Maybe This Is Just What Normal Markets Look Like ft. Alan Dunne

[00:00:01] Intro

Welcome to Top Traders Unplugged. In markets success doesn’t come from predicting what happens next, it comes from being prepared for what you can’t predict.

In each episode we go deep with some of the world’s most thoughtful minds in investing, economics, and beyond to understand how they think, how they prepare, and how they decide, and the experiences that shaped how they see the world. No noise, no short-cuts, just real conversations to help you think better and invest with confidence.

[00:00:35] Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Alan Dunne and I, Niels Kaastrup-Larsen, where each week we take the pulse of the global market through the lens of a rules-based investor.

Alan, it is wonderful to be back with this with you this week. Hope you’re doing well. How was summer?

[00:00:52] Alan

Summer was good. Yeah, we had a great summer in Ireland. Definitely had a long spell of good sunshine which is now coming to an end here. It’s dark and dreary and it’s wet and rainy. So, it definitely feels like the summer has come to an abrupt close in Dublin. But no, we definitely had a really good summer.

[00:01:10] Niels

I think a lot of places actually right now in Europe would say, oh, rain, that sounds great because even here in Switzerland we had, how should I say, information in our mailbox that you’re not allowed to use any kind of watering of your gardens or anything like that. There really is a very, very severe drought even where I am. So anyways, we’ve got a pretty good lineup of topics. Thanks very much for putting that together. We’ve got a couple of questions that came in and so, very excited to dive into all of that. But of course, before we do any of that, as usual, love to hear what’s been on your radar the last two or three weeks.

[00:01:55] Alan

Yeah, well, it’s probably going back at the end of July. It’s been a couple of months since I was on, but definitely thought it was worth commenting on the US intervention in the yen because it still remains quite topical. All of, you know, everything that happened around that. So, I mean, for context (I don’t know if people don’t follow the FX market so closely.) It is very rare for the US to intervene in currency markets. They intervened, I think, in 2011, but the last time they bought the Japanese yen was back in 1998.

So, we’re talking about very rare occurrences which kind of begs the question what’s going on? And it was very interesting this time around – a couple of aspects. One, they sold the euro and bought the yen, which was an interesting twist in it. And then the second thing was they announced that kind of going forward, that if Japan would continue to buy yen, they could tap this FEMA facility at the Fed, which would effectively allow them to borrow dollars, to sell dollars if they felt further intervention was needed going forward.

So, I think that aspect really points to the sensitivity the US has big bondholder selling bonds at the moment, and the sensitivity they have to rising yields. And obviously we saw more on that with Scott Bessent’s announcement the week before last. So, I think it’s very much consistent with the idea that we’re in unprecedented maybe, or certainly very rare occurrences, and there is this very heightened concern about the US bond market, is the sense you get. And also, interestingly, the FT had an article that the US didn’t inform Europe, the ECB, in advance of the euro sales, which was quite unusual.

Now, you might say that’s a bit surprising, but obviously there’s been a lot of surprising developments in how the current administration has dealt with its international partners. But again, it was another angle on it and kind of a twist of the US very much acting in its own interests and not necessarily coordinating with Europeans.

So, I think, yeah, I mean, that the thing I took away from it was this real sensitivity about rising yields and a real reluctance to allow a big asset holder to sell their treasuries.

[00:04:16] Niels

Yeah, I completely agree, of course, but I think there’s more to the story, actually. And later today, I’m actually recording an episode that comes out a few days after this one with Cem and Marvin Barth on Global Macro. And I think we’re going to probably touch on this as well. But I get the feeling that it’s not necessarily just about the level of the currency. There’s so much more into it, including sort of interest concerning industrial production because Japan has actually turned out to become, really, the only place the US can go to get some of their military stuff built in time for it to be used and to a standard that is up to scratch.

[00:05:13] Alan

Yeah, I think there are many dimensions to it. I mean, I think it was positioned as the US helping out a friend in Japan. But I mean, I think that’s a very superficial reading of it. I think the other thing to keep in mind is, I think, with FX markets, a case of careful what you wish for.

I mean, I started off in FX, so I remember very clearly the 1998 episode, and actually it was seemingly successful, initially, in the sense that the yen stopped selling off and then it stabilized, but then the Fed cut rates and dollar/yen had a huge collapse in about four days. So, I mean, you don’t want to have that kind of instability of a massive carry unwind. Not suggesting we will, but it just shows you that you start pushing currencies one way and then back to another way, you just don’t know what kind of second order effects it can have. But yeah, it’s definitely…

[00:06:09] Niels

It’s worth keeping an eye on.

[00:06:10] Alan

Yes, for sure.

[00:06:11] Niels

Yeah. And actually yeah, the price had initially a decent move, but some of it has obviously disappeared again, so to speak. The effect has disappeared. So, it will be interesting to see.

So, on my radar this week I’ve only got one thing, but it involves you, Alan, because I got inspired by a Danish podcast that I sometimes listen to where the two hosts have to guess what a certain number that has been in the news refers to. So, I thought I’m going to try it out with you, Alan. Obviously not rehearsed in any shape or form. So, the number for you is US$16.68 billion.

What do you think that number represents?

[00:07:05] Alan

Wow, US$16.68 billion… I don’t know. It’s got to be something related… I was going to say related to, obviously, the US$30 trillion that has been in the news on the debt side, so I thought maybe, but then US$16.68 seems low… yeah… relative to that.

[00:07:24] Niels

I’ll take you off the hook. Yeah, absolutely.

It is, as far as I understand, the proposed, or part of the proposed settlement between 29 States, Mark Zuckerberg’s meta organization, which also includes some significant changes in terms of how Instagram and Facebook interact with children and teens, which I’m sure you, with a young daughter will welcome – that maybe they won’t be able to interact with young children the way they have been so far.

But of course, US$16.68 billion is not a lot of money compared to the US$60 billion Mr. Zuckerberg spent on his Metaverse, which seems to have been completely a waste of time and money… well, we’ll see. I’m sure they’ve learned something. But anyways.

[00:08:19] Alan

There was a story that he’s bought a castle here in Ireland, in Waterford. So, that would have been another good question to have had for me, but I don’t know how much he paid for that. Probably not US$16 billion, anyway… a little less.

[00:08:31] Niels

Well, there we are. Anyways, I’m pretty sure I’m not going to repeat this experiment with a number for the co-host, although sometimes is quite funny what they come up with, these two guys.

Anyways, another number that is somewhat lower, it’s 43. I’m sure you can guess, that is actually the trend barometer as of yesterday. So, it’s pretty neutral. We are recording Thursday, so we have about two and a half trading days left of the month.

So far August looks pretty decent when I look at the numbers which we’ll go through shortly. But August, actually, hasn’t necessarily been an easy month when you look at kind of the “two types”. I know maybe the official yen intervention happened in late July, but we’ve had kind of these two types of interventions. One was the yen first and then “intervention in the US bond market”, both of which actually went against the bigger trend. So, that would have hurt performance. So, all-in-all I think, actually, it’s a pretty respectable month so far. But of course, lots of things can happen in the last few days.

In addition to the “manipulated moves” in the yen and the bonds, we’ve also seen a big move in bitcoin. I wouldn’t necessarily call it manipulated, but of course it’s completely tied to some policies that the White House is trying to get through, as far as I understand, and I don’t know, I mean we don’t trade bitcoin on our side. So, I have no idea whether this has been a good move or a bad move for trend followers, but it certainly moved 25%, 30% or so in the last couple of weeks.

So, yeah. Any thoughts on your side? I mean now that you have your own fund, you’re tracking these managers closely, I’m sure.

[00:10:32] Alan

Absolutely, yeah, it’s interesting. I mean August is interesting, as you say. You might have said, okay, it feels like the trend has been rising yields, but actually kind of US bond yields have been kind of flat to slightly lower over the course of this month. Yields outside the US have risen a bit. But actually, across the managers that we’re allocating to, notably seeing good gains on the commodity side in August, which is obviously a really positive aspect of allocating to trend. We’re talking about markets like zinc, and wheat, and lean hogs. Copper has been rising again.

So, as you mentioned, we’ve had kind of choppy conditions in currencies, not just in the yen. Obviously, the euro had a big… the dollar sold off on the kind of on the Bessent bond intervention and as did the gold. So, they were both kind of a weaker dollar trade which would have been negative for trend followers. But it’s certainly encouraging to see those strong, strongish gains I would say on the commodity side.

And yeah, I mean, in July it was a decent amount of dispersion again there. Some managers with some idiosyncrasies were outperforming and underperforming. You see some people trading in credit, for example, and that was a negative. Others, with kind of non-trend signals, doing a bit better.

So, I think yeah, we’re definitely seeing a decent amount of dispersion, but I would say, kind of from the perspective of the role of trend in a portfolio and getting it diversification, it’s always a very encouraging sign when you see stronger trends in the commodity markets.

[00:12:16] Niels

And since you mentioned the word dispersion which we normally associate as you say with the difference in performance between managers, CTAs, trend followers, whatever, however we define it, I will say I’ve also noticed there’s been a lot of dispersion in returns among “CTA ETFs”. And I know that the ETFs can be very, very different, I mean, they can really be different. So, I do understand that, but I will say some of the moves have been surprisingly large. Also, I guess my worry a little bit is that most people who buy them probably don’t really know what’s behind it. So, they have probably less of a chance (my words of course), less of a chance of getting a feel for what to expect.

[00:13:13] Alan

Yeah, I think, as you say, there are quite notable differences in the US ETF market with some managers not trading the full set of asset classes, others trading a very narrow set. So, I think that definitely drives a good chunk of it.

[00:13:27] Niels

Yeah, for sure.

Anyways, let’s reveal the numbers. As of Tuesday, 25th August, we see the BTOP 50 up 2.14% in August, up 10.26% so far this year, so, very strong. SocGen CTA up 1.34% in August, up 9.55% so far this year, also very respectable. SocGen Trend up 1.19%, up 9.19% so far this year, also pretty good. And the Short-Term Traders index a pretty good month, I will say, up 1.69% [so far this month], and up 4.93% [so far this year], so, definitely coming back a little bit on that front.

In the traditional world MSCI World (and these numbers are as of last night) up 2.68% so far this month, up 13.49 so far this year. Taking out the US and Canada. So, the MSCI World EAFE index up 2.54%, and up 14.85% so far this year.

The US Aggregate Bond index up 78 basis points for the month, up 45 basis points for the year. So, not a lot of real returns so far this year. And the S&P 500 Total Return up to 2.58% in August and up 12.97% this year, so, a very respectable return.

Now, I mentioned we had two questions that came in, so the first question must have come in just after you were on last time because I made a note in my little sheet here saying that it came in on the 17th of July. So, we apologize but Alan didn’t come back on the show until now, so we’ve kept it for you. And it’s from Jason.

And Jason writes, Kevin Warsh made it known that he’s not a big fan of the Fed’s balance sheet. His thinking is that lingering balance sheet risk acting too much like fiscal policy rather than classic front end only monetary policy like the Fed has traditionally performed before Bernanke. Ideally, we need free markets to be determining price discovery beyond the overnight rate. His thinking is that the Fed should act responsibly, instead of kicking the can down the road similar to what the US government has done with its unsustainable spending. If what was once used as a temporary emergency measure QT needs to be paid back, how does he plan to lowering mortgage rates if he saturates the market with new heavy supply of the Fed’s balance sheet?

Well, that’s an easy question, right, Alan?

[00:16:09] Alan

Exactly. I mean, it does cut to a lot of the points that are very relevant in the whole discussion around not just Bessent’s actions but Warsh’s comments at the last press conference as well. And I think the reality is we don’t really know what Kevin Warsh’s plans are. He did come into the role talking a lot about, as the listener pointed out, the excessive balance sheet. And basically, his suggestion was that the Fed was complicit in the Treasury’s ballooning deficit and debt by engaging in QE.

But at the same time, we haven’t heard of a framework yet as to what’s going to be done. Now obviously, he has his various task forces, so my sense is he’s not going to make any decisions till he gets the reports from the various task forces. And then, obviously, there is this question is he really going to go down this route of normalizing the balance sheet which would obviously increase the supply of bonds in the market at a time when the treasury is trying to increase its demand and reduce its supply of bonds and shift its issuance to T bills, that doesn’t seem unlikely for a Fed chair who’s having regular phone calls with the President as well, as another kind of element to go into the mix.

So, I mean, I think the problem is we don’t know what Kevin Warsh’s latest thinking on any of these things are since he became Fed chair. So, I’m kind of a bit skeptical that we’re going to see much in the way of balance sheet reduction in the short-term and certainly not until we hear what are the various views from all the different task forces.

[00:18:00] Niels

Yeah, I think that is very diplomatic and correct to say at this stage. And of course, I think we’re going to dive into this a little bit later in our conversation today because there is a lot of stuff going on around the policy makers and some of their proteges or vice versa, I should say.

Anyways, we also had a question in from Ben Dasian. He came in with a question for you, Alan. If short term trend has structurally degraded, does that actually make medium slow trend more crowded and potentially create larger synchronized exits when those signals eventually flip? What markets today have the biggest gap between the macro narrative and what systematic positioning is actually saying?

[00:18:56] Alan

Yeah, well I think there’s two distinct questions there. I mean, yes, obviously the last time I was on we talked about the paper from the researchers at CFM, or associated with CFM, about the degradation in short-term trend following, in some contracts but not all. And I mean, I think this is something that’s been known for quite a while that the short-term trend has got more challenging.

I mean some people, some managers still like it in terms of having that fast reactivity, having that convexity that you get particularly in kind of as you go into risk-off periods. So, I mean, I don’t think we’re going to see or we’ve recently seen a big shift into medium and long-term trend. I think that’s been the pattern for a while now.

And I think what the research, actually, from that paper, also showed was that we’re not seeing that the size of the asset increase, that those explanations for the degradation and performance across trend strategies didn’t stack up. So, the size of the CTA industry relative to the liquidity of the futures market is not so large that there is a concern around that.

So, I think, yeah, short-term trend is probably something that managers have in their portfolio to varying degrees. Some keep it in for that convexity, but I don’t think that it’s pointing to a generalized overcrowding in the medium and long-term space.

[00:20:31] Niels

Yeah, I have two thoughts on that. One is, I actually think that short-term… and by the way, I don’t really know that there’s something called short-term trend following because frankly all the managers I know in the short-term space, they’re not really trend followers, they’re like vol expansion type strategies or whatever. But let’s just call a short-term trend.

I’m not so sure that AUM didn’t play a role here because I’ve seen a couple of examples where people did well and had a very good narrative, very strong narrative, and you saw lots of money flowing in their direction and after that return stopped really to be materialized. So, I’ve always felt, and I’m sure I’ve said it many times on the podcast, when I see short-term managers managing even US$2, US$3, US$4 plus billion dollars, I’m really curious, how do they do that successfully without it becoming just way too expensive to execute?

So, I do think, I mean, of course you’re completely right in saying that the overall industry hasn’t really grown a lot. So, I’m not concerned about liquidity and cost of execution when it comes to long-term or medium-term trend. That’s not the issue for sure. But when it comes to short-term, without knowing the details…

[00:22:06] Alan

I think that’s a different question.

[00:22:07] Niels

Yeah, exactly.

[00:22:08] Alan

But yeah, I don’t disagree.

[00:22:09] Niels

Yeah, absolutely.

[00:22:11] Alan

And the second part of that question, which markets is the macro narrative?

[00:22:16] Niels

Right?

[00:22:17] Alan

Yeah, I mean that’s an interesting question. Hard to… I mean, I was racking my brains a little bit. I mean maybe the US dollar, I mean the macro narrative is probably more pessimistic on the dollar arguably, but I mean you could debate that. But at the same time, I think CTAs are still generally okay. They may have pared back recently, with net long dollar exposure. So, that’s one I would say.

I think on fixed income trend positioning is probably in line with the macro narrative. The trend is for higher yields for all the reasons people are worried about.

[00:22:57] Niels

But this is the other thing, because I see now, I mean, in the last, what, let’s say five years, it’s become very normal to receive these emails from the big investment houses saying, oh, CTAs are getting ready to buy US$70 billion worth of equities if the S&P closes above this level for two days in a row, or whatever. I mean, it’s completely crazy to pay any attention to these things, in my opinion, because there’s so much more that goes into that. And to this question, I would say, yeah, we could talk about positioning and being close to narrative, but what people often forget is that, at certain times, even though you’re a “longer term manager”, we can change positioning pretty quickly.

I mean, for example, with the yen, I’m sure lots of people pared down their yen exposure very quickly because it was such a big move after the intervention, and so on, and so forth. So, again, I think yes, we’d love to have a narrative for what trend followers are doing, but in the reality the best thing is probably not to spend too much time on that and just let us do what we do and that is to, in a completely unbiased way, just follow the price and keep our heads down, so to speak. But there we are.

Anyways, let’s move on because we move straight into your current macro view and that obviously opens up a lot of avenues that we touched on already. But let’s dive into it.

[00:24:37] Alan

Yeah, well, again, following up on what we spoke about the last time, the last day we did speak about communication at the Fed. And that was, I guess was the middle of July or something. It was obviously before the second FOMC press conference because after that this whole topic really escalated as something that has been…

[00:24:59] Niels

And sorry to interrupt you here, but maybe just for people to realize, I mentioned we are recording on Thursday, but in terms of communication, I mean, we’re heading straight into Jackson Hole, so…

[00:25:09] Alan

Yes, exactly.

[00:25:09] Niels

So, it is relevant to talk about communication.

[00:25:12] Alan

So, this is the next episode is coming imminently. Warsh is scheduled to speak tomorrow. But we’ve had two press conferences, and after his first one, he said, we’re committed to price stability and he kind of hinted at less communication basically and given less guidance. And then he carried that through into the second press conference where his performance was very kind of debated. Generally, I think he had a poor score for that performance.

But it’s interesting how the market then split into two camps of people. Some people say, no, this is okay, we’ve had too long for the Fed spoon-feeding the market, and this is a good thing, free markets. And then the other camp saying, no, no, that’s not how it works.

So, I would be in his camp of saying, no, it doesn’t work like that. And I think the thing is that it’s not that people want forward guidance. That’s not the issue. I think Warsh is correct. The forward guidance wasn’t necessarily a good thing. But the market doesn’t have a sense on the Fed’s what’s called reaction function, so, how they’re seeing the economy.

At the moment, we’ve got this AI boom. It’s inflationary in the short-term, it may be disinflationary down the line. What’s the appropriate policy for that? Warsh has kind of thrown that question out there but hasn’t given any kind of sense on how they’re thinking about that. How did they think about the supply side issues related to Iran? And I think his comment that the market needs to play the ball, not the referee, I think it appealed to certain people, but it doesn’t really make sense because Wall Street has always tried to infer what the Fed was doing.

Even before the 1990s when they didn’t even make an announcement, all the banks would have had Fed watchers trying to infer what the Fed is doing from their open market operations. Why? Well, obviously what’s happened to liquidity is an important factor for the economy and for asset markets. So, to suggest don’t ignore the Fed, it doesn’t really make any sense.

And then he pointed to the rise in bond yields in the period since the previous meeting, saying this is the market doing the Fed’s job. But obviously some of that rise in yields reflected the fact that the market interpreted his last press conference as being a bit hawkish. And the market understands, or at least the thought of it, that it’s the Fed’s reaction function.

So, I think it’s been frustrating for people. You might say, does it matter? Well, I think it matters in a few ways because obviously the Fed’s trying to reestablished credibility. It’s missed the inflation target for five years now, and he’s come in saying he’s going to do a lot, but actually he hasn’t backed it up with action. And if you’re not backing it up with action, if you don’t have a good explanation as to why, well, then that’s when the market starts to wonder, is there really that resolve to tackle it?

I think that’s what we saw after the July FOMC meeting, immediately during and after the conference and the press conference, the curve steepened, the dollar sold off, gold rose, all of these classic signs of reduced credibility. So, I think what it means for investors going forward is a lot of focus is now on Warsh tomorrow. If he continues to go down this vein, I think the focus may shift to other avenues, such as the minutes as being the more important area to get an assessment of where the Fed is. And the suspicion is, maybe that before he joined, the question is, is he a dove, is he a hawk? My own view is that I’m shifting to the view, yeah, maybe he is more dovish than he’s letting on and he doesn’t want to raise rates.

But I think what it means is that some of the other members, like Waller and Williams, that their influence is going to be even greater now, given that we know there are kind of three in the camp of raising rates. So, I think where it sets us towards is possible fracture within the Fed, that you could get kind of distinct factions.

Obviously, you have Trump trying to stack the Fed with his own appointees and you’ve got Lisa Cook coming under renewed pressure again. So, it does have that sense of the ongoing politicization of the Fed. And we still don’t know whether Warsh is kind of immune from that or not. So, I think that’s a big credibility question mark.

Yes, it’d be great for him if he came out tomorrow and gave clarity and all of that. I doubt he will, but I think it is important that he does so or else we’re going to see this credibility issue hanging over the Fed for a lot longer.

[00:30:16] Niels

Yeah, I mean, there’s an additional twist to this story, and that is of course, that on one hand you have Scott Bessent, and then in the ring you have Kevin Warsh. These two guys, they used to work together and they happen to work together with Stanley Druckenmiller. And Stanley Druckenmiller, of course, came out (and I say of course, but it’s not, of course), he came out with an op-ed in the Wall Street Journal only a few days ago, admittedly helped by AI but leave that aside. He has a different view, let’s call it that, where he essentially, as far as I understand, basically wants the market to decide where rates should be and he doesn’t like this intervention.

Now, what makes the kind of the story even more interesting is of course that Scott Bessent worked for George Soros when they went against the central bank and broke the British pound. So now he suddenly feels, oh hang on you guys, you shouldn’t go against us because we are the good guys here. But he’s getting some pushbacks from his former mentor and former… I don’t know about exactly where Warsh’s stance on this, but it’s a very interesting twist.

And then on top of that, I, in preparation for our conversation, I saw a piece by one of our other guests, Pippa Malmgren, who was on recently, and from the conversation we had with her and I think in her latest writing she talks basically about that Washington is deliberately changing the regime, so we’re facing a different way of doing things.

And then I noticed a little piece I got this morning from one of your previous guests, Ed Yardeni, who basically I think says, well, maybe the bond market isn’t warning us at all. It’s just putting yields roughly where economic fundamentals says they should be.

[00:32:22] Alan

I think that’s right. And I mean, that was Druckenmiller’s point as well. I mean, he’s pointing out that growth is strong, strongish, not mega strong, and inflation has been above target for quite a while. So yeah, 10-year yields that are just heading up to 5% is maybe not that unusual. And actually, if you look at it, if you look where yields are, we’re just normalizing back to where they were in the 1990s and the 2000s, and the 2010s was the aberration. So, in an economy like this that is growing as strongly. Yeah, it’s probably not unusual.

The big problem, obviously, is that the size of the debt is much greater now. So, the debt service cost is greater obviously. And as time goes by that increases because some of the debt that was issued at lower yields will roll off. And now that’s providing the impetus to issue more at the short end, which again puts more pressure on Warsh not to be raising rates because it will feed directly into the higher costs.

But yeah, I mean from that perspective, it’s not like inflation expectations have skyrocketed. They’re kind of still kind of 2.25% or so. What’s pushing up yields is real yields, which reflects greater competition for capital because governments have greater deficits and we’ve got this huge CapEx spend related to AI.

[00:33:51] Niels

Yeah, yeah, for sure, absolutely. Now, we can stay on this topic a little longer if you want, but I know we have a lot of other sort of headlines, at least, that we wanted to touch on. And they’re somewhat related in any way. And so, as I said, I’m going to hand it back to you, but one of the things you also wanted to bring up was these three fractures in the macro regime. So, maybe that’s a natural point to go.

[00:34:23] Alan

Yeah, I mean, I think we’ve been talking about the change regime for a long time now. And we wrote a paper last year, The Regime Adaptive Portfolio. And as part of that, looked at how the economic regime has changed from the last decade, really from the last four decades to the current period.

And at a high level we’ve gone from an environment, a disinflationary to great moderation, the great disinflation period of low interest rates, low inflation, and very little volatility in rates and inflation. And that’s linked to the globalized world, neoliberalism, all of that. And now we’ve changed into this new regime.

And I guess, in the paper we highlighted kind of three key fractures in the regime that are kind of leading to this evolution in the economy and the markets. And the first one is, I think it’s the one that probably gets talked about the most, inflation being higher and stickier, which we’ve seen. And obviously the upshot of that is basically bonds and equities become more correlated, which is something that we’ve seen. And that’s something that everybody, probably most guests that we’ve had on the podcast have alluded to. Certainly, on the Allocator series side, that’s been a very pronounced and notable change this decade versus last.

But the other fractures that I think that we talked about in the paper, we’re starting to see more of those coming through now, is what I wanted to talk about. The second one being, obviously, debt sustainability and the coincidence of high debt and high equity valuations. And obviously, we’ve seen this come to the market and go away. Obviously, we saw it in 2023 when there’s concerns about US debt issuance and then they changed the quarterly refunding with Janet Yellen at the time, which was controversial. But again, we’re seeing it with Bessent now they’re tinkering with the markets because of concerns about debt sustainability.

But not just that. And obviously, this happens at a time when you’ve got unusually high equity valuations or relatively high equity valuations. And I think the concern here is that if you had an equity market decline, the US economy is so levered in the US equity market at the moment, that would have a meaningful impact on debt. Again, because what you’ve seen is, if you look at the trajectory of the debt over the last 20 years, basically every time you have a recession you get a jump up in debt because your revenues go down, there’s generally some kind of fiscal support, so you get a new deficit, and that kind of pushes it up even higher.

So, the concern now is if we got that again, given that debt GDP levels are already above 100%, that could be the tipping point of fiscal dominance. And that’s really where we’re getting to now. We’re edging towards that. And the related concern is financial repression and that’s basically holding down interest rates below where they should be to try and manage debt service levels. And that’s effectively what you’re seeing from Bessent at the moment.

And the third fracture, that we talked about in the paper, is the kind of the fraying institutional order, the erosion of institutional norms. And again, we’re seeing this, we have been seeing this on an ongoing basis with the pressure on the Fed. Obviously we’re seeing it with this more kind of active tinkering in the bond market in terms of issuance. We’ve seen the threat to central bank independence; and not just the kind of institution order, I suppose, the erosion of any kind of conservative fiscal policies as well. So, there’s no appetite to deal with the fiscal debt problem.

So, the point is that I think we’ve been very focused on the first fracture that changed at the higher inflation, stickier inflation, and what that means. That means obviously the bonds won’t be as good a diversifier for equities. But actually, what we’re seeing with these other changes as well, I think has pretty significant implications for asset allocation as well. And obviously the debt concerns also mean that bonds would be less reliable diversifiers for equities too.

But equally, if you’ve got that combination of concerns about debt sustainability and the erosion of the kind of institutional norms, it does mean that more unorthodox policies like these active bond buybacks and whatever else may come, may become more of a feature of the markets. And that’s the whole area of financial repression.

And again, it’s about what kind of real return will you get from holding fixed income markets? And then it’s obviously positive for things like gold and bitcoin, as you alluded to earlier. Because as soon as you get a sense that the US is heading towards these kind of policies, you see it in the dollar, you see it in gold, you see it in bitcoin.

So, I think it’s interesting. I think definitely what we’ve seen in the last couple of weeks is definitely one step closer to fiscal dominance. It’s something that’s been talked about for a while, but I think we are actually getting much closer to the point of that being a reality.

[00:40:16] Niels

Yes. So, it’s kind of make me think that if only you had a Regime Adaptive Portfolio, things life would be so much easier, right, Alan?

[00:40:22] Alan

Exactly.

[00:40:23] Niels

But the other thing is of course that we also live in a world that is deglobalizing, meaning that all the central banks, all the governments are more in it for themselves than necessarily the way it was in the past. And I think that kind of touches on the next topic that you wanted to talk about and that is what about trend following performance in a shifting macro regime?

Because, to some extent, I would say that part of the challenge that trend followers were facing, in the 2010s, was a high degree of coordinated and successful policies by central banks and whoever is involved obviously leading to very low interest rates and very low and stable (and I think the ‘and stable’ is the key here) inflation. All of that seems to have changed. And I think that makes a change to trend following performance even though we and know well not to forecast (well, at least not until we get to the next topic of today). But we know well not to forecast our own performance. But what are your thoughts about trend performance in the shifting macro regime?

[00:41:42] Alan

Yeah, well, I wanted to just go back and look at how performance has evolved this decade because, obviously, we’ve been in a changed macro environment, as we’ve been saying, and now we’re 2/3 of the way, more or less, through a decade, I think. So, it’s kind of interesting time to look back and say, well, what can we say about it?

There are a couple of interesting observations. Obviously, it has been a better decade, obviously, for trend relative to the previous period. Last SocGen Trend has annualized nearly 7.5% this decade to date, where it was just under 2% in the previous decade. And obviously, the big change has been bonds. US bonds were annualized about 7% in the last decade. And it’s been negative this period, obviously, because the starting point was yields of 50 basis points and yields have risen to close to 5%. So, that’s a big headwind, obviously, for bond markets.

The curious thing was, you would have said the last decade was good for equity markets, and equities annualized at 13.5%, but this decade has been even better at over 15%. So, that’s the kind of context. And obviously, we have mentioned the kind of the shifting correlations and that’s definitely borne out by the data. If you look at the bond/equity correlation now, it’s positive 0.3 this decade versus last decade it was negative 0.5. So that’s quite a shift.

But then from a trend following perspective, what’s really notable is that equity correlation with trend was about 0.2 last decade. This decade it’s been negative 0.16. And then on the bond side, bonds and trend were positively correlated last decade 0.33. Whereas this decade bonds and trend are negatively correlated negative 0.37, which is interesting.

And actually, if you look at the performance, obviously 2022 was the big blowout year, obviously for some managers very good in 2021. But 2022, at the index level, was the year where we’ve seen the bulk of the gains this period. And obviously, that very strong performance that we’ve seen from trend has even included a period where a lot of managers got close to their largest drawdown. So, we’ve had ups and downs in it.

But actually, when you look at the shape of performance, I went back and I kind of split up the periods from 2020 to today. And actually, some of the best periods of performance for trend have been when we’ve seen these fractures that I’m talking about when we’ve seen them really start to bite in the market.

So, if you think about when would have been the strong periods of performance, 2021 was when we first started to see the inflation episode starting to pick up. Then this next one was 2022, which was obviously the sticky inflation and bonds and equities selling off together. But also, we had a second big bond sell-off in 2023 which people nearly forget about a bit. And that was another strong period of performance for trend. Between April and October of that year, bonds were down 20% and trend was up 9%. Equities were only up 3%.

And that was the period where there was all the concerns about debt sustainability which ultimately started to weigh on the equity market. And then, obviously, what shifted that was in the quarterly refunding announcement that year, Yellen kind of hinted at shifting away from issuing so much on the long-term bond. So that was the next kind of strong period of performance.

And then the other strong period of performance has been kind of the last 12, 15 months or so when we have seen what have been the big themes. For part of that it was the debasement trade, it was the concerns, the rise in precious metals. Obviously, AI has been a huge theme too, but it has been the big run up in metals was certainly a part of it too.

So, it is interesting that when these… In aggregate, we’ve had positive performance, but a lot of the performance has been, I suppose, concentrated in those periods when these stress factors are becoming more of a market theme. So, I think that’s an important point.

I think another point is that what we’ve seen from trend in this decade has been it’s done well in periods when bonds have done badly. And people say, oh, it’s a better diversifier than bonds. Yes, in a way. I mean, the reality is equity holders haven’t needed diversification. But what we’ve seen from trend following is its more adaptive nature, its ability to capitalize on new themes emerging in markets. Debt sustainability wasn’t a theme in markets in the last decade, it is now, and trend followers have been capturing that.

But in a sense, it almost feels like the performance of trend has maybe not garnered as much attention because it hasn’t… Obviously 2022 was a period when equities did badly, but outside of that it’s generally been in periods when bonds have been doing badly and not when equities have been doing badly. So, I think that’s an interesting feature too.

And the other point is that even though, in aggregate, we’ve had this kind of theme of sticky inflation, it has been interspersed with kind of periods that looked more like the old regime. Remember after the Fed tightened you had that, what was called the immaculate disinflation, where inflation seemed to come down and everybody was saying, okay, inflation’s no longer a problem. But then it did stall-out and found a base at a higher level.

And obviously we’ve had the AI boom as well, which has led to hopes that we’re going to see a disinflationary impact from AI as well. So, it hasn’t been that this kind of theme of supply shocks, etc., that hasn’t been a constant. It’s been interspersed with, I suppose, signs at times that we might be going back to that kind of disinflationary environment. But ultimately, obviously inflation has stayed above target for five years.

So, I think what stands out for me is really that link, that negative correlation between bonds and trend. And obviously the question I think that people are focused on now is like, what if US yields went above 5%?

Obviously, that seems to be what Bessent is worried about. Obviously, when we got up close to the highs, they came out with the announcement and we’ve seen that kind of playbook, to an extent in that October 2023 scenario, that was a very good period for trend. But the question mark is, at some point, if you did see that yield break and we see a ratcheting higher in yields, would that be the straw that breaks the camel’s back for the equity market? And that could be the environment where you really see the benefit of trend from a portfolio perspective.

So yeah, I think it’s interesting, as I say in aggregate, a strong period, but interesting how it’s come at the expense of bonds and trends in those markets as opposed to it being largely driven by kind of not like the 2000s where we had two big equity market sell-offs, and that would provide the environment for trend following performance.

[00:49:54] Niels

Yeah, I mean a strong period for trend in a period where equity returns have been strong. That’s part of the attraction that we don’t need a crisis to make money. But I think the other point I just want to stress also is that this decade, yes, we had a big help from fixed income markets in 2022 on the short side, but it has also been a decade where a lot of the markets that people find very difficult if not impossible to get exposure to themselves, at least successfully, namely the commodities, have done really well and at different times, which has been very useful.

And I don’t know this for a fact, so bear with me here. But when I look at the way the portfolios that I follow move around, there seems to be somewhat more dispersion between markets. They’re kind of doing more their own thing. The correlation between markets are not as high as it used to be within the sectors and that’s generally good for trend. And I think that is partly because of also the deglobalization and the change in policy from the US administration towards foreign countries.

I mean, just look what’s going on between the US and Canada. Lake America, I understand Lake Ontario is likely to be called soon. So yeah, not a good situation. But if we just look at it objectively, it does provide some interesting opportunities potentially for these strategies. And of course, we always try to promote the point. It should at least raise more questions in the investment committees to say, hmm, maybe we need something else in our portfolio that we haven’t had before to compensate for this change.

Anyways, enough about that. We still have a little bit of time left and I know that there were a couple of papers that you’ve come across. I’m not an expert in these things, but I know you are. And so, I’m going to kind of hand it over to you with, I think the first paper you wanted to pick up on is very much related to what we’re talking about, meaning what does the future hold, so to speak. And it’s a paper from our friends over at AQR. So yeah, tell us about that.

[00:52:29] Alan

I mean, it’s two sets of forecasts, really. So, I mean it’s their latest capital markets assumptions. And this is something that you see from lots of asset managers and banks that they periodically produce their capital market assumptions. And I mean, you might say, well, what’s the relevance, what’s the importance of this? But this is basically the kind of exercise that a lot of pension funds go through to try and determine their strategic asset allocation.

Now, I know we’re talking about TPA a lot more, but basically having an estimate of where you think asset classes, what kind of level of return they will deliver over the next number of years is kind of the starting point for most kind of strategic asset allocation perspectives. And there’s basically kind of two ways you can do this. One is you can look at the past and say, well, what have equities done over the long term? Or else you can build in some kind of yield version. So, you could say, well, at the moment, based on the earnings yield in the US, which is the inverse of the price earnings ratio, and based on a certain assumption about earnings growth and inflation, etc., you can come up with an expectation of what asset class returns should be going forward.

And in some asset classes it’s easier in some sense than in others. So, in bonds, if the 10 year yield is 5%, then that’s a pretty good proxy for what you can expect to receive if you bought a bond and held it for maturity over the next 10 years. But obviously in equities you have a lot of moving parts.

And I think the reason I highlighted the two different approaches is just from the radically different answers that you can get doing this exercise, depending on your perspective. In AQR’s analysis, US equities are priced to deliver about 3.9% real over the next 5 to 10 years and that’s a nominal return of 6.3%.

So, I mean, that seems like a sensible kind of number. Obviously, it would be less than what we’ve seen like the numbers I mentioned earlier. It was double digit returns we’ve seen in equities this decade to date and in the last decade. So, you have to assume we can’t go on forever. But then if you look at the GMO forecast, and GMO split it out between a normal interest rate environment and a low interest rate environment. But in a normal interest rate environment, they’re forecasting a negative real return of 7.2%, negative 7.2% for US large.

So, you might query, well, how can you get such radically different results from the same exercise? And the reason is it all comes down to different assumptions. So, mean reversion is a big feature of GMO and how they approach investing. So, they’re assuming not just valuations mean revert, but profit margins would also mean revert. Whereas AQR are assuming that basically valuations stay unchanged and they’re just backing out the return forecast based on that.

On the fixed income side also, I think GMO were a little bit lower, but they had cash at, well real cash at 1.4%, whereas what did AQR have for that? They also had the same. So yeah, both are kind of saying 1.4%, which is about 3.5% to 4% nominal rates over the next decade.

So, I mean, I think it does highlight that something that’s supposed to be kind of nearly scientific in approach can yield such massively different outcomes. Obviously if you take the GMO analysis at face value, you would obviously be totally exiting US equities and even international large cap are negative too. Japan small cap are positive, International deep value are positive, but generally it’s a very bleak picture for equities according to GMO’s forecasts.

The other thing that was interesting is then, AQR also looked at commodities and active strategies. And with commodities, again, obviously as I say, you can’t do the yield analysis because there’s no effective yield. But they basically take the long run average return of an equally weighted basket of commodity futures. And according to their analysis that generates a 3% geometric return over cash over long term. So, again, that’s also, that would be kind of 6.8% nominal. So that would be attractive too.

I mean, the interesting thing then, from the perspective of active strategies, obviously AQR runs a lot of active strategies, so we have to keep that in mind when we’re reading their analysis. But I mean, if you think about it, they were forecasting, what’s a reasonable kind of baseline assumption for a net Sharpe for active strategies, they were saying maybe 0.7, which seems high.

But even if you’re really pessimistic on say trend following and you’re going to say it’s going to be a 0.1 Sharpe at 12 vol, I mean, that’s still a 5% return. If it’s a 0.3 Sharpe, you would be over 7% in terms of expected return. So again, it highlights the fact that these active strategies, like trend following, given the assumption around where cash rates are, I think that’s the important point. If cash rates are going to be 3.5%, 4% over the next decade, that’s obviously radically different from the last decade. It doesn’t take much in terms of Sharpe ratio for these strategies to be relatively competitive versus traditional asset classes in terms of expected returns. And obviously the expectation is they will deliver those returns with a very low correlation based on the analysis that we’ve talked about – negative correlation to bond, negative correlation to equities as well.

So, from a portfolio context, again, it begs the question, why don’t we see much higher allocation? So, I mean, it seems to me that on the one hand people do these long-term forecasts and say, okay, equities are going to deliver 7%, but really they believe that equities are going to deliver 12% to 15% because that’s the way it’s been for the last while. So, I don’t know, I mean, that’s the only way you can kind of square the circle.

[00:59:32] Niels

Yeah, I mean, first, firstly, let me just say that I hope there’s not a lot of people listening to us who are negative on trend following because then it’s the wrong podcast, of course. But on the other hand, the interesting thing about it, and I don’t know if that was made clear, but of course when you invest in a fund, like a trend following fund, the good thing is that actually the higher the interest rates go, the more you benefit as well, because we simply don’t use that much of the cash. So, there should be also a payment there into the fund, meaning that it doesn’t cost a lot. You’re not giving up a lot of your fixed income allocation or interest income by choosing to replace some of the bond portfolio with trend following. Obviously, you’re taking on a different active risk. But in terms of the interest income, a lot of that goes back to the investor when you buy that. So. Yeah, interesting.

I mean also I thought the… I mean we’ve talked about this many times but of course in the GMO paper they also have the lost decades chart.

[01:00:45] Alan

Yes.

[01:00:45] Niels

And that they are actually more common than you think. I think they count something like 11. Oh no, so the average of 11 years.

[01:00:55] Alan

Yeah. Seven distinct periods.

[01:00:57] Niels

Yes. Yeah, exactly. So that’s a long time not to get any return. I know we’ve been close probably as an industry, but I would say most managers who’ve been around for a long time, they probably have never really had a 10 year period with no return in their strategy. Could have been a close call but. Well, at least…

[01:01:22] Alan

And they do point out in the paper that those periods of negative to flat to negative for the 60/40 have all come after periods of exceptionally strong returns obviously, which we have seen obviously last decade was very strong for 60/40, less strong just a decade because of the bond side but still, in aggregate, it’s been very strong kind of 17 year period. So yeah.

[01:01:45] Niels

Yeah, absolutely. So, we managed to get around quite a few topics today. A lot of things for people to consider and think about. Anything in all of this that kind of stands out to you? Anything you thought, well this is the most important thing we should be watching out for going forward?

[01:02:08] Alan

Well, I think the theme has been this evolution of the macro regime, that we’re seeing, that we’ve talked about it for a long time but we’ve seen it coming in different ways. It was on the inflation side first. Now we’re seeing debt sustainability becoming a new theme, and then at some point does it infect the equity market? Is that the next part? I don’t know. You can make arguments on both sides. But I think it’s something that to track and I think it is something to keep front and center going forward.

[01:02:45] Niels

Yeah. And I don’t know if we can stretch our imagination far enough to say that a lot of these analyses, a lot of these papers, they kind of talk about what people should be investing in, so to speak, in terms of their expectations. But the great thing that trend does is actually in a sense it helps with the timing of it, when should we invest in these things?

Because we’re simply not going to buy anything that’s going down, for example. So, we kind of avoid that being early type, because some of these may be completely right. But if you’re wrong with the timing by a few years, you probably lose the confidence of the investors. Now, it doesn’t mean that trend following is flawless and we’re going to have our drawdowns and all that, but at least if people spend a bit of time studying it, that is just part of how it works. So anyway, let’s leave it for today on that note.

Of course, as always, I would encourage people to go and leave a positive rating and review as a thank you note to Alan and all the other co-hosts coming on every week prepared with topics and interesting talking points. It actually is a lot of effort on their part. So, I really do appreciate if you would show your appreciation on that. That and you might still be in the running for the competition we have running until the 1st of September where you can win the actual, not the actual vest that Alan is wearing today, but a similar very sleek Top Traders Unplugged vest. So anyways, there’s still a few more days, but you need to leave a rating and review.

You need to email the usual email the usual address at info@toptradersunplugged.com and tell me who you are, what you wrote, and where we can find it, because we do want to verify, of course, that it was an actual review.

Anyways, next week I’m joined by Yoav. I know he’s already put out to me some notes about what he’s going to cover and I thought that looked very, very interesting indeed. If you have a question for Yoav at info@toptradersunplugged.com is the email and I’ll do my very best to bring them up.

That’s it for today from Alan and me. Thanks ever so much for listening. We look forward to being back with you next week. And in the meantime, as usual, take care of yourself and take care of each other.

[01:05:14] Ending

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