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Michael Green – Global Macro Series – 4th August 2020

In today’s episode, we are joined by Michael Green, of Logica Capital advisors. Michael has over 20 years as a portfolio manager, mainly in the global macro space. Recently he has become well known because of his work on the shift to passive investing, and inevitably this was one of the topics we wanted to ask Mike about. Our conversation wasn’t limited to that however, and we also discussed comparisons between the present day and previous historical crisis (going back to the Roman Empire!), as well as many other interesting subjects.

Topics Discussed in this Episode


  • Passive investing
  • ETFs and target date funds
  • Intergenerational inequality

“(The) growth of passive is now basically built into the system. From a regulatory framework, all the new money that comes into the U.S Savings and Investment accounts (primarily in the form of 401Ks and IRAs), are coming in passive vehicles.”

  • Real interest rates over history
  • Mean reversion and momentum
  • Negative interest rates

“I think negative interest rates are absurd and that they're a view that I articulated back in 2015 and is now, I think, increasingly accepted that they're ultimately harmful to the banking system. They create a tax on the banking system.”

  • Leverage: recourse vs no recourse (limited liability)

“I think another component that people generally under-appreciate is that while we all complain about leverage and we complain about the high levels of debt, the flavor-de-jour of how we solve this is something like risk parity which says, "OK, let's lever our portfolio 10X in the fixed income space, and let's add..."

  • MMT

“MMT is right but it offers almost no prescriptions for how that money should be spent. So, by handing it over to the politicians, we're at least in a situation where you could see outcomes of how that money gets spent that we have never predicted.”

  • Yield enhancement strategies


Catch up with Michael and learn more about his work:


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Full Transcript

The following is a full detailed transcript of this conversion. Subscribe to the podcast to get access to all of our transcripts as eBook downloads!


If I’m running a discretionary program and that’s going into some form of a structured product (and this doesn’t happen for precisely this reason), if I choose to do something that is different than I would have done historically, then the results of that product could be very different than I have advertised them for and I’d become liable. So, I’m forced into a quantitative system. That's actually part of the reason why I partnered with Wayne is that I realized that until the rules change there is, actually, no substitute to a documented quantitative process.


For me, the best part of my podcasting journey has been a chance to refine my own investment framework through a series of conversations with extraordinary investors in every corner of the world. In this series, I along with my co-hosts, Robert Carver and Moritz Seibert, want to continue our education by digging deeper into the minds of some of the thought leaders when it comes to how the world economy and global markets really work to try and learn how they think.

We want to understand the experiences that have shaped them, the processes they follow, and the historical events that have influenced them. We also want to ask questions outside our normal rules-based playground. We're not looking for trade ideas or random guesses about an unknown future but rather knowledge accumulated over the course of decades in the markets to try to make us better-informed investors and we want to share those conversations with you.

Our Guest today is one of few real independent thinkers and a student of markets and market structure and, perhaps, the leading mind when it comes to how the growth of passive investing is changing markets in a way that few people realize. So, I'm absolutely convinced that you will have your eyes opened from our conversation today with Michael Green, of Logica Capital Advisers.

Mike, thanks so much for joining us today for a conversation as part of our miniseries into the world of Global Macro where we relax our usual systematic, or rules-based framework, to provide you, with a broader context as to where we are in a global and historical framework and, perhaps, discover some of the trends that may occur in the global markets in the next few months or even years and, ultimately, how this will impact all of us as investors and how we should best prepare our portfolios.

So, we're super excited to dive into many different topics in the next hour or so, not least because you have done a lot of work on some of the structural changes in the markets due to high levels of passive investing that I'm sure we'll be spending some of the time on. Let me just kick it off with a kind of 30,000-foot question, Mike. Where do you think we are in a big global macro picture?

As I have said before in this series, it feels to me that it's a blend of things we've seen before, in the past. A lot of people compare this to the '30s and '40s; the Japanese bubble in the late '80s; of course, the Tech Bubble; Great Financial Crisis; then, of course, we have added something brand new, namely a global pandemic which makes it pretty unique. How do you see it right now?


So, I think those comparisons are often drawn in terms of where we are relative to history. I think one of the things that is hardest is that we all know the phrase, "History doesn't repeat but it rhymes." So, we're constantly looking for those patterns. I have had the view for a while that it's very lazy to compare the time period that we have gone through to the 1930s - this idea that we're in this great global depression following the global financial crisis.

The primary pushback that I'd have against that is the continuing growth of wealth disparity. Inequality has continued to expand and the 1930s were very much an inequality equalization time period, particularly after the 1929 to 1932 time period. If anything I think we're still in the 1920s and, potentially, haven't seen our global financial crisis yet.


I'm sure you follow a lot of the people we follow as well but it kind of ties in, a little bit, to the Fourth Turning from Neil Howe where...


Yeah, he's a friend of mine, yeah.


Where he says, "You know, the first crisis that you think is the big one may actually not turn out to be the big one. That comes, usually, at the end of the Fourth Turning." We know that he predicts that to be this decade, so, that's pretty interesting. Of course, your friend at Real Vision, Raoul Pal, he talks about the three phases that he's seeing: the unraveling; now we're in the hope phase of the current market; then comes the insolvency phase. Do you think in the same terms or..?


I do think there are a lot of similarities in the line of thought. So, the biggest concern that I have, and I did an interview with Raoul (I think it was April 8th, so fairly soon after the "bottom"), and my objection continues to be that it feels like we are projecting history onto the future. So, we're saying, "This has to happen." The challenge in comparing the 1920s and today is that in the 1920s we had a convertible currency. It could be convertible, and it was convertible into gold. So, the level of defaults, the level of uncertainty in terms of people's ability to source dollars to service the debt was much more constrained in an environment of the gold clause. We don't have that today.

So, to expect the same outcomes; to expect policymakers to sit by and say, "Our hands are tied," as they watch the potential unraveling of the system, I think, is hard. So, I think we'll continue to get lots of signals from the market that effectively say the equivalent of, "Hey, pay attention to us. You have to respond. We have to do something or that will happen again." I think we will continue to encounter those types of crises, but to expect the same outcomes when you have a radically different currency structure than you did in the 1920s and the 1930s, I think, feels strange.


Hmmm, sure.


I really like the point that you made about inequality in currencies because normally you're right. Asset prices get smashed in crises, dividends get smashed and the wealthier people who own those assets tend to see their income reducing. So, that's really interesting. It does suggest that either we're not there yet or this crisis may be truly different. I want to lead that into a subject that I know you have talked about a lot before which is passive investing.


It will be what my tombstone will say. (Laughter)


Well deserved.


So, I think one thing about crises like these is that they may cause these big secular trends that we see and things sort of reverse partly or completely. Obviously, there has been a big rise in passive investing over the last twenty years, I guess, possibly going back further. Does this feel like there might be a change here?

So, there's a little bit of anecdotal stuff going on. There's this investment as entertainment thesis. It does seem like there are more individual investors piling into Robinhood and buying individual stocks.

If you're investing for entertainment you're not going to go and buy a kind of boring, market cap weighted ETF, you're going to want to buy individual stocks, story stocks, name stocks and have some excitement. So, that's one thing that's going on. But I do wonder whether this crisis, generally, could cause that trend, potentially, to stop or even reverse. Maybe there are other explanations of what could be going on there.


So, the one thing that I always highlight for people with passive is that the growth of passive is now basically built into the system. From a regulatory framework, all the new money that comes into the U.S Savings and Investment accounts (primarily in the form of 401Ks and IRAs), are coming in passive vehicles.

So, this is actually, by law (or not quite law but certainly by regulatory fiat), into the 401K space, where corporations, because of the DOL's fiduciary role that didn't fully go into effect but went into effect enough that it caused the changes that have reinforced this. If you are a corporation and you offer a 401K plan to your employees and you offer them a plan that does not have the cheapest and lowest cost index funds in it, then you actually become liable. You become liable not just for the access fees but you actually become liable for the underperformance that could potentially accrue.

Nobody signs up for that. That's not what corporations do. That is actually why they wanted to get away from defined benefit plans. They didn’t want to be responsible for the outcomes, they wanted to be responsible for the contributions. So, the entire system has aggressively shifted to converting those inflows to coming in through passive vehicles, primarily through things like target-date funds. At this point, we’re looking at well over 100% of the net flows that come into, particularly, the equity space and increasingly in the fixed income space are coming in the form of passive vehicles. Until that changes, until we actually change the regulatory structure I have a hard time seeing it reverse.


So, in essence, this means that the HR representative is the new CIO.


That’s exactly what it means.


Those guys make the calls. They say, “We’re doing this, we’re buying the S&P 500, or we’re doing whatever the case may be.

I live in Germany, and it’s the same thing. Long gone are the days where retirement money was allocated to a mutual fund manager and they were discretionarily trading stocks, buying value, whatever the case may be. Right now all of those products are linked to an index, be it the DAX index or the EURO STOXX 50 and they may have a guarantee. So, there’s a long put option or some sort of a guarantee for retirement attached to that as well, but it is an index product. And all of the flows happen at about the same point in time which is the end of the month for the beginning of the next month. That is the sweet spot where all the money flows.

I think what one can see, and it amazes me, is that... Well, first off (this has been long reported), the average correlation and the average co-movement between stocks increases. But what you also see is that the breadth of the market changes. All of a sudden all of the stocks in the DAX, for instance (which has 30 stocks), are above the fifty day moving average. It happens more regularly. Whereas, previously, ten years back, it was a 50/50 type of thing. Now it’s no, no, no, that’s not a 50/50 type of thing that’s a 95% odds that if one stock is above the fifty day moving average all the other twenty-nine are above the fifty day moving average too.


Well, that’s one of the big legacies coming out of the global financial crisis. So, the reason why all those products (in one form or another) are referred to as index products, is because, again, you don’t want to attach any form of liability.

If I’m running a discretionary program and that’s going into some form of a structured product (and this doesn’t happen for precisely this reason), if I choose to do something that is different than I would have done historically, then the results of that product could be very different than what I have advertised them for and I’d become liable. So, I’m forced into a quantitative system. That's actually part of the reason why I partnered with Wayne is that I realized that until the rules change there is, actually, no substitute to a documented quantitative process.

You just can't run on a discretionary basis. You can show a backtest if you have a quantitative process. An institutional investor can disregard that, but those backtests can be used for things like selling a variable annuity. Those backtests can be used for fixed income annuities. Those backtests can be used for structured products in terms of the marketing of those products. The only requirement is that you have to stick by them.

We have so stacked the deck against discretionary active managers that I'm not really even sure it's a game worth playing unless you choose to actually change your process to take advantage of the futures in the market and very, very few people are doing that. It's hard. You have to bend your mind and change everything that you have been taught for the past twenty-five years.


I'm sure we're going to talk more about the effects of passive growing in terms of the equity space, but just out of curiosity, are we seeing exactly the same trends on fixed income? Is passive also dominating to the same extent or is it, in fact, maybe because yields are so low people are saying, "Wow, I need to find an active manager because I can't live with zero."


The fixed income space is about ten years behind the equity space in terms of the growth of passive. In terms of individual discreet allocations, there has been a tremendous amount of growth in the ETFs and the fixed income space. In particular, they have been widely adopted by fixed income managers. They use them to access some forms of liquidity. Again, if I look at the investment public in the United States, by far, the largest source of growth in the fixed income space is through the target-date funds themselves.

So, the Vanguard and Blackrock and Capital Group vehicles that dominate that space, between the three of them they hold well over 50% of the target-date fund universe, those are really the primary sources of growth. Those have their own index construction problems that (in my opinion) actually exacerbate many of the problems that we're seeing. So, fixed income, I would actually say, is analogous to the indexing of the U.S. equity markets prior to the dot-com changes. There is just a structural mistake in the way the indices are constructed.


And in addition to that, I would say, we have, in the U.S., the fixed index annuities and the VA type or products, essentially, all of which are indexed linked. If they're not indexed linked to indices such as the S&P 500, they are linked to custom indices produced by QAS type of bank strategies which, themselves, probably make reference to an index again.

So, it's self-referencing inside the product back to an index. Those products, by the way, are also strongly, strongly growing in Asia, Singapore, Hong Kong, Taiwan, to a certain extent still Japan. So, this train seems to have left the station and gained speed that more and more of the money is going passive.

One wonders, what's the end game with that? How long will that go on? Price insensitive buying and selling at settlement or close, linked to an index, without any consideration of (let's just call it) value or fair price, when does it stop? When will it break?


Well, that's of course the sixty-four trillion dollar question.


Yeah, so, please tell me. Don't tell anybody else, just me. (Laughter)


Part of the way that I always try to solve these problems is that I take them to the reductio ad absurdum conclusion. So, one of the key differences between a discretionary manager and an index manager is how they hold cash or how they treat cash.

So, if you think about the mathematics of what happens, a discretionary manager (and we've got our own proprietary research that we've done on this) will typically hold about 5% cash. Now, in order to keep up with an index they may take that down, and we do things like track the cash balance as a percentage of market cap to give us an indication of this sort of stuff.

Michael Hardnett has a good piece he calls The Flow Show that tracks the level of cash allocations as a consistent negative correlation with the return profile. One of the things that I point out to Michael all the time is that the only people that respond to his surveys are active discretionary managers. Nobody at Vanguard is responding. So, when he says that the market is 5% cash, or 4.7% cash, what he's talking about is the discretionary managers.

The Vanguards of the world run with no cash. My personal favorite example, again, I go back to things like target-date funds, they carry no cash. The vehicles they invest in carry no cash. The only way that they accommodate rebalancing is because they have a constant flow of new capital coming in.

So, you have these sorts of crazy dynamics. If you just walk through the implications of a market that has 5% cash to a market that has 0% cash, the only way that can be accomplished is by inflating the assets themselves. Because what you are really doing is you are saying, "I need to reduce the cash to zero." Well, the cash is neither created nor destroyed at any point in this process. I buy, you sell, cash is unchanged. So, the only way to accommodate lower levels of cash is by driving the asset prices themselves up.

So, how does this conclude? I think it concludes with the world's most ridiculous melt-up. When we do the math and walk through the implications of going from a 5% cash world to, effectively, a 10 basis point cash world, which is roughly the average across the index space, the market has to go up 50X - 50X, not 50%, not 5%, or anything else, fifty times. We're talking Shiller PEs in the 500, 600 sort of range.

Do I think we'll get there? No, because before we get there the volatility has exploded to such an extreme that a catastrophic event that just wipes everybody out and they say, "Well, we're not going to do that again, or we're going to freeze the market, we have to stop the market in some way, shape or form." I'm convinced that is how this ends.


So, you're the school that ETFs, make the market more unstable I guess then.


Well, they do both. So, that's the irony. When you introduce an alternative approach to managing money, it (at least initially) has a diversifying effect. If I have managers who will only buy when stocks are below ten times earnings, well then, if stocks go to twenty times earnings because of some external force, the next buyer is 10X. So, the market has to fall 50%. That's what the dot-com cycle was, by the way.

If I take a scenario in which the marginal buyer is always somebody who says I can't hold this cash. If you give me cash I'm going to use it to buy. Prices are going to inflate.

If you combine those two you get a diverse ecosystem. So, stocks can go up and down in relatively small ranges. There's actually vol dampening up to about a point. On our math, it suggests around 30% passive penetration was the trough in terms of what you would expect, in terms of realized volatility, because you had people who wanted to sell and people who would buy without thinking about it. It was a diverse ecosystem.

Now, as we're pushing out of that, we're moving into a higher volatility regime and, of course, it's really tough to diagnose this. I have a hypothesis, I have got models that show that this is what happens and so far they have been largely accurate, but man, it's awfully hard to argue that a global pandemic is actually linked to passive investing per se. I feel it's very much linked to the responses that we have seen - the reactions in the market.

Like most social sciences it's a one-off experiment. I can't repeat it and be, "OK, everybody let's go back to February and we'll do this whole thing without passive, or without the pandemic." You just can't recreate the experiments. So, you have to have a hypothesis and until you're proven wrong you keep operating on it.


So, it's not like '87 where you could argue that the feature of market structure, which was portfolio insurance. A lot of people probably think that was the cause of the crash.

So, if we go back to, say, 1929. Maybe it's a bit silly comparing 1929 to now because it was such a long time ago. I've seen the figures that stock ownership was lower in the sense that only about 10% of U.S. households owned stocks and now it's 50%. The difference being, of course, back then I think most people probably owned them as individual names and were actively trading the money themselves rather than it being passively invested. Although there were a few things called investment trusts that were a bit strange.

Do you think, would the market be more or less stable if we were somewhere between those two extremes? It's hard for me to get my head around the fact that individual retail investors who, generally speaking, can be pretty wild in their behavior make this system less stable than this mental image I have of a river of money kind of flowing consistently through the system?


So, I think we have to be very careful, right, because one, I do think that you referred to the Unit Investment Trust. I actually think that they are very similar to much of the financial innovation that we're talking about with passive. They largely were designed to deploy capital. There was far less consideration of what actually sat inside them. In many cases they were blind in terms or that they didn't disclose either the amount of leverage that they used, etc.

I think another component that people generally under-appreciate is that while we all complain about leverage and we complain about the high levels of debt, the flavor-de-jour of how we solve this is something like risk parody which says, "OK, let's lever our portfolio 10X in the fixed income space, and let's add..." What you're actually doing is adding debt. You're adding recourse debt to your portfolio and saying, “That's the solution to how we trade a world that has too much debt. Let's radically increase the quantity of debt.”

Well, by definition, if you choose a levered approach, you're talking about increasing the demand for financial assets in aggregate. So, I think there is a lot of similarities. Again, this is one of the reasons why I draw the analog to the 1920s because I think we have financial innovation without a very thoughtful application of what we're actually doing.

Then, just in terms of would the market be more or less volatile? I just think it's really hard to say. The bid/ask spreads in the 1920s, in a world that was dominated by high commissions, by restricted access, it's just really hard to actually draw a direct analog.


Hard if not impossible. All of those time periods are different.


There was a period during the Sumerian... I'm joking. That was a joke. (Laughter)

We have no idea, we really don't. So, the only thing we can do is build a model and if that model broadly fits the data then you continue to follow it.


Yeah, we're seeing... I was really surprised, I saw it on Twitter (I think) last week. “U.S. pension funds considering to lever up.” To the extent that they're doing 60/40, or risk parity, or whatever it is that they do with their long-term asset allocation, but they're going to go (I don't want to say 'all in'), they're shifting up one gear because they need to deliver, I don't know what it is, 7%? They cannot deliver 7% in the current interest rate environment. So, what do you do? You lever up. This, to me, sounds like a recipe for disaster.


I have to agree with you. I think that part of the irony is that most leverage to this point has been held within a limited liability format. So, CalPERS, for example, who is where the headlines were for the last week, they can absolutely buy, as a limited partner, into a fund that is levered twenty to one. That's a way of tapping leverage but it's nonrecourse.

What they're talking about doing is actually borrowing money that is fully recoursed to the pensions and then deploying that. From a risk control standpoint, somebody needs to be slapped upside the head. That's just stupid. It really is. It only happens in an environment in which people are just so arrogant that they honestly can't think about the liability that they are creating for the taxpayer.


There are so many things, really, to unpack with you, Mike. Now, since we are talking about pensions I'm curious about a couple of things. One is, of course, a lot of people talk about the looming pension crisis. I think, actually, on Real Vision, you ran a whole series on it so I'm kind of interested in your view on that. But I'm also interested in demographics. How does that all play in? I imagine that the younger generations, obviously (most likely), are passive type investors, Robo-investors, or whatever; I imagine that the older generation, my age plus, maybe not so much; then there is the whole demographic shift, the boomers retiring and needing money back, where does this all fit in?


Yeah, I know. I think you're hitting on, obviously, the critical issues. Again, we don't have a model. We can run things forward but we have to do so with uncertainty about the asset return framework. So, one of the brilliant things about, at least, the way it seems to be structured is that if I think the market is going to go up 50X, or more accurately 20X from these levels, well then we've solved the problem. It's all fixed. Let’s just go levered long and everything is going to be fantastic.

The problem is, though, that what that's doing is that's pumping up the claims that the boomers have on the system and that, in turn then, needs to be sold. So, you have this perverse impact where the money that is coming out is a function of the level of the asset price. But the money that is going is a function of the level of incomes.

So, when I start talking about incomes, I'm obviously talking about earnings and those can be both on the corporate side and on the personal side. They're linear in their construction. They basically have to be one-to-one against an income stream. There are only so many pieces of the pie that can be split up. If we decide we're going to pay a lot more for that and we build that on the backs of young people who are deciding through no fault of their own, it's simply the system that we have set up, that 6.5% of their paycheck, every two weeks, goes into trying to buy stocks at higher and higher valuations while they’re getting less and less ownership for each dollar that comes in. The money that is coming out is ultimately going to swamp that.

So, to me, that's the real pension crisis is that, at the end of the day, the cash flows don't match. So, the only solution to that is somebody else has to step in and either suspend the prices on the assets so that they can't be driven downwards, which is what I would argue we have done for the past twenty years. I think this is largely the phenomenon that we see with the Feds reaction function. Or we could decide that we're going to replace the actual cash income that's lost at some level.

The problem is that politically where do you pin that? Do you pin that at S&P 15X earnings? Do you pin it at 30X earnings? Do you pin it at 100X earnings? The problem is that we keep setting that level higher and higher. The Fed's reaction function is getting quicker and quicker and quicker because this problem is just growing.


When I'm talking to people who are quite a bit older than myself about pensions and I said, "You know, pensions don't really exist they're just, essentially, a contract between you and the younger generations as to how you're going to transfer money to each other." Ultimately that has to happen in through some mechanism, right? So, in this country, I guess, we have a bigger state pension government-funded pension and any shortfall in private pensioning income will, most likely, come through higher state pensions. Of course, where is that coming from? Well, it's going to come from general taxation. Who's paying the tax? It's the younger generations.

The distribution of how that kind of reallocation of wealth from old to young happens, maybe, differently, depending on the mechanism but ultimately, if the boomers have got these huge claims, then they're either going to have to be reduced somehow, or repudiated effectively, or there's going to have to be another mechanism of getting the money out of the younger generation to ultimately pay it.


Well, I think there are a couple of different ways it can happen. One is that, as you said, we could explicitly reduce it. That's difficult to do in a Democratic system. It's fascinating to watch, and this is obviously one of the implications of something like Neil Howe's generational view, that ultimately there is a war between the younger and older generations, and do we choose to actually stick by that?

Well, the older generations control the infrastructure. They control the political systems. At least for now, they certainly control the access to the power in the form of police and everything else. I think we're starting to see these systems bang against each other. Historically we have not had problems to this level with the exception there are just a very few empires where you have anything remotely close to this.

The Roman Empire had achieved a level of relative affluence and it had to deal with stuff like this. So, the transition over the first century B.C., from the Roman Republic to the Roman Empire, is one that I continually emphasize for people that we are looking at a system where what everybody is crying is, "We need a single, strong individual who can take control of the system and force people to make the changes that they are refusing to make as a Democratic politic, as the voice of the people. We are refusing to do that so we need to have a strong and..." Well, that's a dictator. That's what a dictator literally is.

So, I'm very concerned that we're meaningfully stressing the Democratic institutions. I would highlight in the United States, and I think this is also very true in Europe, that you're seeing the discussion right now with Germany and the rest of Europe ultimately deciding how we're going to choose to allocate those resources is really hard.

California is broke, totally broke. If I look at it from a standpoint, I had a Twitter response the other day that in this version of the European debt crisis the role of Greece will be played by California, and Italy will be New York. We need somebody to bail out California. We need to bail out Illinois or we need to decide we're not going to do that. If we choose not to do that then there are going to be huge implications. There are going to be huge implications if we choose to bail them out. We don't have good choices in front of us and we don't have good systems for dealing with it.


That's essentially the picture that we're looking at here in Europe. We don't have the fiscal union, we have a common currency, and a common central bank but no fiscal union, no centralized taxes, none of that stuff. So, the system is under permanent tension of breaking because of the imbalances that it creates.




What I want to come back to is, what you always read is, "During these uncertain times, if you need any guidance, look at me..." But in markets, it's always uncertain. Even the easy peasy bull market trading is never easy. There is always uncertainty. What I want to say is that we're getting to more and more levels of extremes. That is at least my feeling.

When I look back over the past, say, twenty-five years we've had many crises and all of that and there has always been uncertainty. But what's happening now; every crisis that we're getting into seems to be a little bit worse than the one that we had before in terms of money printing, in terms of central bank reaction functions, whatever the case may be.

So, it feels like, at some point, we will get to this end game and something will break. Democracy will break, whatever the case may be, there will be something weird going on. My question is, how would you best, from an asset allocation, trading, investing trading point of view, how would you best prepare for that?


So, that's actually why I joined up with Wayne and we chose to launch the Logica Absolute Return product. We have actually tried to design it to be a product that takes advantage of the futures that we think are likely. So, rising volatility; a market that is increasingly extreme in both directions, those are outcomes that lend themselves to strategies that use derivatives. So, that's what we've tried to do. We've actually tried to build a product that is capable of exploiting this phenomenon.

It's challenging, though, because as volatility rises the price of that non-recourse leverage (which is what we think of as options…) the price of those begins to rise and other people begin to pursue these strategies. So, we have to be thoughtful about how we adapt at every step in the process.

We have gone, in the period of (give or take five months that the Logica Absolute Return product has been live), we've been through almost every possible node in terms of our allocation schema, and as a result, we're actively involved in developing more technologies, more approaches to what could happen next. How would we be prepared if X happened? How would we be prepared if volatility rose from an already elevated level? There's a different answer to that than volatility rising from a very depressed level.

So, we just have to be very thoughtful about how that's done. I don't think that there is anyone system that you can set and forget and say, "Here's a permanent portfolio.” A lot of people have spent a lot of time trying to do that and they have used the past hundred years of data but we've been talking for twenty minutes and I have already introduced the Roman Empire. So, now we need two thousand years of data; and I mentioned Sumeria, let's get five thousand years of data; and then let's consider the fact that we happen to be the only inhabited planet that we know of. Somewhere out there is probably a ten thousand or ten million year history of an investable society, maybe there isn't.

Moritz: Passive investing.


Passive investing, who knows. It's intergalactic, who cares. That's part of the point. You use the phrase 'non-argotic'. It is a non-argotic system. Our participation in this system changes it. All of the models that we have adopted, over the past seven years, especially passive investing, assume components of an argotic system. We use the phrase 'Monte Carlo simulations'. By definition Monte Carlo simulations assume argodicity. They assume that the distributions are stable and unchanging and that's just wrong. It's just wrong.

So, we build this giant edifice that now manages roughly half the assets on the planet under the assumption of the earth being flat. It's not flat. That's going to cause accidents. The more resources we allocate to a system built on the idea that the earth is flat, the more people we're going have to burn at the stake to prevent the truth from getting out. So, we've built an edifice that I think is absurd.


I agree. You have people like Nassim Taleb talking about the massive impact of the tails and he has a big following, but this is only one part of it. We know there are tails. We know tails are fatter on both sides of the distribution, actually, but what you're talking about is that the distribution that we're looking at may actually be completely wrong.


Right. I think that is absolutely correct. I think the irony is that the process of building the perception that the system is understandable, under some form of log normality or some form of Brownian motion which sits at the heart of all sorts of Wall Raousian equilibrium models, the process of assuming that and putting capital to work under that framework (this is what I was referring to earlier) perversely, actually, imposes that framework.

If I have capital and every time something moves two standard deviations down, and I buy it, well then, guess what? At two standard deviations, the tails are going to increasingly be less fat. It's going to look more normal. Actually, it's going to experience increased kurtosis.

The center is going to be higher because there are more people engaged in the process of mean reversion. Now, all of a sudden, what causes it to break is when forces that we couldn't have foreseen overwhelm those mean reversionary characteristics, and then the market is forced to unwind in an extraordinary fashion.

So, this is very much the Minski type framework. Stability begets fragility or instability. So, we have built up this giant edifice that is just predicated on assumptions that were made because it was easy. The math is really easy with log normality. The math is really easy if we have mean reversionary behavior. There are lots of assumptions and things that we can point to and the fact that markets, largely, behave that way because individuals discounted historically.

So, if individuals discount, if the market participants discount, then the market will exhibit mean reversionary behavior. If the systems are built to reinforce the momentum characteristics; if the system is built to say, "Hey, let's reinforce these dynamics" (because we assume that everybody else has already done this work), and we put all the capital there; then we destroy the mean reversionary characteristics of markets. That's exactly what we're seeing.


You mentioned history and, I guess we all study history, we all use historical data to build our models and, as you say, we try and draw some analogs back in time. But one of the things is (and I'm curious to see whether I can make this fit into the discussion), when we go back in time, one thing that we observe is that countries were much more individual because we didn't have the technology.

So, a lot of the time, when we had a crisis, these crises were isolated (OK, so Japan had a crisis but the rest of the world was doing OK and then Europe had a crisis but other parts of the world did OK), right now it seems like correlations between economies have increased dramatically for the first time. It's not happening just now, but it has been around for only a few years in a bigger picture. So, economies are coordinated, and, for the first time (I think) right now, we have G10 currencies. We have the interest rates pretty much at the same level. So, what risk does that introduce that the whole world seems correlated (for lack of a better word)?


I think you know the answer to that. If there is increased correlation then there is decreased ability to diversify your risks. The system becomes more prone to extreme behaviors. Wayne has a really good illustration that he uses that says, "Look, if you think correlations are low at 0% correlation, well, that means things move in the same direction 50% of the time. If they're 25% correlated that means they move in the same direction 62.5% of the time, and if they're 50% correlated then they are going to move in the same direction 75% of the time." So, the more correlated they get the more extreme the peaks and valleys. There is very little modulation that becomes possible.

Again, this goes back to the underlying building of the fragility of the system. If the system is predicated on the assumption that the authorities will do everything that they can to keep the system in place, to maintain the current functioning of the system, there is a huge moral hazard associated with that which is the exact same one we were just describing in terms of the mean reversionary characteristics of markets. When that breaks, when some external force causes that to be challenged, then all hell breaks loose.

I would say that this pandemic has been interesting. We have seen some very real-world stresses where optimized systems don't work really well. The U.S. experienced toilet paper shortages. That's absurd. We experienced shortages of very basic things like personal protection equipment for doctors. We were told masks don't help, not because it was true but because we needed to preserve the masks for use by medical professionals. We didn't want to see hoarding activity. We didn't want to freak people out.

So, I think there is no question that there is an extraordinary amount of fragility that we have established. Breaking down that element of cooperation, whether it's between the U.S. and China or whether it's between the European States or the U.S. States, all of that effectively exposes the gaps in the system. If California decides to horde PPE and not share it with New York, then both have to supply more PPE on a short-term basis and it becomes more difficult for an already stressed system to meet that. That's a reduction of the surplus that I would actually characterize...

People talk about, and I have spoken openly about this before, people use the phrase, "We live in the age of uncertainty." That is such a pile of dog doo-doo (I guess is the technical term). We live in an environment of absolute certainty.

How are you going to get to work every day? Well, you get on this giant concrete structure that has been built by the resources of society and you transport yourself and your four thousand pound piece of equipment to a parking garage where you're going to take an elevator that had to be constructed to take you up to your office. You only build those systems in environments of intense certainty.

I tell the story, and I use the analog, in places like Africa where they still wash their clothes in the river. The river has crocodiles. Well, what happens if you wash your clothes in the same spot every day? The crocodiles are going to be there. They'll be waiting for you. There's a rule that says (not rule but it's a rule-of-thumb), you can swim across the river at a point of entry once; if you do it twice the crocodiles are going to start paying attention; by the third time, they're waiting for you. Imagine if, every three days, you had to change your route to the office because there were crocodiles waiting for you. That's uncertainty. It's only when we have extreme surplus that we create the certainty that we can then turn around and go "Gosh I'm so uncertain. What am I going to have for dinner tonight?" Not, "Am I going to eat dinner?” or, “Is something going to eat me for dinner?" It's, "Do I want Vietnamese or Chinese or Tai?" That's not uncertainty.


It's still a very difficult decision. (Laughter)


It's always going to be Thai, but yes. (Laughter)


I guess one effect of certainty, I'm not sure about going back to Roman times, but the Bank of England did do a paper, relatively recently, with interest rates data back about seven hundred years and that showed a slow secular decline in real interest rates, globally, from about 15% to where we are now, which is pretty close to zero. I guess lower real interest rates are a byproduct of certainty because you don't need as much of a premium for lending money.

We talked a little bit about the kind of hunt for yield and the hunt for using leverage to do that. That's an obvious byproduct of having this low-interest-rate environment. What else is out there? What are the other kinds of carry trades that you see, potentially, people going into or that are already in and that will become overblown as a result of the backend of seven hundred years of falling interest rates that don't look as if they are going up anytime soon?


So, I think that's an interesting paper for a couple of reasons. I'm actually doing some work collaborating with a Brown [University] professor. His name is Mark Blyth, on a paper that talks about some of these components. One (again remember), anytime you look at a long history of data, anything that is predicated on uncertainty, like interest rates, if you are looking at a long history of it, it almost, by definition is going to fall because if it has risen you're in the dark ages and you don't have the ability to access long reams of history. So, you just have to be somewhat careful about the point in time. That's the reason we don't have a five thousand year history of interest rates.

The second component that I would say is that a big chunk of what drives real interest rates, and there was a really good paper out of U.C. Davis talking about the dynamics of pandemics back through the ages and comparing it to wars. So, real interest rates are actually driven in a large part by the availability of competing uses of capital. So, if I don't have a road between two major cities, or I don't have a train between two major cities, there's a high ROI associated with that. Anything else I want to use the money for, rather than expanding the trade between those two places, is going to have to compete with that underlying dynamic.

So, I think part of what you're actually seeing with the low level of real interest rates is a combination of low to negative population growth rates particularly adjusted for demographics in the developed world. What's the return to widening the highway between New York City and Boston? It's pretty low. There is not a lot of value there. If anything, the disruption associated with that construction is far more than the value that could be created. We see this with the dynamics of high-speed rail. So, those factors, I think, largely are responsible for the low level of interest rates, the low level of real interest rates that we're experiencing.

The hunt for yield, the search for yield is a second dynamic which is that we have, by-and-large, chosen (through policy) to lower interest rates and raise the value of existing capital and lower the opportunities to invest new capital. Yet, people are living longer and facing a need to drawdown assets in a way that forces them to seek out forms of yield that allow them to live off of their assets.

Unfortunately, the way that most people are choosing to do this (whether it's because they don't understand the implications of what they're doing or whether it's because they understand it and consider the risk offset by the socialization of losses), they're choosing to monetize greater sources of volatility. So, yield enhancement strategies that involve things like selling puts or selling calls is overriding. That's just another way of creating an interest rate.

So, an investment-grade bond has a functionally identical payoff to that of a deep out of the money put on the S&P 500. You capture a little bit of premium that you amortize over time and you get a fixed income component to it and your prospect of loss is quite low. So, what we're doing when we decide that we're going to lever up investment-grade bonds is we're saying, "Let's sell lots and lots of puts." Or if we move to high yield, all we're doing is shifting that stripe closer to the money. If we decide that we're going to lever up equities then, theoretically, we're actually moving to selling at the money options. So, you hear people talk about it all the time, "I’m going to sell one put and buy ten calls." Well, you just sold a put. You basically sold a near the money put that, potentially, creates nearly unlimited liability for you.

So, most of these structures, in one form or another, are undoing a feature of the 19th Century that dramatically increased risk - actual real risk-taking activity which is the introduction of the limited liability corporation; the introduction of what we classically think of as equity. We're now in the process of trying to convert all that back to a “Lloyd's of London”. If I write puts on a stock I have a very different profile in terms of potential losses than if I actually own the underlying. In one, the most I can lose is my investment, and the other I could theoretically lose many, many times the margin that I have posted against it.

So, I think we're in a process of returning risk and putting more and more risk onto the household, onto the individual investor with the presumption that the state is going to be there to bail them out.


I agree. I want to, coming back to the put selling, I completely agree. The volumes of what I hear, from speaking to some of the dealers, on systematic selling of vol and systematic selling of out of the money puts in particular [is that] they're not back to the levels that we saw in January/February, but they are substantially up from where they were, say, two or three months ago. So, the memories of those that have been hurt seem to be super, super short, and, even though they have been hit on the chin, it seems that they just don't care. The addiction to getting a yield and generating a little bit of extra income, be that 2% or 3%, is kind of blinding them to the risks.


Again, I would almost flip that and say that is actually a byproduct of the memories getting, "longer and longer." So, if I have got a fifty-year history of vol events and after every single one of those vol events, it was super profitable to sell volatility, which is somewhat by definition, because if it wasn't then guess what? The world ended by a somewhat terminal event anyway.




Well, if you have that "certainty" associated now with a fifty-year history that says, "This is what happens," and you don't have any deep understanding of why this happened or the fact that you're observing that this happened means, by definition, that your dataset is skewed, then you become more confident. This is what we have been taught.

There is an entire field of behavioral finance and behavioral economics that tells us that all the cautious behavior that we engage in is foolish. We have programmed the machines to intentionally ignore this. So, by definition, it's going to look like our memories are getting shorter but in reality, we're more reliant on a longer data series of history.


Good point.


You talked briefly on interest rates. We talked about interest rates coming down and historically have gone down. I couldn't help notice that Jeremy Siegel came out, this week, on Barry Ritholtz’s podcast saying that he wanted to go on record, or he had just gone on record saying that he thinks interest rates have bottomed for a generation, at least, maybe even forever, which is quite a bold claim. Of course, he could be right.

I'm curious to know where you think, or how you think about a potential regime shift, in interest rates. Interest rates, historically, has gone in cycles. This cycle is a little bit longer than usual, never the less, we don't really know if the cycles have broken. So, there is certainly an argument for higher interest rates (maybe not in the short end) where central banks are in control. I know they want to try and have some kind of yield curve manipulation going on but they may not succeed in that. How do you see the whole interest rate spectrum?


So, first of all, I think it's impossible to make that type of call or forecast. I think it's tempting to make that sort of observation when you have an environment of negative interest rates.

To be clear, I think negative interest rates are absurd and that they're a view that I articulated back in 2015 and is now, I think, increasingly accepted that they're ultimately harmful to the banking system. They create a tax on the banking system.

I would just phrase it differently. What would you call anything in which you give a registered agent of the government $100 and they give you back $99? Well, you call that a tax. So, negative interest rates are just a form of taxation. We recognize that (for a variety of reasons, primarily because of the collateral basis of a credit system), we can charge people negative interest rates for holding that collateral. We can charge them a tax on that collateral.

Now, that's caustic to the banking system and it ultimately inhibits risk-taking, but we are able to do that. We could also make it very explicit and say, "Hey, if you want to maintain a bank charter you're going to have to pay a million dollars a year, or ten million dollars a year, or some scaled to your assets framework.” That would be the exact same thing as saying, "We have negative interest rates."

So, as you would expect in that type of framework we see the banking systems getting hollowed out. We see them consolidating. We see fewer local and small banks that are ultimately predicated on the idea that they can earn a return on the capital that they are investing because the governments are choosing to tax them out of existence. So, the systems are consolidating and, by definition, are becoming more fragile.

So, is there a limit to that? Yeah, ultimately we will enter into a regime of capital scarcity. Do I think it's possible to pick that it happen now versus that it's going to happen five years from now, versus it's going to happen ten years from now? I just think there's a huge element of hubris associated with that. By and large, I think Jeremy Siegel's long run type forecasting should be clear, I'm very skeptical that it works.


Yeah, now a question (I guess we're almost out of time), but an observation that when you're actually running money or trading, your worrying about trends that are going happen three, four, five years in the future is a little bit pointless.


I think there is that, but I also think... So, look, the one thing that I will say, and I do think that this is actually really important, is when you think about dynamics of things like risk parity, I think the market is already pricing in elements of that. Post 1998 it became the response function of THE central bank (the only one that really matters which is the Fed) that anytime something goes wrong they're going to cut the price of money. They're going to reduce the yield.

So, what does that actually do? That means that bonds, which go up in price (risk-free bonds which go up in price) when the interest rate is cut now have a negative correlation with risk but a positive expected return as long as they maintain a positive yield. Modern Portfolio Theory tells you that the optimal portfolio, in which there is something that has negative correlation with risk yet offers positive return, shifts from a backpack problem (a 60/40 allocation), to a levered portfolio.

Now, what happens (and I would argue that this is actually the core of the reason why we see negative term premium in the United States) is people are increasingly paying for that put. It's an explicit acknowledgment that there is value to that ten-year bond because of the duration and the response that it has in your portfolio. If we move those interest rates negative, then guess what, all you have is puts. As a negative expected return and a negative correlation to risk, all of a sudden we have to switch back to the 60/40 portfolio, away from the levered portfolio. That creates a net decrease in the demand for financial assets.

So, I think the endgame is relatively close to this nonsense of, "Hey, we're going to cut interest rates every time something goes wrong." But I think the irony, of course, is that almost nobody thinks about it in those terms. We tend to think about it as how much yield is left? How much yield can we get? That's not the value of that asset. The value of that asset is that you've got a positive expected put, and we're close to the end. I hope so.


Yeah, maybe in the U.S. interest rates are going to stay above zero, or about there. Then the other measures may be yield curve control or some form of MMT. We'll see what that brings.


I know we're almost out of time, but you just brought something up that I think is really important. I do think it is important to distinguish MMT between a description of the financial system and the monetary system (which is what it really is), and prescriptions around what we can do with that. So, I hear people use the phrase MMT all the time when talking about, "Well this is where we're going." No, that's where we are. We are in an MMT system. There is no convertibility. The only way that dollars are created is because the government decides to spend them and put them into existence. Taxes are then a means of mopping them up. Interest rates, in that environment, are just another form of fiscal policy.

If we choose to actually believe MMT, Peter Thiel, when I was working for him, had a great line on this which is (I think this might accurately describe it), if anybody actually tried to run a government this way it would be the end of the system.

I think that's really critical that we have maintained these convenient fictions to prevent governments from spending money in the way that they want, in any way that they want. We created restrictions, initially. We had the gold standard to limit the ability to increase the quantity of money. So, the governments had restraint. We then decided that debt provided that tool. Well, none of those were actually true.

It really is just a question of what's the productive capacity. So, the MMT is right but it offers almost no prescriptions for how that money should be spent. So, by handing it over to the politicians, we're at least in a situation where you could see outcomes of how that money gets spent that we have never predicted.


Yeah, it seems that those restrictions that you were referring to, they become weaker and weaker and less and less. There is more leeway in the way the money gets spent. In the U.S. you've received your, I'm not sure what the name of those checks were, signed by Donald Trump, it's a form of helicopter money.


Yeah, paycheck protection also.


Right. A form of helicopter money essentially. So, the same seems to be happening here in Europe. We're going down that route where things that you thought, previously, impossible all of a sudden start to become possible because those restrictions that we imposed on the system, that everybody believed in, all of a sudden there's a reason to do away with them and people acknowledge it and just get on with it.


Yeah, I think it's more pernicious than that. You start your children off believing in Santa Clause, not because you actually want to lie to them but because it's a convenient reason for why they should be nice rather than naughty. "Santa is keeping a list." By the time they realize that Santa Clause may or may not exist in the real world. (I'm not going to spoil this for any five-year-olds that are watching.)


That's our target audience. (Laughter)


Yeah, that works fine. By the time we get to that point, they have actually already established norms of behavior. So, it is a convenient fiction to say, “Well, government spending is limited by the quantity of debt that we can issue if it's done in fiat terms.” That's a convenient fiction. But there is actually value to the restraint associated with that belief. So, my fear is, exactly as you're saying, the more that we recognize, “Well, there is no limit based on the quantity of debt or the need to service debt that's written in Uncle Sam's script,” the bigger the risks are that we actually have uncontrolled government incursion in our lives.


Well, it seems like the big reset comes the day when we lose confidence in that notion that you can just keep adding and adding debt. But we're not there yet it would seem.


I would flip it and say that moment comes when we realize that there is no reason for us to actually pay our taxes. If there's no reason for us to pay our taxes, either because a foreign power has invaded or because the government is illegitimate in terms of its claim on force, then that problem is here.

The concern that I have, honestly, is that, if anything, we're showing the exact opposite. We have become, in the United States, in a way that I don't think anyone could have forecast (I think in Europe you were further along this path in a lot of ways), my kids said to me, going into the CaronaVirus, "How do we protest if we're not allowed to go outside; if we're not allowed to say that we object to this; if we're not allowed to say that we can't gather together and say, "Hey, we shouldn't have schools shut down," if there is no mechanism for that, how do you avoid paying your taxes?


Well, it's very convenient. I know this is a completely new discussion, and we could spend another hour or two with you, Mike. I mean, it is another discussion, right? That what the pandemic also did was it kind of took away some of our ways of protesting and saying, "No, we don't agree." That's an interesting concept which a lot of conspiracy theorists have their own thoughts on. But let's leave it with that.

This was really great, Mike. Thank you so much for spending some time with us. We really do appreciate it and I'm sure all of our listeners do as well. By the way, make sure to follow Mike's work on Twitter, Real Vision, and his new venture at Logica Funds. From Rob, Moritz, and me thanks so much for listening and we look forward to being back with you as we continue our Global Macro Miniseries. In the meantime be well.

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