Preparing Your Portfolio for the Second Half of 2024 ft. Christian Mueller-Glissmann

[00:00:06] Christian

Will the US government care about the size of these companies, the dominance of those companies and the income inequality that comes with those companies? You mentioned that earlier, Cem. You could say it’s also another very populist topic. Is it correct that these companies are dominating the equity market, dominating the economy, dominating portfolios, dominating income wealth creation? If you had them, great. If you didn’t have them, you’re looking at very different returns.

[00:00:38] Intro

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

[00:01:33] Niels

Welcome and welcome back to another edition of the Global Macro series where today, as usual, I’m joined by my co-host, Cem Karsan, as well as our very special guest, Christian Mueller Glissmann, who is the Head of Asset Allocation Research at Goldman Sachs and who’s back to help us try and make sense of how investors should allocate their capital in an ever-changing global economy as well as in a year where we have an incredible amount of important elections.

Welcome back to the show, Christian, and thanks so much for joining Cem and I for what I’m sure will be another insightful conversation. It’s been a few months since we last spoke. How have you been?

[00:02:10] Christian

It’s an incredibly busy start to the year. Lots of changing macro currents, especially this week. So, it just feels like a very good time for us to reconnect.

[00:02:22] Niels

Absolutely. And how are you doing in the Windy City, Cem?

[00:02:25] Cem

Amidst a gut rehab of a home. But in some ways, it’s spring here, beautiful, but dealing with a lot of other things.

[00:02:33] Niels

As long as it’s not a rehab of your gut, I think we will be fine. Okay, let’s kick things off. Perhaps the best way to do this is really for me to ask you, Christian, if you could share your current big-picture macro framework and perhaps also add how it’s changed since we last spoke, which I think was in September last year.

[00:02:56] Christian

Yeah. Listen, as you know, I like to dissect things into different cycles; the structural cycle, the business cycle, and the sentiment cycle. I think coming into this year, there’s definitely been significant shifts on all of those fronts. I think at the beginning of last year, people probably were a bit too bearish, so the sentiment was arguably bearish because of recession fears, because of this very sticky and elevated inflation at the time which was coming down but there was a lot of uncertainty. And then throughout the whole year, the sentiment shifted more bullish.

We’ve seen this across the board; risk premia compressed, credit spreads compressed, vol came in, and it culminated in this kind of Goldilocks type thinking that emerged in the fourth quarter where it got quite a bit extreme, where the market was kind of expecting strong growth to continue, inflation to come down, and central banks to cut quite aggressively this year.

I think since the beginning of the year, the sentiment has shifted. It’s shifted a bit from Goldilocks to a bit more pricing reflation. I called it in my last asset allocation update “reflation flirtation” because it’s pretty early. It’s not like we have phenomenal growth pick-ups here. I think we see some lead indicators like manufacturing PMIs pick up. We see obviously selective areas in terms of growth looking a bit better after looking quite weak, and that includes China. There has been a bit of better data there.

But I think the problem right now is, is this reflation flirtation turning into desperation? Because you obviously have inflation potentially being more sticky than you’d like, and we can discuss that. So, the sentiment is shifting, but it’s definitely not a desperation. I think it’s still at flirtation stage. So, equities are still at all-time highs and volatility is still relatively low. I think the business cycle is certainly between a bit of reflation and a bit more inflation right now and we need to learn this in the next few months.

I think all of us, both policymakers, investors, we want to understand how much the better growth might influence the inflation picture to understand the growth inflation mix. I think right now, the market, especially equities, are still taking a slightly more benign side and there’s a risk that you get disappointed how much more inflation you’re going to have for how much more growth.

So, I think what’s happening is the market is potentially getting very sensitive to growth in the next few weeks. Because so far, it’s digested these higher rates and the sticky inflation remarkably well, partially because there’s this perception that the inflation is sticky because of better growth. So, if that’s not the case, we’ll have to be careful about equity volatility potentially having a bit of a revival tactically. It comes back to what we discussed last time.

Remember, last time we spent a lot of time on the structural cycle, the structural cycle being the longer-term trends in growth, inflation, and policy. What we said at the time is that we are dealing with much more inflation volatility most likely; much more uncertainty on inflation compared to what we’ve been accustomed to the last 10 to 20 years. And while the market was happily fading that problem in the last year, we’re coming back to it.

We’re coming back to this idea that inflation is, actually, uncertain, more volatile, and potentially becoming more of a risk factor in the portfolio on a more sustained basis. We can talk about what we discussed in the past. The drivers behind it, I think they’re still the same like decarbonization, deglobalization, demographics on the negative side, and then maybe more fiscal dominance and fiscal policy expansion on the demand side, which also can drive more inflation.

And then the positive which can potentially get inflation a bit down is innovation, technology, AI, GLP 1. We can talk about all of that, but I think certainly, we’re shifting back to the inflation debate a bit and we’re shifting back to this idea that we’ll have to diversify and manage inflation risk in the portfolio much more than the last 20 years.

[00:04:34] Niels

Now, this is a great framework. Before I hand it over to Cem, I just want to stay a little bit longer on the topics you mentioned there because I’m curious. I’m sure you’ve done more analysis on this than I certainly have. Last time, we also talked about that a good starting point, in many cases actually, is the 60/40 portfolio. We also talked about how correlation-wise, stocks and bonds had been very different from the long-term in the first two decades of this century.

Clearly, that’s changed a couple of years ago and so on and so forth. But actually, what I’m curious about is these changes in correlation, which we can go back 125 years and we see them change from time to time, but I’m trying to find out, in my own head, whether it actually relates more to the level of inflation or, as you pointed out just before, the volatility of inflation.

I don’t know if you’ve made any observations or conclusions about what the role of volatility in inflation does more so than the level of inflation which we can all see, we can all go back and check. But maybe we’re not so, how should I say, maybe we don’t notice this thing about volatility in inflation.

[00:08:42] Christian

It’s a good question. I would say the best way to characterize this debate is, how many growth shocks are you generating relative to how many rate shocks are you generating? I think if you generate more growth shocks versus the rate shocks, the equity-bond correlation tends to be more negative because the bond market, most of the variation will be driven by growth rather than by rates.

Whereas if you generate more rate shocks, the equity-bond correlation will be more positive, because essentially, the bond market will be driven by those rate shocks spilling over to equity occasionally. I think the idea has been that into this year, as inflation settles from a level point of view, you generate less rate shocks because central bank policy is already very restrictive. At least in level terms, you had pretty high levels of front-end rates. If it’s restricted, we can debate considering how strong growth has been.

But either way, that means that rates volatility is starting to come down, rate shocks are going to come down, and growth shocks start to dominate, and year to date, certainly the equity bond correlation on higher frequency measures has started to turn a bit less positive. So that was the narrative so far.

But clearly, the risk is now that if inflation picks up again, that you have a bit more rate shock potential, especially in the back end where there’s a certain amount of cuts priced, there’s a certain amount of inversion of the yield curve, a certain low level of bond term premium, and it does still leave a bit of potential to generate rate shocks. I think, in terms of more structural estimates, to answer your question, the two things are actually very linked. Levels of inflation and inflation volatility are very linked.

It’s the same with rates volatility by the way. Levels of rates and rates volatility are also very linked. It’s just a mechanical thing because you’re looking at volatility of percentages if that makes sense. As a result of that, I would say inflation volatility and levels of inflation are very closely linked.

The only time where this was not the case was during the Great Depression where you actually had inflation completely collapse and then rebound, where inflation volatility was remarkably high without levels of inflation being very high. But if you look at periods of high inflation, you find that inflation volatility and inflation are very closely linked.

So, to answer your question, both of them matter. Both of them will, if they’re higher, drive higher equity-bond correlations. And sadly, the CPI release we just had increases the potential of inflation being a bit higher for longer, equity-bond correlation not coming down to where we’ve wanted it to be at the beginning of the year. It also highlights in line with our structural discussion. You made that point before.

Yes, the last 20 years, you had this phenomenal benefit of lower or negative equity-bond correlations which led to the risk parity boom. We have to be clear, the return to that or the return of that might be pushed out further and possibly less likely based on what we’re learning here.

[00:11:58] Niels

Yeah, very interesting. And of course, you mentioned the CPI number we just had out this week. Of course, today, or was it yesterday, in Germany, Lufthansa, 16% wage increase over the next three years. There are some interesting things happening when it comes to inflation at the moment. But Cem, let’s see where you want to go with this.

[00:12:20] Cem

I would add on to that piece of that conversation and we’ll take it from there. I absolutely agree. It’s both the level of inflation and the volatility of inflation. The level drives not just less demand for assets because they’re higher bond yields, because the cost of money goes up, but also the TINA effect. You send money away from equities. It also drives margin compression, so less earnings, but the risk premia goes up across the market and that increases the risk in risk assets, which also reduces the demand.

So, I really think it is a risk and a reward hurt to risk assets. It hurts on both ends. So, both are very critical. I couldn’t agree more. I tend to agree with Christian on a lot of things. The one thing I don’t tend to agree with is that 60/40 should always be our starting point, and I think we’ve talked about that a bit. But I’d love to dive into that a bit.

To use the most recent period we had inflation for an extended period of time structurally, the ’70s. ’68 to ’82, equities lost 67% of their value in real terms. Bonds, if you were long-duration bonds, obviously you did not do well. I think that’s pretty clear. Why should 60/40 always be our starting point would be the way I start out. And do you believe the odds are potentially higher that we’re amid structural inflation that could last on and off for a decade?

[00:14:02] Christian

I think it’s a really nice push back, which I kind of agree with as well. I don’t want to say that it is the main starting point or should be the main starting point. It’s just how a lot of investor portfolios are structured. And so, it’s a benchmark. Also, if you do a reverse Markowitz optimization, since 1900, and just ask if you would have invested at the beginning of 1900 for the last 125 years or so, what would have been the optimal asset mix between the S&P 500 and US 10-year bonds, it will actually come out as 60/40.

So, you kind of wonder, where does the 60/40 stuff come from? It is actually over very long horizons, it has proven to be the optimal asset mix. For specific periods like the ’70s, you’re 100% right. It was not the optimal asset mix. What I would say though is yes, you lost a lot of money with 60/40 in real terms, but you also did with cash.

So, the challenge is always are not necessarily sitting in cash and not being in 60/40. Maybe the challenge is to some extent, what do you own within the 60 and what do you own within the 40? What we wrote in our “Balanced Bear” research, and you might remember we discussed last time, we said for the next decade, if this inflation volatility is higher, you need to diversify that, you need to address that in the portfolio.

It might alter the optimal asset mix. Generally, higher inflation is obviously a bit more in favor of owning equities because equities can have real cash flow growth, at least those companies that have pricing power, those companies that have the ability to benefit from inflation and essentially keep cash flows growing in real terms. You will suffer on the valuation. We know that equity valuations are very sensitive to inflation, but some equities more, some equities less.

So generally, when you have high inflation periods, the optimal portfolio tends to shift towards 100% equity, but you need to own the right equity. So, for example, if you run a reverse Markowitz optimization for the ’70s, what was the optimal asset mix if you had to own either equities or bonds? It would have come out 100% equity. Clearly, it would have still lost money, but equities were better than bonds.

But now to the point, what is the right portfolio? Because to mitigate losses, to diversify inflation risk, what we always said is real assets play a much bigger role. I think real assets in the last 20 years, they were less useful because there was no inflation. If anything, it caused a real problem which we’re dealing with right now, which is leverage. So, you had real estate infrastructure, a lot of assets that have real cash flows, because of the lack of inflation, they tried to make more money in other ways, which is leverage.

They levered up because the low inflation side effect was obviously low rates. So, the whole real asset spectrum has become over-levered, and now they are deleveraging, which has meant that real assets have been terrible despite high inflation in the last two to three years. But in the ’70s, if you look at real estate investment trusts or if you look at infrastructure assets like proxying them, would have been a phenomenal diversifier.

Similarly, commodities would have also helped to diversify. What we actually did is we did the reverse Markowitz optimization since 1950. You can’t go back that far because real asset data history doesn’t exist before 1950. And we asked again, if you have at your disposal real assets, what’s the optimal portfolio? Since 1950 up until today, what was the optimal asset mix? And it came out roughly 1/3 equity, 1/3 real assets, 1/3 bonds.

I would say that actually is a portfolio that I can buy into a bit more for the next decade considering what we might be facing. There’s lots of questions and we can discuss what real assets, because as I said, there’s limited history, there’s TIPS, there’s oil, there’s gold, there’s real estate which is going through deleveraging. But you can also think about unlevered real estate, and that actually has done much better in recent years.

Think about housing, how strong housing has been globally, like residential housing. So that would have actually done what it says on the tin. It would have delivered real cash flow growth and the net asset values would not have fallen off a cliff. And then you can think about infrastructure dealing with a lot of regulatory risks. Like the utilities in Europe, if they’re making too much money, they get a tax on them.

So, there are a lot of problems when you get into the weeds. But broadly, the message is 1/3, equity, 1/3 real assets, 1/3 bonds, and then we can talk about the new starting point which I think makes sense.

[00:18:55] Cem

It’s interesting how we look at our world from very different perspectives but we actually do fall in a similar place. We do some wealth advisory for super high net worth clients and family offices and our asset allocation mix is actually, from my angle very related, we do 1/3 thematic equities, we do 1/3 alternatives. So, we do hedge funds that are doing trend following, global macro, event-driven strategies, opportunity distressed assets, all things that when risk premia goes up and you’re getting more regime change actually outperform their own historical, never mind the relative value of equities and bonds.

And then the other third we do, we benefit from the value of derivatives. So, we do short-dated bonds, but we stack, much like a structured product would, a yield on top which is non-correlated. People forget that derivatives came created options in the ‘70s. That’s not a coincidence. We had the idea of options well before that, but the reason they became listed and became actively traded was because of the capital efficiency they provide.

Capital efficiency is critical during a period when yields are going higher. We have a much more robust built out derivatives market now. That sounds scary. When we say the word derivatives, people get scared. But it’s a very robust market, very different than where it was in the ‘70s when we were just starting out. So, there are opportunities to do all kinds of things to get risk, a little bit more yield than you might be getting on that short-dated T bill but do it with really significantly lower risk than you might be doing in equities or in bonds.

So that’s kind of how we look at the world. I think there’s a place for derivatives more broadly. I do think in the next decade, if this does happen, which I believe that we have a structural period of inflation, that we’re going to have a much bigger derivatives market, we’re already seeing that happening, a lot more structured products. And I think the way people look at things will be very different than that 60/40 portfolio, obviously right in time for 60/40 to perform again.

[00:21:01] Niels

It’s quite interesting from where you sit clearly, Cem, 60/40 is the starting point, right? But from where Christian and I are sitting, and certainly continental Europe, maybe not so much the UK, I’m not sure, but certainly continental. I don’t know about what it is like in Germany right now. But certainly not long ago when I started going there, it was nothing like 60/40. It was like 80% bonds, 20% equities.

On top of that, let me just throw this in, the risk we have when nations become incredibly indebted, they have to get rid of their bonds. And one way they can get rid of bonds is of course if somehow they, from a legislation point of view, start to ask banks for example to hold even more bonds, for example, if the demand isn’t coming from other countries, etc.

So, I’m just curious. I know we’re speculating here a little bit. But let’s start with you, Christian. What are the risks that you see given the fact that maybe the starting point of many economies, certainly in Europe, is not the 60/40 starting point? If we are going into structural inflation periods and you’re sitting with a lot more bonds than you really should, what risks do we face?

[00:22:32] Christian

It’s a really interesting discussion. First of all, I think it’s all linked. This whole idea of high debt, low growth, and essentially like saving more with bonds and saving more in general. It’s just the structural macro conditions that lead there, Japan being one of the most extreme example, and Europe, where a lot of people say that Japan is the template that Europe might follow and eventually China as well because of certain longer-term trends in population growth and certain types of longer-term trends in productivity.

I think there’s a lot of economies globally that are facing a very different macro backdrop to the US. And that’s not just linked to the macro, it’s also linked to the equity market. The equity market has just not been a great investment in Europe. And so, you could say actually, the households in Europe have done the right thing to be in bonds rather than in European equities.

Actually, earnings growth in Europe, in the last decade pre the COVID crisis was zero, zero earnings growth for a decade. So, to some extent, this different allocation mix reflects macro conditions. There are some bad reasons as well. I think the equity culture in Europe has lagged materially versus the US. But again, they’re linked. They’re linked because if the equity market does really well, it does attract a retail investor, it does actually generate excitement and interest.

I think we’ve had, unfortunately, that type of virtuous cycle. We didn’t have that. I always say the US has been very good in the equity market to give investors the exposure to a combination of innovation and conglomeration. It’s very unusual what the US equity market delivered both relative to its own history but to most equity markets that exist in the last 20, 30 years.

You had phenomenal earnings growth. You had companies that were already the biggest companies in the index keeping doing well, which now led to this extreme market concentration which we can discuss. It creates of course some risks as well but for investors has been phenomenal. But now to your question, what does it actually mean?

So, this is how we got there. A combination of structural macro conditions and the equity market doing so well in the US drives this big divergence in what I guess the starting asset allocations are for a lot of households. It does expose, of course, those households and those countries that have this big exposure to bonds to exactly the scenario we’re discussing, that you will over time have real returns that will be quite poor.

I think the important question you have to ask yourself is, is the inflation risk in Europe in the next 10 to 20 years the same as in the US? I would say there are similarities, decarbonization, deglobalization, demographics, but there’s also differences, and we see that right now. In the last few months, the European inflation picture has actually continued resetting, whereas the US has stabilized because the growth backdrop is better there.

One of the big differences you have in the US is the private sector financial balance is very healthy, very early cycle, and households actually are doing really well. Unemployment rate is low and the S&P is up, which means the households in aggregate, they actually have a very healthy financial backdrop to consume of, where it feels like in Europe, yes, Lufthansa might have increased as you were saying by 16%, but I also heard at the beginning of the week, the chemicals industry in Germany has actually entered the collective bargaining with zero.

That might be just bargaining but the fact is they said, listen, we’ve cut the dividends, we are in a global manufacturing recession, we cannot pay any wage increases. And we have to be clear, Europe is very exposed to manufacturing. Lufthansa is an exception because it’s linked to the global travel and leisure boom with all of us wanting to go more on holidays since COVID.

But there’s in Europe a lot of industries that are actually not doing that well right now. So, wage inflation in aggregate in Europe might actually be much less strong or much less supported than in the US and in certain sectors. So, I would argue that in the next year or so, inflation risk in Europe might be lower than in the US. In the next decade, I think they all face similar issues. That’s the problem.

There, I think these households with these high bond allocations, it’s not even bonds, Niels, in Germany, and I am German as you know, it’s very popular to just have money in a savings account. You’re very exposed, very exposed to inflation because there’s a proper money illusion where you kind of feel you’re harvesting maybe like 2%, 3% per annum, but you will find that over time, your real return is very poor.

[00:27:39] Cem

It’s interesting again that we approach things from different ways but come to a similar conclusion. I’ve very recently in the last several months been working more on looking to potentially buy relative value European equities relative to the US. I think that some of the primary drivers for the thesis there are in fact some of the things you’re saying.

I think that EU is broadly much less likely to have its inflation accelerate relative to what the US is seeing. I think that’s a structural issue by the way, not just a one, two-year thing. Populism has been a thing in Europe for a long time. The US’s inequality has expanded dramatically quicker in the last 30, 40 years than it has in Europe.

I think that creates a potential is what we’re seeing we’re populism is really, as we’ve seen with Trump and Bernie Sanders and AOC, really vibrant here in the US and not going away anytime soon. But the push back in Europe is more significant I think, or people are more used to this. So, it’s less likely to go as far. That’s one.

Two, from an energy perspective, LNG is coming online and there’s overinvestment in LNG. And we’re about to get, in my belief, a real reduction in costs for plentiful energy in Europe. If you’re trying to grip manufacturing right now, you shouldn’t be leaving Germany, you should be going into Germany. So, I think that’s going to pave the way especially when you look at prices on a relative value opportunity. It’s a really interesting backdrop.

[00:29:10] Christian

It’s a great point you make there. Actually, we looked at this recently. I think electricity and energy prices in Europe are already at pre-COVID levels, like below pre COVID levels. I think our team also thinks in line with what you’re saying that natural gas could continue to come down. So that’s a good story. That’s a good story for Europe.

I think what you mentioned with regards to the fiscal policy, that’s important. I think in Europe, you actually have much less risk of a fiscal excess because you have too many checks and balances, too many people on the table. In the past, that’s been a real negative. Remember, Europe never got its act together to maybe fiscally ease when needed and support each other.

But this time around as people are worried about fiscal expansion and fiscal risk premium, you could argue that Europe, by virtue of its structure, poses less risk. What you can pose against that is the defense spending needs. Because we are obviously- with the deglobalization I mentioned earlier, that’s both economic and geopolitical deglobalization.

In the last few years, we’re dealing with more conflicts sadly, and I think Europe is close to them. We know that Europe has relied a lot on NATO and that seems to shift right now from all kinds of perspectives and for all kinds of reasons. As a result of that, you could say that there is some fiscal expansion coming as well.

But it’s not the type of fiscal expansion like in the US where you have a fiscal deficit of 7%, 8% with the unemployment rate at a 50-year low where I think there are a few question marks if and why you have that type of fiscal spending. So, I think that there, Europe to some extent looks a bit less scary on the fiscal side partially because of that political backdrop you mentioned.

[00:31:06] Cem

I absolutely agree. That’s a very good point that you make. It underpins another thing. If you look at the ’70s and you look at the structural drivers of inflation just to talk about this thing we talked about, it really was driven- people point to three things. They say, oh, it was fiscal policy, the Great Society Program here in the US, the Vietnam War and global conflict, the spending on that, and then the OPEC crisis and resource scarcity.

People don’t realize how connected those three things are. Populism drives the fiscal spending, it also drives protectionism, because populism is local. If you’re sending money to capital, that’s global. You get peacetime during capital expansion. But when you go to populism, people put up borders, and that drives more global conflict and that also drives resource scarcity. That’s kind of the general framework that we’re in.

I think your point is in Europe, you’re still subject to that conflict piece of it more than the US is, and you have a long way to make up on the defense spending as well. I think that’s a very good point. Although I do think the resource scarcity piece we’re getting through, as you mentioned with the LNG part. So that’s a very interesting and relevant point. I think that’s great.

I would like to bring up another point here, which is, during these periods of going with this trend of talking the ’70s, again, we’re talking about that because it’s the most recent time that we had structural inflation to be clear. I’m not just picking a random decade. It’s the last time we had a period of inflation. As we mentioned, ’68 to ’82, that broad period, 0% nominal returns. ’67, two thirds loss in real terms in the equity markets here in the US and broadly globally similar.

What I found interesting when I went and looked at the data is what happens during the election years in that period. If you look at a data set for elections, 1928 all the way to 2020, take that whole data set, you have an average nominal return of 11.5% give or take for that period. So, part of what leads to this narrative that elections years are great years.

What I found was really interesting, if you just take those four elections of that ’68 to ’82, period, you could actually expand it to ’64 to include, if you want, it doesn’t make much of a difference. You can include 2020 which we could argue is another populist type election. But if you take these populist elections, the data is the same whether you add those two elections or don’t.

All of them are positive. All of them are positive double digits, and the average returns of those four or six is 21%. If you take those six out of the dataset, the return for the whole 28 to 2020 period is 5.5%. So, election years outside of these populist periods are actually not very positive. It’s these populist elections that are positive. I want to be clear, they are all positive double digits.

I know it’s not a lot of elections, but you have six of them. They’re all positive double digits, the average return is 21%. So, I think that’s very interesting. Importantly, the next step is you take those elections out of that dataset, ’62 to ’82, we said it nominally went nowhere. What do you think happens to the other 10 years outside of those election years during that 14-year period?

Average down 9% per year a decade, and that’s nominally. The real we already know was down 67% with the whole dataset. So, it is a very telling data set. I think that’s very interesting that people don’t point to or think about. But these periods, inflation periods, are very negative for equities, bad for bonds, awful for 60/40, but with one exception that those election years, when that spending in that fiscal impulse is the strongest and the incentive for positive equity performance is the greatest, equities actually have these massive bounce backs and do quite well.

So, I’d love to hear your thoughts on that and if there’s anything else you’re looking at with the election season in particular.

[00:35:10] Christian

Yeah, it’s a very interesting point. You could argue in these periods, clearly, there must be some type of discontent because inflation is high. I remember the misery index, or like the unemployment rate plus inflation ticking up. That’s the misery in the economy rising materially. And then elections are coming.

I can definitely see that in the run up to the elections, there is hope. There is hope that there is a solution. Maybe that’s exactly what the politicians are promising. And then there’s maybe some afterwards despair. So, you have many hope and despair phases. So, I can definitely see what you’re saying being true, that election years kind of create some type of short-term relief because people are hoping that there will be a set of policies coming their way that will solve the misery.

I would say there’s maybe an element of that this time around as well. We have to be clear, there is a pretty strong start to the year for equities. So, into the US elections, it seems like the market is taking a similar turn. I would say though, I’m not 100% sure because it’s a bit early. But in the conversations we have, I would say that most people are not looking forward to the US elections.

I feel like people currently are worried from a geopolitical point of view. We discussed NATO, we discussed the Russia-Ukraine conflict in the past. I think it’s certainly a key concern for my European clients what the US government will look like and think about supporting Europe and Russia-Ukraine from here.

And then there’s obviously the uncertainty with regards to trade tariffs and what will happen with China, which actually is inflationary. But the interesting thing is there’s a lot of support for those tariffs in the US from what I gather in looking at surveys. So, you could argue you have an inflation problem, you actually have inflation struggling to come down, but still, there’s a bit of support. I saw some numbers, 70% to 80% to put tariffs on China right now.

So, it’s again not exactly the same template looking for solutions for what’s not right, right now. It seems like people are actually still driven more by ideology and driven by deglobalization tendencies. So, you have that as well. And then the last thing is obviously this idea of reflation desperation risk, where there’s a perception that if you have a Trump victory and a Republican government, the tax cuts could be extended.

The Fed might look very different compared to now, and suddenly, you might actually have another driver of inflation risk. So, I feel like most of my conversations, it’s early, I would say that a lot of my clients are looking at the election still much more with interest and with traits or direct portfolio implications. But most of my conversations are actually not hopeful in the sense that people are particularly excited about the equity prospects that are coming from the US elections.

But I think it’s fair to say that what you said is right as well, that elections, like everything we just discussed, is probably more in favor of equities than of bonds. The geopolitical stuff a bit less, but US equities, obviously not European equities. So, I would argue that you could see a bit more of that template. I think one other thing that’s important, going into the US elections, and we’ll discuss that shortly, is market concentration and AI.

Part of the reason why the equity rally has continued is obviously also AI optimism and the fact that the government as of now is not hindering the combination of innovation and conglomeration. There’s a perception that a Biden victory might actually be less good for the Magnificent Seven. A Trump victory might be better because he doesn’t care about antitrust and regulation, at least that’s what I hear from my clients.

That matters as well because the leadership and the strength of the US equity market and the global equity market links a lot to AI and the Magnificent Seven. I know there’s not seven left. Out of the Magnificent Seven, you’re probably down to four now, I don’t know, depending on how you measure it. But certainly, it does feel like this also plays a role into the elections.

Will the US government care about the size of these companies, the dominance of those companies, and the income inequality that comes with those companies? You mentioned that earlier, Cem. You could say it’s also another very populist topic. Is it correct that these companies are dominating the equity market, dominating the economy, dominating portfolios, dominating income wealth creation? If you had them, great. If you didn’t have them, you’re looking at very different returns.

[00:40:23] Cem

Yeah, I think you bring up some very interesting points. I’ll kind of push back on some and agree with a few others here as it relates to election years. I think that wall of worry is part of why. You had this broad period of worry, but then you go into this election year, which, again, historically, to draw it out, those numbers aren’t just relevant that I gave you, but that every year, except for Nixon getting reelected and then eventually getting kicked out of office mind you, every year was a year of turnover. 2020 was a year of turnover. It feels like 2024 might be a year of turnover.

There are years where we don’t get incumbents winning. It’s bad to be an incumbent during these populist periods. It’s difficult. And that leads to the incentive to have to do something, and you have the levers of power. So, I think that said, it tends to be a holding pattern year or two in the sense that there’s a pause. People are waiting to see who gets elected. So, there’s less likely to be focus on is China going to invade Taiwan this year? No, they’re waiting.

There are all kinds of things that won’t or are less likely to happen right now that can happen afterwards. So, I think between that holding pattern where some risks kind of subside for a year, the wall of worry, and then this idea of turnover incentives for more fiscal policy. We’re seeing a lot of these things still happening. The Fed all of a sudden December announced that they were going to choose an environment that seemed very much stagflationary, choose growth over inflation.

That rhymes with all these years. That’s what happens, this broad choice to stimulate. When given a choice, we’re going to stimulate these years. I think importantly, to say the name Trump, I think that’s important. Only Nixon was said that he could go to China. I think there’s an argument that a Trump election, yes, you have to worry about tariffs are whatnot. But that bluster is actually is the one thing that could potentially [be a game changer,] he may be much more likely to make a deal with China, to try and use that leverage to kind of win something and then make a deal.

There’s at least that perception which I think needs to be thought about as we get later in the year, that that might start to drive some more positive. Yes, he’s very populist, but what did he do in actuality? He gave tax cuts to the wealthy. So, you could have a very business-friendly situation despite a very populist rhetoric is I think the end takeaway there.

Despite all the fear, I think we need to look through that a little bit to see in this wall of worry what might actually be, if you turn it a little bit may look a little different come the end of the year, and that perception could very much change as it relates to Trump. So, I think that’s important to think about in the context of what we’re seeing this year. But an important year to say the least, an important election. What comes on the other side of it is probably even more important as we take a picture here.

So, I’d love to dive a little bit into one of my favorite topics, which is volatility too if you don’t mind. I’d love to hear your thoughts about structured products, whether you think they are playing a significant role in reducing volatility. We talked a lot about the 1970s and how derivatives came about during that time, but they were not very actively traded, not reflexively important to the market structure during that time.

Currently, there’s more notional trading of options than there are equities. It’s hard to argue that they’re not having some type of meaningful effect. I’d love to hear your thoughts about that feedback loop, if you’re seeing anything related to that, any thoughts you have about volatility.

[00:44:14] Christian

The question is always, are you generating a material short gamma position that could unwind in function of markets moving? The most famous one in our recent time was the 2018 VIX carry bubble. I think a lot of people are currently looking at these ETFs and these funds that are overwriting, they are really popular, and they’ve become quite large. But I think that’s a very different story. That’s the opposite.

You’re reducing gamma. You’re selling volatility but we actually don’t think that this is necessarily a concern for us, that there’s a major imbalance here where people are harvesting carry in a very vulnerable way especially with leverage. These products are all leveraged. The VIX ETFs in 2018 were leveraged like a sieve. So, I think the broad volatility picture right now is first of all driven a lot by the macro.

I think the macro has been friendly. It’s been Goldilocks in the fourth quarter, and since then, it’s been more reflationary and growth is usually okay when there’s reflation, and that normally matters for volatility. Growth and volatility are very linked. So, the base case is that volatility is a bit lower. If you look at our volatility regime switching model right now, it gives you roughly an equal probability that you’re switching into high vol or low vol regime. But actually, for the last six months, it was pointing towards low vol. So, I think generally the starting point is that you are in a low vol regime.

Now to your question on structure products. So, if you’re in a low vol regime with high rates, you know the answer. It is actually not a terrible backdrop for capital guaranteed products. It’s very different to what happened in the last cycle where it was all about TINA, There Is No Alternative, and you had huge issuance of autocallables. These autocallables and any type of yield enhancement structures, they do create a bit of instability maybe because they’re inherently short vol.

There’s also some other reasons with the autocallables as you know in terms of moving away from the upper strike. There can be quite a few interesting elements especially with dividends, which is a topic I often like to look at. So I think we are currently seeing a shift in the structured products world away from short vol autocallables which are maybe a bit less easy to manage considering barrier features, considering conditionalities, to actually theoretically plain vanilla capita guaranteed products.

It’s a typical late cycle product. Because late cycle, what tends to happen, macro conditions usually are good, tick, like a bit of reflation, and yields are usually high, tick, and investors are struggling to get bullish on equities because you’re late cycle. So why not get exposure to equities in a risk-controlled way? The coupon you’re getting from the bonds can fund the call option and you suddenly get some quite interesting payoff profiles that resonate with the psychology of end investors.

So, I think generally, you would expect more issuance of capita guaranteed products. I think that’s one trend. From what I gather, having looked at this a bit in the last few months, it’s quite slow. It’s been quite slow that type of flow, but it certainly should pick up. But you’re looking at this much more, Cem, so you let me know. But ultimately, that’s the transition.

Is that a bad transition? Not at all. I think it ultimately drives a bit for volatility. At the margin, it creates maybe a bit of upside convexity risk for the market occasionally, that when the market goes up, it squeezes up a bit more. But these are very longer-dated call options as you know, so it should not necessarily be as risk-increasing for the market if that makes sense.

[00:48:05] Cem

I think the big thing that I’ve really been left with is the reflexivity of the vol products, of structured products broadly, on market outcomes tends to be vol compressing. That’s simply because people are rationally allocating capital to what’s a more likely outcome. As that happens, markets are more balanced to what should be happening.

What we’ve seen, at least in 2022 and 2023, with markets performing less well and bond yields, 60/40 broadly performing poorly is a massive increase in structured product issuance. Primarily, it involves selling products that in some form or another really fed back (this is the first time we’ve really seen this) into a vol compression at the center of equity markets. Most of these things are tied to indexes, at least the vol selling parts are, and a lot of that ends up compressing the center of the vol regime.

That said, the broad volatility environment as we know historically increases. Risk premia tends to increase when interest rates go higher. So, we’ve had this push-pull where interest rate volatility is going up, FX volatility is going up, commodity volatility is going up, but where the structural products are mostly issued is actually very pinned. So, what we’re getting is massive dispersion trading. Dispersion is very unlocked to historical norms.

In your research, you tend to point to more macro regime change rotation things that are causing this. Yes, that’s true, but I think there’s a much more important structural effect and that’s really this, these structured products that are specifically sending implied volatility to the center of the markets, to the core indexes, while not supplying single list. And that’s why we’re seeing, relative to history, a massive breakdown.

It started really all the way back in ’17 with other vol selling at the index level that made us realize that that effect is very real. I was in the belly of the beast experiencing this. I can point to the exact trades that pinned the S&P 500 during that year and caused 30% lower implied volatility and realized volatility than any other year in 125 years, 30%. So out of sample and lowest correlation, the best performance of dispersion in history by similar numbers.

So, I think that’s a very interesting change. We can go look at how history rhymes, but history also moves forward, and things change the market structure changes. I think this is one of the most important pieces of market structure that has dramatically changed that will cause dramatically different outcomes.

When we talk about implied volatility and volatility of this cycle, it is easy to say, volatility and risks are likely to increase during this time and risk premia is likely to go up. But this is a different feature that will have a secondary effect. In the short term, in the short periods during that, if you zoom out, and I think you and I have talked about this maybe before, but when you zoom out though, ’68 to ’82, because these are nominal assets, the market went nowhere.

So, actually, long-dated implied volatility compressed during those periods. I would argue even though short-term volatility was about in line if not a little higher, I would argue that you’re likely to get shorter-term volatility compression because of these products that might actually tie into that longer-term trend as well. And it might be very bearish for implied volatility in the next decade.

[00:51:42] Christian

It’s a very interesting discussion. I think we discussed it before I remember because in the last 10 to 20 years, you had this increase in vol of vol where you generated a lot of convexity, especially downside convexity obviously in the big bear markets. But in general, you had a lot of very fast and sharp volatility spikes and sharp corrections with very negative spot vol correlation.

I think what happened in the last two, three years is that spot vol correlation has not been as high, vol spikes have been smaller, vol of vol has come in, and it has a lot to do with the drivers of volatility. If the drivers of volatility or growth, then especially if you had low inflation and possibly with the risk of deflation, that’s the most devastating scenario for equities.

You generate a lot of downside convexity because the market worries about the deflation, worries about the recessionary tail, and these are the things when you have equities easily correct 10%, 20%, 30%. Whereas with inflation, first of all, as you were saying, these are nominal assets. It’s not as scary. And we certainly learned that in the last two, three years looking at earnings.

If you look at earnings in the last two, three years, they were fine. Yes, there were a few factors that might have helped which are not related to inflation, but equities are nominal assets. But there’s one very important feature. Inflation is very autocorrelated. It trends. So, it takes a long time to go up, it takes a long time to go down. That means that by extension, it takes longer to generate the price movements.

The information aggregation is slower, and that actually means you don’t generate the same convexity, which means that skew has collapsed I’m sure you’ve seen. I think it also means, and Niels, that’s your area, that obviously trend following works. We showed that before, in periods of high inflation, it doesn’t matter if it’s rising or if it’s falling, usually trend following delivers among the best returns and actually among the most important diversification benefits because the inflation being autocorrelated tends to drive more autocorrelated price behavior in particular in the assets that can drive inflation like commodities, and then you suddenly have the ability to capture those things with relatively simple trend following rules really nicely and you generate breath in the trend following cross asset trend following.

So, I think that has been a core feature and a core discussion with people who don’t like real assets because they just say I can’t own real assets because of ESG constraints, because of the leverage I don’t like, because they’re very volatile. It’s not easy to get liquidity. A solution can be to just think about allocating to trend following which has that characteristic of benefiting from elevated inflation.

[00:54:39] Niels

I’m of course incredibly pleased that you brought that up, Christian. And of course, I was extremely surprised to hear that Cem, earlier in our conversation, said that even he is now looking at trend following, so I can see our conversations really grow from here. But actually, you did something that that I wanted to do, because we’re coming up to the hour so we’re sort of starting to slow down the conversation a bit here.

We started with your big-picture framework. We started with the 60/40 as a starting point. We’ve gone all the way down to the microstructure of the markets just a few minutes ago. Then you started to open up a little bit about other things to have in your 60/40. Maybe just expand on that a little bit more.

In the context of the fact that we’re sitting here mid-April, gold is hitting new highs. Cem, a long time ago, actually pointed out possibilities in volatility of gold. We have Brent and oil, generally speaking being, close to some high levels we haven’t seen for a while. Copper, other commodities.

I think we are at a very, very interesting point in time for investors that if you get it wrong, if you get this environment wrong, you can really mess up a portfolio quite badly for a while. So, I’m curious, as we are here today, mid-April 2024, what does a portfolio look like in your view, Christian? Same for you, Cem?

[00:56:30] Christian

Listen, we’ve been running a slight equity overweight. We’ve been avoiding fixed income, especially levered fixed income like corporate credit. We think the higher-for-longer environment gives you more optionality on the equity side and creates downside convexity in credit in case the higher for longer turns into more of a recession story.

But at the margin, as I said, you want to be relatively balanced. I think the bond market in my view does at 4.5% yield provide you a buffer for growth shocks. So, if you have a geopolitical risk, if you have a financial imbalance, if the CRE problem in the US turns into a savings and loan crisis, and you do actually have these concerns coming back, I think the bond market would be very reactive to that and the Fed will be very, very reactive.

We have to be completely clear why we are worried about inflation completely getting down to 2%. It’s already come down quite a bit, giving the ability to central banks to react if there is something serious happening. So, I think you want to think about balance, but equity has been our preferred asset class. The challenge you have in equities is the strength of the start. You could definitely see a bit of a setback considering positioning and sentiment where we’ve gotten to.

There are two types of risks you worry about. One of them is a growth shock, and I think the bond market might help you with that. And the other one is that this sticky inflation generates another rate shock a bit like what we had in the summer of last year and in 2022. We discussed that at the beginning. More rate shock than gross shock risk means equity bond correlation positive, which means 60/40 down together, which can easily then exacerbate the downside volatility because people obviously need to de-risk.

For that type of scenario, what we said is you probably want to think about dollar as an overlay, because the Fed is the one that has the clearest inflation problem. I think Cem mentioned something earlier. At the margin, we heard yesterday from the ECB as well that they are gearing up for the June rate cut and they’re willing to decouple, which I think they have been not saying as clearly and the market is not believing that this will be possible.

So, I think it’s all shaping up for the dollar to help you a bit at least in the near term. And then you come obviously towards gold and commodities. I think if you have sticky inflation and central banks struggling maybe for all kinds of reasons, not wanting to sacrifice growth, I think Cem mentioned that earlier, prioritizing growth versus inflation fight, or maybe just because of rates not being the right tool right now to deal with inflation.

There’s another problem which I often hear where people say the rate sensitivity of the US economy is lower, which might make it not possible, coupled with the fiscal expansion you’re dealing with, to get inflation down much more. With that type of scenario in mind, you probably want to diversify the dollar a bit because you will still face the risk that inflation is sticky, and eventually the market might turn against the dollar and say, wait a second, the real yield here you’re getting is starting to erode.

And that’s I think what some investors are doing, where they just say, listen, the dollar might be one thing where shorter-term, it’s reacting to rate differentials, it’s reacting to the Fed’s inflation fight. The further out you look, the more you worry about fiscal, the stickiness of inflation, and actually, you need to diversify that risk. That’s where commodities come in.

I think gold has a lot of other drivers on top. It does have to driver of fiscal risk premium, it does have to driver of de-dollarization and concerns around the dollar. But there’s also a lot of places in the world right now that are probably buying gold for their own reasons. If you are in a war-torn country, if you have geopolitical tensions, if you have the prospect of multi-year stagnation and losses in your house values like China, they’re starting to collect these gold beans and that’s become a big thing there.

You suddenly have also I heard in Costco, in the US, they’re selling the gold bars now and they’re flying out of the door. So suddenly, you have also a lot of retail demand and a lot of demand for people for their own reasons to try to reduce the psychological anxieties. So, I think there’s a place, depending on what type of investor you are and what type of time horizon and risks you’re facing, for some of those value preservation assets right now because you certainly worry about value preservation right now.

[01:01:05] Niels

Any final thoughts, Cem?

[01:01:06] Cem

Yeah, absolutely. So thematic equities, yes, that includes commodities for sure. But where’s the money going to be coming from not in the just election year but broadly during this period? Government, the mouth of the fountain, infrastructure, national defense, health care, housing, deglobalization, onshoring, nearshoring. That’s going to be a trend that’s here for a while. High DCF businesses, going back to the basics. Invest in the economy, not in the market.

I think when you lump those two things together, the economy in real terms grew very well ’68 to ‘82. That’s the part that people get confused on. Yes, nominally, the market went nowhere and in real terms lost two thirds of the value. But the real, not just nominal growth, the real growth during that period was above trend. It’s very counterintuitive.

Business will do okay, but the market likely won’t. The equity market likely won’t. So, this move from growth to value I think is really something that we need to think about. But again, we mentioned that that’s still a third. You don’t need to be 60% equities. Even if this is an election year and even if there is positive performance, go look at things that are going to perform better in the cycle structurally that are not beta tied.

Hedge funds, incredible opportunity there in terms of trend following as we mentioned, global macro, event driven, opportunistic, distressed assets, volatility, arbitrage, the list goes on. And you get that added benefit of capital efficiency, efficiency with derivatives and being able to stack returns above what’s already a short-term yield that you’re getting. So, there are embedded advantages.

This is a time of opportunity, dramatic opportunity. But we need to not be so close-minded to just thinking 60/40 would be my opinion. And then lastly, dimensionality. We don’t need to bet in two dimensions. The Fed allowed this monetary dominance that allowed things to be very controlled and really operate in a more two-dimensional way. The world is becoming much more multipolar.

We’re going to see much more volatility in FX and bonds, commodities, all these things that we’re already seeing, and we’ve talked about for years. What that means is that you need to be betting with dimensionality. Instead of betting on a stock or bond or a commodity, try and use options and the capital efficiency of options. Go buy call options in a year like this, longer dated when implied volatility is cheap. Go fund that in other ways of the distribution that are less likely.

I know that sounds complicated to most people but if you are willing to try and bet on the different range of outcomes on a distribution, you’ll have much more opportunity. So that would be the other part I’d throw in there to diversify the assets.

[01:03:50] Niels

Good stuff. Good place to end our conversation today. Christian, this has been another awesome conversation. Thank you so much for spending time with Cem and I today. Of course, for all our listeners today, make sure you go and follow Christian’s work, because as you can tell from today’s conversation, we truly live in a global macro driven world and it is perhaps more important than ever before to stay well informed.

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

[01:04:30] Ending

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