Preparing for a Pivotal Time in Global Markets ft. Cem Karsan

[00:00:00] Intro

You’re about to join Niels Kaastrup-Larsen on a raw and honest journey into the world of systematic investing and learn about the most dependable and consistent yet often overlooked investment strategy. Welcome to the Systematic Investor Series.

[00:00:23] Alan

Welcome back to the latest edition of Top Traders Unplugged Systematic Investor where we take the pulse of the markets from the perspective of a rules-based investor. It’s Alan Dunne sitting in for Niels again this week and I’ll be joined by Cem. Cem, how are you?

[00:00:39] Cem

Doing great. Here comes fall. Interesting times, election a month away. So, getting back in the swing just like everybody else.

[00:00:48] Alan

Good stuff. Yeah, as you say, the election is coming into view very quickly. So definitely a good time to be speaking to you, from a US perspective.

We’ve a lot to go through from a macro and a flows perspective. A lot of interesting stuff going on in markets this week with China unveiling the big bazooka, as it’s been called, or whether it is a big bazooka or not, we’ll talk about. And as you say, election, commodity markets, a lot of stuff going on in markets.

So rather than disrupting the flow of the conversation, I thought we might do our trend following recap straight off the bat today. So, looking at performance so far this month, there’s positive performance in the CTA world. SocGen Trend is up 1.45% as of Wednesday of this week, and the SocGen CTA Index up 1.35%. So, it’s a positive month for CTAs and that’s bringing the year-to-date number to 2.7% and 2.75% for the CTA and the Trend indices respectively.

So, I think, generally, from a trend following managed futures perspective, the ongoing rally in equities, gains in bonds, weakness in the dollar and the down move in oil, are all relevant in the trend following world, I would say. So, it has been a decent month from a trend performance and that pushing the year-to-date perspective up to reasonably positive levels.

Cem, from your perspective, in your space in volatility from a performance or trading perspective, before we get into equity markets, anything noteworthy there?

[00:02:27] Cem

Quite a few things, actually. As tends to happen when you get a decent-sized rally in a relatively short amount of time, vol compression gets overdone and particularly in long-dated calls. The reality being that vols that we are now priced on, given the geopolitical landscape, given the election, given everything else that’s out there and the big changes we’re seeing across markets, the price of those calss is dramatic.

So, we’re talking about a sub-10 vol in the S&P 500, and calls are long-dated, where long-term average vols, (not for calls, but at the money) is closer to 17.5. So, we’re talking about something that is really cheap and particularly in the context of what’s likely to be a very bullish period and push us into sliding lower into that vol being at the money.

So, from a just 30,000-foot level, we don’t need the world to blow up for vol to go up here. And actually, I would argue the highest probability, if you look forward into early next year (so the next three and a half months or so), is for us to go higher and actually long-dated vol to increase in a fixed strike basis.

Now, in the VIX, when you look at the VIX, you won’t see it go higher. It’ll level out type thing. But in reality, the vol underneath the surface, as you slide up the curves, these cheaper calls, those things will have to come up on a vol basis at least, in my opinion. So that’s if we go up. There’s argument for going down. We can get into why we’re likely to rally here.

There’s a ton of big structural effects that we’ve been pounding the table on that are likely to push this market higher from a flows perspective. I’m happy to dive into those. But rebalancing at the end of the year and a big up year is a big part of it. And people call that the wealth effect. There’s much more to it than wealth effect. We like to think of it as a re-leveraging. The world keeps risk neutral.

I’ll be happy to dive into that, as well as just the holiday season that comes around. There’s a much higher than historically normal skew in December, January, November, partially because of the election, but also just broadly because of the wobbles and the risk-off we saw earlier this last couple of months. And that high skew is something that people call the wall of worry, broadly.

There’s an actual thing. If you have high skew, it drives these vanna and charm flows that we talk so much; the buyback by institutions in the street that is structural, that drives markets higher in these environments too, particularly in low volume weighted time periods like Thanksgiving and Christmas that slow down.

So those things are big factors that need to be watched as we move here into the election period and beyond, and really what we’re watching from the vol perspective right now.

[00:05:36] Alan

Well, it’s a good starting point. I think it’s interesting. Obviously, we had the summer volatility in markets, particularly in equities, but also volatility trading.

And then as we moved into September, I mean, it was noteworthy, the number of people highlighting how September-October period is tough from a seasonal perspective. So there seemed to be quite a bit of caution at the start of the month, but obviously we’ve managed to move higher despite that kind of seasonal headwind, if you want to call it. You’ve touched on a number of kind of structural factors there that you think may be supporting the market.

I mean, of those, anything, you talked about the re-leveraging. I know that was a big theme last year. Is that something you’re really focused on again this year?

[00:06:21] Cem

Yeah. So, seasonality, people like to just call it, it’s like a magical construct. It’s just like people think of it because they don’t understand it.

They just put… the Santa Claus rally is my favorite, right? Just like these magical names, and people attribute it to just psychology. People are just happy during that time. So, markets go up, that’s nonsense, right? That’s not why markets go up. There are actually big structural factors that are consistent and reliable that create higher probability outcomes during different periods of the year.

We won’t go through all the seasonality. Maybe at some point we do an episode where we talk through the structural flows, how they affect these seasonal outcomes. And they’re not, by the way, first of the month. So first of the month, people think that some major effects do fall at the end and beginning of months, but some of them are in the middle of months as well as tied to expiration cycles, et cetera. So, there are several different big effects.

But right now, let’s talk about the seasonal end of the year. We’ve done this before, but it’s incredibly important, and particularly important this year, I want to emphasize. However important it is in other years, when it’s always important, it is significantly more important this year than normal. And why is that?

So first, I mentioned the rebalancing effect. What the rebalancing effect is, is if the market is up, think about it this way, there’s $50 trillion, actually closer to $60 trillion here in US equity assets. There’s another $50 trillion in global equities that are all correlated and tied together. There is another $150 to $200 trillion (I don’t know if I said the word trillion, but the word is trillion there) assets that are tied to the S&P 500 and broadly to equity indexes writ large.

If you wave your hands out and say, okay, that’s about $250 trillion of equity correlated assets, if the market’s up 20% a year, how much has that increased? That’s $50 trillion of new money. It’s not just money that these things have just gone up in value. It’s not new money. It’s new money.

Why is it new money? Because assets are collateral. If you have something that goes up in value, something was worth $10, and it went to $10,000, your situation has changed. You may not monetize it. You may not be selling it and spending it, but you have new collateral. You can borrow against that, et cetera. To be clear, most people think of it individually as a human being. What does that do to me? Most of us, even though people call this the wealth effect, it has nothing to do with your average person. This has to do with institutions. This has to do with big funds. This has to do with banks.

If banks’ value assets go up, they can lend more. If a fund’s value goes up, they can reinvest that. They need to reinvest that. The way most asset managers and most institutions that manage capital, including banks, is they invest risk neutral. I want to make sure people understand that. There’s embedded leverage in the whole system. The whole system is built on leverage.

If the value of things go up, they have to take on more risk. I’ll give you an example. As a hedge fund, if my value of my investment for my clients goes up from a million dollars, and we make 50%, then that’s a million and a half dollars. Now, I have to invest a million and a half dollars. My returns are judged on a million and a half dollars. Just because those things appreciate it doesn’t mean I don’t have to invest anymore.

I need to invest more. My risk is what matters there. The amount of money that’s at risk is what matters there. That’s true for risk for banks who have leverage for anything in real estate. The majority of investment goes risk neutral. That re-leveraging effect is incredibly important to market’s investment.

In a year where it’s up to 20%, $50 trillion, not all of that is coming in Jan 1. A lot of it comes in continuously every day. Some of it has to be rebalanced with banks and other entities. Some of it, even more, happens at the end of each month because reinvestment, funds, et cetera, end of month. Some of it’s quarterly.

Some percent, call it about 10%, comes in on January 1st. These are slower lagging, private equity type things, other things, real estate, that need to be reinvested with new funds or new entities and new things. If 10% of $5 trillion gets invested January 1, that’s $5 trillion. I know we’re weaving our hands to this, but this is the general type of money we’re talking about, how big of an impact it is when the market is up big. $5 trillion, to put it in context, is more than an order of magnitude bigger than the, I would say, 20 times what the average daily volume that moves markets is.

On your average day, it’s actually about $100 billion that moves markets, which seems incredibly low, given the size and scale of the markets. The whole market, that people don’t realize, is like a leveraged private equity or venture capital deal where there’s a small amount of float that’s traded, and 99.5% of markets is not traded in these places. Given that gets funded, everybody sees that coming and prepares for it.

That’s at the end of the year. That’s one day, but that’s all the preparation going into it and everything coming out. That is why, by the way, seasonally, the most positive by month, by far (it’s not even close) of the year is not December or January. It’s actually the middle of December to the middle of January. There is a four-week period there, and we call it the Santa Claus rally, and we call it the January effect.

But if you put those two things together, the percent winning and the size of returns in those periods over 125 years, there’s no way, there’s no explanation for it. It’s not just that people feel good. This is the why.

By the way, if you just take the years where the market is up, it accounts for almost all those gains, which is most years. That’s the seasonal effect there, and it’s critically important, particularly in a big up year like this.

Number two, people see that coming. They have to report at the end of the year, so people are afraid to… It creates a cascade where people have to chase, and that chase matters.

But number three, the most probably important after this big investment, in fact, is November, December, early January. You put those three months and a half together, starting at Thanksgiving, and that is by far the most holiday time there is during the year, and not just most holiday weighted holiday time. If you take the actual volume weighted time (which means that whole period, how much volume is happening), it’s dramatically lower because Thanksgiving in the US, Christmas around the world, New Year’s, MLK here in the US, you go through all those.

There are a ton of holidays where people take a lot of time around the days. It’s not just those days off. And that total volume weighted time being dragged lower means we have an increased passage of speed at which we go through this period, which increases a lot of what we call charm and vanna flows.

It compresses time and removes risk more quickly from the market and drives a ton of buyback of tail, basically, in the market, from this period. That’s also over emphasized, it’s also made bigger by the fact that the biggest expirations for structured products options, all kinds of other risk products that manage the tail are December and January, and that’s because it’s end of the year. December is for indexes and broad structured products. January, actually, expiration and early January is for most single stocks.

That’s just a historic anomaly, historic reality of how these things were created in the ‘70s and ‘80s and ‘90s, and how they’ve been traded, but December, January. December in particular, so it’s getting traded way ahead of time and there’s massive open interest.

Now, this year, why is that more important this year? Because we have an election November 8th, and there’s a lot of fear of contested elections, all kinds of things, and it’s already a big place where there’s short interest, so skew in the market (the downside versus the upside) has become incredibly much larger, much bigger.

Plus, this decline in August and September we saw, which had a lot of stress on that tail, has actually juiced, has set that skew against people who are shorted, and market makers, dealers, banks have raised the price of all those. So, skew in the market back there, in that time period, is incredibly high.

What that means is that dealers are short puts on a very high price with a very high delta and they’re short stocks. What that means is that as that accelerates, and when the time is low and we go through that, that is going to drive a massive amount, a tidal wave of positive flows that will come into the market over that time period.

Now, there is a tail, when you have a lot of short interest in the downside, and there is a risk there. If we were to get a 20% decline after the election or something, I do not see this as clear. The way the distribution works when there’s a bunch of open interest is that it is a very right distributed tail.

What we are doing is we are going into an end-of-the-year period, which is very right distributed with a bit of a fat tail. Because of that end-of-the-year reinvestment part, that also can have the opposite effect. If we were to lose 20% in the market, we would lose all those positive flows at the end of the year, and you could get a real tail. That is always in the cards, I want to make sure, but the distribution is very right distributed during this period. Once it starts going, it has a reinforcing mechanism where those flows lead to the damp it down-side and then re-accelerate, et cetera.

These are the core reasons that once you get past the election, there are a ton of positive flows. On top of that, the election itself has a big event vol, which elections tend to have, especially lately. That has a bunch of skew in it, and that also will drive positive flows. Regardless of who gets elected, those flows come to the market.

Again, it is kind of the whole idea of the wall of worry. This is what is actually boots on the ground, rubber meeting the road, what the wall of worry is this whole idea. It’s not a magical construct. It is actually a structural phenomenon.

Those are the primary things driving these positive forces into the end of the year. Particularly, if the point is bigger than usual, seasonality, whatever you will, matters, but it matters in the context of what these flows are, what’s actually happening. It’s a really positive setup for markets, even despite all the risks. To be clear, we’re talking about flows perspective only.

If you start talking to me about macro and the bigger picture, I’m going to get pretty bearish. You need to be able to hold those two things in your head at the same time and say, hey, the flows are incredibly bullish into January 13th or 15th, or beginning of the year, in the context of a very dangerous coming period, post election, into the new year. If you look at how tops are formed, this is also a perfect setup for a blow-off top for all of these reasons.

That is what we’re currently watching from a flows perspective while keeping the whole big weighing machine picture in our heads.

[00:17:50] Alan

Interesting. From a macro perspective, obviously, there’s a lot going on since we last chatted in terms of Fed and giving guidance there, which has been an important driver and a support. But this week, obviously, news came out of China and a whole raft of stimulus measures being unveiled.

I guess there’s a little bit of the wall of worry sentiment in China as well. There’s a lot of commentators saying that, despite the aggressive nature of the new policy measures, there’s some skepticism as to whether it would really do anything in terms of changing, say, consumer spending and the fundamental trajectory for the economy. But certainly, there’s a lot of liquidity being injected and a number of measures aimed at boosting the equity market. We’ve seen very strong rebound in Chinese shares in the Hang Seng, et cetera.

Do you see a spillover effect into developed markets from that? Or is that just adding to the positive sentiment? Or how important do you see that being for developed equity markets and US equity markets?

[00:18:56] Cem

Yeah, so, policymakers in China are aware, I’m not the only one aware of a lot of these effects. So, timing this, doing whatever it takes type, Draghi, right? To take that approach and pull out the bazooka is wise at a time like this, especially given the clear gap evaluations and issues between the two.

So, they are striking a period of broad positivity in markets, positive flows into the end of the year. And that’s likely to be very positive for them into the end of the year, as well as adding benefit to broad markets that will only help diminish downside broadly for markets and help drive these flows that we’re talking about.

So, when something peels itself off the bottom after being left for dead for some time, it starts moving up as a broad structured trade, it’s one of the worst times to try and short. You want exposure to that at this moment.

Now, if we’re going to back up and just talk about, again, into the end of the year versus bigger picture, there is a knee jerk reaction to China in the US both whenever they go a three, five year period where they dramatically underperform historically. There’s an easy game that can be played in macro where you just go look and say, well, all right, it seems to be starting to mean revert. Now’s the time to really be all in on this mean reversion, and it tends to go for years when that happens and dramatically outperform them. This isn’t new.

The problem here with this is that happens in 85% of scenarios, and works really well, or 90% of scenarios, I would say. But then there are the scenarios which we like to not talk about so much like Russia, or other like Iran, or situations where markets, they got really cheap. And then it dragged along the bottom for five years and the people said, well, it’s coming back. And then 20 years later, it’s left for dead. And that’s for big structural reasons, right? Those are reasons that are much bigger than kind of valuation.

If people lose faith in investing in the country because of rule of law, because of fear of losing their assets at large, because of all the reasons we know, right? There’s a lack of trust and belief in a country’s ability to protect your assets, essentially. And my fear is that’s actually what’s happening in China from a broader perspective.

So, the problem here is that, in most cases, when countries move evaluation dramatically away from each other over a multi-year period, historically, nine times out of ten, these things mean revert. And there’s a great global macro trade out there when things hit bottom and drag along the bottom and then start moving to mean revert. Generally, it’s a great high sign for a multi-year move.

One getting long the pair… well, that works out 10 times and is a great approach. The problem is the counter examples, which are Russia, Iran, we can go through a whole list. You could even argue Japan for many years, which is a little bit different story.

But the issue here is, in a lot of those cases, at least in the case of Russia, Iran, is that there’s a rule of law problem. There’s a bigger structural issue that makes people unwilling to invest because they fear that all their money can be commandeered and taken away at any moment. And it’s also a lack of ability to interact in foreign markets, other issues that are tied there.

My fear is that despite this being a very positive time until January for Chinese assets, is that bigger issue is really what’s at play here. We believe that there’s a real bifurcation that is only partially beginning between China and the West, particularly the US. And to the extent that that is still in play, China remains longer term to have some real big structural issues.

If we’re truly at a global conflict with China, Russia, and Iran broadly, which is what we see happening here and what China has told you for the most part, we are going to continue to walk down a path that is particularly dangerous for investing in Chinese assets. And if that’s the case, no amount of the valuation gap is really going to close that difference.

And so, unless we see a detente, some type of relief of that continued bifurcation, and that’s the question we need to explore when you talk about elections here a little bit later, I’d like to explore that. We have some different thoughts based on whether we could get a detente under either one of these presidents. And I believe there’s a chance there for one, but we’ll dive into that. But that is a major driver.

So, we could get a rally here to December, January. You could see some mean reversion, some meaningful mean reversion off before. But based on the election outcome, we could see either a complete decline back, and that would be leaving for dead the Chinese market again, which I would not surprise me, or a continued wait and see under another presidential candidate.

But yes, for right now, the flows are very positive. There is a huge election component tied to China that we need to be very aware of. So, I think that’s one important thing to watch.

But again, the flows are positive globally. The flows are particularly positive in China right now, particularly in the context of a really huge valuation gap. So, it’s something to play with calls, with leverage, with limited downside, and as a trade, not as an investment, I would say right now, watching the election and several outcomes, which we’ll dive into.

[00:25:35] Alan

Okay, well, before we get onto the election, just wanted to talk about a couple of other themes, which are obviously highly relevant for equities and all markets and flows, etc. And, you know, we’re recording Friday, we’ve had the PCE data just out today, which is again, showing kind of a declining trend on the headline PCE. Core PCE actually, I don’t know, month-to-month was below expectations.

But when you look at the year-on-year, it’s still kind of, you know, it’s not coming down anymore. So around 2.7%, I think. But obviously, in the last few weeks, the message from the Fed has seemed to be very much, you know, inflation is no longer a major problem.

Obviously, there was one dissenting voice at the FOMC. But generally, the message from Powell was, not worried about inflation and increasingly attuned to the downside risks for the labor market. Just curious to get your thoughts on the Fed, the outlook for rates, and also, I guess, do you see this structural downtrend in inflation as something that will persist? I mean, the structural inflationary period has been a theme you’ve talked about in the past. So how is this cyclical downswing in inflation changing anything, if at all?

[00:26:58] Cem

Yeah, this is the part of the trade that’s the hardest and the most profitable. And there are ways to do this, by the way, without just being long or short. We’ve talked about that for some time.

So, the trade related to this, actually, has worked quite well, which is really the steepening, right? You know, the curve has been giving you a credit to put up what we think is an incredible secular long-term trade. And why wouldn’t you kind of take that edge? I mean, it’s a win-win.

Now, the way this works is exactly, at least historically, exactly at this period when inflation cyclically is declining and is exactly the moment that we start to see a counterintuitive steepener that starts to happen. And if you look at all the news and everybody out there, a lot of people are scratching their heads because they haven’t seen a steepener happen like this, right?

This is more than a bear steepener. Be clear, interest rates are… Yields are starting to go up on the back end of the curve. Why are yields going up on the back end of the curve if we’re really going to be a recession, and people are worried about it and all these numbers are negative – the Fed and everybody… What people don’t realize here is that we have been structurally in a very inflationary period now for about four years.

And what do I mean by structurally inflationary? I think it’s important. You don’t have to have actually headline inflation to be in a structurally inflationary period.

There are two things that drive inflation, right? There’s just business cycle. There are the cyclical effects of, oh, we’re in an expansionary, you know, part of the cycle. The economy is doing really well and there’s a ton of demand. And the demand is driving inflation. And then, oh, the economy’s slowing down, we’re in a deflationary period. That’s just the business cycle.

For the last 40 years, up until about 2020, we were in a period where that’s really all that mattered because structurally we were in a very deflationary environment, right? And what do I mean by structurally?

We were expanding, money was going to the top of the distribution through primarily Federal Reserve policy. And we won’t do a long episode on this as we’ve talked about that in the past. But Federal Reserve policy, when you do monetary policy, those two assets, you’re putting money into asset markets, and who’s borrowing the money as well?

Corporations, high net worth individuals are borrowing the overwhelming majority of money. So, when you keep interest rates low at 0% or you have declining interest rates, the top gets the dramatic benefit of that. Corporations get the money; wealthy people get the money. What happens?

Corporations are there to make a profit. So, globalization happens. Corporations don’t care about the people of America or Europe or China or anywhere else. They care about making money unless they’re owned by the government. They care about making money, period.

And that leads to capital markets, free market economics, globalization, which has been a major deflationary force for four years. It also leads to technological development because corporations are trying to find a way to expand margins, to find ways to replace humans, to do things more efficiently.

And technological development also is helped by 0% interest rates, which allows people at companies to look out 20 years and become Amazon and Uber and Tesla. These are companies that didn’t make money for 20 years but invested in the future and eventually became profitable companies.

That’s the cycle we were in for four years, a massive deflationary cycle driven by technological development, globalization broadly, and incredibly low interest rates, driving easy investment to corporations. That’s why we have record margins the whole thing.

The problem is that inequality is the effect of that. And you can get a deflationary environment where the effect can just keep stimulating and not get inflation, keep putting more money in, and they get good GDP growth, and they get low inflation. But what happens when structurally those trends actually start to go the other way?

The reason they do is because there are people in the system. We’re not just cogs as much as sometimes we’re treated as it. We are actually humans, and we care about an idea called fairness. You know, life isn’t fair, but guess what? We care about fairness, right? We care about justice, right?

Well, if people begin politically to vote, they can vote. They can say, hey, I don’t like this. I want to maximize median outcomes. I don’t care about total GDP. I care about how I’m doing and how we as a people are doing. And when that starts to happen, which started really about 10 years ago, but now it’s grown to political dominance with millennials and people who have been labor the last 20, 30, 40 years. Now that starts to become an issue, right?

And this leads to fiscal spending, which is not the same as monetary. That’s demand pushing, getting money to people. It leads to redistribution of wealth from top to bottom. And when we start caring about our people, populism of our countries, now it’s my people versus your people.

Now it’s not globalization, now it’s not cooperative. It’s competitive. And that leads to de-globalization. That leads to conflict. That leads to scarcity of resources and hoarding of resources. And an OPEC crisis, the last time we saw this, we saw all these things and it rhymes with what we’re seeing.

This is the structural. This is not tied to the business cycle. This is secular. This last decades when it starts. And that’s what we’re amidst now. That’s what’s actually happening. And when we saw this last time, these structural affiliations, it didn’t mean we didn’t have the business cycle. It’s not like the business cycle.

It’s not like we didn’t have poor…, When the Fed had to raise rates to battle inflation in the ‘60s and ‘70s, what happened? It slowed the economy, right? It’s not a surprise. Yes, it slows the economy. That’s the cycle. And that slows inflation in the short term. But that doesn’t get rid of the structural inflation under the hood.

They’re battling structural inflation with cyclical pressures. And yes, you can get inflation down with high enough interest rates and enough work. But the problem is that demand/push economy is still there. That populism is still there. And what happens is you have sequestered demand that’s sitting in there, that’s being held at bay by monetary policy.

What happens when you lower interest rates? This is an inelastic… People don’t realize this, but the effective interest rates are not linear. It’s not like we raise interest rates 5% and the economy linearly just gets dramatically hurt.

What it does is it sequesters demand. It holds back demand, like people can’t go buy houses, but they want to buy houses. They’re doing well enough to buy houses, if only these interest rates came down. They’re looking, they’re trying to wait. So, when interest rates came down, what happens? All that sequestered demand all of a sudden flows and it’s inelastic, right?

And so, this is what happened in December. And the Fed went out, and it was amazing. People were amazed, like the Fed came out and talked about cutting rates, right? They priced in at 2.5%, but all the bad news, everything that people were worried about didn’t come to pass. There was so much sequestered demand. Everybody, the second the 10-year came down, started jumping back in, the numbers started coming in hotter and all of a sudden, the economy re-accelerated, then there’s the wealth effect that we talked about.

So, it’s the same situation here. Now, to be clear, you can only do so much, and you lose a little bit of that sequestered demand. If you do it more frequently, it becomes less effective. That said, we expect that we will continue to run a very hot demand/push economy in the grand scheme of things.

Much like it’s been transitory 1.0, 2.0, 3.0, I think transitory 4.0 now, we will continue until, essentially, the long end of the curve begins to say, hey, I don’t believe it anymore. Every other time you’ve said transitory, it just comes back, and begins to see the bigger structural inflation and starts moving the long end of the curve, which itself is reinforcing to inflation. I think that’s the part of the chapter we’re in, as much as it doesn’t feel like it to most people right now, because everybody’s looking at the cyclical effects and saying, well, the last 35, 40 years, in this scenario, interest rates will just come down and will accelerate and inflation will go back.

[00:35:30] Alan

So, is that steepener now, Is the market looking through the rate cuts and seeing a reflationary scenario? Is that what the signal is reflecting there, do you think?

[00:35:40] Cem

Yes. But again, the word reinflationary assumes the cyclical pressure. And I want to be clear, I think it’s a removal of the cyclical deflationary pressure that allows the structural inflationary pressures to then reignite.

And I guess that’s semantics, but the point here is you have two pressures, and one is consistently securely now deinflationary. And we believe the Fed will get put back in a box into this slowdown. And that’s what stagflation is all about.

And we believe in a decade of stagflation, here, going forward that the Fed will be forced to deal with. Which is much harder than if you have a deflationary pressure that you’re allowed to just stimulate against without any structural issues.

So yes, the best way to play that is to continue to play the steepener. If you think about it, if we’re right about this, when the Fed lowers interest rates, every time the curve should start to steepen, because that will be increasingly inflationary and reinforce longer term inflationary trends while lowering the front end of the curve.

So, this is the trade we were looking for. We’ve talked about it now for nine to six to nine months, and it’s now playing out. Even though you’re not seeing inflation short term, I think that that’s speaking to some of these effects that we believe are out there.

And again, we can get to all of the inflationary pressures themselves and talk about them in politics too, because I think who becomes president will speak to some of the different inflationary pressures. Because again, this is a much more geopolitical, populist driven, political driven reality and will come in fits and spurts despite the fact that we think this is a 15 year, 10, 15 year phenomenon.

[00:37:36] Alan

Just before we get into that, I have one other thought. Last year, if you look at the pattern of how markets traded, we had this spike in yields kind of from August to October around concerns about refinancing the debt and debt sustainability. And then we had what seemed to be a tactical shift in terms of issuance from the treasury towards bills away from coupons. And now this has now kind of become more of a theme in markets.

I know that the next refunding announcement comes up, I think it’s on October 30th. Is that a date in your diary? Are you seeing any interesting activity around that date? Obviously, it comes just, I guess, a week before the elections that are probably all tied up together. But is that part of the scenario that you’re monitoring as well in terms of this, the steepener trade?

[00:38:34] Cem

The reality is the treasury is going to continue to be as supportive as possible until the election. I know that’s only a couple days before the election, but I see no reason for them to do anything different than they’ve been doing, which is again, part of why, and we’ll talk about elections, but why election years are so positive in general. They have every incentive to make sure that the short-term looks really great and may not be as focused on the long-term as long as they can justify it by winning at the end of the day.

Their reelection and policy and the big picture that they believed are important is what they are trying to preserve. And so, yeah, I see no change there from the current situation, which again, is only more stimulative and reinforcing of the trends we’ve seen.

[00:39:37] Alan

So maybe just to delve into it from the election perspective, obviously, there are a number of different, I suppose, dynamics here. You’ve got the economic policy, you’ve got, as you talked about earlier, the possible detente with China. That’s an important mix.

And it’s not just pure economic policy in terms of fiscal, but you’ve also got policy around immigration that could be relevant and also, you know, differences or potentially interesting policies around how the Fed is treated, Fed independence, et cetera, and things like the dollar as well. So maybe just to give us top level, I mean, Trump versus Harris, how do you see markets trading on the back of each outcome or which is the most kind of obvious trade that you see on the back of either kind of person winning?

[00:40:35] Cem

Yeah, before I dive into each one and how they are different from markets, I do want to re-emphasize the point that from a flows perspective, regardless, in the very short term, on a kind of two week, one month basis post-election, you’re going to get naturally structural, very positive flows coming off the high skew and the event vol coming out of it. That doesn’t mean though, that come January, we have the same flows kind of moving through that we have the same effects for them. Let’s kind of dive into how they’re different, and how they might be different, and how they might make a difference in the bigger picture for markets.

In particular, I think the focus needs to be inflation, or populism, not just in rhetoric, but in terms of policy, in terms of what’s actually going to get passed. And I think there are some critical things that people aren’t talking as much about, which are really important for the upside.

Obviously, most people out there who are looking at Trump versus Harris, here in the US, would think, well, Harris represents the status quo and, at least politically, the left, if you will. And in their view, the first reaction would be like, oh, that’s more populist, that’s probably more structurally inflationary.

But let’s understand where the actual policy differences stand. As I see it, inflation needs to be the primary focus in terms of how the two will drive different effects in the market on the structural piece of things.

The biggest issues are fiscal policy, global conflict, labor costs and protectionism, and then commodity and input prices. Those are the things that drive structurally and are all connected. And I want to look at those issues and how each candidate is different.

From a fiscal policy perspective. I think it’s fair to say that Trump would be (despite the rhetoric being just as populist), on policy perspective would be more supply side, as he did with the tax cuts last time. I don’t think he would politically be as capable, and we’re eight years now down the road from his original election. I don’t think that he would be, given the amount of youth dissatisfaction, broad populism, and the increase since that first time even, I don’t think he would be able to pass that kind of a law or that kind of policy anymore, but he’s more likely to do that.

Now, he will continue to give away new fiscal as well, to be clear. I think it’s fair to say that a Trump economic policy is stimulative in all ways. It is monetary policy. He’s more likely to put pressure on the Fed to bring them in house to try and stimulate on his behalf in the short term, as well as from a fiscal perspective.

I like to think of him as somebody that I know all too well being from Turkey, like an Erdogan type figure, who does not follow traditional monetary policy. He, again, uses the power of the US in any way it can to stimulate on behalf of the US. I think that creates a massive cyclical positive for markets in the short term, but also drives a much worse structural secular inflation pressure. What that looks a lot like, actually, is Nixon.

Again, there’s a lot of similarities between Nixon, different periods, but it rhymes. And again, a person from the right who was expected to be fiscally conservative, but for the sake of power, was willing to do whatever it took, both for himself and at least in the perception of his voters, on behalf of the United States as well.

It’s an America first policy. That’s not a political statement but true, America first, but we have the cost of that as well. And one of those is inflation. And that’s what we saw during Nixon as well. The Arthur Burns story rings true. And I think that’s something we need be mindful of.

That’s from a policy perspective. Now, Harris is structurally inflationary as well. I want to be clear if you’re taxing capital gains and you’re trying to send that money to people, and it’s really more of a rebalancing story, it’s less extreme cyclical push, but it is inflationary. It’s something that can be very stagflationary.

Both, I think, are inflationary in different ways. Trump is much more likely to be cyclically so hot in the short term that the long-term inflation gets even worse, but in the short term, he’s running a super hot economy. Whereas the other one is more measured and in some ways not as expansionary and yet still inflationary, which could be, short term, even worse for markets.

From a global conflict perspective, I think this one is very important, very interesting. There is this looming cloud of China. Nobody likes to talk about it. Whenever we do, people are kind of, oh, not this again. Nobody wants to think about it, or they’ll want to just ignore it. But the reality is that if you actually look under the hood, and you talk to real policy makers, you talk to entities who have the information, the odds (and this is what China is telling you), the odds of China moving in some form or another against Taiwan is about as high as 50% in the next four years.

People would say, no way, that’s not going to happen. They’ve told you as much. And again, we’ve seen what Russia did in Ukraine. We see what’s going on with Iran and Israel. These are not independent events.

This is a structured approach to a much bigger movement. And that global conflict is something we really need to be thoughtful of because it’s the number one, number two economies in the world. It’s crazy to think that’s where we are.

And under a Trump administration, he told you last July, I think it was July 14th, he said it before, but he was pretty vocal out there. That’s part of what actually drove the drop in Nvidia that began some of this rotation that we saw at the time. But he said, look, Taiwan, if you want our support, you better pay us. We’re not sending you weapons. You can pay for your weapons. And what that is, is his broad policy. When people say something, take them at their word.

The intention there is to be more isolationist and not get involved in a global conflict. If you’re not going to be a deterrent to China, China is going to move more quickly. They have every incentive to, and they’re waiting. And they’re not the only ones waiting. The world is waiting to see who becomes president.

We’re in a period of, think of it as the eye of a storm where everybody’s in a holding pattern. Nobody’s going to move. Everybody’s just waiting. We’ll be either they’re moving one way or another based on that outcome, whether it’s a corporation or a country or whatever the thing. And you better believe China’s in a holding pattern. And the second the results of that election are known, it will have a different reaction function.

And the reaction function under each number is different. I think they will likely move sometime in the next four years, but it will be different based on who is president. It is more likely to come very soon, I think the next year, if Trump is president.

It is more likely to wait, be longer, wait four years or so if it is a Harris presidency. That said, if it happens sooner, it’s also likely to resolve sooner. And we’re actually a little more likely to get a detente with China sooner. And then that could drive a reversal of some of these populist effects. Again, could is the important word.

We’re talking about probabilities in terms of global conflicts. And there are many outcomes, and politically it matters. It doesn’t just matter with the president wants in a country, it matters with the political response is from the electorate as well.

But I think there’s a much higher probability of a Trump presidency leading to a quicker, more abrupt action, geopolitical move in China. And in a quicker resolution (I’m not talking about six months or three months, I’m talking about a year or two, three years) moving past it. Which, if that were to happen, would be incredibly bullish for Chinese assets relative to the rest of the world and all kinds of things.

So, the election is very important for China. It’s very important for that global conflict and the geopolitical risk and the inflationary pressures tied to that. Again, it’s more likely to be a slow moving, bigger issue. And if and for when it happens four years or so, three years from now, with a Harris administration, if it happens, it could be longer, and is more likely to be a bigger global conflict and continuous. So that’s a major thing to be mindful of.

Lastly, two other points. I’ll start with it. The less important one or commodity prices, that’s a very inflationary thing. Historically, what’s going on with energy now?

The US creates enough of its own energy now. But the West broadly, we’ve seen this in Europe, has major problems as does Japan when energy costs go up. That can be an inflationary pressure if we have a major stimulus from Trump. That said, he’s probably aware of that. And I believe there is a higher chance of Trump making a deal with Saudi, giving guarantees on security.

And if Saudi is willing, they’re being, again, a detente there, which has been kind of rocky for some time for the Democratic party. And that could be, again, stimulative and less inflationary under a Trump administration than Harris administration, which is, again, not willing to negotiate as much under those terms now. So that’s something to be mindful of, that people aren’t talking as much about.

It’s not necessarily going to happen, but something to be mindful of on the oil. I think people are maybe not thinking about under a Trump administration.

Lastly, I think this may be the biggest of all of those things I’ve talked about. I’ve talked about a lot of big things. But all of those things, up until now, that I’ve said on the Trump administration have been less structurally inflationary, more right than left, despite some of it being very cyclically inflationary with more stimulus, et cetera, on some of those fronts. The one thing that I think is incredibly structural inflationary, that would be more likely to happen under a Trump administration than a Harris administration, is ‘whistling by the graveyard’ on immigration.

I think the one thing that has been holding down labor inflation in the US, relative to how bad it could have been given the de-globalization of everything we’re seeing, is massive immigration. It has been politically unpopular, and Trump has been, in his base along the southern border of the United States in particular, vehemently pounding on this topic.

Xenophobia doesn’t only happen here in the US, it happens globally, particularly during populist periods. It’s about mine versus yours. That is an incredibly populist impulse that Trump will continue to hammer on.

If we close the borders, if we truly start exporting people or putting up borders and not allowing more immigration, labor inflation in the US, and broadly in the West, will continue to be hotter than expected and could be a major inflationary pressure. I think that’s something that people are missing on that side. That immigration policy change, a hardline immigration policy could be very structurally inflationary and enough to offset, by the way, some of those other rebalancing pressures, right versus left.

So again, a mixed bag of issues, something to think more about distribution in different areas and how hot the economy will be, but clearly different outcomes from different channels.

[00:53:58] Alan

I mean, you talked about the flow as being very positive for equities in the period after the election. How do you think the markets would trade in the immediate aftermath?

Is it a steepener? Is it a bond sell-off under Trump? Is it an equity sell-off on the CGT issue under Harris? As the dollar has been more of a focus for Trump as well, is the dollar at risk in that kind of immediate aftermath? Or does it depend on the outcome of the House and the Senate? Or do you see potentially big moves in the four-week period after the election?

[00:54:35] Cem

One thing that people aren’t really watching very closely, which I may have pointed out before, but I want to reemphasize in terms of the election. If Trump wins, he likely wins both houses. I want to be clear.

If Trump wins, he likely wins both houses, even though it’s a very close election. If you look under the hood, the Democrats’ only way of winning the Senate is by the election of Harris. And that’s because she has, or as president would have the tying vote to balance the Senate. And based on which states are up for grabs, that’s the only way. So, if Harris loses, the Democrats lose the Senate. That’s pretty much how it works.

And in the House, we have never seen in a hundred years of history. That doesn’t mean it can’t happen now. Probably realistically, it happens because people vote down the Democrat, Democrat, Democrat, Democrat, Democrat, or Republican, Republican, Republican, Republican, Republican.

We’ve never seen a situation where the House has swung from one direction to another without the presidential candidate winning. And so, swinging the House for Democrats is highly unlikely to happen unless Harris wins. And so, you have a situation where if Trump wins, the House probably stays Republican, and they win the Senate.

And that is a major deal. That means dramatic ability to make huge impacts on policy, not to mention this time around we’ve had a Supreme Court decision that now adds increased power to the presidency in a dramatic way, not underestimate the power of that. So be mindful that a Trump administration is likely to be all complete cart blanche to institute these policies and his issues. And he would take it as a mandate if he did. So, I think that’s incredibly important.

Again, it’s not up down, but this is understanding the risks and the distribution of what’s likely. It’s more of a mixed bag if Harris wins. It’s not necessarily clear if she’ll have a full House and Senate, it’s possible. Again, kind of a coin flip there.

[00:57:05] Alan

Yes. There’s more potential for a dramatic move on the Trump win by the census.

[00:57:11] Cem

Absolutely. So, I think that’s an important thing to know.

I want to back up and talk about a couple statistics I’ve talked about before. I’ll do it really quick, but I think it’s important to take a step back and say regardless of its Harris or Trump, if we’re in this structurally inflationary period, like we think about, the populist period, and you look at the data tied to that. I think we’ve talked about this before, but those periods are very bad for equities and bonds. Obviously, cost of money goes up. The tide goes out, and equities, despite how strong the economy might be going, there’s an alternative to the bond market, that people are against equity markets, margins get compressed.

You have all kinds of bad effects for equities and obviously bonds, particularly long dated bonds, don’t do well if interest rates go higher. So, 60/40 is a problem. In ’68 to ‘82, I would say was for a 14 year period, markets went nowhere and lost 70% of their value in real terms. So, that’s the last time we had increasing interest rates.

The funny or interesting part is if you take the elections out of that data set where the market does very poorly, during that 14 year period, if you take the four elections, actually if you even take the one right before that period, you take all those elections, you can do either data set, they’re the same. And you can also, by the way, take the last election, which I wouldn’t even qualify as well or not.

Either way, the data says the same thing, whether you have four data points, five data points, six data points. These are the ones I call the most recent populist elections. The average performance is 21%. Every single one is up double digits.

Consistently strong, very strong, a winning percentage is a hundred percent. Again, that’s not data that may feel like cherry picking, but you tell me what the populist elections are. Go ahead, tell me and go take a look at that data.

And if you pull those elections out of hundred years of that history, going back to 28 elections, all other elections are up only 5% on average. So well below the market broadly. These are the ones that are very positive. And the great irony is they all come during very poor economic long-term outcomes over a decade to15 years.

That’s very counterintuitive. Why are these elections so big? Yet those decades are very poor. And again, the populist period, very contested elections, massive stimulus on the part of the party in charge in order to try and win that election and to drive money to voters and to make them vote for you and you get positive outcomes. But the bigger picture is very poor because there’s a rising secular inflationary period. And these periods are dangerous.

So, the last thing you want to do is, after that election year, go in long in the markets. There’s likely to be not only a mean reversion, right? This is just kind of you’ve been pushing kind of sugar into the system and then you remove the sugar and you’re right back to kind of where we were.

But you could actually get even worse because you not only get mean reversion, but you can get retracement and decline. And again, there are other effects geopolitically, right? I think people are in a holding pattern that year, it’s classic, peaceful, and there’s not as much big things. And then the election passed and everything switched back on. Here we go. Welcome to your populist decade. So that’s our broad view from 30,000 feet. I know that’s a bigger picture, right?

And you’re asking me, what happens January 1st, or what happens? Our view is whether it happens January or February or waits till September of next year. we do believe that this push that we’re really seeing is likely to be just a sugar high. And with the Trump administration, it could be more of a sugar high, right? But we believe that ultimately retracement is likely to come out of this. And it won’t end well.

Again, sometimes these things take longer than you expect. We expected a housing crisis in 2006. It didn’t happen until ’08. We expected a tech bubble burst in ‘99. And then the NASDAQ doubled and then it dropped 92%, right? Blow off tops are kind of the way of markets.

I’ve been doing it for 25 years. And I don’t remember one bigger decline that didn’t come with a rally and, you know, all the stuff right before. I mean, that’s structural for all the reasons we mentioned, short interest, the wall of worry, all the things drive positive outcomes. Keep the plates spinning until it gets to a point where something happens, it’s unsustainable. And then it’s precipitous, right?

So yeah, the earliest that’s likely to happen is January. You’re not likely to get a rally until that January time. We’ll see if it happens in that window. But there are all kinds of things. And again, I’ve been around this business long enough. I’m usually early.

When you see the warning signs, it usually takes way longer than you expect because we’re trying to short it. Because people are trying to take advantage of those fixed structural issues. They see it, they’re under investment for a reason. And you kind of got to get them back in and into an uncomfortable position.

[01:02:28] Alan

Good stuff. Well, there are the positives and negatives to take away there. I’m sure we’ll have you back on before we get into the potential down move.

So still a lot to talk about there, but great to have you on again. And thanks very much for those insights. We’ll be in an overdrive, I guess, between now and early November with election analysis, but great to get those insights. So, we’ll leave it at that.

Next week Niels is back. He’s here with Nick. So, if you have questions for Nick, please send them in. And in the meantime, from all of us here at Top Traders Unplugged, thanks for tuning in. And we’ll be back again soon with more content.

[01:03:14] Ending

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