What Will 2024 Bring? 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 Niels

Welcome and welcome back to this week’s edition of the Systematic Investor series with Cem Karsan and I, Niels Kaastrup-Larsen, where each week, we take the pulse of the global markets through the lens of a rules-based investor. Cem, great to be back with you this week to kick off the new year. How are you doing? How was your festive season?

[00:00:41] Cem

Good. Happy New Year! 2024, another trip around the sun. It was obviously a very eventful year for myself, for markets, a good time to sit and reflect and think towards the future, obviously. I did a lot of that, got a lot of downtime with family, and excited to start the new year.

[00:01:08] Niels

Yeah. Actually, that’s kind of what we’re going to be doing today, maybe a little bit of a different episode than normally because it is the beginning of a new year. It is the first episode of the Systematic Investor in 2024. So both you and I felt that it would be a good idea just to discuss a little bit about what we expect from the year ahead.

Before we dive into all of that exciting stuff and the topics that you brought along very kindly, since we last spoke, which is like a month ago when we had the group conversations, is there anything other than what we’re going to be talking about in a few minutes that’s been on your radar, anything that you’ve noticed that you thought was interesting?

[00:01:52] Cem

I think the two big things are, one, the Fed, we’ll call it pivot. After today’s data, we’ll see the ‘mission accomplished’ banner and what that really means. I think that’s an interesting thing to get to. The big question the market had, is this transitory 3.0 or is this actually a turn?

The other big one would be geopolitical, what’s happening in the Middle East and the Red Sea and how it continues to move along. I think we’ll get to both of those as the show goes on. But I think those are the two biggest developments and I think they both have major, far-reaching implications for what will happen this year.

[00:02:36] Niels

Yeah. Well, I couldn’t agree more. You just mentioned the December jobs report that came out only a few minutes ago where they were expecting 170,000 jobs added last month. It came in at 216,000 and an unemployment rate of 3.7% which, as you rightly say, doesn’t quite jive with the pivot, if we can call it that. But we’ll see. We’ll see. It’s early days in the year.

Before we dive into the topics, let me, as usual, just give a quick update on trend following. Since the year just ended, let me recap December where we really saw a continuation of what started in late October, which was this massive trend reversal in stocks and bonds that kept finding new Fed statements and FOMC minutes to refuel itself on.

Now, the good thing is that many trend followers had actually started to turn bullish again on equities after going flat-ish over the summer period. But I think most longer-term models would still have been short across the curve in fixed income markets. Overall, that led to a loss in December. But also, the Fed “pivot”, if I can call it that, it did also have an effect on currency markets where a combination of some new tone from the BOJ saw the yen surge 4.5% in December alone.

That obviously came against some short positioning among CTAs and hedge funds and so on and so forth. To round things off, maybe some markets that people don’t follow as much, and a year, like Andrew did in our group conversation, Cem, he called it the year of the whipsaw, and I completely agree, we did have some pretty big moves in December.

Sugar fell 21% alone in December, and that certainly also inflicted a little bit of pain for the trend following crowd. Yesterday, my trend barometer finished at 48. It did finish the year, actually much higher, much stronger. So we’ll see how that all plays out. CTAs this week have had a little bit of a soft start the first few days of trading.

But, just to round off the year as a whole, December 2023, we saw the BTOP 50 Down 37 basis points, so the year ended down 1.36%. The SocGen CTA Index was down 82 basis points in December, down 3.5% for the year. SocGen Trend down 32 basis points, down 4.17% for the year, and the Short-Term Traders Index gained 46 basis points and was down for the year 1.77%. Actually, these were quite small losses even though some people are quick to say, oh, not a great year for CTAs. I would argue the opposite. Managers have generally given back about 15% to 20% of last year’s gain and I think that’s pretty decent.

Now, of course, we couldn’t compete with the traditional assets. MSCI World up 4.8% in December, finishing at 21.77%. World Government Bond Index up another 3% or so in December to finish 4.76% higher for the year. And the S&P 500, obviously charging away, up 4.54% nine weeks in a row, I think it’s the longest weekly winning streak since 2004, and ending the year at 26.29%. So a very good year for those markets, complete opposite of what we saw the year before.

Now, Cem, before we dive into your topics, we did have a question that came in from Rick. I can’t remember if I sent it to you, but in any event, I’m sure you can deal with it on the fly. He writes, “I enjoyed part two of 2023 year-end conversation, or group conversation, and the look ahead. As regards to upcoming interview with Cem, he mentioned in a recent interview that he thought the recent spike in SOFR was a canary in the coal mine. Would you please ask him to explain on that? What are the implications and risks that he sees?”

[00:06:52] Cem

Yeah, that’s a great question. What that tells you is that, given the amount of issuance that’s happening and the Treasury’s dependence on issuing in the short end of the curve and leaning against that liquidity which is the last real solid source of liquidity there in reverse repo, even that is fragile at times of relatively what you would consider otherwise liquid environments at the end of the month.

If we’re going to get spikes in SOFR during a November end of month, we saw it a little bit again at the end of December, when things are liquidity is broadly very strong and you’re seeing lots of other things that would otherwise be supportive, what happens when you have illiquidity? I think that’s what I mean by canary in the coal mine.

When you start to see those clues in otherwise placid times, you have to really think to yourself, okay, what happens when things are illiquid and then we’re in the same situation? It’s just a clue to how issuance is starting to bleed out the amount of supply that’s out there. That can mean aggressive and volatile moves across markets, particularly in the treasury market and other things that are related constellations of the Treasury market.

[00:08:28] Niels

Yeah, that’s great. On that note, I was either listening to some podcast or reading something not too long ago, and someone brought up the point that actually, maybe the Treasury is a little bit in “default” with the law about how much they can issue in the short end, how much they have to issue in the long end, and the balance between the two. I haven’t seen anything about it since. But it’s interesting if they really have been.

[00:08:58] Cem

I think that’s something we’ll dive into. But I think it’s important to note that, now that interest rates are coming down a bit or have until today let’s say, it gives an incentive if the market is hanging and we’re past the beginning of the year for the Treasury to shift that balance a bit and go longer duration. I think that dynamic is actually going to be important going forward.

[00:08:58] Niels

Okay. Yeah. Very good. Well, let’s jump into your topics and focus on them and where we will, as I mentioned, look into the crystal ball and discuss what may lie ahead of us in 2024. I think most people listening to us today will agree that the last couple of years have been pretty difficult to navigate, with lots of uncertainty.

As a person born in Denmark, all I can say is that 2024 already started with a bit of a bombshell because on New Year’s Eve, our queen of 52 years announced, out of the blue, that she will be abdicating in about 10 days. So we’re certainly off to another year of surprise. Let’s see if that spills over to the market. So far, I think her news is pretty unrelated to what’s going on in the market.

Anyways, I’m going to give you a little bit of a prompt in terms of the topics and then we can discuss that. One of the things that I heard someone talk about, the other day as well, and I think it’s interesting because when we look into a new year, often we look at what we expect the data to be. But actually, his point was, well, maybe we need to look much more in terms of what has happened in the past in order to see what’s coming ahead.

I think that ties well into the first point you wanted to talk about because you wanted to talk about some of the trends that we have seen in recent times and lead that as a look into the new year.

[00:11:01] Cem

Yeah, great ending here. Absolutely. If we stopped and looked at what happened, take markets aside and actually look at what has happened in 2023, all the things that you and I have been talking about for three years did not reverse in any way. If anything, they accelerated.

Those things are labor, populism, all of the trends behind not just labor rights and everything along those lines, but there’s been an acceleration of protectionism, accelerated US v. China, lots of policies passed this year accelerating the bifurcation of the world economy. OPEC came in the fray multiple times to try and support oil. There are all kinds of other resource scarcity, again, things that we’ve talked about, and entities flexing their muscles geopolitically in using those resources.

There’s simple geopolitics. We’ve gone from a continuing war Russia v. Ukraine now to a war in the Middle East, which very much, in my opinion, is tied into that bigger picture. It’s a second front, I would argue, on a much larger global war. So all of these things, they’re speaking to the broader structural secular trends that we’ve been talking about and how those aren’t going away and those are only becoming more and more entrenched.

Again, we’ve laid out a broad roadmap for why that is and why that will continue. I think that’s important. We are always on the lookout for counterfactuals or other things that would make us doubt that broad thesis because that structural thesis is so important to the broad investment view. All those things have been not only affirmed but have had an exclamation point put at the end of them this year.

I think that is very interesting in the context of what markets have done. In lots of ways, equity markets, risk assets, growth versus value, we’ve had a lot of moves that are really counter-trend to those things that have now started as trend. I think that speaks to some of the performance of certain strategies and things that we’ve talked about as well. I think that’s important to keep an eye on and understand.

The real big question here is 2023, was that in terms of certain asset performance counter-trend or is it a new trend? Are we moving away? All the data underneath the hood, we can talk about cyclical effects and things that are happening, but is that affecting the broad structural trend? Everything that we’re seeing says this was a counter-trend year to a broader trend.

I think that’s an important thing to keep an eye on and focus on when you’re looking at what happened this year. There are lots of clues of that in markets also under the hood. It’s not just the facts that we’re seeing in the headlines and what’s happening, but you can actually tease out a lot of these things as well. I think a lot of that happens and tends to happen historically, and this speaks to our approach when positioning gets offsides.

In the long term, again, we say this again, but markets are a weighing machines. These things do matter. But things don’t go in a straight line because people start to absorb the narrative of what’s happening and understand what’s happening. That knowledge is vol dampening. There’s a counter positioning against it and that can cause pretty big and violent moves that often have to convince that narrative that it’s not the case anymore, have to squeeze out that positioning.

That supply and demand ,or that voting machine, really needs to get back in line for the next resumption of the trend to continue. I think that’s really what we’ve seen this year. If you look at how people were positioned at the beginning of 2023 versus how they are now, broad narrative and sentiment, all of these things have changed, obviously, dramatically. All of that follows price. So I think that’s important.

When these secular opportunities that you continue to play, now cyclically in terms of positioning, come into line, that is when the biggest opportunities exist in markets. We really believe that’s what setting up here into 2024. I think you can see that again and again. If we look at the last 40 years, and we’ve spoken of this before, there was a clear structural trend.

If you bet growth versus value, if you bought the dip on risk assets aggressively into all the dips, if you were long bonds as a hedge against your equities, all of these things, if you go on and on, all those trends. There are a bunch of others, geopolitical, betw on emerging markets in China, you could go on and on. You did incredibly well.

If you got the structural trend right for 40 years, you are an incredibly wealthy individual despite major drawdowns in 2008 and 2009, major drawdowns with a tech bubble 2000, 2001, 2002, 70% type drawdowns. So, I think the key is to understand what the bigger structural trend is, what’s happening, and then when the opportunity presents itself cyclically, to really continue to push on those trends over a longer structural period of time.

I really do believe if you look at the macro and understand what’s happening that those structural trends that I believe will be here 15 years or so are not only alive and well but accelerating. We’re looking for opportunities to get back into all those trades aggressively as we enter these windows.

[00:16:54] Niels

I couldn’t agree more. I still feel that when we have these conversations, not necessarily with the people who listen to us, but I think in the world at large and among a bigger group of investors, I’m not so sure that they have fully embraced what you’re laying out. I wonder if you think that, at the end of the day, it all comes down to how you view the interest rate environment, therefore also the inflation environment of course.

Last year, people couldn’t get started quick enough to buy bonds. Even some of the really smart guys that we’ve had on the show, you and I, that we’ve talked to, they got bullish on bonds even in 2022. So there is this framework out there still where people believe that interest rates really ought to go back to something that is much lower than what we saw during this year and that’s the way it’ll play out.

So one, do you agree that it really does boil down to that part of the financial world? And how do we then dissect that from there?

[00:18:21] Cem

That is the biggest question. You’re absolutely right, Niels. What is happening to inflation and what is happening to interest rates? Now, that is a representation of what’s happening underneath the hood. What drives inflation is demand versus supply. It’s that simple. Interest rates are driven ultimately by inflation. So I think we need to start with inflation and supply versus demand in the economy. It’s that simple.

The question is globally, where are we going to be in terms of that demand in the market? Again, there are two components to that. There’s a cyclical component which comes and goes right, that there’ll be a reaction function to re-stimulate if demand is weak, etc. But then there’s a much more important structural element which happens secularly, and which is what’s happening to money going to the bottom versus money going to the top. What’s going on to the people, to the consumption engine, on the demand side, versus the supply side. This is how I think about it.

The reality is that, globally, there’s not just a broad demand for demand-side economics, as opposed to supply-side economics, but it’s gotten to a point of political action. Betting on politics seems like oh, that’s a dangerous game. How can we be so confident that lower quartile, that lower 50% even, is going to get more of the share of growth going forward? The answer to me is simple. It’s the fact that the younger generation has been labor.

We’ve talked about this. It’s been labor for 40 years. Their whole lifetime has essentially dramatically underperformed and now is coming to political dominance. It’s that simple. If you go talk to any millennial on down, when you say these words to them, their eyes light up. They say, yes, this is true, we need to fix these things.

There is an underlying deep emotional feeling that this system is not fair and that there needs to be some redistribution, or at least more fairness put upon the system. That is true here in the United States, that’s true in Europe, that’s true in Australia, that’s true in Asia. Anywhere you go and you talk to people, this is the sentiment, and it is widespread and universal.

If you poled that 10 years ago versus you poled it 5 years ago or if you poled it now, those are only increasing, at this point, right as baby boomers where the divide exists generationally are dying off and these people are growing, this generation is growing to political dominance. I think that is going to create, as we’ve seen, we’ve been saying this for three years, more and more policy that helps those people. It’s that simple. I’m looking for counterfactuals all the time.

Again, we looked at the trends this year. None of these things went backwards, they’re just going forward. So that’s going to create, at very least, a lot more money to demand. Ironically, and this is an important piece, the more that we send more money to demand by fiscal policy, by protectionism, by labor rights, however we do it, that creates higher inflation levels which then pushes interest rates higher.

Higher interest rates actually pull money away from capital and the rich, and that is actually pulling money away from supply. So not only are you increasing demand, that would be enough, but you’re removing supply. So this whole engine that we’ve had, which has been deflationary, which has been sending money to supply and not giving enough to demand, is now being reversed and giving money demand and pulling money away from supply.

This whole cycle, once it gets started, it doesn’t go in a straight line. It accelerates because the more entrenched the psychology of inflation becomes, for multiple reasons, then people start pulling forward demand. We know the whole storyline here. Eventually, it burns itself out and the young become older, inequality becomes a bit more balanced, and then we go into the next cycle. But this is just the tip, just the beginning of this broad cycle.

We know that because the generation is just starting to become politically dominant. We’ve just started to address some of that inequality. We are making progress towards it. If you look at the numbers in the last eight years, there has been a significant amount of money going to the bottom quartile and a significant improvement there. But it is still a very small fraction of where it would need to go to get back to where it was 40 years ago. I think that those are the most important things in my mind.

Again, those are the most important things because they drive everything. They don’t just drive inflation and interest rates, they drive deglobalization and protectionism. They drive geopolitical conflict, resource scarcity, all these other things we’ve talked about. You go from a very cooperative environment globally, and corporate profit-focused environment, to a very competitive environment where people are more focused on the people of their country as opposed to the broad GDP and growth globally of the corporation.

That is a very dangerous time. It tends to lead to crisis and political upheaval. That sounds like all the bad stuff, right? But there are good things that come through these periods. We’ve seen them again and again ultimately, but it usually is a very volatile, very painful time at least for a decade or two.

[00:24:49] Niels

One of the things that I’m thinking of, as I hear you speak about that and speak about inflation, speak about the younger generation, I think about the dangers that I don’t think they necessarily completely realize, just yet, from the fact that it became popular I don’t even know how many years ago, maybe it’s 10, maybe it’s 15, to become freelancer and a contract worker and all of that stuff where, yeah, it all sounds great and you can have multiple employers, so to speak.

Of course, many companies thought, yeah, that’s great, we don’t have to pay for health insurance and all of those things. So it becomes cheaper. I worry about the time when this generation, who may not have then saved up or have the benefits or big enough pension essentially for when they get older, realize that, oh, shoot, we should have thought of this 10 years ago or 5 years ago and it all goes into reverse.

Now, we obviously saw a little bit this year or last year, I should say, with the unions striking against the car dealers. I think also in lots of other countries where perhaps the employers have had the upper hand for a long time, I think that those things are changing.

The other thing I wanted to mention, before I forget, I do agree with you about demand and so on and so forth. When I think about interest rates, what I worry about is the thing where maybe we actually don’t have an economy that fires on all cylinders, yet interest rates keep going higher.

Maybe I remember this from my early days back in the ’80s, where the Berlin Wall went down. I was a government bond dealer back then and interest rates went up a lot. Part of that was just the uncertainty that this new world situation created. So what I really worry about is that we get to a point where the market demands a higher premium to buy the government debt, essentially, and therefore also the corporate debt and so on and so forth. That’s one of the things that I think about as well.

[00:27:29] Cem

Yeah, I agree. You’re hearing a lot of people say, and this is what I talk about, positioning, how it matters, and how you want to reenter when the narrative changes. You hear a lot of people saying the words soft landing. You’ve heard that anywhere lately? Saying the word Goldilocks. I’ve heard that a lot lately as well.

What I think people fail to realize is how closely connected Goldilocks and soft landing are to stagflation, which is almost the worst thing. They almost connect on the other side of the circle. There’s this tenuous feeling of, oh, everything’s perfect. Everything’s in the worst possible situation. My view is broadly that we are heading towards a more stagflationary environment.

It doesn’t mean that growth is catastrophically bad. It doesn’t mean that inflation is necessarily incredibly awful. But you could really end up in a situation, and I think that’s where we’re heading here, where cyclical pressures to try and control secular structural inflation push us into just lower inflation than it was, but still elevated inflation, while growth itself is in a really bad place.

This is the problem that we have with trying to control what is increasingly a structural inflationary picture with cyclical pressures and cyclical tools. I think we’re going to go through more of a stagflationary environment as a result. What do you do in a stagflationary environment? When you’re in a massive inflation environment, okay, pretty easy. You cyclically try and remove demand and try and bring down that inflation as long as growth doesn’t get too bad.

But now we’re entering the period where growth is dramatically slowing. What do you do now? That’s the Fed being in a box. The Fed has now limited things that they can do. If they do pivot truly here, if that is what happens, let’s say the economy slows down dramatically and markets pull back 20% or something, presumably, in our election year, you’ll not only get fiscal stimulus as a response, but you’ll get monetary, you’ll get a bit of a pivot to help support the economy.

But what if inflation is still at 2%, 3% at that point with a significant pullback in recession in the economy? What do you think is going to happen to inflation? Again, we’ve seen this story before. You’re now removing those cyclical pressures against this structural inflation, and now you’re going the other way cyclically. That’s when you get a resumption of inflation.

Yes, it’ll accelerate the demand picture, but that demand picture will now be out of balance with a supply situation that we know is quite bad across lots of different markets in the US and globally. The next chapter is going to be interesting. The most interesting chapter in the ’60s and ’70s, I’ll note, was not the first move in inflation, it was the second. The second like higher is when long-term yields started to break out.

There was an entrenchment of the psychology of inflation which really accelerated inflation dramatically. That started in 1970, ’71 when, actually, not Burns, but William McChesney Martin pivoted and really started to stimulate, again, into a year and a half recession, a mild one, a year and a half recession in the United States. That eventually led from inflation to 6.5 and then down to 2.

Sound familiar? And then went all the way to 12. It topped at 12.5 or so in ’74 and then deep recession as the Fed cyclically tried to push against it again, brought inflation down to 4.5 but into a deep recession. That’s that stagflationary type situation we saw that second time around, and then Burns pivoted again, famously, and then inflation went to 18 or 17 or so percent. Again, it’s not a straight line.

These are the secular realities you need to keep an eye on in the context of other cyclical realities. I think we are so used to playing that cyclical game because that’s all that mattered for 40 years. It was very easy, two-dimensional for the Fed to just push against a deflationary environment with cyclically inflationary tools. That is much easier. You get the best of both worlds under that environment.

Now the Fed is in the opposite situation and it’s a much harder game to play. There are very few things that they can do as long as we choose to maximize median outputs.

[00:32:19] Niels

I know it’s still early where you are on this Friday morning so you may not have caught this story. I think I saw it first time appearing maybe last night, and it is related to inflation. I read it on Bloomberg, but it’s on many different outlets. It’s about the largest, I think the largest, supermarket chain in France, Carrefour.

But actually, it appears now that it’s also other countries as well where they’ve simply removed all products from PepsiCo because they simply cannot accept the price increases that they have demanded for their goods. So while officials and some experts are busy saying, oh, well, inflation, we’ve got that under control, it seems like it’s very different when you’re out on the street and what price levels we are seeing in reality.

[00:33:16] Cem

Yeah. There’s a big dispersion, as we’ve seen, not just in markets but in terms of inflation and types of inflation, not to mention where in the economy, different pressure points, are hitting. That’s why I say under the hood, yes, we can look at broad markets, but under the hood, it’s not just what happened when we’re seeing the headlines.

If you look under the hood, you see these things still very much alive and well. Structural, secular, inflationary pressures are still very strong. Core inflation is still 4% after all, taking interest rates to 5.5 over this period.

Yes, you have had the benefits of oil’s decline and other things coming down because of the cyclical slowdown, broadly, of the economy. Those things will clearly bring down the headline number, but you have to worry about what happens when those things are now reversed, which we know are just cyclical. There’s a lot of other clues under the hood.

[00:34:23] Niels

We’re going to go into some other topics, move away from inflation and interest rates. Before we do so, I don’t know whether this is the right time to bring it up, but there was one thing I was thinking about, and that is the word normal. I’m not sure myself anymore.

What is a normal world? What should we expect more normal to look like after everything we’ve been through in the financial world, but even in the world at large? We’re going to obviously come to that when we talk about the geopolitics. But I wonder when you think about what is normal, from your perspective, have you any suggestions?

[00:35:10] Cem

Oh, wow, Niels, I think we need a four-hour podcast about what is normal. It’s all about perspective. It means times, right? Are we looking at a short window of what’s normal? In the context of what? If we really want to talk in the bigger picture what is normal, if you really want to zoom out the last 200 some years of free market, the broad freedoms that people are given and individuals, this is in the history of 4 billion years of animal history is incredibly not normal.

What’s normal is survival of the fittest, everything accruing to the top power versus subjugation. So, what is normal? In the natural system, that is normal. We had, clearly, a move globally towards a much more fair, equitable, just system. It doesn’t feel that way to people, but their visions of normal have now adjusted to this world where there is broad fairness and that we deserve some type of fairness, and we could ask for that. That didn’t used to be the case.

People used to assume that that the emperors were kings or gods, they deserved and were entitled to x. You just talked about the Danish Queen abdicating. Things have changed dramatically. But they’ve also swung to such a point that we now expect those things and not just expect them of this younger generation. I’m not being an old curmudgeon guy. This is just the reality – expect a certain level of fairness and equity and equality.

They’re not the first generation to do this. But again, we keep going down that spectrum further and further away. We’re almost like fairness is assumed to be the way of the world or the way things should be. I would say the last 40 years have created this level of placidity and level of expectations have also brought calm and peace, the technological development. This is also very rare and not normal. That’s the longest period of peace we’ve seen globally, maybe ever.

A lot of that is driven by some very new, I guess we call, abnormal things. In history, there is one entity with complete control over the global economy, which is monetary policy and new tools and new experiments to help us control the whole thing from afar. That has led to, yes, great technological development, globalization, high growth rates, broadly.

But the cost of that is a move back towards this system, which is a winner almost take all system. Now these two things are in conflict and we’re trying to move back. The pendulum is swinging back. Now, a normalization back to something where the pendulum is not so far one way, from recent history to where it’s been in the last 250 years where people are fighting back and trying to regain their part of the economy, will lead to a more, in the last 250 years, normal environment where market forces are more balanced and lead to things, less compressed volatility, more policy changes and geopolitical movements, more war, less peace, which again, in the broader history of things is more normal. So a very complicated question, again, that we could spend many hours on.

But my view is in the shorter timeframe, if you’re looking at a broadly shorter timeframe, I think there was a normalization, I think we can use that word, to broader market history happening with the removal of the compressing forces of low interest rates and free money. I think that will broadly release and normalize a lot of the things that we thought were true, and economists thought were true, from prior centuries here to a bit more normal in that sense.

In the very shorter picture, if we’re not going back thousands or hundreds of thousands of years, I think that is probably the more correct current answer to people’s perspectives.

[00:39:49] Niels

The reason why I wanted to bring up this what is normal type question is the next topic that I know that you wanted to mention, and it has something to do with the election cycle in the US, I imagine. If I think about what’s going to happen 11 months from now, the world can be very different a year from today depending on the outcome of that election.

I don’t mean just if Trump wins. Actually, what if it isn’t Trump or Biden who wins? There is a third person in the race. This is also why I think that is something we need to just be aware of. We are in an election year and that’s going to have massive implications for the world we live in.

[00:40:38] Cem

Not just an election year, an election year and a broadly increasing populist environment where things are moving quicker and bigger macro shifts are happening. Not all election years are created equal. If we do believe we’re broadly in a regime shift, that election matters even more towards a potential release, or step function, in some of these things. So, yes, incredibly important.

The last election, people will talk about COVID and everything else, but the reality is it wasn’t just COVID. It was the fact that the change in who was in charge, as COVID happened, led to a historic amount of fiscal policy, an order of magnitude more fiscal policy in real terms than we’ve ever seen. Again, an order of magnitude bigger than the New Deal in inflation-adjusted terms.

Now, for the size of the economy, the same amount. But that’s politics at work. That’s the power and importance of elections at work. You could argue there would be a very different reaction function potentially. It doesn’t mean the secular trend would have changed, but at least the speed and move of this trajectory, the path would have been very different. So I think you’re absolutely right.

This election really does matter, especially when we’re looking over path and how does the next two, four, maybe even eight years change as we’re moving along this timeline. One thing that we do know from elections is that there’s more spending that goes into them, more policy, promises, more stimulus that probably comes in, and that’s why elections tend to perform better in those election years. That’s not a coincidence.

People broadly want more. Politicians front load it and give it to them so they can get elected. It’s all about incentives. So I think you can expect that. I think if we were to get some volatility here in Q1, which is what we’ve been calling for, some giveback of the recent gains, I think you can assume that the reaction function will be bigger than normal in this type of a year and faster than normal.

I think policymakers might even want, incumbents might even want a little bit of a pullback so they have an excuse to stimulate into the elections next year. The last thing any incumbent wants is economic volatility into the election season. That will affect the path. I think being aware of that is incredibly important when you’re drawing your distributions for what may or may not happen over certain timeframes in the next year. So that’s over the next year.

Now, your real question was not what happens in the next year, it was why is this election important for going forward? How does this affect things there? To your point, yes, a Trump election versus Biden will introduce significant changes in rhetoric and policy and will not only affect things here in the United States, but obviously globally and what will happen in terms of the path of geopolitical realities, maybe, most importantly.

But you can’t dismiss the third one, which I think a lot of people are sleeping on, and maybe it’s not this election cycle, maybe it’s the next one. But we’ll see. there’s a higher and increasing probability of a very new entity, whatever that is, coming in and really changing things. We saw this. Yes, we had a lot of change between different presidents, different types of presidents in the ’60s and ’70s, for example.

There was more turnover, less eight-year incumbent presidents. There were several assassinations. There are other things that happened, as well, that I think people have to be aware of. I think there’s a big mismatch, particularly between the age. This is becoming a big narrative and important to the younger generation, between the age of both these politicians and the political aspiration, the political dominance of a younger class, a younger generation. I think that is something people are sleeping on.

I think that is right for somebody who is younger to come in and really speak and gain broader political popularity. What that person brings in could make dramatic changes positive or negative. We don’t know what that person is or who they look like, but that is an important thing that people are not thinking about. I think both of these candidates are incredibly unpopular, and I think that’s probably one of the more interesting things to your point.

It’s maybe what’s happening on the third party. There is an incentive mismatch between the debate that’s happening here and a broad demand to blow it all up and bring in something completely new. That can make dramatic changes to market policy. In a very volatile time, you’re introducing a potential unknown to what’s already a volatile situation.

[00:45:57] Niels

I completely agree. Of course, we are incredibly US-centric because so much really starts with whatever the US decides financially or geopolitically. But of course, a lot of the geopolitical uncertainty, right now, is taking place much closer to where I am and also in the Far East and the Middle East.

I know you’ve mentioned that, for a long time, this is something we need to pay very close attention to. Is there something that you’ve been thinking that tells you that 2024 will lead to some kind of, how should I say, surprising next move in some of these conflicts or a new conflict for that matter?

[00:46:48] Cem

I think 2024, because it’s an election year, is leading to certain entities waiting a little bit. They’re saying, okay, we don’t know what’s going to happen this year. We’re going to try and get involved in these elections. You better believe there is a broad pressure from both China and Russia, globally, the Middle East, all to try and affect this outcome because it is very important. So there will be a lot of both covert and overt ways of trying to affect the outcomes here.

In that sense, we can create some type of volatility and issues in the short term. That said, I think the biggest, we’re talking China moving on Taiwan or other things of that ilk, which is much bigger, decisive actions, I think those are in a pause mode until they resolve who the candidate is and what the reaction function is of their adversaries. That’s just incentives on what you’d expect.

That said, come November of 2024, once that decision is made, I think late 2024, more probably 2025 becomes a very dangerous time regardless of who becomes president because it now is a new four-year cycle. There are less stimulative issues from fiscal and whatever as well stabilizing forces in that regard. There’s also just more volatile potential from entities that are heading along the secular path of confrontation. I think that is something that I really worry about for 2025.

I know we’re talking about 2024, but I think that’s an important dynamic to really think about as well. But again, not a small thing that everybody is very focused on what happens in the US which affects what happens globally in terms of the election. I think lots of entities are going to be really, really trying to do all kinds of things, not just interfering with the election process itself, but really trying to do things that might make current entities unpopular or other entities that are counter their incentives.

[00:48:53] Niels

I hate to add to your list of things that doesn’t bode well, and that is actually one thing is to talk about the external conflict. I’m actually also really worried about internal conflicts in some of the bigger “democracies” that we have, both in Europe and the US. We live in a very divided, very tense environment at the moment, and it doesn’t seem like much needs to go wrong for things to really break out.

Whether this is true or not, but from what I hear, and maybe this is from some of the more outspoken people that I come across, but they talk about how, in the US, the whole demographics have changed. You tend to move to states now that are more politically in line with yourself and that actually leaves fewer swing states for the coming election, potentially, I guess.

There are lots of moving parts at the moment, and demographics, by the way, is also one of them in general, not just when it comes to elections.

[00:49:59] Cem

Yeah. I think the one thing I want to say, again, we’ve been very negative here and for good reason because we’re focusing on a short time frame. I do want to zoom out occasionally and make sure we understand that the ’60s and ’70s, which I’ve referred to, everybody you talk to who lived through that generation felt like the world was coming apart at the seams.

You think we’re at each other’s throats now, generationally, politically, it’s almost nothing compared to what we saw during that period. Go back again to the 1930s and ’40s, I think we all know what happened in the 40s, in the ’30s, in the depression. You think things are coming apart at the seams now, it’s all about perspective. Now, things did not ultimately come apart. It may have felt like it was, and it may have come close even.

But I do believe in the ability of, given where we are in the cycle, it won’t always be the case, global bigger cycles, that there is still a mismatch in power and belief in the global system of freedom and democracy and capitalism that I do think these things will be revitalized and given another cycle, at least another 40 years. I don’t think we’re at the end of it. A lot of people, well-known people are out there saying, okay, things are going to change right away. I’m skeptical of that.

I think there’s still broad unanimity here, in the US and globally among the Western, the dominant economic and political powers in the world, for a preservation of the system. That’s from left and right in the US. The problem is we’ve had 40 years of going into our corners. Part of that’s driven by the Federal Reserve and the placidity. We haven’t burned the underbrush for 40 years, and that creates a very dangerous situation. But guess what?

If we burn down the forest, all the seedlings, not everything dies, it will rejuvenate a much healthier, more stable system for the next cycle mouth. Now, fires are not fun. That’s why this has been a negative conversation. But what fires breed is a revitalization and health. We need crisis. We need crisis. If we eliminate crisis from the system, we bolster the structures that were built in order to preserve all these things that we’ve benefited from.

So again, a little note of optimism. There’ll be some fires between here, there’ll be some crisis between here and there. But I think ultimately, the thing that we can hope for is that that is actually going to bring back the health and more balance to the system.

[00:52:59] Niels

I want to touch on one more thing that I know you wrote to me or listed as a topic, and then I want to throw in a little bit of a teaser for a conversation you and I are going to record next week. The first thing is just, as you said, we’ve been a little bit gloomy about the outlook, concerned, let’s put it that way. We’ve been concerned. It doesn’t mean that markets actually go down necessarily.

I think some people, perhaps including yourself, might see some fireworks before it all comes apart, but not necessarily in the sectors that have been on fire this year or last year, I should say. So how do you, if you were really going to put on the crystal ball and give us a glimpse.

[00:53:49] Cem

Now we’re zooming into very shorter timeframes. When we do that, the thing that matters less are the bigger macro things that matter over 5-year or 10-year periods. What matters more is positioning, flows (broadly), and liquidity response from the authorities that matter. So if we zoom into that and look again, it’s an election year. First and foremost, there should be a positive reactionary force that comes against any slowdown both in the economy and in markets.

That doesn’t mean that we’re not going to have that slowdown at this point. It does look like they’ve been pushing against trying to, up until this point, slow things down, and I think the economy is slowing broadly despite what we’re seeing in employment. The question is, do they go too far on that? The answer broadly is yes. I think the pivot we saw took a lot of people by surprise.

Yes, the minutes walked it back a little bit recently. But the fact that we priced in six cuts in a year, all of a sudden, is pretty dramatic given that inflation is still at the headline of 4 in core. You can’t help, as I’ve said before, wonder how much of that is political. That’s not a conspiracy theory. That’s just the realities of incentives. I think we will continue to see that. That’s more likely to lead to some type of positive liquidity situation.

The way these things usually end, they don’t just peter out and die. There’s generally some type of blow-off kind of move. So, in the very short term, again, we’ve run almost 20%. We did and now we’ve pulled back a bit in a very short period of time. That was based on a lot of positive seasonal flows that you and I talked about many times here and saw coming.

Does it make sense in Q1, now, to see a little bit of the reversal of that not just a little bit, maybe even more? Absolutely. I would expect that if that becomes more than 10% in the market, which I think we’re likely to get more than 10% decline at some point here in Q1, you better believe that entities, political forces and whatnot are looking for more and more excuses to continue to push against that.

The deflationary narrative will come back in full force. You’re hearing it more and more. I think that will give an excuse for a lot of the resumption of trend, as I mentioned at the beginning of the show, for a much bigger perspective. I think you’ll start to see other areas perform better into the next rally, which will be things that have underperformed in 2023 which are much more structural to government spending, inflationary pressures.

There will be a broad move away from the trade that has worked as well as it has. That doesn’t mean those things won’t perform as well. But I think there’ll be similar to what we saw in early 2022 and even 2021 where you saw the growth value rotation, really before the market rolled over. I think you might start to see a lot of that especially as I think we’ll probably see a steepening of the curve, which I think, given that interest rates will be coming down broadly, will be very interesting,

If the back of the curve stays relatively strong, that could then lead to more inflation for several reasons as I’ve mentioned before as well. So if I’m forced to look in the crystal ball, I think there’s two paths. One in which a decline starts some somewhere between here and end of February and ends broadly in mid-March to late March. In that case, a buyback that’s forced by both a quick pivot in fiscal and monetary, I think that’s the most likely path, and then a relatively strong period until election season, maybe the fall, where we could get some tumult into the election season.

Based on outcomes, etc., I see 2025 as quite dangerous, as I mentioned. The other path would be we don’t get enough of a slowdown. Today’s number was particularly interesting to that, enough of a market decline, there’s this market chasers that are more stable during this period, then we don’t get enough something for there to be a reaction from fiscal or monetary.

This thing kind of runs early, and then as you get in the fall, things are more dangerous because you had a real positive outcome in markets. That actually, in my opinion, is actually even more dangerous in some ways because then you’ve really set up for something that’s more dangerous in 2025.

[00:59:05] Niels

Absolutely. Speaking of dangerous situations, it’s always dangerous when we invite David Dredge to the podcast, but it’s also become a very nice tradition actually. I think he’s been on the show in January now, it’s going to be the third year in a row more or less, and he has this wonderful way of framing things and setting us up for the year ahead.

I’m sure part of the conversation we’re going to record next week, part of it will touch on something that actually is also really changing, but maybe more under the radar for many investors, and that’s what’s going on in Japan. They could actually still be tightening in 2024 while the rest of the world is now thinking about cutting rates, which is a complete game changer of course. Even though it’s not massive amounts, I don’t see them going to 5% or anything like that, it can have massive implications especially because they are the biggest creditor country.

The question is, in terms of you talk about flows, what happens in a country where the home bias is pretty strong to begin with, if they suddenly have a chance to buy JGBs at 1% instead of minus 0.1% or whatever it’s been down to? How does that affect the demand for US debt or other debt that needs to be issued? Things like that. I’m not sure exactly what it will affect, but I think it could be an interesting place to watch.

[01:00:48] Cem

So two things. One, David Dredge is one of the best. What he is best at is global frontier, all kinds of emerging markets, everything globally, and finding the little spots where things can be the most impactful globally. My strength, obviously, is US-focused broad macro. Now, where do those things intersect?

We’ve seen an incredible dispersion in recent history where non-vol core centers are moving and there’s opportunities, whereas the center has been pinned due to structured product issuance. What I believe we’re seeing, I haven’t really said much about this in this this episode, is as interest rates go lower, some of that structured product issuance, a significant amount can really start to go the other way.

I think that, which I proverbially call the Dutch boy with his thumb in the dike, is actually he’s been really well fed because interest rates are a bit high. If we do see a reversal in that in the short term, I think that could be very interesting to unpinning really the vol at the center, and the risk there is that broad volatility increases. But the places that are at greatest risk then, which I would put Japan as out there to connect here, all of a sudden become much more at risk.

The places where vol has been the most compressed because of US involvement in broad volatility, compression, again, Japan, create dramatic opportunities. I’ve talked about this before, but this idea of Sumo markets, there are tremendous pressures building in the system. It’s like tectonic plates. They’re pushing up against each other. When you have that much pressure, and all of a sudden something moves, things can be dramatic and violent.

It is not the same thing as placidity where there are no pressures. But in markets and when you look at a VIX number or something, you look and you say, oh, things are placid, nothing’s happening. That’s not the truth in this global world. You have to understand that the pressures are building and building. They’re just balanced in a lot of ways. Somewhere like Japan represents a very, very potential source of violent volatility from a very low level if those tectonic plates start to shift and become unbalanced a bit.

I do think that’s probably where we’re going in the next two years, year and a half. It’s hard to pick out the exact timeline but the probabilities are dramatically increasing. There will have to be some normalization. Japan is very dependent on the US, particularly US monetary authorities. An increase in volatility or the Fed starting to lose control, it would be, in my opinion, the greatest sign that that trade starts to really perform dramatically. I do see that happening down the road in the next year.

[01:03:49] Niels

Well, I’m excited for our upcoming recording next week that’s for sure. Of course, the episode will come out probably the following week or so. Cem, this was wonderful. A great way to kick off the year. I love your big-picture thoughts. I’m sure the audience do as well. You have a wonderful community following you, a really strong following.

Now, if you enjoy these conversations, why not share them. Why not go to iTunes or Spotify, Amazon, wherever you listen to podcast, give us a rating and review. We would be so appreciative of that. Next week, I’m back with Rob, so this is going to be lots of fun. If you have any questions for him, please do email them to info@toptradersunplugged.com.

From Cem and me, thanks ever so much for listening. We look forward to being back with you next week. Until such time, take care of yourself and take care of each other.

[01:04:50] Ending

Thanks for listening to the Systematic Investor podcast series. If you enjoyed this series, go on over to iTunes and leave an honest rating and review and be sure to listen to all the other episodes from Top Traders Unplugged. If you have questions about systematic investing, send us an email with the word “question” in the subject line to info@toptradersunplugged.com, and we’ll try to get it on the show.

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