Behavioral Macro

We are probably still in the sweet spot for the emerging market cycle. This doesn’t exempt us from the risk of corrections. It doesn’t eliminate geopolitical flare ups, trade war rhetoric, or the macro scare du jour. And it doesn’t make September/October calendar effects any less scary. But it does mean if you are an investor the wise choice is to stay in, stay the course.

(Pro memoria: the dominant error in professional investing is over-forecasting corrections and then chasing bull markets from a position of weakness.)

I’ve given the reasoning for this view here, here, and here. And my broader views on central banks and currency markets are laid out here. Basically, it all boils down to:

1.       At this point in the global risk cycle the US looks mature and investors go abroad

2.       The Fed is closer to its terminal policy rate than expected; other CBs are at the front end of their normalization processes

3.       Investors desperately need yield, and emerging market currencies have it

4.       Country differentiation is less important than asset allocation  

And demand is strong. I continue to hear of managers wanting to get into the space and/or increase their allocation, while, as PIMCO points out, local markets deepen.

Technically, the picture is strong. USDTRY and USDCLP have already broken down. It is likely that currency pairs like USDMXN, USDBRL and USDINR are to follow. Here are the charts:

Turkish Lira

Chilean Peso

Mexican Peso

Brazilian Real

Indian Rupee

I have a childhood friend who loves to rant and complain so much that I jokingly preface giving him good news with an apology. The market feels very much like this right now. The overwhelming sentiment is “cautious”, “we are due”, “valuations are unsustainably high”.

But the truth is our collective memory of the GFC has made sentiment a countercyclical stabilizer, stretching out both the financial risk cycle and the economic cycle. Every time we get a little confident or frothy, the scolds come out and remind us of our 'irresponsibility' and we all slow our roll for a little while and digest gains.

Credit managers have been suffering for years now. Yeah, I know that sounds strange given the run credit markets have had. But the truth is they’ve been suffering from sticker shock since 2011. “But what can I buy at these levels?” has been their constant refrain. Many have been underperforming their benchmarks and bogeys for years.

How did they fall into this trap? Start with the chart of the BBB spread over the last 15 years. 

Credit managers have anchored on spread levels and yields from the strong phase of the last risk cycle, 2004-2007. Spreads then were 110-130bps. Today they are 138bps. Five-year BBB yields then were 5-6%, whereas today they are 3-3.5%. Credit managers have been forced into chasing yields lower and lower for the last 5 years.

What they’ve been overlooking is the risk free rate. The 5 year risk free rate averaged around 4% from 2004-2007, and now we are at 1.8%. If you look at how much risk-free yield (opportunity cost) you are giving up to collect extra spread, it becomes obvious that a spread of 138bps is far, far cheaper when the risk free rate is at 1.8% than when it is 4%. Spread-to-spread comparisons just don’t make sense. Yet that’s what we keep hearing. It’s kind of shocking, really, how many professional managers--especially those with a lot of experience, paradoxically--have been blinded to this simple but powerful consideration.

The forward points on BRL and MXN show, approximately, a 6% breakeven depreciation over the next 12 months. Or, in other word, 6% carry. If you believe emerging markets are in the early phases of the same kind of slow, muddle-through recovery we have seen in the US and increasingly Europe, it is hard to imagine spot underperforming the forwards as a longer-term investment proposition. This is the phase of the global risk cycle where the desire for returns is very high but the forward-looking scope for returns in the US market appears limited.

It also looks to me as though there is still tons of scope for further “normalization” from the unwind of the EM bear market.

Up until recently oil stocks have been about playing/gaming some type of normalization from the 2014-15 crash. Mostly, repeated attempts at knife catching. Over this past month or two it seems investors are finally looking a little beyond this and starting to price in the secular challenges facing global oil supply & demand.

1.       Electric car dominance is no longer a question of “if”.

2.       The fuel intensity of global growth continues to decline, as emerging economies catch up with the well-established trends in the advanced ones.

3.       Extraction technologies have become vastly more productive and less expansive.

From an investment standpoint, this is a headwind—whether the price of oil is rising or not. If the price of oil were to rise, no doubt oil stocks would also, just probably with a lower beta to it. It makes the sector a much less attractive risk-reward proposition, despite how beaten up it has been.

I’m trying something new.

I’ve been looking for months for a better way to share my core competency: global macro investing and trading. My public twitter account and blog no longer reward my effort the way they did when I started tweeting, disincentivizing thoughtful output. And I’ve got tons to say about patterns, narratives, correlations, investor reaction functions, position sizing tricks, portfolio construction, managing mental capital, fundamentals, etc. I live for this game.

So, I was pretty happy when I stumbled onto Premo, the brainchild of the folks at the Bespoke Investment Group. Through Premo’s new platform, I have set up a private, subscription-based Twitter account, @BehavioralMacro, and expect to add to it a locked blog in the near future. It will be all global macro, all the time. And for those of you who’ve followed me on my public Twitter feed, @mark_dow, you know what I mean when I say all the time. There will be no dog pics, no cat pics, no politics, and no puns, either. The focus will be exclusively on reading market trends, patterns and sharing my macro trading/investing processes.

Becoming a follower is easy. Once you subscribe at my @BehavorialMacro profile page on Premo, it’s done. You’re immediately added as a new follower. You can cancel the subscription at any time on Premo as well. Couldn’t be easier. I’ve already been posting to the new feed for over a week, so you should be able to get a sense of what I want to accomplish right away. Most of it will be about process. Some of it will be actionable, but the focus will not be on specific trade recommendations or a blow-by-blow of what I am doing with my portfolios. It will be about sharing my tricks, techniques and frameworks for reading markets and managing global macro risk.

DMs will be open, and I’m going to use the feed to engage as much as possible.

The subscription will be set at $30 a month—at least at the outset. Targeting institutional investors would allow me to charge considerably more, but it would then not be accessible to motivated individuals who want to piggyback on my experience to get up the learning curve faster. If I were to price it too low, I would be basically giving it away to a market segment that could and should pay more. From preliminary discussions, I suspect the price is more likely to be adjusted up rather than down, and, at some point, I may want to cap the number of followers, but it’s really too early to say for sure. I want to be responsive to how things unfold. I hope you bear with me through the trial and error. 

I’m excited about this new experiment. It should allow me to better share my skill set. The platform looks cool. I hope you’ll give it a try. To join, you can subscribe below:

I know everyone likes EM. I know it has had a great run the last 18 months. I know the Fed is reducing its balance sheet.

But consider this:

1.       EM had a prolonged bear market, and large allocators are always slow to get back in after a cyclical bear. Expressing bullishness and acting on it can be very separate things.

2.       The EM cyclical bull is on—albeit much in the same muddle-thru way we saw in the advanced economies. Expect ‘slower for longer’. It was a global credit boom, and we are experiencing a global, asynchronous, muddle-thru recovery.

3.       This is not your father’s Emerging Markets. It’s well past time to give up on the generational blowup he bought his beach house with.

4.       Other major central banks are far earlier in their monetary tightening cycles than the Fed is—and the Fed (and markets) have just penciled in a lower terminal federal funds rate—again.

5.       This is very bearish the dollar—ergo bullish EM. Moreover, the other factor holding back EM bullishness has been the fear of what higher US rates might do to the asset class. This fear too has lessened considerably.

6.       Others have been unwilling to chase and have been ‘waiting for a pullback’. Well, we just had one and it was so shallow and fleeting (common at the beginning of bull cycle) that few got the chance to wet their beaks. And, to quote from the Trader’s Bible: “They’re panicking out there right now, I can feel it”.

7.       EM indices all over the world are breaking out to new highs (pick one).

8.       The dollar (to my eye) seems to have made a blow off top in the wake of the US election (red circle). Lots of scope for depreciation.

9.       Long term EM currency charts suggest massive room for further appreciation. Here are a couple from our backyard (they also have tons of carry):

10.   European rates are now rising faster than US rates. If this really is the moment where markets recognize that Fed normalization is closer to its end and ECB normalization is just starting, this is likely to persist. 

The Great Financial Crisis shook a lot of trees and made many economists/investors/traders go back and question first principles—at least it should have. Here’s a quick list of Things We Should Have Learned by Now:

1.       Potential growth in developed economies is lower than it was before the GFC. And policy can’t do as much about it—whatever your policy inclinations—as we’d like to think. 

2.       The interest rate sensitivity of economic activity is far less than was believed to be the case.

3.       Printing money can cause inflation, but doesn’t always. Asking what are the conditions under which it is likely to, and if those conditions obtain, is the smart question. 

4.       The economic channel of monetary policy and financial channel of monetary policy have to be thought through jointly and separately, and often have very different requirements and equilibrating dynamics.

5.       Oil matters less. It didn’t help the consumer as much as forecast when it fell, and didn’t hurt GDP as much as others suggested, either. Oil intensity of GDP or share of consumption basket is far lower than the levels most observers—consciously or unconsciously—had anchored on.

6.       The overall commodity intensity of output has declined significantly and will continue to do so. It is in some sense the very definition of technological advancement.

7.       Commodity markets (IDK about softs) are driven in the first instance by speculation, which regularly overwhelms fundamentals.

8.       Inflation/wage impulse per increment of GDP has been systematically lower than thought. And transitory shocks are often, well, transitory.

9.       EM has structurally changed—for the better.

10.   Government intervention is a necessary evil in a financial crisis. What’s desirable isn’t always feasible. Path dependency is dominant. And circuit-breaking the self-reinforcing downward spiral of panic is essential.

11.   The bond market—in both shape and level—has been telling us very little about US economic prospects/activity. However, short-term changes do inform us as to the prevailing narrative.

12.   Economics should be used for diagnostic purposes, not predictive ones.

13.   Very few investors/traders can disentangle their political preferences from their economic analyses. Systematic traders, disciplined risk managers, and passive investors have a big advantage in this regard.

14.   The Mexican peso is not a petro-currency; Mexico imports more petroleum products than it exports.

These are my views of where we are in markets right now:

1.       The Fed is more committed to the abstract notion of normalization than the market, still, in the aggregate, gives it credit for.

2.       We now know with very high likelihood that they want to start with the balance sheet reduction ASAP, and will, in the first instance, push hikes out further as need be to see how well it goes.

3.       Grinding global growth (by historical standards, not recent ones) is likely to continue as global demand continues to work its way out from under the Global Credit Boom. This means the ECB, BOJ, and BOE will be talking more, not less, about their own normalizations. And they too would love to normalize.

4.       Central banks normalization, New Normal-style global growth, and EM muddle-through is likely to be the dominant backdrop theme for the foreseeable future.

 The implications of these beliefs:

1.       On balance, a weaker USD. The US shifting to the balance sheet from rates as the front-burner tool, and global CBs ‘catching up’ to the Fed are the major drivers. EUR, AUD, EM all good. The positioning/psychology in the USD doesn’t strike me as too extreme, so USD weakness doesn’t have to be dramatic.

2.       Bond yields should go higher in Europe and be flat-to-marginally higher in the US. The ECB catching up with the US should bring European yields up off the floor, but the Fed pushing out rate hike should take the pressure off fixed income sellers, who have been under a little bit of pressure of late. I don’t think, in the event, the tapering of Fed reinvestment will have a material impact of yield levels over the short-to-medium term.   Only longer-term, when the taper might be faster and the cumulative amounts greater, should we see any discernible impact.

3.       Weakish USD and weakish bonds put precious metals in a box. They tend to respond positively to the former and negatively to the latter. Of the two, they tend to be more responsive to bonds than the big dollar, but both matter.

4.       Central Bank normalization means they have won and the doomsday scenarios lost. Basically. This too drags on precious metals over time.

5.       Grinding global growth means ‘slower for longer’ in the equity market. Up over time with earnings, down with the occasional (and lately infrequent) corrections. Not sexy. But positive —more positive than prevailing market sentiment at least--and certainly not tragic.

Long-term chart of $EURXAU (long euro, short gold):

AUD over the past 5 years:

I just sent out these brief market thoughts to my favorite client (Of course I say this to each of my small number of clients. I learned this from the Sell Side). 

Here they are:

--Market sentiment is not massively bearish. It seems mostly anxious and confused, though with an identifiable bearish hue. The overall set up going into the best seasonal part of the year is good. Good-to-quite good.

--The US continues its recovery with subpar growth and low (but growing as a function of time) odds of a recession.

--EM has begun its L-shaped recovery. I still like EM local ccy bonds more than equities, but EM equities over DM equities should work over the longer term too. Too many got caught out betting on the kind of EM washout many of us cut our teeth on. Many quietly still cling to that view. IMO too many things have changed for that to be the base case.

--I expect funding ccys vis-á-vis the dollar to decline somewhat, but risk ccys (EM) to appreciate gradually. The combo of L-shaped recovery and reach for yield will attract flows back to EM local ccy bonds now that the long bear market appears over.

--I don’t fear the Fed that much but from time to time fear others’ fear of it, contingent upon sentiment and positioning at those points in time. Why? Because IMO equity levels today are much less propped up by the Fed than the market is inclined to believe. The average investor doesn’t seem to understand the transmission mechanism of monetary policy any more than s/he did before the GFC.  Plus, investors systematically overstate the role of the price of money in risk appetite. Moreover, the obsessive lookout for bubbles kicks in periodically to help keep bubbles in check. Nonetheless, it is good for the Fed to have put FinStab on their radar last year because excessive risk build up is a positive function of time and we are inching in that direction, as memories of the GFC slowly fade.

Over the post-GFC period, I’ve made many references to a new, structurally lower rate of growth in the US and in the other highly developed countries. Prompted by an interview last week with ETF.com, a tweet by @reformedbroker, and the Fed’s growing recognition of the phenomenon, I took a sec to boil it down to three paras. Because popular expectations are still being calibrated on the old reality, the message, IMO, can’t be stressed enough.

Why has the rebound from the great financial crisis been so tepid, so modest? In short, there are demographic, technological and globalization trends below the surface that we papered over for a long time with global credit boom. Median income hasn't been good for a long time in the U.S., but we didn't notice it because we had access to progressively more credit. Our growth numbers seemed faster as a result, and we felt richer. But the underlying growth rate was deteriorating.

Under the surface several things were evolving. The baby boomers were getting older and less productive. The US labor force was barely growing. The effect of women coming into the labor force had maxed out. At the same time, China joined the WTO, and fresh flowers that once had to be locally sourced, could now, thanks to supply chain technology, be brought in from Ecuador overnight. Technology and globalization worked together to create, effectively, a huge supply shock to the US labor market, dampening our growth rate and wages. As a result, the lion’s share of US growth accrued to those who controlled capital.

In April of last year, the market didn’t seem to be picking up on fairly heavy Fed hints about its thinking, so I wrote a quick post entitled Avalanche Patrol. This morning a friend asked me if I’d update the concept. Given that we just hit another patch where the market was again caught out shrugging off fairly heavy Fed hints, I though I would take a sec and post my response.

The biggest variable that's changed is 'remaining slack' in labor market is now a live debate in a way it wasn't in April of 2015. The uptick in wage growth, while low relative to the impulse we've received from job growth, is real.

However, the main reason many of the members are antsy to get off of war footing is still the understanding that financial stability risks are a positive function of time. I don't think they believe there are systemically significant areas of excess in the US at present. They just want to stay out in front of that risk as best they can this time around. We're not the only ones suffering from PTSD. 

In short, they need/want to hike ASAP in their minds but know they can only do it when there is a very, very low probability of having to reverse later. And the Fed knows there are still questions about slack, whether inflation will come back as much as they hope post-oil stability, and weakness/potential instability in the global economy.

The final thing that some on the Fed are mindful of is that the level of policy rates (within reason) is not as much a deterrent to leveraged financial risk-taking as uncertainty about the path (Just compare the risk-taking in 2005-06 with Fed Funds at 5% relative to post GFC with rates at zero). I'm not sure the freshwater guys get this; they tend to focus more on the level of rates, because that’s what theory has pounded into our heads for the past 25 years.

So, with the above, what would you do in their shoes? I know what I would do: In my talk, err on the side of hawkishness to signal my intent; in my actions, err on the side of dovishness until the issues of slack and oil price drop out become less ambiguous; and, finally, keep market participants from getting complacent with Fed path and don't let them run too far with errant narratives (which can feed on themselves), 

It looks very much as though Brazil is about to impeach Dilma. In a country with a system of governance as deeply flawed as Brazil’s, it would be too much to expect that whoever comes next will simply flip a good governance switch. Yes, Brazil has had the occasional bout of good governance, as it did in the under Fernando Henrique Cardoso, but to old EM hands and Brasileiros this seems to have been the exception to the rule.

However, without getting into the weeds, there are two reasons why it would be wrong to assume things will automatically get worse. One, traumatic change tends to breed honeymoon periods. Hard to imagine there wouldn’t be a sense of relief—at least in the short term. Two, Brazil’s next leader is unlike to be the next FHC, but he or she will have degrees of freedom to jettison policies that didn’t work—including ones that even Dilma no longer liked but couldn’t afford politically to change. In short, a kitchen-sink-under-the-bus dynamic will provide political cover for a decent amount of low hanging policy fruit. And given the starting point of post five brutal years, the fruit tree is heavy, and deeply negative investor sentiment is ripe to be wrong footed.

I often have exchanges with old friends who are institutional HF managers. I’m lucky to have such a sharp, experienced and dialed-in network. Sometimes I clean up my side and post it. Here’s the latest stream of consciousness on the current state of risk over the medium term. It lacks nuance and respectable syntax. But I hope you can still infer the questions and arguments that provoked it. And I hope it’s helpful.

Thanks for your thoughts. I think the rolling global deleveraging we're going thru keeps a loose cap on Fed rate hikes. Also think the Fed wanted to get a hike on the books to shake the risk tree early and get out in front of growing financial stability concerns, what I call 'Avalanche Patrol'.

On oil, not sure where it goes, but the correlation to other assets has been dropping and guys have stopped trying to trade every tick. For me, this opens a lot of encouraging doors. I'm looking to a flip to positive in the euro and SPX corr to confirm USD M-T top. Could even happen w/o it, but I suspect not.

I think the selloff in equities was recession fear coupled with 'QE coming out of system fear', splashed with negative rates. Agree no recession, but I think the QE coming out of system was a scare, not a reality. It never really went into the system in the 1st place and the economy/earnings have largely caught up with asset markets. The effect beyond pockets of fixed income was mostly psychological, IMO. The new-found 'impotence of the Fed' argument is a reflection of that. The money trade last 8 yrs has been fading fear of Fed, and I think it still is; it's just to a much lower degree these days, as many have figured the transmission mechanism of monetary policy out by now.

Chinese depreciation is likely. Agree they need it. Dollar unit labor costs went up massively there. A euro rally would take much of that pressure off. Muddle thru way more likely than collapse.

The deval play in CNY IMO is not a good one. The ‘they’ll be forced to print and this means big depreciation’ story has too many holes in it, empirically, for me to even start rebutting here. China will go slow and take every precaution not to do anything destabilizing. This has long been their MO. And the outsized reaction to their small Aug. move scared them.

Also, much of my broader view on risk assets is really about how much sentiment swung. The breakout in things like iron ore and AUD is much more about reversion from extreme sentiment than identifiable fundamental change. But it could run a long way--possibly long enough to give fundies a chance to come around. Late last year I started saying it was too late to short EM and commodities, and now, at this stage, I want to be with it, not just not against it.

Agree Brexit has long term implications for the EU--which is L-T unsalvageable--but I don't think it would be a huge market mover in the near term: if it happens it will have largely bled in prices by then. The really bad stuff in EU (I think) will now be well into the future and driven by politics, not market-induced financial shocks. ECB et al have finally got out in front of this concept.