Allocating Assets when Goldilocks Inverse ft. Christian Mueller-Glissmann

[00:00:07] Christian

You want to create a portfolio that deals with the risks but also gives you upside options to the opportunities. The biggest threats to your portfolio will always be inflation and stagnation. So you need to find ways in your portfolio to address those, and preferably, as I mentioned earlier via SAA, because it’s a structural cycle risk and it can take a long time to actually manifest itself in asset prices. So that’s the way I think about it. I just want to have these ways to tilt the portfolio without being too aggressive on taking a view on these things.

[00:00:44] Intro

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:40] Niels

Welcome and welcome back to another edition in our Global Macro series where today as usual, I’m joined by my co-host, Cem Karsan, as well as our very special guest, Christian Mueller-Glissmann, who is the head of asset allocation research at Goldman Sachs, to try and make sense of how investors should allocate their capital in an ever-changing global environment.

Welcome to the show, Christian, and thank you for joining Cem and I for what promises to be a lively and very insightful conversation as part of our Global Macro series. How are you doing? Where do we find you today?

[00:02:13] Christian

I am in London. Thanks so much for having me. Thanks to technology, it seems to be working all well.

[00:02:20] Niels

Absolutely. What about you, Cem? Where are you chiming in from today?

[00:02:23] Cem

Chicago, back home, kind of getting back in a routine here. Post Labor Day, everything gets started, so back in the pilot seat.

[00:02:32] Niels

Good stuff. Now, before we dive into all the hardcore investment stuff, Christian, what I’d love to do is if you could just help us set the stage a little bit, just provide our audience with some context as to how you went to head up the asset allocation research at Goldman Sachs. How did you get there? What was your path?

[00:02:52] Christian

Yeah. Listen, I’ve been at Goldman now 20 years or so. I started out here after university. I actually started in derivatives trading. I’ve always had a bit of a quantitative affinity, let’s say it like that. Then I got the opportunity to join a team that develops quantitative investment strategies, focusing a bit more on micro angles. One of the big things we were looking at at the time, which a lot of people know me for, have been dividend swaps. That’s one of the markets where we were some of the innovators developing dividend swap related strategies in the early 2000s.

Then I moved over to macro strategy 15 or so years ago. Originally, I focused a bit more on equity, but over the last 10, 15 years, there’s been this huge shift towards multi-asset investing. Considering it’s a bit more quantitative, there’s often derivatives involved, there’s often modeling involved, that’s kind of where I’ve migrated to and I’ve been doing it now more than a decade. I’m very happily.

[00:04:00] Niels

Yeah. Absolutely. Sounds exciting and just what we’d like to get into. So let’s kick things off. Maybe to kind of warm up our conversation, perhaps I could ask you to share your current big-picture macro framework. I recently heard you talk about inverse Goldilocks scenarios and all that good stuff. So perhaps you can talk a little bit about what that all means and where you see the environment right now.

[00:04:28] Christian

Yeah. Listen, when I think about asset allocation, I always look at three cycles. There’s the sentiment cycle, the business cycle, and the structural cycle. The structural cycle is your longer-term trend in growth, inflation, policy. I think there’s a lot of uncertainty about what the structural cycle in the next 10 to 20 years is going to look like. It’s very likely to look quite different to what we had in the last 10 to 20 years, and we can discuss that. But certainly, the focus right now into year-end for us has been much more the interaction of the business cycle with the sentiment cycle, which is a bit more short-term relevant.

You mentioned already, what we’ve been writing, what we’ve been saying is that since the beginning of the year, a lot of investors were surprised by the strength of the risky asset recovery and how well markets have performed, how risk premia have compressed, how volatility has settled. Normally, when we talk about these very risk-friendly backdrops, they happen during Goldilocks. They happen in periods where growth accelerates without inflation, and that (for obvious reasons) is good because it generates good outcomes for risky assets without a drag from higher rates. We haven’t had that this year. The growth backdrop hasn’t really improved.

The real thing that happened is that inflation has come down. So I call it a bit like an inverse Goldilocks. It’s not like growth picking up with inflation staying where it is. It’s more like inflation coming down with growth staying where it is. It’s not the case everywhere that growth has stayed where it is. It’s particularly in the US. The US has been remarkably resilient and I think that has been the big surprise. You can have a soft landing and disinflation. That is something most investors haven’t been prepared for.

But I think in our research, we found, for quite a few times now, significant disconnects between growth, inflation, and policy. When people think about business cycle investing, they often have this template that growth picks up, inflation picks up, central banks tighten policy, growth goes down, inflation goes down, central banks ease policy, you start afresh.

But what we learned in the last 20, 30 years is that it’s not working like that anymore. You have much more periods where growth picks up without inflation, and sometimes, policy gets tightened without inflation. There’s huge disconnects between these three variables, and that’s why it’s so interesting. So to me, that’s been the big surprise that you can have inflation coming down without the growth damage, especially in the US. So that’s the inverse Goldilocks.

I think the challenge you have from here, as you were asking what’s our view, is that everything I’m telling you is quite well reflected in markets. I think when you look at the sentiment cycle, we’ve seen a significant pickup in risk appetite. So you have seen compression, credit spreads, volatility settling; you’ve seen rotation into cyclicals; you’ve seen down in quality shifts. So my sense is that the key challenge from here is, what are we going to get in terms of the macro? Are you still going to get disinflation without growth damage and what is the market pricing?

From here, in our view, it’s got to be more bumpy because the disinflationary momentum is definitely starting to come off a bit, we’ve seen it with recent data, and it’s better reflected in markets already. So we are relatively neutral on risk, relatively neutral on both beta in equity and on duration, being a bit focused on portfolio construction, on balance, on specific areas which we think are attractive.

[00:08:13] Niels

Great stuff, Christian. You touched on something where you said, certain relationships that people have been used to were breaking down, and that’s what you found in your research. I think one of those relationships that we have to bring up, at this stage, that I think a lot of portfolios have been very used to and probably were surprised about the breakdown last year is correlations between stocks and bonds. Clearly, people have relied so heavily on the 60/40 portfolio construction for a few decades.

But when you broaden the horizon and if you go back say 100 years or so, what people may be surprised to find is of course that actually, most of the time, correlation between stocks and bonds is actually positive, not negative. So I’d love for you to talk about this. I think you’ve written about this as well and kind of how you see this relationship maybe in the short term, but actually also on a structural level, because as far as I can tell (and you know this much better than I do), as far as I can tell, there is some reflection of inflation. Inflation plays a role in this relationship. So I’d love to hear your thoughts about this.

[00:09:26] Christian

Yeah, 100%. I think what we’re learning, and what again, as you were saying, has been a bit surprising for investors is that the last 20 years, which have dominated most of our careers, I think are more the exception rather than the rule. I think these negative equity bond correlations have come from a structural backdrop which was characterized by disinflation, by deflation in a lot of the places in the world, and very anchored inflation. To me, one of the most important variables to watch here is inflation volatility. It’s not just the level of inflation that matters. It’s actually how predictable or unpredictable inflation is.

We found actually that both the term premium in bonds and the equity risk premium, both of them react badly to inflation volatility. So it’s something that, for both of those assets, actually drives a correlated move. My sense is that more inflation volatility in the next 10 to 20 years is a decent base case. We need to acknowledge the 3 Ds. I think we all know the 3 Ds: decarbonization pressure, deglobalization pressure, and demographical challenges, which at the margin are leaning towards more inflation uncertainty. We can talk about those in detail.

The magnitudes, we don’t know exactly, and certainly, it shouldn’t be as bad as most people are fearing with regards to stagflation and ’70s. I don’t think that’s what you should pencil in. You should think about higher inflation, maybe a bit higher, a bit more unpredictable, which means the equity-bond correlation probably will average closer to zero, maybe a bit positive. But what’s important, as an asset allocator, is that’s still quite valuable. It’s absolutely fine to be correlated at 0.1 or 0.2. You still have a huge diversification benefit especially if occasionally when something extreme happens, you do get a benefit.

Think about the regional US banks crisis where I think the bond market was incredibly reactive, rightly or wrongly, and maybe that was just a bit of a Pavlovian reaction from the bond market, and eventually, these types of protection values and systemic crises will disappear. But for now, the empirical evidence is that despite high inflation, which we had at the beginning of the year, the bond market could help you with systemic risk. It probably won’t help you as much with cyclical risk, and that’s what we know from history.

When you have high inflation, exactly as you said, the central bank reaction function tends to be constrained, you don’t have the ability for counter-cyclical buffering, the equity-bond correlation (just based on the traditional growth shock, not like a bank crisis) is probably not going to be as negative as we are accustomed to.

[00:12:21] Niels

Yeah, absolutely. Cem, what’s on your mind?

[00:12:25] Cem

So listening to your stuff, I kind of mentioned this offline, but I really find a lot of commonality in the way you think about the world coming from a very different perspective and a very different background. Maybe it’s that start you had in derivatives trading that binds us together. But when you talk about structural cycle, cyclical business cycle, and sentiment cycles, obviously, these aren’t independent cycles. They influence one another considerably.

In particular, the business cycle, during the past structural cycle (maybe 20 years, as you mentioned, 30 years, I would say), the business cycle has been dominant because the structural cycle has been one where the Fed and monetary policy has been dominant. So there has been a Fed put in the market that essentially allowed the business cycle to be what really ultimately mattered, and it was very two-dimensional, in some ways. If you go back, you have short periods where things diverge, but for the most part, if you got the direction of the business cycle right, you got the direction of the market quite right over those periods.

I would argue during this new structural cycle, which is one of the highly (I agree with you), higher probability of higher structural inflation. We can debate how high that inflation is going to be. But during periods of that, the Fed is less dominant because their two mandates, in particular, are opposing one another. Through that process, the business cycle ( this is why stagflation is a problem), the business cycle is less predictive necessarily of equity market and risk outcomes. So it complicates these cyclical motions in the market and using them to predict, and actually, the structural moves in the bigger picture end up becoming more dominant.

Again, think ’68 to ’82 where the markets went nowhere but GDP growth, in real terms, grew well above trend. Those are two things that are, for most people, a very confusing concept. So I’d love to hear your thoughts on A, if you agree with that, and B, how you see the business cycle and equity returns performing relative to one another in this period. Do you think it will replicate something like ’68 to ’82 where equity market performance can be very poor, in real terms, relative to economic strength? I’d love to hear your thoughts.

[00:14:55] Christian

Listen, a lot to unpack here. Let me start with this interaction of the structural cycle, business cycle, and sentiment cycle. I agree they are affecting each other in real time and we know that investors love to pull forward structural problems and possibly exacerbate structural benefits like AI. It’s a very good example. So I think you’re absolutely right that you shouldn’t necessarily look at structural issues and say, oh, it’s really far away, it won’t affect markets in real time right now. But generally, the way I think about it is, like your tactical, your dynamic asset allocation should focus on most of the variation in the sentiment and the business cycle. The structural stuff you should try to address in your SAA, in your strategic allocation, and you can do that.

You were saying that the structural cycle, to some extent, affected the business cycle but not really markets that much in the last 20 years. I would say the biggest trend in the structural cycle, in the last 20 years, was real yields. I think real yields trending down are providing a valuation tailwind, and as a result of that, equities are probably doing much better (to your earlier point) than what the economic picture actually suggested. I think that was a trend. I think you had structural changes with regards to taxation which allowed the corporate sector and tech probably do much better than the economy.

So there are a few things that bubbled in the background, but you’re right, there’s also this interaction with the structural cycle and the business cycle which had a huge regime break. It’s funny how you explained that because we’ve done a bit of work on that recently which to me came out with a very similar result to what you said, but we actually used machine learning to come up with the same conclusion. What we did is we actually developed a machine learning approach that looks at growth, inflation, and policy, and tries to market time between equities and bonds and between cash and the 60/40 portfolio, and we saw exactly what you said, because in the last 20, 30 years, inflation volatility has been so low.

If you run the machine learning model and you let it train. You train the machine just since the ’90s, it will tell you, the only thing you need to know is growth. Like it’s all about growth, forget about inflation, because there was no inflation volatility, and growth and policy were linked. In other words, if growth was getting too strong, you got policy tightening even if there was not much inflation pressure. So that was a quite weird regime.

But if you take that whole machine learning exercise back to 1950 where pre the 1990s, you had a lot of inflation volatility, exactly to your point, suddenly, the model will say, look out for inflation, that is the destructor of your portfolio. As we discussed earlier, in high inflation periods, equities and bonds go down together. So suddenly, the tail risk is shifting completely where inflation, according to our machine learning model, is possibly a bigger risk than growth over the long run. So I think you’re right. We have to think about a bit of a regime shift in the next 10 to 20 years.

I would also agree that inflation volatility is likely to be higher and going to drive more asset price variation. If it’s going to be more important than growth remains to be seen. I think I would say it just gets more important and it comes down to the growth-inflation mix. If you have the risk of falling into stagflation, then inflation will matter more than growth, and that’s a bit like what we’ve been dealing with in the last year and a half. I think if it’s kind of more the nuances, how much inflation you generate for how much growth, I think there can be occasionally equal importance on both of those.

To answer your question on the ’60s to ’80s, I find that’s a very interesting discussion. I think for sure, like what we found in our research as well, there are so-called lost decades. There are periods where asset prices just don’t go anywhere in real terms and you were better off probably putting your money into consumption or cash, if that makes sense. There is a risk that we are going in the next 10 to 20 years into a structural macro backdrop that is much less friendly to asset owners.

What I would say though is if you split the ’60s to ’80s into two periods, like the ’60s and the ’70s, that’s a very different asset outcome. The ’60s were actually very good for asset investing, in particular, for risk-adjusted returns. The ’60s were remarkable with regards to the low volatility you had. The ’60s were one of the lowest volatility periods in terms of macro on record. Actually, if you look at S&P realized volatility, you also had one of the longest low vol regimes. I remembered as I wrote a report on this some time ago, one of the longest low vol regimes on record. So while the returns on equities were not particularly attractive, the risk was also not very high. So as a Markowitz investor, you could say it was fine.

No doubt the ’70s destroyed any return you accumulated. But I would say, it always comes down to structurally, to me, the fight between growth and inflation structurally. You have on the growth side currently, in my opinion, two major drivers that are fighting: AI and population growth. I think AI has a lot of upside optionality on productivity. Population growth is an inevitable drag on growth globally, especially in Europe and China, and so on. Then you need to look at inflation. I think you have the structural factors we discussed earlier, the 3 Ds. But then you have, again, the impact of technology.

I think technology is going to be a key driver of what happens with inflation, but also, what central banks will do. Because ultimately, which one my colleagues, Jeff Currie, always told me, is inflation is a political phenomenon. So a lot can be done to get inflation under control and that makes it so difficult. With everything I know right now, I’m not very confident because we know that there could be huge tax incentives with regards to all kinds of problems in the world that need to be solved. Some of them are there, like maybe the Inflation Reduction Act with renewable energy investment. But it’s got to take time, and in a lot of cases, unfortunately, it might not be enough.

[00:21:34] Cem

I couldn’t agree more with everything you just said. But I think the key is, I think way too often we talk about inflation as one thing. I do think you have inflation as a function of supply and demand, which again, relates to that business cycle piece, which again has been what inflation has been about really the last 30, 40 years and why that data that you were looking at in the machine learning model that you mentioned really saw inflation is not the critical component.

But if you go to other periods, you have inflation that’s much more tied to structural phenomenon, and those are political, you mentioned. I agree, but that key difference I would to kind of highlight is that political doesn’t mean that anything can happen. In the short period, maybe. But a lot of these political reactions are a function of reactions to much bigger things, in my opinion, like inequality. We’ve had this dramatic increase in inequality which has been driven by Federal Reserve dominance and monetary policy driving money to capital for 40 years.

So we had a model that essentially muted, and that by definition also created deflation because we sent money to capital which created technological development, globalization, etc. We created a deflationary machine which ironically was driven by the Fed. So the Fed could then go business stimulate whenever they needed to use their Fed put. But the problem is the cost was inequality, and the more you get these inequalities in the world, the more you start getting populism which we see globally.

These things are not just somebody deciding politically, oh, we’re going to have populist policies. It’s a function of people pushing back on structural cyclical issues. Those inflationary pressures are not going away. I think you see them in Europe, we see them here in the US, labor rights, deglobalization, protectionism, etc., and those are the things that happened during the ’60s and ’70s. That’s what drove the structural inflation and that’s why I would argue that this inflation is different and it’s not going away tomorrow, and it can’t be muted by the Fed.

Ironically, you can argue that the Fed is going to exacerbate these issues and is exacerbating them. They used to send money to Palo Alto, which is like the technology center of the world, and send us back deflationary goods. Now they’re taking money away from capital, from corporations, and structurally, that’s inflationary. So it’s interesting, they’re two separate inflationary pressures that have very different effects on the model. We often lump them together and assume the Fed can control both or the central banks can control both when one is really not only not controllable by central banks, but they can often exacerbate it structurally. Anyway, I’d love to hear your thoughts.

[00:24:33] Christian

Yeah. Listen, it’s a very interesting argument. Definitely, the real yield is a key driver of short-term disinflation pressure and long-term inflation risk, because exactly as you said, if you push up the real yields, you will constrain investments, which eventually can come up with technological revolution and/or supply. I think we’ve had under-investment into resources for other reasons. It wasn’t even related to the cost of capital, it wasn’t related to ESG regulations, etc.

That has been costly and possibly will be costly because it means that you have the marginal swing producer having shifted back in the Middle East, and that means more oil price volatility, exactly as you said. I think that’s one example where you have the real yield changing and the reversal, as you were calling it, of this kind of Fed shift in the last cycle pushing down real yields, driving income inequality on the one hand but creating a lot of innovation in Palo Alto and in tech. I agree. It remains to be seen, in the next few years,how this AI revolution will deal with these higher real yields. So far, so good. If you look at valuations of AI beneficiaries in the last three to six months, it’s been remarkable.

Last year, you remember this, the NASDAQ was trading in lockstep with real yields. So as real yields went up, you actually had the valuations of those stocks suffer a lot. Whereas in the last three to six months, that relationship has broken down and we were thinking a lot about it. Why is that? It’s that on the one hand, the longer-term growth optimism that’s embedded in these AI beneficiaries has gone up so much that it’s counterbalancing the real yield increases, which means the cost of capital for those shares, for those companies, is actually stable and they’re lucky because investors essentially are happy to know the required return, or is there some mispricing that’s due to be unbound?

We also have to consider that obviously, the private markets industry has accumulated trillions of dry powder which is still from the last cycle and they’re still looking to deploy that. So there’s another cushion here for these higher real yields. So it will remain to be seen if this higher cost of capital will actually stifle the supply side and why we get demand under control in the next few months, like eventually you have supply issues returning. But to me, the thing I’m struggling the most with is really what that technological progress really will be. Because that’s, to me, a debate which has a huge range of outcomes currently.

No matter who you speak to, I think there’s all kinds of views what AI might mean for the world, but also other technological and cycles that are bubbling in the background. Think about obesity drugs, think about renewable energy where there’s been a real turn. Renewable energy has had a real setback, and suddenly, healthcare has had a huge renaissance. So it feels like all these technology cycles are bubbling in the background and I agree with you.

It’s good to be skeptical and it’s good to look at history in terms of how often these technology waves disappointed. But it to me will be critical as soon as you look beyond the next two years, what will be the growth impact of technology and what will be the inflation impact? I agree with you, will they have enough money to actually invest? That’s a really important question as well.

[00:28:15] Cem

Yeah, I couldn’t agree more again. It’s fascinating how you’re coming at it from a different perspective, but we kind of see I had on a couple of these things. The thing with these structural effects is there’s such a lag. As you mentioned, there’s so much money from the last cycle still pushed in forcing maybe the last wave of technological development.

The problem we often see is, everybody always thinks, oh, well, this time, it’s different. This technology is going to change the inflationary pressures. Look at what’s happening. It’s a new technology that’s nothing like we’ve ever seen before. But since the invention of the wheel, we’ve seen things that have never been seen before that have changed the course of human history.

I think the thing that people often don’t appreciate is how important it is to continue to breathe oxygen into those things, in other words, money into that. Ideas take much longer to come to fruition. I would argue, the Amazons and Ubers and Teslas of the world would never have existed without 0% interest rate. The more you pull 0% interest rates, the more you pull that money away from that system,and structurally have to as a function populism and all these other structural inflationary pressures, the more those ideas will still remain and still secularly change the world but at a much slower pace. I think that’s a critical point.

[00:28:51] Christian

It’s a very good point. I think one other thing I find really interesting is if you look at the US in the last cycle, to me, what’s been so remarkable is the combination of innovation and conglomeration. It’s not just that you had technological progress which was investable, but actually, some of the largest companies gave you access to the technology revolution. I think the US has been very good in that. But it also means as a result of that, these large companies now, they are very healthy because that’s the remarkable thing. They have no debt, very little debt. They are cash generative. That’s a big difference to the tech bubble.

I think during the tech bubble, you’re absolutely right. Cost of capital was critical, and to some extent, it contributed to the bubble. But I think this time around, you have these incumbents that actually come from an incredible position of strength, again, as you said, because of the last cycle. So it’s a lag effect that might disappear soon if they make wrong investments; if they put too much money into the wrong projects. We know the R&D spent, for these kinds of large tech companies, is absolutely mind-boggling. There’s billions being spent.

Then you ask yourself, what’s coming out of that? I agree with that. We need to see, in the next few years, if they spend in the right places and generate revolutions that are more meaningful for society and for the problems we were discussing earlier. I think, at the margin, it will be highly path dependent. The way I think as a result of that, in terms of asset allocation about is that you want to create a portfolio that deals with the risks but also gives you upset options to the opportunities.

The biggest threats to your portfolio will always be inflation and stagnation. So you need to find ways in your portfolio to address those, and preferably (as I mentioned earlier), via SAA because it’s a structural cycle risk and it can take a long time to actually manifest itself in asset prices. So that’s the way I think about it. I just want to have these ways to tilt the portfolio without being too aggressive on taking a view on these things.

[00:29:52] Niels

Cem, before you chime in, I just want to maybe, while we’re on the inflation discussion (and then we can move on to the more investment side of things), I think there’s a couple of other things that you already touched on, Christian, that I just wanted to highlight. One is, of course, demographics. We see the boomers leave and we see the zoomers say hello to the workplace. They may certainly not have the same views about working hours and things like that, that their parents did. So that’s kind of one thing.

The other thing we see, at the moment, which we haven’t seen for a while is unionization. We see at the moment the auto workers in the US demanding 40% increase. That will have to be dealt with as well. Then perhaps the most important one for people like yourself, Christian, that live in London, and that is the new one that you could refer to as unhappy hour. Because I’ve just learned today that the biggest British pub owner, they have announced that they’re going to put up what’s called polite notices warning drinkers that during peak hours, the cost of a pint is going to go up by 20 pence, which is another kind of inflation.

Now, what we saw in hotels and in airlines, at peak times, you have prices go up. Now we see this in day-to-day stuff were suddenly your beer is 20% higher during this hour. It’s a little bit of a cheek point here. But it’s also I think an important point because you talked about unpredictable inflation. I think if some of these new, I wouldn’t call it technology, but if some of these new things are happening even to this kind of inflation, that certainly is not going to make it easier for us to find out what is the real inflation in society.

[00:32:14] Christian

I think you make a good point. I always call the last 20 years the age of abundance. Everything was available at your fingertips, often at a discount if you look somewhere online. We’re entering an age where there will be scarcity. I think scarcity will be there because of supply-side issues and sometimes they will create scarcity because they know there’s demand like this pub and the same we’ve seen here in the summer. I can tell you this was an expensive travel season. Everybody I speak to here in London is complaining coming back from the summer holidays how expensive it was.

So I feel like you’re absolutely right. There will be more unpredictable inflation in real time and over time, and that’s what we’re dealing with. I think it’s a shift for the consumer and it’s a shift for investors. I think ultimately, some of the things are faster moving, some of them are slower moving. I would say the demand-driven inflation is faster moving and what you’re talking about is the perfect example, like peak hour, there’s a lot of demand but the same supply. But there’s not a supply issue here. I would say it’s just more demand.

Then there’s the slow-moving stuff, which is to me scarier, what you were mentioning with regards to changes in the demographics of the workforce like the dependency ratio. I think that’s a very important metric to track. Everywhere in the world, the dependency ratio is coming down, in China, in the US, in Europe, to different degrees. So how many people actually in the workforce are the people that are contributing to the overall GDP and how many people are retired? I think that matters from two perspectives.

First of all, the people that are retired, they’re spending more. They’re spending their savings. They have more demand. They are the people that are going on holidays, that are causing us these incremental costs. At the same time, they’re selling assets. Guess what? The dependency ratio means that they have to rethink how much equity do I actually want to have considering I’m closer to retirement, and possibly, they might not even want to take duration risk anymore. They might want to lower their duration because they’re getting closer to their peak consumption. So they’re driving asset price disinflation and real economy inflation.

Then you have the labor force that is shrinking and getting more bargaining power. That comes at a time, which absolutely right, as you said, there are societal shifts in attitude towards work which comes post-COVID, which comes with different generations. So I absolutely agree on everything you said. That is something we need to deal with. That’s something we need to find an equilibrium for, and for the next few years, it looks definitely scary.

[00:36:46] Cem

I think one of the most interesting things that very few people highlight, and why cycles like these continue to persist, is that simple fact that stratification is not just a function of wealthy versus poor, but almost by definition, you can flip it horizontally versus generation because when people come into the workforce, they are labor. Millennials on down have been labor as part of this period of inequality. They are the ones that are by definition, they’re 40% of the wealth creation and household formation of baby boomers at this time in the generation.

So they as a generation have had a completely different experience because they were labor during this period, whereas baby boomers have had the exact opposite period and represent the top of the stratification. So it’s not just inequality. It’s generational inequality. That happens again and again through cycles, because you come out, you’re young, and you are labor.

I think that’s a critical point to why cycles work like this and why they perpetuate themselves again and again. So I think it’s a very interesting point. I think the point you make about the unevenness, and that Niels also mentioned about the unevenness of inflation, speaks to other areas of much more dimensionality to the system. Going forward, where there is inflation, not always inflation uneven, but when you have deglobalization as a function of protectionism like we’re seeing as well, that creates a different unevenness, an unevenness across borders, an unevenness of different types of goods that might be able to be produced somewhere, that might have more success.

It also creates new puts, new areas of strength where maybe those things were not as strong. Think ’60s and ’70s and OPEC and the OPEC put that existed during that period. Why did that exist during that period but didn’t exist more recently until the last couple of years was because we had globalization. There was no incentive to flex muscles and to push back and to try and compete in that regard.

It’s harder to now, with less Fed dominance, with more deglobalization, we’re a competitive system. And guess what? Resources and entities that have control over them now can flex their muscles more. Not a surprise we’re seeing that from OPEC again now in a different way and from other entities. That drives different types of volatility and performance in different asset classes in a dramatic way. So it’s a much more multi-dimensional system.

I’ve heard you speak about the importance of active management, going forward, as opposed to just this passive riding the business cycle, riding the broad performance of beta. So I couldn’t agree more. I’d love to hear your thoughts more about how to approach active, what you mean by that, and kind of take it from there.

[00:39:35] Christian

Yeah. As you mentioned already, I think we’ve had this boom in passive and I think static 60/40 was a very tough benchmark. We have to be completely clear, if you had that for the last 20, 30 years, it would have delivered phenomenally for wealth creation. I think broadly, the active management industry had other issues, performance-related stock picking, etc., which again comes back a bit to what we’re discussing here. Because since the ’90s, you had these two big bear markets where everything became correlated and stock picking didn’t necessarily matter.

If you did right, it was timing-wise very difficult. Good companies became bad investments and vice versa. I feel like it ultimately meant that you had these highly concentrated bear markets, and outside of that, nothing happened and it was just fine to be long. I think now we might have more frequent bear markets and we will have probably more opportunities both to time the market cycle and I think also for stock picking because you probably won’t have these extreme crises where literally everything gets wiped out, like where the equity market is down 50% and people just start fresh.

I think it will be smaller bear markets, possibly. They might even be slower, not the high vol of vol we’ve seen, but they will still be there and I think they will be timeable. I think this comes back a bit to what also you guys talk a lot about in the past as trend following. I think there is definitely the potential that macro momentum will be more persistent because inflation is more persistent, inflation clusters. That might actually mean that you have much more opportunities to capture cycles because the challenge is vol of vol made it incredibly difficult to capture cycles for tactical allocators.

You have to obviously consider that the market has become smarter and smarter. You have to be completely clear, like there are machine learning tools, there are all kinds of things you can do. Which means that if you had information to digest, the market is digesting it faster and faster the information aggregation, which means however, if the macro momentum takes time to build and it’s not obvious what’s going on here, like a financial crisis, a tech bubble, I think then there’s more momentum to capture.

So I’m definitely of the view that there is a case for active management. How to do it will be interesting, because people have shifted more passive and a lot of the asset allocators have been getting more skeptical with regards to market timing, the academic literature obviously contributing to that. I think, to me, a lot of the clients I speak to are shifting, in terms of complexity, more towards the complexity of portfolio construction but not the complexity of market timing.

I think there will be a shift again where people will invest more again in market timing tools, in market timing abilities and generally in trying to understand the business cycle. Because if I think about risk budgeting, I would say that a lot of the investors we speak to that have really large pools of capital, a small proportion of their capital will actually be actively market timing. A lot of that will actually be focused on portfolio construction, like building portfolios that are robust, that are well diversified, that identify attractive risk premia. I think there will be a bit of a shift more towards market timing, I think.

[00:43:12] Cem

Yeah, sounds a lot like ’68 to ’82, three recessions. But overall, GDP growth was above trend in real terms despite three recessions. You had, again, a market that went nominally nowhere but lost 67% of its value in real terms over that 14-year period. But to your point, much less volatility actually when you look at it over that period because not only did the market go sideways, but during those recessions, there were more shallow market dips, etc. So it kind of speaks to a similar copy, not that everything is the same.

Active management did incredibly well during that period. There was the introduction of hedge funds broadly for a reason and macro funds did very well. The I think part that’s unique, that’s different, because it always rhymes but there are always secular changes that make it difference is the introduction of derivatives. Nobody has really talked about this, but really didn’t exist last time we had inflation. So we’ve never had a time of structural inflation with derivatives. I think there’s a major feedback loop that people are missing here that is structurally changing outcomes.

When I was thinking about your cycles, the one thing that, again, this is coming from my bias, this was my world. The one thing I think that is not really encapsulated in those cycles is the structural cyclical effects of supply and demand on the derivative side; on the index level in particular, and the effects that are happening. I think that’s muting volatility at the index level. We have massive structured product issuance which is dramatically increasing as interest rates go higher.

If you think about that, as interest rates are going to 5.5%, you can get a much better structured yield that is much more competitive particularly against a market that’s more risky. Ironically, that’s driving vol compression, but it’s not driving it across the market. It’s driving it specifically at the S&P 500 level where that structured product issuance is added. We know that because we’re getting historic dispersion. We saw the same thing in 2017 with massive supply of vol. So ironically, this dovetails back into the active versus passive thesis.

The reality is, you’re less likely to do well from a beta perspective, but you’re going to get volatility outside of the center where there aren’t volatility centers. It’s not a surprise that volatility is happening in AI where there’s short vol. It’s the most short vol center and in a market where the middle is pinned. It’s causing rotation, because by definition, the index is pinned and things are going up, that means the other things have to go the other way. So that thesis of active management becomes much more pertinent even than the macro dictates because structurally there are reasons that are being exacerbated as well.

So I couldn’t agree more. I think the thing that’s so important is this index dominance. So many people from a fundamental perspective are still thinking about the index as the conglomeration of the parts. But the index is often the dog actually, not the tail, and I think that’s having a significant difference. Anyway, with your derivatives background, I thought I’d go there, but yeah.

[00:46:34] Niels

Cem, can I just throw something in? Because you guys may not have seen it, even though I’m sure you see everything. I think today it was announced that they’re going to have now an ETF that sells puts zero-day options on the NASDAQ. I mean, what could possibly go wrong at this stage, right?

[00:46:52] Cem

Right. All of these things are reflexively having… Yeah, it could even dampen volatility more. I’ve heard you mention, Christian, that equity volatility you would expect to pick up, and I would have agreed from a macro perspective historically. But I think it’s the structured products and vol compression that’s coming from other places in the market that are having a unique effect relative to history. Anyway, we’d love to hear your thoughts, especially given your derivatives trading background.

[00:47:21] Christian

No, 100%. Listen, to the supply-demand ins and outs on structured products, they definitely play a role. I agree with you that these types of rates moves we’re currently having are driving significant changes in structured product flows, away from carry towards capital guaranteed products, so you kind of change very much the demand versus supply for vol. I think, to me, there’s two very interesting things to mention just from a vol point of view.

You mentioned one of them is dispersion. In line with the active management we discussed earlier, I think I would expect dispersion just to kind of be higher in the coming years. It’s both related to innovation I think which is a bit the story that has exacerbated dispersion recently, but it will also be related to what we discussed earlier, like shortages on supply. If you’ve got the right stuff that people need, you’re going to have pricing power, and that will vary.

Now think about the dispersion that has been driven in oil, oil versus the rest last year. So it’s not just dispersion on tech, it’s last year been also linked to that. So I think dispersion will become more common ground because you have this type of scarcity that occasionally will drive large dispersions and winners and losers. There will be companies that suffer from higher energy, there will be beneficiaries.

But the other thing I find very interesting is also the autocorrelation of S&P. If you do track autocorrelation of S&P, that’s changed materially and again looked very different in the ’60s compared to what we’ve seen in the last 20 years and the last three years look more like the ’60s, ’70s. So in other words, you’re starting to see a regime shift here where to some extent because of what I mentioned earlier or what you mentioned as well, the central bank put being less reactive, you get more autocorrelation in returns, which then helps trend following.

But that also means that you essentially don’t get sharp reversals which often drive volatility because you move more slowly. That can also mean that you’re dealing with a slightly different vol regime structurally. So I 100% agree. If you generate macro momentum, that takes time to digest, and you generally have a base level of higher macro volatility that actually means less of vol of vol. I always say it means that you need to think about carefully about trading shorter-dated options because you accumulate much more risk.

It’s essentially about accumulating risk, which increases the potential move beyond the strike. Whereas in the short run, it takes time to move beyond the strike. I think that means that you want to rethink how you hedge, you want to rethink about the value of longer-dated options, you want to rethink how far out of the money you want to go. But I think the important thing as well is the volatility paradox in all of that.

The reason why you had these extreme swings, like this high vol of vol, is the volatility paradox were these Goldilocks regimes which we started the conversation with, they generated like you mentioned ’17 at some point, they generated these low vol carry bubbles which then unwound. That generated a lot of vol of vol and a lot of vol on average. But if you don’t go into these carry bubbles anymore, you’ve won’t see the unwinds of them anymore.

If you have higher macro volatility and less frequency of these Goldilocks regimes, that means that exactly to your point, there’s a good chance that you on average will actually be less volatile most of the time. So I think the best way to put it is less bifurcation, less frequency of high vol versus low vol regime, more time spent in the middle. That’s been the remarkable thing about the last 20, 30 years. You were either in a high or low vol regime, very little time spent in the middle. Whereas now, you might spend much more time in the middle.

[00:51:25] Cem

Yeah, I couldn’t agree more. We’re turning back the clock to an older regime it definitely feels like, and again, that dispersion and the center holding essentially and not being dominant to the total outcome, and more being tied to what happens on the outside of the dispersion essentially of the market is a critical outcome. Again, we saw oil at 30-some percent of the index at the peak in 1982. I think it’s at 3% right now, so crazy things can happen. You could make a tremendous amount of money just getting the rotation right despite the market really maybe going nowhere for some time and being less critical to outcomes. So yeah, I absolutely couldn’t agree more with how you see that.

The last thing I would want to bring up is kind of a bigger picture one. Ray Dalio recently talked about the debt and the size of it. We’ve had others like Gundlach come in and talk about how they don’t find bonds attractive here because of what might be coming as a result of the amount of issuance and the cost of that on the budget. I’d love to hear your thoughts about how that might affect things in the next 5 to 10 years. Is it relevant? How do we navigate that and what is that likely to mean for us and global outcomes?

[00:53:03] Christian

Definitely a concerning conversation. The way I think about it, first of all, I agree with the idea that cash is still a key competition for bonds where we are. That’s both because of the inversion of the yield curve and because of these issues. You are taking risk. You are taking credit risk in corporate bonds, you’re taking some type of sovereign risk and/or bond risk premium repricing risk in government bonds. Again, that’s new with regard to government bonds, at least. We’ve been through Italy, we’ve been through the European sovereign crisis, which was very different, as you know, because it was a political crisis not a real sovereign crisis.

So I think we want to think about it as follows. You are dealing probably with higher debt-to-GDP ratios in the coming years. I think at Jackson Hole, I think Eichengreen, he kind of made this presentation saying that we will have to deal with that. It’s unlikely we’ll get these primary surpluses to get these debt-to-GDP ratios down. Guess what? We had the biggest fiscal expansion since World War Two. It’s going to take time to get a more normal debt-to-GDP ratio. So someone needs to buy that debt. I think that is really the discussion that needs to be had because it really depends on the clearing price, how much of a problem that will be.

It again comes back a bit to our conversation on growth, structurally. How much real growth are you going to generate relative to the cost of debt? So if you have AI generate a huge amount of productivity and GDP growth, maybe you’re less worried about debt. But as you correctly said and I agree with, we don’t know. It could take time. So for now, the main variable that’s moving is the real yield and we need to understand where this will settle.

The reason why there’s so much concern in the marketplace right now about that is that there is a bit of an endogeneity where the higher the real yield goes, the more you’re worried about that sustainability, the more it pushes up the real yield and the bond risk premium you should ask for. How do you stabilize that? We note from Japan, it comes via the central bank. But that comes back to our earlier discussion that they are actually having another problem to deal with right now and they’re actually doing QT. Then who else could stabilize the back-end yield? It could be international buyers of treasuries. But we know to our earlier discussion of deglobalization, there’s less demand there.

So then it comes down to one important variable to me, exactly like in Japan, households. In Japan, households are among the biggest buyers of JGBs and/or providers are financing for the government in different ways. The problem in the US is that the household allocation to equities is at all-time highs and it’s been a very popular thing to own equities for the long run, and the bond allocation is very low. To me, the key challenge will be to get households to buy those longer-duration bonds. I actually think that the value proposition for bonds as a long-run investor in the US is not terrible, at least for TIPS.

I don’t like necessarily the yield that’s on the 10-year bond because I don’t think the breakeven that’s priced there is particularly appealing. But if I look at the real yield in the US being at 2%, where you get essentially paid 2% per annum to protect your purchasing power for the next decade, that’s an attractive proposition. You need to consider the fact that yields will go to 3%. That’s your key risk, that they go to 3% first until you kind of harvest your money. So mark to market risk is the consideration, which probably matters for a lot of institutional investors.

But for end investors that are really buying to hold, I think these TIPS are already at levels that should attract household demand. The challenge is that it’s just not a particularly sexy investment for households. It’s not like necessarily the type of investment that you see that upside convexity. Protecting purchasing power is just not as exciting as buying AI beneficiaries. That’s why it’s going to be difficult to find a clearing price.

At what level of real yield do you cap that upside? Because the alternative cap, we all know what the alternative cap is, is essentially the government having to consolidate in fiscal austerity that you do actually get some type of negative feedback loop from the bond market to fiscal spending a bit like what happened in Europe, and that would be not very good at all. But what I find so interesting about the TIPS market is in that scenario, I think it would do very well because you would obviously have a bigger stagnation risk because the government would have to, on the fiscal side, be much more restrictive.

That’s why one of our favorite assets to focus on for long-run investors has been the TIPS market, to essentially look at longer-dated inflation-protected securities as an overlay hedge for the portfolio.

[00:58:22] Cem

Similar to the 1970s, which is very interesting.

[00:58:25] Christian

Exactly right. It didn’t exist at the time. It’s another market that didn’t exist in the ’70s and I absolutely agree. In the ’70s, if you would have had TIPS, and we actually have a backtest where we estimated how TIPS would have traded if they existed. There’s this backcast from the New York Fed that we replicated and it showed that TIPS would have been a very good investment, especially if the real yield is already high, i.e. central bank tightening is behind us. There’s a very interesting asymmetry that TIPS can offer you.

[00:58:57] Cem

Yeah. To your point, if the US consumer is not going to buy the debt, at least at these levels, at least not until they get to higher, higher levels, it seems most likely that the Federal Reserve is going to have to do what the Japanese central bank did. That can’t be good for more inflation, either at the end of the day if they’re cyclically stimulating as opposed to trying to do the opposite. So yeah, I couldn’t agree more. Fascinating times. There is a tail out there in the bond market and I think other major investors like Dalio are also beginning to realize that.

[00:59:34] Niels

The challenge, of course, as well is the fact that, and coming from the trend following world of course, believing in human behavior, it doesn’t help that governments and central banks have basically been punishing anyone who wanted to own a bond in the last 20 years. Now they’re coming out saying, oh, we really need you to line up.

So to me, it’s more likely that they’re going to come in with some kind of policies forcing pension funds and banks and so on and so forth to buy a lot of the debt. But that is another discussion which I hope we will be able to have with you, Christian, since this was amazing. Before we close out, I had a couple of things I wanted to bring up. One is this is really just curious on my part. You talk a lot about cycles, and I’m interested because you didn’t mention the interest rate cycle. Do you believe that there is such a thing as a 40-year interest rate cycle?

[01:00:25] Christian

Hundred percent. As I mentioned, you have the sentiment cycle, the business cycle, the structural cycle, and there are three dimensions to each of those. So growth, inflation and policy, and policy encapsulates the interest rates. So there’s a structural rate cycle, there’s a business cycle in rates, and there’s a sentiment cycle in rates. So to me, it’s like a multi-dimensional assessment. So you have like three dimensions with regards to the cycles, three dimensions with regards to the variables in each of those.

[01:00:55] Niels

Maybe as we close out now since we’re at the hour mark and we appreciate your time, if you want, and this is completely up to you, one thing that we didn’t bring up specifically but we talked around it a lot is the series of papers you did called The Dynamic Balance Bear. If you want to talk a little bit about it just to explain what it is, people can go and look it up, feel free to do that, and then any other things that you feel that we forgot to bring up in our conversation, Christian.

[01:01:26] Christian

Yeah. Listen, I think this was incredibly comprehensive. I think we touched a lot of things on my mind and I think on a lot of investors’ minds. The Dynamic Balance Bear, I’ve also mentioned already our machine learning approach on dynamic asset allocation. I think essentially what we’re doing is, because we also want to be part of that AI wave, we want to kind of apply more and more techniques that are available to us in our investment problems, and this was one of the first attempts.

I’ve been very cynical about these things because I’ve seen a few structural regime breaks to say the least and we discussed a lot of them. So there’s a lot of problems with these models, but we still gave it a shot, and remarkably, our machine did a decent job in adding value in the last 70, 80 years in terms of allocating simply based on some very, very low-frequency data. So we didn’t even try to be smart and be ahead of the market.

We tried to use hard data only and try to assess where are you in the cycle and what should you do. We gave like GDP growth data, rates data, valuation data to a machine, and it did a relatively good job in allocating. What we found is it did a better job in timing inflation and interest rate cycles, not a good job in timing growth cycles because growth cycles have much more convexity to them. That means you have to be fast. Whereas the interest rate cycles are much more trending and the inflation cycles.

That’s an interesting takeaway from that paper in line with our earlier discussion. I think if you get more inflation volatility, it creates more tactical dynamic allocation potential that can be captured, whereas very different to last 20, 30 years where these growth cycles are so fast. In some cases, that’s very difficult to allocate. So I think that’s the key takeaway. If anyone is interested, that’s available on our research portal.

[01:03:23] Niels

That’s wonderful. Christian, this has been an awesome conversation and we really appreciate you sharing all this knowledge. Of course, from a trend following and volatility perspective, the fact that you think that there are definitely room for these type of strategies in a portfolio makes it even better. If anybody wants to go and follow you, we’ll put some links up on the show notes page of course, because as our audience for sure will be able to tell from today’s conversation, we are living in a truly global macro driven world and it is perhaps more important than ever before to stay well-informed.

Christian, thank you so much. From Cem and me, thanks for listening. We look forward to being back with you as we continue our Global Macro series. In the meantime, take care of yourself and take care of each other.

[01:04:14] Ending

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