Why Risk Appetite Is Back | Alfonso Peccatiello, Michael Kantrowitz, Andy Constan & Jack Farley

Hello, hello, this is Jack Farley, host of the Forward Guides podcast on the Blockworks Podcast Network. Soon we'll be joined by Alfonso Peccatiello, author at the Back Row Compass, and he also has a podcast, Macro Trading for Floor on Blockworks. We will be having a conversation at the Blockworks Digital Asset Summit on September 13th and 14th, called the Macro Crystal Ball. I'll also be interviewing Alf, Daniel DiMartino Booth, Mike Green, Yuri, and Timmer. So this conversation is sort of meant as a primer for he and me and Al to catch up, see what he's thinking about in markets. I think the narrative from the very beginning of the year until, let's say, June 15th was pretty easy to describe in terms of inflation rising, inflation expectations rising, although those debated it earlier, and basically the Federal Funds hiking of monetary conditions all across the yield curve, but particularly on the short end, and that sort of fomented a sell-off in risk assets, in credit, so spreads rose, but mainly it was that risk-free component. So the Federal Reserve, in my view, was at the forefront of the sell-off. And of course, since June 15th, we've had a pretty stunning reversal. But stunning is too dramatic a word. I was just looking at the NASDAQ ETF, the QQQ, is up something like 18% since June 15th. So I wanted to ask Alf, why is that the case? Why does he think the market has been rallying, and what's he seeing going forward?

Yeah, so I was just saying the markets rallied in an epic fashion since mid-June. What do you attribute that rally to? And later on, we'll get into whether you think it's sustainable. But if you had to list two or three main reasons for that rally, what would you say? So there were probably two. I would say the first one was that investors interpreted the July FOMC statement as a higher likelihood that the Fed isn't going to keep blindly hiking. That was the interpretation. And as this happens, Jack, effectively the first thing you do as a macro investor is to reprice down real yields. Because if the Federal Reserve isn't going to keep being tight for long, then real interest rates across the curve do not need to be priced as restrictive. Restrictive means mildly positive interest rates in the US. Now, when you reprice down real interest rates because the Fed is apparently telling you that there will not be that very long-lasting restriction that they were predicating before — at least this was the market interpretation — this leads to several things being mispriced. Obviously, the first one being equity valuations. If you believe the three-month rates are going to be lower and assume the same level of risk premium in the economy or in markets, then you will have equity valuations repricing too. You will have gold repricing. You will have anything that is very much real-yields-related and valuation-intensive being related to asset repricing. So it was basically a repricing of the probability distribution of Fed outcomes going forward, not leaning towards the super hawkish side anymore, but a much more nuanced power. And if power is nuanced, effectively it means that he looks at inflation data, and as long as you see some economic deterioration as well, it's going to be more leaning towards softening his stance. Then you can also price in a lower probability that he is going to be rigidly hiking going forward. This impacts real yields, impacts valuations, etc., etc. The second part of the rally, though, was a bit different. The second part of the rally was a big gamma squeeze, slash volatility targeting funds, risk parity funds, and asset managers in general, which were pretty much under-allocated to risk. So that is a bit of a more technical part, but it's not very difficult to understand. Most of these funds out there that are targeting volatility use volatility as an input for their allocation and their leverage. And given that volatility had increased materially across assets, even in places where it was sleeping for years — effects and rates, for example, has increased so much — and correlations also didn't work anymore, so bonds and stocks went down at the same time for instance in H1. They effectively were forced to de-leverage their exposure because volatility as an input is going up. Then as a gross nominal exposure, you can have less obviously because your volatility otherwise will be too big compared to what your model tells you it should be. And on top of it, if correlations break down, this really doesn't help. So you add a lot of these funds that effectively had to degross of the leverage. And now the side effect of Powell telling us that he is not going to — he didn't tell us that we can discuss about that in the future, but in the later part of the call — but the market interpretation that the Federal Reserve isn't going to be so rigid in hiking anymore also led to some implied volatilities being crashed across the board. Effects volatility, rates volatility came down pretty aggressively. And together with the valuation expansion, that effectively led to some ability from these most targeted funds to re-leverage and to buy. And interestingly, you had the place where people were under-allocated the most actually rally the most too. So you had cyclicals at some point started leading, with the Russell outperforming the NASDAQ or the S&P. And you had emerging markets rallying, and you add meme stocks running, and you had high-beta stuff running, and homebuilders selling 30% from the lows, etc., etc. So that was the second leg of the equity repricing or the risk asset rally.

Thanks for that, Al. So two stages: the first, real yields falling; the second, volatility falling, and as a result, folks are able to take more risk. You mentioned volatility targeting. I know a lot of books about 2008, about how as assets fell and volatility rose, banks had to sell more in order to keep the amount of money that they would essentially lose in a day at the same rate. So if you're telling your investors that you want to have a fund and we're telling investors that we're within a 95% confidence interval, the maximum we can lose is 2%, and we're able to — and the VIX is at 40, if the VIX falls to 20, or the assets that we own, the volatility falls, we're able to take on a lot more risk because we're still able to fall within that mandate. Okay, so the second one makes a little bit of sense to me. And you definitely can see that in the sort of the dogs of the stock market, let's call them: the Carvana, the Netflix, like the worst — the last shall be first and the first shall be last. The assets that have really led the way down for the first half of this year have been leading the way up. We've seen AMC, GME, Bed Bath & Beyond go back. But let's talk about the real yields, because you're very familiar with the plumbing of the fixed income space. So real yields are inflation-adjusted, but they're not really inflation-adjusted by actual inflation but by forward inflation. So something that in the US, it's Treasury Inflation-Protected Securities, typically I think what the reference rate is. And then the sort of inflation that's projected is called the inflation breakeven rate. Why were real yields falling? Was it the nominal rates falling, which are in the short end really all about the Fed? And then also, why to some degree were short-term real rates — sorry, nominal rates falling because the Fed is going to pivot and we're all going to be happy? And then also inflation breakevens were falling at the exact same time. Is that it?

Actually, what happened there is that nominal yields started falling, especially at the front end, reflecting a Federal Reserve which isn't going to validate market pricing. This was the original interpretation from markets. And then on top of it, you had inflation expectations that actually rose. Because think about it, Jack: if the Federal Reserve isn't going to be really that committed to slow down inflation, that's what the market is going to be doing — pushing inflation expectations slightly higher. Because the very organization, the very central bank supposed to anchor inflation expectations down is actually easing down their stance. So there was a double whammy: yes, real rates at the front end went down because nominal yields went down and inflation expectations went up. Now, this was the first part of the rally, or it explains the first part of the rallying in real yields that then basically spurred a rally in valuations and valuation-intensive assets, or risk-sentiment-intensive assets — for instance, crypto as well was in that basket at the very beginning of the rally. What I found most interesting was that after that, Fed speakers came to the wires, and you had all of them, one after another, from Kashkari over the weekend all the way to Evans during the week, telling us, "Hey guys, sorry, but we didn't really mean that. We are not going to step off the gas pedal until we actually see some pretty solid results when it comes to fighting inflation. We want to see inflation all the way down to 2% convincingly. So don't get too much over excited. We try to maybe give you an inch, and you took an entire mile." So as you started hearing that, what happened is that the front end of the bond market had to reprice up. Because obviously, the Federal Reserve has quite an influence on front-end Eurodollar contracts and two-year Treasury yields because they influence that directly by monetary policy. If you're buying a one-year-ahead Eurodollar contract, you're basically looking at the next live or fixings over the next year, and that is highly influenced by the path of Fed funds right over the next year. Of course, there is some basis and LIBOR-OIS risk, but let's not talk about that. Big picture: the Fed can influence the front end a lot. So what they did there is they were able effectively to push back two-year yields to 3.20%, which is not far from the highs that we have had, about 3.4%, when the terminal rate was priced at 4% a couple of months ago. Now, what this has done is it has effectively pushed the real rates back to a little bit higher levels. But nevertheless, the equity rally continued, and it was led by cyclicals. So the second leg of the rally is what I found the most interesting. Because from a macro perspective, if you want to leave aside the volatility targeting funds, if you have real interest rates going up and you have the cyclical part of the spectrum leading the rally as well, that generally means that economic growth is getting repriced higher than expectations. It means that despite real yields being higher and still being in a slightly restrictive territory in the US — forward real yields are roughly 20-25 basis points in the US, even if those are above neutral estimates of neutral, and they are going up — you have the cyclical part of the stock market and the FX markets actually leading the rally. What that means from a macro perspective is that growth is being repriced higher. Or alternatively, there is no macro explanation for this, but there is a bunch of macro-insensitive price — let's say macro-insensitive buyers out there that are re-leveraging their books, they're getting squeezed on shorts, and they are re-leveraging the book up by buying exactly the same things that went down the most recently. And I think the explanation has to be the latter rather than the former, because all forward-looking and coincident indicators of economic growth are not painting a very nice picture. Just today, we had the Empire State — the Empire State manufacturing, the New York Fed basically manufacturing survey — coming out. And if you look at the sub-components of this survey, which I found very interesting, they depict a picture of four leading indicators. For instance, new orders or new orders to inventory. If you look at the sub-components, they are looking really bad. They're looking as bad as 2008. It doesn't mean necessarily it's going to be as bad as 2008 growth, but at least it tells you the magnitude of forward-looking economic indicators weakness is pretty big. On top of it, it's telling you that the employment side is also weakening — both hours worked and the amount of employees effectively went down. And don't forget the survey that asks about 200 CEOs in the state of New York what the prevailing conditions for business are in that area. So it should be relatively significant as a survey, and it's telling you that the employment side as well is weakening. So the more coincident part of the market, from an economic standpoint, also seems to not be doing very well. It wouldn't really back the idea that we are going to be seeing not only a soft landing but also perhaps slightly higher economic growth, as apparently it should be the macro explanation of the latest rally — lack of the rally in the equity markets. So I don't see, at this point to be honest, the macro picture and the data I use do not validate the second leg of the rally. I can easily — well, I can try to explain and rationalize from a market perspective the first leg of the rally. The second one, led by cyclicals, EM FX, and all of that, honestly makes less sense. It seems to be more a macro-insensitive buyer activity that generally tends to be — once exhausted, that's a difficult part to estimate — once exhausted, it tends to be a good opportunity to scale back into trades that are fitting the macro picture better.

Thanks for that, Alf. And when you say cyclicals, those are assets that are exposed to the economic cycle. So they do really well when the economy is growing, like let's say 2021, and they do really poorly when the economy is rapidly contracting, like let's say 2008. So what would those be? Because I follow oil pretty closely, but what has been going on? I don't know, cyclical like whether it's copper or non-commodity cyclicals as well as in the emerging market FX space. What's going on there? Because I know we are all "King Dollar" and DXY reached what, 108, 109, but it's recently backed off. So just give us a little bit more color into the cyclicals that you're talking about, the specifics, and then also the emerging market currencies.

So, Jack, what I do is I have a multi-asset class dashboard that basically looks at every single asset class out there and also about surfaces across asset classes, queues, etc., and it looks at volatility-adjusted moves. So what I did is I looked at the last month or six weeks, and I looked at what were the biggest movers in volatility-adjusted terms across asset classes, across geographies. And you know what stood up on my dashboard? The biggest winners over the last five or six weeks were credit spreads in Europe. So when I talk about technicals, we are talking about a relatively high-beta open economy like Europe, and also talk about credit spreads, especially high-yield credit spreads. So you are definitely talking about a risk sentiment but also economic growth-sensitive side of the equation. So credit spreads in Europe — really big moves in volatility-adjusted basis. I think over the last month, I have it in front of me, it should be like more than a three standard deviation move tighter — it's pretty big. Then you have the Australian dollar, which also did very well — now today it's taking a beating, but it did pretty well over the last month. Then you have the Russell, the Russell 2000, actually led the rally and also moved 15% up over the last month, which seems to be, according to my dashboard, almost three standard deviations. Then industrials did very well. The S&P Transportation ETF did very well. The S&P High Beta ETF did very well. The Brazilian real did very well. So those are all — for instance, the sub-sectors of the S&P I mentioned: industrial, transportation, and high beta. We're talking about all stuff that needs and breathes higher economic activity to generate the highest flows. Those are not companies that have large growth plans for the future where you can discount future cash flow 20 years down the road with decent probability and higher growth rate and network effects. Those are real economy, cyclical industries: industrial and transportation. And high beta also includes a bunch of more volatile stocks than normal, also relatively dependent on cyclical activity. All of those were the biggest winners on a risk-adjusted move over the last four to six weeks. So what this tells me is that definitely there was a leading side in the second part of the rally, which was again something I don't know if you have to justify it from a macro perspective. It has to be that economic growth has to be repriced higher, because if real yields are also high at the same time and nevertheless this stuff is rallying, it means that economic growth is priced to be higher. And honestly, everything I'm seeing on the screen right now screams basically the opposite. On top of it, it seems to be for the first time in a while that not only real economic growth is trending down, but also now that nominal growth might be trending down. That is a material difference as well when you go and look at asset classes, especially at bonds.

Okay, thanks Alf. Really interesting about the widening of European credit spreads. Why do you think credit spreads in Europe have widened? And what is going on across the pond? Perhaps some of the folks on this call may follow US economic data pretty closely, but I for one am pretty far behind the curve when it comes to European data. So how bad is it out there? I know that the energy pricing is quite bad. But what's going on there? Anything that stands out in terms of the European data?

Well, let's say the forward-looking economic indicators in Europe that I track have been looking pretty bad already since February or March. That was mostly a function of real incomes getting squeezed faster and earlier than in the US. So because in the US, the inflation story was much more, in percentage terms, a demand — an aggregate demand push story. It also translated into a pretty weak — a pretty tight labor market. And also, effectively because of the structure of the labor market being much more rigid in Europe than it is in the US, in the US this tends to translate into higher wage growth. So as you know, nominal wage growth was still good, below inflation, so real wages in the US were negative. But in Europe, it was much more negative because of rigidities in the labor market and because the inflation composition was much more energy and food driven than aggregate demand driven. And again, this is to be expected given the size of the fiscal stimulus in Europe compared to GDP was completely different than the size of the fiscal stimulus in the US. Obviously, when you have that happening, you have also, together with the energy squeeze in Europe which affected much more the European continent than the US, forward-looking indicators were looking pretty bad already early on. And now when you think of credit spreads and highly leveraged companies — I'm talking about, for instance, stuff that is set in the high-yield CDS in Europe. When you look at the constituents of this index, you have a bunch of energy companies, and generally those were relatively well supported because they could enjoy a decent pickup in free cash flows. But you also find a lot of leveraged companies with high-level business models that actually did okay over the last five to seven years because the online borrowing rate for a high-yield company in Europe was roughly 3%. I will repeat it: if you're a junk company in Europe between 2016 and 2020, you could borrow on average for five years at roughly 3% to 3.5%. This is extremely low as a nominal borrowing rate for a junk company. And this was basically the result of risk-free rates being extremely low and also priced to be extremely low for five to ten years in Europe throughout 2016-2020. And on top of it, ongoing QE that effectively made sure that people try to extend down the risk curve and bought credit spread as much as they could. So you had a combination of very low risk-free real rates and low credit spreads on top. Now, these companies were able to effectively carry on with their high-level business model despite pretty tight margins, mostly because of that. But the situation dramatically changed when the economy was already showing signs of weakness early on in Europe for the reasons I explained. And with a bit of delay, but later on, the European Central Bank also had to turn hawkish pretty quick, Jack. So you add this spike up — impressive spike up in high yields in Europe. Then now you're seeing reversing. So high yields have tightened. European high-yield spread tightened by 140 basis points in a month. It's pretty aggressive as a tightening move — it's three standard deviations in a month. And you are seeing these effectively as a re-leveraging trade. If somebody would show up to me, I would say, "I think these highly leveraged business models, while economic growth keeps deteriorating and it's very likely to deteriorate going further, and the energy situation hasn't materially improved since February — actually slightly worse than one might argue in Europe — I think those credit spreads should be macro-wise tighter. It can be justified from macro that these spreads are tighter. I actually have a hard time buying from Jesus." This is basically I think the outcome of re-leverage and carry is a great component into this trade. Because obviously, if you can buy 100% at 600 basis points and nothing happens in the meantime, you keep making money until something happens. So being short credit spread is very expensive, and the market took the opportunity to basically re-lever on this. This is the poster child for cyclicals leading the second part of the rally that has better to do — I think with macro and a lot to do with implied volatility coming down, carry being back in play. But I don't think the macro environment underlying supports this narrative for too much longer.

Yes, and just listening to you now, Alf, I can't help but think about the mismatch in some areas between the cost of capital and the return on capital. For example, I just saw in the Financial Times this morning that real estate developers — building office parks — they have to obviously borrow a lot of money. It's a debt business. And their costs are now higher than the money that they're getting from rent, which is the first time that has happened since 2007. So you can't — your borrowing costs in monthly terms could double, obviously depending on the loan and the structure, but you can't double rent. I mean, we've seen some pretty extreme rent increases in the US and probably around the world as well, but you can't double rent. Likewise, if you're selling a product that has inputs like copper, gasoline, your input costs can go up 60%, but it's pretty hard to double your prices. So what do you think? How do you think it goes from here, Alf? Because you wrote a recent story on your Macro Compass newsletter called "Fading the Soft Landing Narrative." Why do you think the soft landing is so unlikely? Which sort of assets do you think will be most vulnerable in the period going forward?

So if I look at what my macro framework is telling me, Jack, we are probably heading towards a further economic slowdown when it comes to real economic growth — probably worse than what's priced in consensus, or at least according to my models. And then on top of it, you're perhaps looking at an inflation slowdown as well. This would basically turn into a nominal growth slowdown on a rate of change basis. Now, the other component there is monetary policy. So if you have a nominal growth slowdown and on top of it you would have central banks accommodating this environment by basically reducing Fed funds rate or ECB rate and making sure that conditions remain accommodative, this generally would be a pretty supportive environment for risk assets. But this is not the case. The case today is that central banks are looking at the most lagging indicator of all, which is inflation. Arguably, it is going to come down — we're at the first signals in the last CPI report — but it is all about the pace of slowdown. And we don't have any material evidence yet that the pace of the slowdown is going to be very aggressive. And central banks are going to be extremely reluctant, I think, to take the foot off the gas pedal until there is very, very actual progress. And I don't buy as well the fact that if inflation slows to a trend that looks like 3.5%, they're going to be happy with it. The central bank's target is 2% for a reason, because it anchors inflation expectations long term around the very same level. Which is far away from deflation, which is terrible in a credit-based system — it just doesn't work. But it's also far away from a level where inflation expectations could get anchored to 3.5% or 4%. If you signal you're happy with the trend of inflation that is 3% to 3.5%, you are definitely sending the wrong signal. And I don't think that neither the Fed nor the ECB after this inflation scare are in the position to send that signal. So what I'm trying to say is that the Federal Reserve and ECB stance won't become very dovish very soon because of the structure of their mandate and because they're looking at the most lagging indicator of all. And I'm also referring to liquidity here, which is a very well under-covered topic. You are looking effectively at a combination going forward of both ECB and Federal Reserve balance sheet shrinking. The ECB very much under-looked as a topic, but it is going to be shrinking as the result of TLTRO repayments from banks. And in the US, it's a much more covered topic, but the QT that we'll be going on right now doesn't have an immediate soft path ahead. The reason for it is that the balance sheet of the central bank right now can shrink on the asset side — it's very easy to understand: they want to invest maturing in the assets or treasuries up until a certain cap per month. That's very easy to understand. So the balance sheet on the asset side goes down. What happens on the liability side of the balance sheet? What happens is that you shrink that. Right now, the Federal Reserve has basically three ways. One requires the government to actually collaborate very aggressively — those are the TGA, the Treasury General Account size, and the reverse repo. And the other one is basically the residual, but also I would argue the most important of the three items, which is bank reserves. Now, the TGA and the reverse repo facility — especially on the reverse repo — they could have an easy way to sterilize the quantitative tightening going forward by collaborating with the government issuing a huge amount of bills, so that this money which is parked at the reverse repo facility from money market funds could effectively be reallocated into bills. Because they can't reallocate those into treasuries due to mandate restrictions. Now, if you would issue more bills at a decent price — actually, because bills are trading today through Fed funds, right, so they're not attractive at all, indicating a scarcity of bill availability — if you would issue more, so this is Janet Yellen's job, you would be able to actually shrink the balance sheet by sucking away RRP rather than bank reserves. You could do the same in an opposite situation with the TGA at the Treasury General Account. But both the RRP and the TGA actually require the US government to collaborate. If they don't actively collaborate with quite a big strategy effort, I would say — and I'm not seeing any signs of that until today at least — the residual item that has to go down is bank reserves. And when bank reserves go down, what you're effectively doing is you're asking the private sector, or actually you're asking banks in this case, to absorb more issuance of a collateral of US treasuries of duration-intensive US treasuries that will be coming to the market. You're asking them to absorb more of that check having less bank reserves at disposal. Now, these bank reserves are used within the banking system to settle payments, including repos within banks. So if you're a dealer and you have effectively a shrinking amount of reserves but have more treasuries to actually have to accommodate, effectively you have to make space for those. So what happens is the private sector, starting from the banking system but also then reverberating into pension funds, asset managers, etc., they are forced to reprice what is their appetite for risk assets because the availability of bank reserves — which is basically money for banks — is going down while the requirement to absorb collateral risk and duration risk is going up at the same time. And so when that happens, it's generally pretty difficult for risk assets to rally because the marginal amount of capital moving towards risk assets goes down. So again, wrapping everything: looking ahead, you have forward-looking economic indicators pointing to a real economic growth slowdown — pretty sharp, I think. Possibly a nominal growth slowdown on a rate of change basis. That generally wouldn't support cyclical assets or earnings going forward, and it would on the margin actually pretty much support bonds — nominal bonds. So that's starting point. What about central banks? Central banks, I think because of the design of their mandate and the fact that they're looking at the most forward-looking indicator of all, which is inflation, they will have to remain tight for longer. And as they need to remain tight for longer, they will effectively compound this tightening effect and the slowdown of the economy. As they do compound that, what happens is that the long end of the bond market can reflect weaker growth and weaker inflation going forward in 10 to 30 years from now, because the damage being done today to the economy is pretty big. So these environments — government bonds, I think, remain relatively favorable for long-end bonds. The fact that QT seems to be impacting or likely to be impacting bank reserves — the more actually to add special downside, I would say, to risk assets going forward unless they do something on the reverse repo facility or the TGA. We'll have to see that. But as I see things today, I would summarize everything by saying that if you're a long-term investor, it seems to me that over the next six to 12 months, being long bonds and pretty conservative on risk assets is the right stance to take. If you're a more tactical investor, I think the cyclical rally we have had is a pretty good opportunity to scale up back into some defensive trades. For instance, we're going to just — at the end of the spaces, I went long Japanese yen and short US dollar and Canadian dollar. Both have I think held up pretty well and done pretty well in this rally. But those both are very cyclical effects, very growth-oriented FX pairs. They are commodity-oriented FX pairs where we're seeing the first pretty decent signs of commodity overhangs. On the other hand, you are having — and also they both have a big real estate problem — what I mean, potential problem, but big setup for a potential problem. Both — the island in Australia, private sector debt to GDP is as high, especially in Canada, as high as it was in Japan during the 80s. Private sector debt to GDP. And when you jack up interest rates and you make borrowing conditions very tight in such a leveraged part of the economy, it's easy to see some cracks appearing. So that compounds the thesis, I think, to be short these very cyclical FX pairs against the yen, which on the other hand is a play on slowing economic growth and as Euro yields come down, Treasury yields stop going up again. And at that point, the Bank of Japan's policy starts to make a bit more sense compared to how much sense it made three months ago. So I really like the combination of shorting the dollar and the Canadian dollar and the Australian dollar against the Japanese yen. And alternatively, I would just lean — try to be in short to discuss — make a little bit of use of the rally we have had, which has been massive. Partially justified in the beginning by the reading that the market said of what Powell said — laid around much less money or justified because it turned into a gamma squeeze and volatility targeting funds re-leveraging on cyclical assets. And there's to do with macro.

Yes, I think the rally in cyclical assets — like I think commodities, industrials — but yeah, I think also the surge in let's call them high-beta stocks has been quite extreme. I was just looking through the Russell 2000 and the stocks that have rallied the most over the past month — it's not like copper miners are going up 100%, they're not dubs. It's the biotech companies, it's the crypto companies. A lot of that is base effects coming up from a low base. But yeah, I think the apparent liquidity, the apparent risk-on appetite has been more evident in financial markets than it has been in, let's say, the price of oil, which is down below $90 today. So that just speaks to the economic fundamentals deteriorating. But despite that, the liquidity still flows. And I think of my good friend and colleague, Joseph Wang, who I frequently do episodes with for guidance. He had a recent piece called "The Money Still Flows." That's about how even though the 2-10 yield curve is inverted, all of these forward-looking indicators that you look at, Alf, and all the strategists and researchers — that's not going to impact JP Morgan's credit card lending. Credit card lending has exploded higher. So I think going back to quantitative tightening, which is the really important mechanism of monetary tightening — I work in the financial press, and on CNBC it's all about "Is it going to be 75? Is it going to be 50?" It's fun and it is important. But I think behind the scenes, the quantitative tightening that's sort of on autopilot, where bank reserves — which I found it interesting you did refer to as money — it is a form of ledger money. You can't go and buy a donut with it, but that doesn't mean that it's not extremely important. That is being drained from the system, and that will be reflected in asset prices over time. Of course, however, Alf, that does not mean that banks are going to stop the old-fashioned business of credit card lending, of lending money at variable interest rates and making old-fashioned bank loans. Even if they're going to be issuing fewer specs, they're going to be the high-yield spreads are going to be wider, blah blah blah. But outside of the sort of high finance, banks can still lend. Bank lending was still high in the summer of 2008. It's an extremely lagging indicator, perhaps almost as much as the labor market. I don't know. But it's a possible — Alf, that just as quantitative easing couldn't force banks to lend, as we saw in Europe the past decade, quantitative tightening can't force banks to stop lending. And that it really won't be that effective of a disinflationary force if people are still getting mailed five credit cards a month.

That is a very fair point, Jack. And banks don't lend reserves. So the amount of reserves being higher or lower has virtually no impact on bank lending. So QT is not a system to make banks lend less directly by withdrawing reserves, because banks don't lend reserves. So there is no direct impact from that perspective. You're right that bank lending is a very coincident indicator, let's say. And it also — the other thing I would like to point out is that not every type of lending is the same when it comes to economic growth and the impact on earnings and economic growth in general. So when you talk about credit cards, credit cards are not a form of lending that can spur long-term capex. It can't, because you need to renew and roll over your liabilities for the short term. Right, so effectively it's a bit like a revolver facility for a company. It can short-term boost a little bit cyclical economic activity, but if you're not able to re-leverage again over the next month or six months, then that effect will quickly fade away. Very different instead is a form of long-term loan — a long-term loan or borrowing actually on the bond market, for instance from corporates, or actually even better, fiscal deficits. Because fiscal deficits create net assets for the private sector without the attached liability. That's quite a different thing. When the government sends you a check, you don't need to pay any mortgage attached to it, right? You don't need to pay any loan. You literally just have more money on your bank account. That's a different form of credit creation. And credit cards are very different because that's long term — it stays on your balance sheet. It created a net asset without creating a corresponding liability. While a credit card is a short-term form of loan that also created a short-term form of liability with it that you need to be able to refinance year in and year out. And most likely, it is not going to lead to long-term investment and topics. Right. So when looking at credit, you have to really be careful, I think, in assuming what is what. But I agree with you definitely that bank lending is a very coincident — actually even lagging — indicator. I worked in a bank for a long time — I mean a long time, oh my God, I sound very old — I worked for a bank for eight years. And what I noticed there is that it's an extremely procyclical behavior by risk management and senior management when it comes to taking risks, both in an investment portfolio or on a bank lending book. I mean, you were basically asked to buy CLOs in January 2020, and you were asked to not look at anything that smells like credit risk in 2016, where people thought that China would free flow — the renminbi. It's extremely lagging and even procyclical, because effectively banks lend or tend to invest more in risk assets when they see that the creditworthiness behind and the fundamentals behind are good enough to justify the investment. So the first rule is not to lose your principal. It's not a smart way to do it, but it's the incentive schemes that are skewed that way. And that generally leads banks to be pretty late in the cycle when rates are also very high — or higher — which also means that the total loan yield or the return they make on a certain riskier investment is higher because risk-free real rates are higher than they were maybe earlier on. And economic activity which is looking good or has looked good for a while has improved fundamentals of the borrowers. Therefore, I'm going to lend more. Yes, you're right on that. It is quite cyclical to procyclical and lagging indicator.

Yeah, and on the credit card point, it's kind of a bifurcated outcome. If you don't pay your credit card at the end of the month, you pay like 27% and your guitar is like a late fee. But if you do pay it off, you get charged negative 1%, or if you have a rewards card, negative 2%. So the fact that the Fed funds effective rate is now at 228 basis points instead of 7 basis points — to me, that affects the credit card industry in a negligible fashion. I'm sure there are intricacies that I'm not aware of. But yeah, I also wanted to say earlier that you said the high-yield spreads in Europe seemed a little overdone. Well, you're in good company, Alf. Because I actually recently interviewed Jeffrey Sherman, Chief Investment Officer of DoubleLine Capital, just over $100 billion mainly in fixed income. And he said the same thing about US high yield — he said it was perhaps a little bit overdone. And actually, Alf, we have the extremely intelligent investor who's worked with tons of very experienced backer hedge funds, Andy Constant, in the audience. And based on what I've seen him recently, he is even becoming skeptical of this recent rally. So it'll be interesting to see what happens. I really should mention — we are looking at the crystal ball now. You're looking at your crystal ball. It's always a probabilistic game, but sometimes you can sort of see where things are headed. We are having this conversation with your entire — Daniel DiMartino Booth and Mike Green at the Blockworks Digital Asset Summit in September. And folks, I think there's a link that has been shared in the space. People should click. The promo code is MACRO 200. I think they get $200 off their tickets. That's MACRO all caps. Yeah, we see — the Blockworks chat is applauding. So I'll — how — when do you think the Fed pivot is? Actually, no, I'm asking about the dollar, Alf. So the dollar is probably — obviously I have to focus on it, but it's like kind of in the middle of my list. It should be higher, but I don't follow the dollar nearly as closely as you or foreign FX specialists. Why has the dollar eased over the past month? And to what degree has it been the dollar easing relative to emerging market currencies — you mentioned the Brazilian real strengthening — or is it the sort of developed market giants like Japan and the euro that have been extraordinarily weak as the Federal Reserve has tightened while they've essentially been sitting on their hands?

Before I answer, I would like to say that it's going to be fun in New York to sit with the other guys. And people who won't attend the conference — be my guest, we can chat pizza and bread, which probably is my best skill rather than macro. But it's going to be fun to be there. First time I attend the conference not as an investor, so I actually feel free to say what I want. That's cool. The answer to your dollar question is — well, I mean, okay, let's make it like this. You can split the dollar rally in two. First of all, when I get asked about the effects, I always laugh because it's "dollar against what?" would be my first answer. And the DXY is basically a euro-dollar proxy with some Japanese yen in there. And obviously, if I look at how the dollar has performed against different currencies, then I see that over the last month, it has basically weakened pretty aggressively across the board. But there are two things that stand out. The first is that the weakening against the yen and the Swiss franc is pretty interesting, I would say. And the second is the weakening against the Brazilian real and the Australian dollar. So this is the two ways I'd like to split the dollar softening. So the first is against the Japanese yen and the Swiss franc, which is basically suggesting that the Federal Reserve is about to slow down their hiking cycle. If they do slow down their hiking cycle while macroeconomic growth is slowing down, then you have yield differentials actually compressing. And carry becomes less attractive in being long dollar against the yen or the Swiss franc, which have generally speaking and historically speaking pretty low levels of carry. And better than being long — then ceteris paribus, you get the dollar weakening against these two currencies. But those two are also safe — those are currencies that you tend to buy when economic growth is slowing down. Okay, so this was effectively mostly true in the first part of the rally we have seen in equity markets, that led to a weakening of the dollar. And the dollar weakened first against the yen and the Swiss franc. Later on, it also moved to — again, we can — against a basket of emerging market commodity exporters, and especially the commodity exporters which were hit very, very bad in — I think it was mostly June and July when we had a commodity drawdown. And so what happens again there is that that side of the weakening of dollar — Aussie dollar or dollar Brazil — it's rather a re-leveraging, lower-vol, carry play. It's exactly the same explanations I would give before. People that have been very under-allocated or stopped out in Brazilian real and in Australian dollar — now they see a yield differential that, because of the perceived commodity story is going to remain there for a while, they see carry being very attractive against lower levels of implied volatility going forward. Because the interpretation is the Federal Reserve is going to stay relatively easy. On top of it, if economic growth apparently has to be related higher — commodity exporters or cyclical economies like Australia and Brazil do well. So that's the second part of the rally. I would give exactly the same prescription when it comes to how to interpret these rallies as I did for cyclicals in the equity space or for credit spreads. As I said before, I just added the position where I'm long the yen and short Canadian dollar and Aussie dollar. So it goes to show how much I believe that the cyclical growth re-rating component of these EM FX or commodity exporter FX could actually last. I don't think it could last.

I'll thank you. You've been generous with the time. I know you've got to go in a few minutes. We'd love a question from the audience. If you're focusing the other questions in now, maybe I can answer a question or two, but Alf has to go soon. So anyone would like to raise their hand, we'll be happy calling you. By the way, after Alf leaves — oh, here's Andy.

Hey, Andy. Oh, good. How are you, man? Very well, thanks. My comments were that Alf and I are actually in fairly strong agreement regarding the outlook. In particular, I would weight things differently, but the general path is consistent with my thinking. Back in June, my indicators of leverage and deleveraging and the sustainability of high vols and low diversification benefit triggered such that I went very aggressively long assets on June 28th and 29th, precisely because I expected this re-leveraging flow. And to be honest, I would weight that flow higher. And I'd add one other comment on that: there was also at the same time a very low Treasury issuance due to the very high tax receipts and very high Treasury General Account that resulted. So the government didn't need to issue. And that was — the last two months we've seen a lack of issuance being supportive of assets. So those two combinations of things — and I would go further about volatility targeting. There are formal targeting funds that use these inputs aggressively, but pretty much everyone on Earth is a volatility targeter. When you've been experiencing high portfolio volatility, your natural response to that is to reduce your footings, your longs and shorts, and for long-only asset holders to reduce assets. And that happened over the first six months of the year and just got to an unsustainable level. So I would just say that I would weight that more than the other — the other tailwind that I think Alf also correctly identified and is definitely the case, which is — which actually kept a lid on bond prices lately and supported equities — which is a growth expectations surge. I do think there was a growth expectation surge. I don't think it's warranted. And I also have forward-looking projections on growth that are weak, as does pretty much everyone. But I would think that the level of expectations today isn't necessarily at an extreme. I think what was at an extreme was the level of growth expectations prior to today, and it was too negative. And so I would cast the rising growth expectations as not at an extreme level but more in line with reality. And that fuel — that rise in growth expectations from extreme pessimism to neutral — was the way I'd characterize that tailwind. The reason why I've become bearish on assets, in particular stocks, is because of the looming but not yet felt storm of QT and the related storm of high issuance. Both of those things were revealed in the QRA a couple of days or weeks ago. The government is going to issue a lot more bonds than was expected, and QT is going to start in September at double the pace that it had been going for this relatively calm period. And I think that's a significant headwind on assets and on the economy. However, that issuance — which is partly due to the CHIPS bill and partly due to the ironically named Inflation Reduction Act — will generate spending. And the spending is the part that's concerning to me because that will be inflationary. And this brief — we didn't mention the zero print last week — this brief respite in inflation is simply not going to last. And so the QT and issuance headwind that will be difficult for assets to recover from — and I expect Powell to make very clear what all of his lieutenants have said: that we're not done, we have a long way to go, and that'll last into the new year in terms of hiking, because inflation isn't dead and it needs to be killed — truly and well and truly dead — before any sense of easing can take place. So I don't think the market's prepared for that. I think the market expects cuts in 2023 and expects a hard pivot or that a hard pivot has already occurred. And when Powell, by both words and deeds, addresses that in Jackson Hole and subsequently in September and possibly even in the minutes on Wednesday — where I think there might be talk of outright sales of mortgages — I think the markets — this euphoria that's now — we're sniffing — we're up 600 points from the lows and great — we're still 500 points from the highs. So this thing can go on a little bit more — this re-leveraging flow can go on a little bit more. But ultimately, it's going to run into this reality of tightening financial conditions and more asset sales that the private sector has to accommodate. And so for those reasons, I've become bearish on stocks. I'm actually bullish on bonds right now because I do believe that term bonds will benefit — I think I'll mention this when the Fed doesn't pivot because inflation expectations and growth expectations will fall, despite the headwind of risk premium expansion due to QT. So those are where I'm at. I'm also bearish on gold because I think that tightening will be very bad for gold. And so that's how I sum up where I'm at at this point.

Thanks, Andy. That was great. I would love to ask you tons of questions about your framework, but I know Alf has to go. So Alf, you want to say a quick goodbye to the audience and then head out?

I first want to thank Andy for the very elaborated and data-backed analysis. I really like what he does. And also, hey, Michael Kantrowitz is here as well — another great macro guy. Thanks, Andy, for your thoughts. I unfortunately don't have time to attend. I need to jump to an interview. I'm sorry, no time to reply to your comments. I would love to. I need to jump in an interview. But Jack, maybe an idea for a podcast to invite Andy and I together for a discussion — although we agree in this time, so there it won't be much fun. My last thoughts for the space is that ultimately, it depends. If you're a medium to long-term investor, what you're looking at here is probably an allocation towards safer assets until there is very strong evidence that economic growth has bottomed — we're not in the last inning of this pretty sharp slowdown in terms of real economic growth. And at the same time, inflation has also trended down towards the central bank target, which is not all of a sudden 4% or 3.5% — it's still 2% for very good reasons. Until you get there, probably the best thing to do is to be relatively defensive and prefer bonds as a long-term investor to equities generally speaking in these environments — to have a better return from long bonds than from cyclical equities. And if you're a tactical investor, then I think there are some opportunities that this very, very strong volatility-targeting-led rally — and I think Andy has a very good point there — another evidence of the fact that this was a macro-insensitive buyers-led rally is in the skew. If you look at how many people reached out to buy out-of-the-money calls effectively to have an exposure — if not to risk assets, at least to the convexity of risk assets performing well — if you look at how much that skew actually moved over the last six weeks, it is pretty big in terms of adjusted move for standard historical moves. It is another signal of the fact that people effectively reached out to re-lever and get back their exposure on the book that they had degrossed for the reasons that Andy explained. So when you have these things and this kind of macro-insensitive buyers-led rally, generally it is a good opportunity for looking for trades out there that have a good risk-reward from a macro perspective. Also tactically speaking, I mentioned a couple of those: I'm short euro-dollar, I'm long the yen against the Aussie dollar and Canada. I also am looking into re-entering shorts outright in equities — I think especially on the Russell and the more cyclical kind of indices, European bank stocks, and that kind of more cyclical stuff — we probably have seen a rally large enough to justify being short. Also from a tactical perspective, equities — I prefer expressions in FX. Today, I think euro-dollar, which I did at 1.026, probably has to go below parity again. And the yen is poised to outperform more cyclical commodity exporters like Canadian dollar and Australian dollar. And this was the recap basically for the spaces. I would like to thank again everybody who was kind enough to attend and listen to me rambling for about an hour. Thank you.

Yeah, thank you, Alf. And again, you can get $200 off to our conversation at the Blockworks Digital Asset Summit in September by using code MACRO 200, all caps. That is one of the few macro conversations out there. It is the Digital Asset Summit, so very focused on crypto. And of course, speaking of the sort of rebirth of risk assets that we've seen over the past two months, I think crypto has been front and center. And I know actually a lot of folks at the Blockworks research team who I've been in touch with timed that really well. So if you are someone who is an institutional investor or you're running a decent-sized personal portfolio and you're interested in digital assets, definitely check out the Blockworks research product. I think you can use the code "guidance" all lowercase to get 50% off. It's a pretty good deal. So that's obviously a reference to my podcast for guidance, which is a reference to the central bank tool. Andy, I want to get enough of me talking about my book. I want to get back to something you wrote recently — that there's a nip of euphoria in the air. And then you also, which fascinated me, because you sort of — almost every single successful investor in the world, hyper-successful investor in the world, you lean bullish. I mean, look at the S&P 500 since 1950. People who are bearish, who are structurally bearish for a very long time, tend to not make money. So I don't want to sort of — saying you're bearish is by no means an insult. But you do tend to lean bullish. And the fact that you are now quite bearish, saying there's a nip of euphoria in the air, is very interesting to me. And you also — let's see if I can find this tweet — you reference one of my favorite movies, "Margin Call." It was set in 2008. The bank — the bankers knew that the market was about to collapse — they were selling CDOs. And they were probably working all night, and they said, "Look at these people walking on the street. They have no idea what's about to happen." Where on a scale — it's Andy, from 1 to 10, with 1 being when you know everything's going up, volatility is very low and falling, you want to just short the VIX, own emerging market risky equities, and just go to the beach and take a nap. And 10 is you're driving and talking to your fellow banker and saying, "People have no idea what's about to happen." On that scale from 1 to 10, where do you think we are now?

Yeah, so I would say that 0 through 1 through 7 of those — I'd want to own a diversified portfolio of assets that's bonds and stocks and a risk parity type framework, because that's how you make long-term money. And then 7, 8 — let's call it 8, 9, and 10 are where I would want to be short assets. And I'm a little into the 8 category. I'm nowhere near 10. The reason why I put that quote up was really just to say I was watching the movie because I had sent out a poll about trading places, which everyone should watch, and was told I had to watch "Margin Call." I enjoyed it, so I quoted the movie. It's not my outlook. My outlook would become that outlook if and only if the Fed pivots. And the reason why is they aren't done fighting inflation. And a Fed pivot would reignite inflation, causing long-term inflation expectations to become unanchored — the discount rate, 30-year bond yields rising significantly, and the discount rate for equities rising along with that, resulting in another tightening that's less effective because one that would have pivoted recently — there's going to always be an expectation of another pivot. And cause significant long-term inflation problems in this country and around the world. And that's when I'd get to 10. If they pivoted, but I'm around an 8 because I think they're going to do their job. And so my outlook for equities is that we probably go — we've seen the lows. If they do in fact kill inflation, but the process of tightening will cause a 5% to 8% drop in the markets to the 3,800 level. Where I think, as long as they continue to fight inflation well, we can look forward to a year from now — a pivot that's at the appropriate time, not a pivot that's too early. So I would say I'm fully positioned for this sell-off because I do believe there is euphoria in the air. I do believe that the Fed will do what they're supposed to do, and aggressively through words and deeds — and that's why a sell-off will occur. The alternative case to me — the bold case to me here — is that they landed perfectly, that we've had the soft landing, that inflation is in fact dead, and now we can go to a neutral policy — not really delve into a restrictive policy. And that's the bold case. And you have to believe that — even though it's a very narrow, incredibly complex inflation story right now, particularly given the high employment levels and high wage leverage — it's a new wild card of the Inflation Reduction Act spending and CHIPS spending. It's very hard to believe that inflation is dead. But maybe they killed it. And if they did, we can see a 4,500 print on the equity markets. And being bullish, expecting that a soft landing has occurred, would be the appropriate response if that's what you believe. I just don't.

Thanks, Andy. Yes, the inflation report that we saw last week — month-over-month headline CPI, including everything — energy, food, and everything else — technically it was at 0.0. Actually, I think it was slightly negative. Of course, that was due to energy prices falling drastically. Let's see exactly — I think energy prices fell something like 4.6% month-over-month. And you can't rely on gasoline falling 7% or 10% every single month. That's extremely unlikely. So — well, because we saw that — yeah, go ahead.

The only thing I would say about that which is — that is in fact true that spot fell quite a bit. But if you look at the one-year forward oil future — CLU3 — you'll see that it's priced at $82, which is well below the current futures contract — it's $89 now on West Texas. So that's $7 on $89 — one year from now, oil is expected to have further fallen close to 10%. Which is interesting if you think about expectations for inflation. That should keep a lid on inflation expectations and be a downward drag through time for inflation. So the question for me is not "Has spot bottomed?" but "Is the one-year future going to represent the price of oil a year from now?" If so, headline is going to continue to be weak. And so that speaks to a possibility that they've nailed the soft landing, and this euphoria is well-justified.

Yes, and on all things quantitative and really all things finance, I defer to you. I just did — I think energy fell 4.6% from June to July — or from July to August. And unless I definitely could be getting my data wrong, I'm sorry. But no, you're right. The reason why headline was so low was oil fell in that month. But it's projected to fall and continue to fall — is my only point. It's still projected to fall. And that's what expectations are. So it's going to have to be something else that's going to cause sticky inflation. And what I'm saying is that there are plenty of things that will cause sticky inflation — specifically, you guys mentioned it: jobs, the number of people working, the wage they command, their balance sheet — some people's balance sheets — we're still having tremendous inequality that spreads continue to widen, with the lower 99% being impacted much more by inflation. But balance sheets are good — both at the corporate level and at the personal level. And credit availability is good. So people can spend. And that spending is the thing that — and then the government has just announced they're going to spend. And that spending is enough to more than overcome any continued weakness in oil if that were to happen as priced. And so I don't think inflation's dead. And for that reason, I think the Fed is going to do its job and kill it finally, but it'll take some time.

I hope you're right, Andy. I want to bring in Michael Kantrowitz, a strategist who has nailed the price action that we've seen this year. He's been a frequent guest on George Noble's Twitter spaces, which are very good. Michael, welcome to the space. How are you viewing these markets? What have you thought of the risk-on appetite that has come to the market over the past month?

Thanks, Cantro. So sorry, Michael — I'm used to calling you Cantro because I hear George Noble calling you that. So my question for you, Michael, and then I want to get Andy's thoughts on this too — the scenarios depend on whether the bad economic news is bad for stocks. Bad economic news — bad for stocks, or is it good for stocks? Don't forget — we saw in 2020, even as airlines and cruise lines were losing hundreds of millions of dollars a quarter, billions of dollars, their stocks were going up just because — that was flying liquidity. That's just the way it was a bull market. But Michael, the fact that we're going to have a recession — that's actually bullish because it would cause the Fed to pivot. So is bad news good news, or is bad news bad news? So Michael, and I want to hear Andy's thoughts.

Michael, we're having some connection issues. So Andy, how about you take it? Michael, sorry, we can't really hear you. Okay, sure. So it depends on the news. Bad inflation news is bad for markets — though healthy, as it'll cause the Fed to stay and kill inflation — it's bad for markets. Bad growth is also bad for markets. So given I think both of them are bad for markets — high inflation or low growth — I would say — answer your quip — but bad news is — bad news is bad news. Michael's connection isn't cooperating. Yeah, just share my own thoughts on the matter. For bad news to be good news — in other words, for a slowdown to cause a Fed pivot — I think that drastic economic slowdown has to lower inflation. But there are scenarios in which the economy still is — rapidly — earnings don't grow or they actually fall, and inflation is not moderated. For example, the price of oil — if you drive to work, you're still going to have to get oil no matter what the economy is doing. We have some really interesting — Jack, please go ahead.

Sorry, can I just say one thing about that? I think it's a matter of pricing. I think the idea that bad news was good for markets because it would reduce inflation and encourage an earlier Fed pivot was at 3,800, 3,700 — at 4,300. To me, growth expectations are now high enough, and Fed pivot expectations are now high enough, that additional bad news is just bad news because it hits the earnings power for stocks while not changing radically the inflation discussion or the pivot. I just don't think that'll happen — it will be quite as influential on bad news as it was 500 points ago.

Right. Thanks, Andy. I've got a question. So Andy, that's your framework — you think the market right now is headed lower. But it's one thing to have a friend — let's say you're right. Someone who has a similar framework to you — they think the market's headed lower. It's one thing to be right, but it's another to actually make money. So for example, I just pulled up the stock I like to track — Revlon. It's a bankrupt company. It has negative equity, tons of debt that exceeds its assets. It's losing money, and it declared Chapter 11. But the stock has rallied — let's see — it's rallied 21% today. And since its low in June — which actually by the way, its low in June was the day before the bottom in June — that's probably a coincidence — it's rallied 570%. So if you said, "Okay, the economy is flowing, everything is — recession is coming — I'm going to short the stock," you'd be down a lot of money. So how do you navigate that environment, Andy, in terms of entering positions and market timing?

Yeah, that's a good question. Number one, I don't play those stocks. And I trade macro, so I care about major indices which don't exhibit quite that degree of volatility and also are liquid and can be — the underlying assets themselves are significantly less levered to both diversified and also less levered to idiosyncratic news. So that's the first step. And then the second step is through risk controls, which I outline in a number of threads on my Twitter account. But in terms of market timing, that's always tricky. You have to have a system that you like — whether it's discretionary or systematic — that enters trades when your signal fires. And your signal is almost by definition never going to be at a turning point. I've seen no evidence over my career that people can pick tops and bottoms with any sort of skill. And the ones who have were lucky. Even great shorts like "The Big Short" were a year or two early. And so for me, it's just about when my signals fire. And the catalyst for me — I'm going from sort of maximum long through the summer to a sizable short now. I actually added Euro stocks today. The QRA — where I saw significant issuance — and the pricing of a pivot which I don't think is going to happen. And lastly, the thing I had identified as the primary driver of equity markets and risk assets in general in June — that has abated as well. One of the major deleveragers in the last six months has been long-only asset managers. And if you look at any of the trading and financial futures data, you can see that last week they stopped buying and started selling some of their re-leveraging. And so a variety of factors come together with a signal, and then you execute. And sometimes you're early — I'm a little early so far. I saw — I bought some more puts today, but I did buy puts last week and the week before, and those are underwater.

Thanks, Andy. And yeah, you can be extremely right, but the instrument you think is the best way to express the trade may not be. For example, "The Big Short" — by the way, two people who were in the movie and the book and worked for Steve Eisman — this is Daniels and Porter Collins. It actually is my favorite interview that I've ever done. You should check it out — it aired in late January, early February. That was a fantastic trade — buying credit protection on these insanely risky instruments. But looking back, there have been papers about this — you could just have shorted the banks, which they also did, or even shorted cyclical industries and stocks that have nothing to do with housing. But they ended up going from 100 to 3 just because the economy was the way it was. We only have a few minutes left. But I'm seeing a lot of really interesting people in the chat — Michael Cow, Byron who writes the great news at Blockworks. So if anyone wants to join and ask a question, please feel free to do so.

Yes, I can. Michael, please take the reins.

Sorry, that question was for you, and you're muted. I'm sorry — could you repeat the question? I thought it was for Michael. Oh, sure. What have you made of the earnings season that we've seen over the past few weeks, and how robust do you think the transmission mechanism will be from a weak economy to weak earnings?

Yeah, so I'm — my outlook is that real GDP is going to continue to be weak — stronger than it was in the first half. And my outlook for nominal — for inflation — is that it's going to bounce again. So I've always been — I've been sending out a lot of comments about earnings around nominal GDP being the driver, not real GDP. And I think most people missed that in placing very negative expectations on earnings. So I would say I'm — I think that the market has recovered a lot, and earnings expectations are now more in line with what's actually in print, which still has about a 225 number for S&P in 2022 and a 235 in 2023. But I think at some point this summer — probably in June — the whisper consensus was probably closer to 210, which was last year. And I think that was wrong because of this very strong nominal GDP growth that we have. And equities are a nominal asset — they make nominal profits. And so I was a little more optimistic than most, and I think most now have come to where I'm at. And I'm probably going in the other direction.

Andy, where do you get that 235 for next year? What's the score?

2023 — Ed Yardeni's consensus number — not his number, but the one he prints — says the consensus — on facts, I still see 244. That's a bit lower, but okay.

Yeah, so just for context, that is essentially dollars earned per share of the S&P 500. So 210 was the earnings forecast — and you said in mid-June — and I'm looking — well, no, what I mean is it wasn't the forecast — the printed forecast has been pretty much rock solid at 225 for about four months. But I think people had undercut that, saying it just hadn't adjusted yet given this weakening economy. And I think what they missed is this idea of nominal — phenomenal earnings — where real wages weren't keeping up with top lines. So I think now — people were very pessimistic in June, and I think they had marked down that printed number from 225 to 210. And now they're coming back up to 225 again. And the market's pricing that. Right. And again, just for context for the audience — the S&P 500 in mid-June was a low of about 3,660. So if you divide 225 by that, that gives a PE of about 19. Excuse me, I got my data wrong — give me one second. Well, divided by 210 — 3,660 divided by 210 — that was about a PE of 210. And now we're at 4,300 divided by 225, and we're at 19. So the price-to-earnings multiples have gone up even as the earnings — the whisper earnings number — has gone up as well. It's both — earnings expectations going up and multiples expanding — because of this re-leveraging factor that Alf and I both mentioned. So both things are happening, and I think both are vulnerable.

Right, yeah, so we're talking around each other a little bit. The printed number has been coming down — or stable. The whisper number — what people actually think — and no one knows what this is — there's no data source for this. I'm only saying that I believe this is true — was much lower three months ago, two months ago.

Got it.

Great, well, thank you, Andy and Michael Kantrowitz. If there's anyone else who has a question and would like to join — I don't want to name any names, but I do see some heavy hitters here in the audience who I would love personally if they would join and have a question. Please feel free, but we are going to wrap it up in the next five minutes. So if you do have a question, raise your hand, we'll try to get you in.

Andy, just based on your experience — you've seen a lot of market cycles, you have a lot of knowledge — to what degree is the easy narrative that — I'll ask that to you a lot later. Andy, hi, Roseanne. Hi there, thank you for having me on. Love Andy and Michael — fantastic group of people here. I appreciate that. I'm a CFO of a manufacturing company here in New York, so we experience the data that was reported today. In quarter one, there's a data delay, so we've been experiencing an economic slowdown for quite some time. Margins are getting compressed. Cost-push inflation is embedded. We see an increase in cost of goods sold as well as operating expenses — increase in cost of capital, production, labor, and also turnover expenses. There's a lot of turnover right now. People are resigning. There's unemployment going on. There's definitely a rise in unemployment in my area. A lot of small businesses have closed down. I'm getting people applying to our business who are former owners of those businesses — manufacturing small businesses, mostly niche businesses. Those were all cut out — the niche industries. However, the contracting of the belt right now — people are going for the essentials: food, energy, consumer staples, defensive. And those are the industries our manufacturing company is selling to. So we're noting the earnings — I'm bearish. I tend to be long-term bearish. Short term, I'm riding this rally — it's been great. I don't know — I think it's a relief rally. As the bear goes on, the rallies get longer and larger, and it's led by human emotion. So to me, I'm having a good time now, but I got my eye on the macro because the macro trumps all. And what we're seeing today with the 40 points down with the Empire State and the NHB down another six points — it does not look good. New orders, manufacturing — last report down. Inflation — I have to say the shelter component — one-third housing prices are not coming down. There's just general consensus that because home sales are down, prices are coming down — we're not seeing that. I'm reading — just last week, home sales are down 14% year over year, but home prices are actually up 13%. So there's a lot of issues going on. There's a lot of exuberance in the market right now, but I'm not falling for it because I see it on the forefront from our business and what we're seeing. So I just wanted to add my two cents — that's what we're at. And I do think earnings and employment are the next shoe to fall, coming into Q3 and Q4. I don't foresee a pivot anytime this year — it has to be in 2023. The inflation — even Bullard came out and said they're not — or I don't know which one — all of them are talking too much. But one of them came out and said, "We're not going to let happen what happened in the past in '91." I think you said — we're going to keep raising, we're not going to stop. Or what they do — they cut and then they come back and raise again. They want to keep raising. So I think it's going to continue. They have to be proactive. Buying that in — last year, last summer would have been better if they at least started with some small increase of 50 basis points — would have been better off. But now they waited, and they're going to have to — because inflation — the CHIPS bill and the Inflation Reduction Act — I don't know why it's called that, but it's a lot of spending and the issuance of bonds, exactly as Andy said. I am very concerned. And quantitative tightening in September — we're going to see more. It's really beginning. So there's a lot of things going on, and it's going to take time for these — they're just all inequities — they're all misaligned, just like the workers coming to our business — most of them are overqualified, applying for jobs they shouldn't even be applying for because their businesses went under. And it's going to take time to work through this. I'm thinking in the next probably six to 12 months, we're going to see the market definitely retrace. It has to — it can't diverge this much from the macro. And things are not improving. As we see all the data — energy is the main reason the CPI went down. If energy does creep up or stabilizes or even goes down a little more, we still have elevated shelter, food is still elevated. And now there's more spending with these two bills. So I'm definitely — long term, I added puts into the indices for next year — January 2023 — and I'm scaling into them, dollar-cost averaging. And that's my plan. I am long anyways my equities, but I'm definitely bearish in that six to 12 month period.

Thank you, thank you for that, Roseanne. Yes, I definitely — your experience and what you're seeing on the ground is very compelling. And I do agree with your macro framework, which is Andy's framework, which is Michael's framework — we all sort of agree. But you said it just can't go higher — I don't know, but it can always go higher — you never know. But I think you're probably right. Roseanne, do you have a question for Andy? And then we should probably get going.

Sure, I would love to ask Andy. So I see you said you're bearish on equities — 8 on a 1 to 10 scale. Are you still net long some of your positions? Are you short the indices — any specific one or all of them? How are you positioning for the next six to 12 months?

So no, I don't trade individual equities — don't invest in individual equities. I run an alpha portfolio exclusively. My long-term savings are in a diversified portfolio of bonds, stocks, gold, and so on, and index equities. So I don't really play individual names — I used to when I was starting out in my career, 17 years at Salomon creating equities, but that's not my thing. And right now, all I do is this alpha portfolio. And the alpha portfolio is short NASDAQ — I bought 2% of AUM in NASDAQ puts. I bought 2% of my AUM in S&P puts. And today — I was early on those so far — and today I bought 1% of AUM in Euro Stoxx 50 puts. So if I'm wrong, I'll lose 5% of my money. And if I'm right — I use put spreads, so that creates a lower cost and a maximum return — but if I'm right, I'll make 30%.

Hey Andy, you're —

I am bearish on nominal growth because I think the Fed will kill inflation and also simultaneously kill real growth, and that'll be bad for earnings. And I am bearish on what I call risk premium because I believe the Fed will tighten monetary policy, which hurts all assets from gold to bonds to stocks through the multiple — when you think about stocks.

Why — which is basically large-cap growth — when your narrative is more about a coming earnings and economic slowdown, why not be short more indices like the Euro Stoxx or mid-caps in the US or small caps in the US?

Yeah, those are fine and all. I've tried to really focus on the most liquid indices. So there's no good answer to that except that's what I do. So someone who has a more refined view could take my view and make indicators that deal with some of the idiosyncratic risk of all those other things you mentioned — would potentially have a better way of expressing the trade than I do.

Yeah, one thing Alf said is that the cyclicals have rallied. And that is accurate. But I think there has been a drawdown in commodities stocks — particularly non-oil and gas commodity stocks, like Freeport-McMoRan — they mine a lot of copper and some gold too — it's well off its highs. So I don't think the sort of reflation optimism is at its zenith. And I think — that's down 40% from its highs. So we have seen some repricing. Cantro — actually, sorry, Roseanne made some interesting points about housing. Andy, do you have any views on that? And then we really should be going.

On housing, I would say that my catalyst for a leg down in housing will be the minutes and whether the outright sale of mortgages by the Fed was being contemplated — and thus they are prepared to announce an actual sale of mortgages in September at the September meeting. If they ignored that conversation, that means that mortgages will basically only run off — which they're not — through the fall, possibly as late as December, before they're prepared to make an outright sale of mortgages. The outright sale of mortgages would generate a sell-off in housing.

Yes, I've been speaking to Chris Whalen, who knows a lot about the plumbing of mortgage securities. He said that the types of mortgage-backed securities that were bought by the Fed in March, April, May of 2020 were, as could be expected, very low-coupon securities — Ginnie Mae twos — so they pay 2% a year on the par value of 100. And since then, mortgage rates have risen, as have Treasury risk-free rates. And as such, it is extremely hard — the market for the folks who are trading on the desk — who used to be one of them working at Salomon Brothers, people at Goldman Sachs, JPMorgan — who are trading billions of dollars of mortgage-backed securities every single day — they are not trading Ginnie Mae twos. They're trading Fannie Mae fives, Ginnie Mae sixes and sevens. So effectively, if the Fed were to, instead of rolling off in terms of just letting them expire, actually sell those mortgage-backed securities, it would be Armageddon — that's the word that Chris used with him. Does that sound about right, Andy?

I don't know about that. Certainly those are not the on-the-run mortgages, and there'd be some impact on the on-the-runs as people made room in their book for this illiquid, off-the-run stuff. And there'd be a discount paid in the market for both on-the-run and off-the-run if somebody tries to push out off-the-run stuff. So yeah, it's going to be messy. And the point is true that the Fed — many Fed members in particular have been very focused on the mortgage balance sheet. And it's about a third of the existing balance sheet. And the goal through the end of QT is to have that balance sheet have no mortgages. So something has to be done — it's just a matter of time. And that pain that you described has to come — it's just a matter of when.

Very interesting. Andy, Michael, Roseanne — thank you so much for being a part of this space. Again, I'm going to be having a talk with Alf and Daniel DiMartino Booth, Yuri, Timmer, and Mike Green at the Blockworks Digital Asset Summit in New York City on September 13th and 14th. And there are tons of digital asset talks there — it's going to be fascinating. And you can get $200 off by using the code MACRO 200 — that's MACRO all caps. And guys, everyone, thank you so much for listening. I really appreciate you joining us through today. Hopefully you found it valuable. I did. Thanks, and have a good day.