whereas it is deflationary today.
However, there is a new inflationary factor today we didnt have back then: easing Fiscal policies funded mostly by the central banks, and a little bit by tax hikes. UBI, student debt condoning, helicopter money, minimum wage increase, etc. It seems like the West is taking a political turn towards these type of practices. I dont know whether to label them as inflationist or currency devaluationist, but the end result seems similar: lower purchasing power.
Wouldnt those type of policies favor hard assets for the following years?
All the policies you mention could potentially be inflationary, assuming the private sector does not offset them or the government does not drain resources from the private sector (with taxes later on, for example).
I don't think authorities are ready for a full fledged MMT, so I would also caution about assuming this is a 100% probability going forward.
Hello Sir! New subscriber and I’m really glad I did. Ton of great information (especially for a retail investor). I have read a lot about the whole secular inflation vs deflation debate and each time my mind gets even more confused. What are your thoughts on the permanent portfolio as a means to cover all bases?
25% Stocks
25% Gold
25% Cash
25% Long US treasuries (TLT)
Or how would you adjust it for the “buy and hold” investor. Thank you so much in advance.
The portfolio you depict is little exposed to risk premium, effectively only with the 25% in stocks. Earnings grow at about 4-7% per year on average, and I don't think one can afford not being invested in a positively skewed long-term market like equities for at least 40-50% of his portfolio (especially if still relatively young person).
25% cash is a very expensive optionality to own: it costs you -2% negative real yields + wealth taxes.
As a buy and hold investors, I'd skew the portfolio less towards cash and more towards stocks.
Thank you so much for your reply, Alfonso! That makes a lot of sense. My last question (I promise), is if you see the same type of growth in tech stocks (thinking large cap US tech) in the next 3-5 years given their strong balance sheets, cash flows etc or is something more like the total world fund (VTWAX) better for what you see materializing in the future? Thanks again
Hi Alfonso, ok, so regarding your thoughts on the 2020's v the 1940's.
I can agree that the Fed will do everything in its power to maintain negative REAL rates certainly over the medium term, say 3-5 years.
I think your idea that this will come from negative NOMINAL rates is way off base. It just is not in the American DNA to even contemplate negative NOMINAL rates - heck they'd rather give up their guns! These Americans are not Europeans or Japanese.
I think inflation, and not runaway inflation but around target, sometimes up to 5% like now, sometimes back toward 1%, will do most of the work of creating the negative REAL interest rates. An inflation target of 2% and very low Fed Funds nicely achieves your negative REAL rates.
Now whether you want to own 30 year debt in that environment... I will leave that up to you to decide. Certainly it will move around. I would be long rate vol especially given it's current level.
No argument with your thoughts on LSG and TFP. Medium term US growth will certainly be
considerably lower than the 40's. I like your line of thought that the Feds medium term dot is roughly R* plus the inflation target. So potential REAL growth is around a half to one percent., policy is about the same and inflation at target -> negative REAL rates.
Good luck with your trade but I have to say it's the antithesis of what I'm thinking.
Great article! Thanks.
My pleasure
Thanks for other fine article. Three more differences between the 1940’s and today: 1) YCC was paired with austerity. Everything valuable to the war effort was rationed. 2) In the US, Medicare and Medicaid did not exist. Social Security was new, small, fully funded and not considered an entitlement. 3) The war effort took Americans to their highest peak of social cohesion. It’s at the second lowest point today. Only the American Civil War was lower. Try austerity today and you’ll see social unrest that makes 2020 look like a Girl Scout picnic.
Agree!
Hi Alfonso, Thanks as always for helping me understand and tie the pieces together. It's been a couple of months since this update--are we still in Quadrant 1 and/or where do you see us now? Would Fed tapering push us down to Quadrant 4?
Hi Carl, thank you! I will be updating the model over the next few weeks :)
Thank you!
Good day Alfonso,
If: we attempt to achieve "[poor] structural growth" by "expanding credit" but the "private sector does not want to borrow more, and banks don’t lend";
Then: I understand the short leg of the trade.
But: how does it make one confident on the long leg of the trade? Is it because of the short maturity of it (1 to 2 months), relying on the lagging effect from the previous quadrant we were sitting on?
I am very grateful for your work, please keep up on the high value content, I feel it getting from good to better with each article.
Hi Levy!
Interesting comment, let me explain.
The long leg of the trade is useful for two reasons.
1. If we remain in the secular quadrant 1, Nasdaq will outperform European Banks on a relative basis - the trade will make money. Even if Nasdaq drops, as long as European Banks drop more I am ok with it. The secular trends are clearly favoring long-duration, high quality cash flows from the here-to-stay tech sector versus the highly cyclical, steeper yield curve-linked cash flows from European Banks.
2. If we peek into the scary quadrant 4, the EUR/USD embedded short should make money and also long duration Nasdaq should hold on better than European Banks on a relative basis.
If I go only with short European Banks, I am hoping into Quadrant 4 only. If we stay in secular quadrant 1, European Banks can also trade sideways without providing any P&L to the trade. Adding the long Nasdaq improves the risk/return of the trade, imho.
Hi Alfonso. Very interesting thanks.
I don't quite get point 2 though as I must be missing something. In quadrant 4 isn't that going to be a 'classic' risk-off event and in fact all get hammered also the Nasdaq. And in risk-iff wouldn't the banks do better as they are a flight to relative quality and do better? Clearly that's not your analysis. It it something to do with a flattening of the curve then which is painful for banks specifically?
In a risk-off environment, I expect the relative value performance between Nasdaq and more value driven indexes like Euro Stoxx Banks or Russell to be positive, i.e. tech to outperform value/cyclical.
This is because banks or companies in the Russell need earnings and a steeper curve to do well, while companies in the Nasdaq are seen as high-quality, long duration bond proxies.
Good article. The public sector debt can be sustained indefinitely and eroded by keeping rates below inflation. Don't think you mentioned the extent of the private debt but agree private section will pay off or save public deficits.
The ageing workforce should be offset by technology / AI / machine learning ... etc plus medical service job growth.
Given this - is it not business as usual expect perhaps now we move into greater public deficit spending / MMT with a monitory issue down the line.
Euro banks are in a downtrend on daily but not on weekly timeframe (would need to close below low of week April 19 2021. Source : SPDR® MSCI Europe Financials UCITS ETF
The NQ is up on NQ100 cash immediate target is 16051.
So I think reasonable trades - yes if one has access to market to short EFT/CFD
I'm new to your work and am loving it. Many thanks.
My pleasure, Bruce!
Hi Alfonso, thanks for sharing your analysis. A question about the trade. Does the monetary quantity on both nasdaq and bank futures have to be equal? So about 66 bank futures? Correct? Thanks
Hi Giulio. I did it equally weighted, but in theory the trade can also be done beta weighted for the volatility. In that case you should sell approx 0.7x quantities of Euro Stoxx Banks future for every 1.0x Nasdaq future you buy.
Alfonso have you back tested your model and what do you think your blind spot is?
Great question. I think the blind spots are:
- timing to switch quadrants, especially if your performance is judged on a monthly basis as The Macro Compass is not that accurate in the exact timing but very much on the medium term direction
- estimates of r* can of course be wrong
Hi Alfonso. What constitutes the "Observed Real Rates" when looking at whether or not rates are constrictive or not? Thank you.
Hi JM! Observed real rates are a blend of Fed Funds adjusted for the Fed long-term inflation target (at the moment: -2%) and 5y forward 5y real interest rates based on swaps and inflation expectations (also pretty negative at the moment).
Hello Alfonso, very interesting read. Thank you!
I agree that demographics are totally different in the 1940s vs the 2020s: it was inflationary back then whereas it is deflationary today.
However, there is a new inflationary factor today we didnt have back then: easing Fiscal policies funded mostly by the central banks, and a little bit by tax hikes. UBI, student debt condoning, helicopter money, minimum wage increase, etc. It seems like the West is taking a political turn towards these type of practices. I dont know whether to label them as inflationist or currency devaluationist, but the end result seems similar: lower purchasing power.
Wouldnt those type of policies favor hard assets for the following years?
Hi Hector!
All the policies you mention could potentially be inflationary, assuming the private sector does not offset them or the government does not drain resources from the private sector (with taxes later on, for example).
I don't think authorities are ready for a full fledged MMT, so I would also caution about assuming this is a 100% probability going forward.
Do you think the war on carbon will change someting?
Hello Sir! New subscriber and I’m really glad I did. Ton of great information (especially for a retail investor). I have read a lot about the whole secular inflation vs deflation debate and each time my mind gets even more confused. What are your thoughts on the permanent portfolio as a means to cover all bases?
25% Stocks
25% Gold
25% Cash
25% Long US treasuries (TLT)
Or how would you adjust it for the “buy and hold” investor. Thank you so much in advance.
Hi Troy, my pleasure! Happy to have you here!
The portfolio you depict is little exposed to risk premium, effectively only with the 25% in stocks. Earnings grow at about 4-7% per year on average, and I don't think one can afford not being invested in a positively skewed long-term market like equities for at least 40-50% of his portfolio (especially if still relatively young person).
25% cash is a very expensive optionality to own: it costs you -2% negative real yields + wealth taxes.
As a buy and hold investors, I'd skew the portfolio less towards cash and more towards stocks.
Thank you so much for your reply, Alfonso! That makes a lot of sense. My last question (I promise), is if you see the same type of growth in tech stocks (thinking large cap US tech) in the next 3-5 years given their strong balance sheets, cash flows etc or is something more like the total world fund (VTWAX) better for what you see materializing in the future? Thanks again
I own the MSCI World rather than a single sector, but being a market-cap weighted index tech is very heavy in there anyway.
Short-term, I believe tech will outperform other sectors again.
Hi Alfonso, ok, so regarding your thoughts on the 2020's v the 1940's.
I can agree that the Fed will do everything in its power to maintain negative REAL rates certainly over the medium term, say 3-5 years.
I think your idea that this will come from negative NOMINAL rates is way off base. It just is not in the American DNA to even contemplate negative NOMINAL rates - heck they'd rather give up their guns! These Americans are not Europeans or Japanese.
I think inflation, and not runaway inflation but around target, sometimes up to 5% like now, sometimes back toward 1%, will do most of the work of creating the negative REAL interest rates. An inflation target of 2% and very low Fed Funds nicely achieves your negative REAL rates.
Now whether you want to own 30 year debt in that environment... I will leave that up to you to decide. Certainly it will move around. I would be long rate vol especially given it's current level.
No argument with your thoughts on LSG and TFP. Medium term US growth will certainly be
considerably lower than the 40's. I like your line of thought that the Feds medium term dot is roughly R* plus the inflation target. So potential REAL growth is around a half to one percent., policy is about the same and inflation at target -> negative REAL rates.
Good luck with your trade but I have to say it's the antithesis of what I'm thinking.
cheers, Karl.
It's ok to agree to disagree, Karl. It's what makes a market :)
I think the US will fight hard before giving in to negative yields, but I expect them to be forced to somewhere in the 2020s.
Great post! Thank you so much for sending this out.
What about the positive effects of Capex which hasn't really picked up yet?
Also, given the high (2000ish) valuations in the components of the Nasdaq 100, do you think Quadrant one could be a sell everything event?
I get the low nominal (neg real yield) is a positive for long-duration assets such as tech but in Quad one, I would assume everything sells off, no?
Thanks again!
Hi JM!
That's Quadrant 4, when credit impulse decelerates and Central Banks are on a relative net tightening path.
Quadrant 1 is about secular trends, and generally portfolios equipped for that make money.