Why All Roads Lead to Higher Yields ft. Alan Dunne

[00:00:01] 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 Alan Dunne and I, Niels Kaastrup-Larsen, where each week, as usual, we take the pulse of the global market through the lens of a rules-based investor. Alan, wonderful to be back with you this week. How are things in Dublin?

[00:00:39] Alan

Things are good here. Great to be back. Yeah, nice sunshine in Dublin and plenty to talk about as ever.

[00:00:46] Niels

Oh yeah. There’s definitely not much sun or positives in what we’re going to be talking about perhaps, but we were commenting, before pressing record, that we for the first time in a while we both have nice sunshine where we’re sitting, respectively. But we do have a really, really great lineup of topics.

I know I say that each week, but we really do and it’s going to take a while to get through that. But before we could, before we do, always curious to hear what’s kind of come on your radar that’s not related to the topics of today.

[00:01:20] Alan

Yeah, well, you could pick so many different topics. But one thing, I guess, that was kind of highlighted again during the week that’s going to be an important theme, I think, for the next while is just the variability and the patchiness of the economic data because of all of the disruptions that we’ve seen. So, durable goods orders were out during the week, and they were, I think, down 7% or 6%, 7%, have been up 6% or 7% in the previous month.

But obviously what you’ve seen is a lot of stockpiling or a lot of activity ahead of the tariffs. Then you had a pause when the tariffs came in. Then obviously it looks like that, when the tariffs were paused, the expectation is you would see a spurt of activity again. And now we might see another disruption in relation to, obviously, the court ruling.

So, we had, already, this debate going on about the difference between the hard data and the soft data. You know, the soft data, the sentiment data already shown a lot of pessimism and big impacts, in terms of consumer and business sentiment. But then it’s going to be very hard to get a read on the hard data for a while because of these kind of disruptions.

So, we’re already at an interesting point where the economy could be turning down and then it’s hard to really get a read on that given the volatility of the data. So, I think it’s going to be unusually tricky in the next few months to really get a read on that.

Arguably it has obvious implications for any strategies that are based on a read of the high frequency macro data. So, that could be tricky in those cases as well. But that’s certainly something I’m trying to get a sense on, and I think, as I say, it will be an added complication to the picture in the next few months.

[00:03:03] Niels

Yeah, I mean on that topic, I saw yesterday an interview with the head of the Port of Los Angeles. So, that’s the biggest port in the US, and what he was saying is that yeah, they’d seen a little bit of a pickup in terms of ships that were booking slots (or whatever it’s called) in the port, but not nearly as much as they would have expected with this pause. And he also said something interesting, he said, you know, even if you do a pause of 90 days, it’s not really long enough for companies to essentially get the things produced in China, then sent to the port, and then shipped over. So, they were definitely still seeing fewer bookings in terms of the big kind of transport ships that they normally get from China.

So yeah, interesting times.

So, we’ve got so much to cover today really. But I did come across a few things I wanted to sort of bounce by you in this little section.

The first thing was a headline from the Financial Times, from May 21, so, about a week ago. We’re recording on the 30th of May. And this is something I think we may have mentioned in the past on the show, but something that kind of worries me a little bit and that is this, there was this, it says the billionaire co-founder of buyout firm, Thoma Bravo (that’s $180 billion private equity firm), and the founder, or the co-founder of this company was basically saying he saw signs, worrying signs that a lot of these private equity products were now being lined up to be sold to private investors, to retail investors, packaged. And he says this is a clear sign that there’s just simply no demand – they can’t exit.

So, they’re going to do an exit and put it on the private retail investor. And that’s a sad thing to see, if that’s really what’s happening at the moment, which he says he sees signs of.

[00:05:11] Alan

Yeah, I mean, yeah, I guess it’s a skeptical take on what’s happening. It could well be the case. You know, certainly one of the big themes is, obviously, the low kind of level of cash coming back from private equity transactions. I mean, that’s definitely something I’m picking up speaking to institutional investors.

What they call DPI has been unusually low, which, obviously then, constrains further flows back into private equity. So, I mean, I suppose the more favorable reading of the trend is the democratization of all access to private markets.

But yeah, a more skeptical take is, well here, let’s find the last buyer being private wealth, or high net worth investors, or retail (whatever you want to call it) and sell on these highly valued companies with very rich valuation. So yeah, definitely, I think there’s an element of both aspects to it.

[00:06:08] Niels

But it also ties into some of the conversations I’ve been listening to in terms of just this boom in demand of private credit in a sense that, you know, it’s all private. But you know, certainly the way people were talking about it, that I listened to was, you know, people shouldn’t think that there’s a lot of diversification in private credit. I mean it’s all kind of the same type of sectors, and industries, and lack of good credit rating that you’re buying. And it’s not the Google debt you’re getting in these funds. So, it’ll be an interesting thing to follow.

Another headline, which I’m sure you’ve been following as well, and that’s just this weak demand that we had in the Japanese 40-year bond auction, which, I mean, Cem and I actually have been talking about this, along with David Dredge, for more than a year. I think we started talking about it last January or maybe even the year before, saying, you know, follow Japan. It’s going to be super interesting and it could have some pretty big ramifications. And now you’re really seeing how yields, especially in the long end are really, really surging in Japan.

And, of course the yields are still relatively low compared to many other countries, but they’re exceptionally high for many Japanese investors. And so, the whole incentive to go out and buy foreign debt, which we’ll talk about later on, you know, dwindles when you see something like this. So, I don’t know if there’s a comment or question there. It’s just, it’s interesting to keep an eye on.

[00:07:46] Alan

It is, and I’ve been keeping an eye on that one and I find it a bit curious and kind of have seen different interpretations. Obviously, we’ve seen the big spike in yields in Japan but, I mean, the obvious then next point is, oh, this is going to see a huge unwinding of the carry trade but, you know, dollar/yen has hardly moved. It’s been up and down in range around the same point. So, there’s been no real surge in the end which might have been the obvious takeaway.

Now it could be that, I mean, it could be that local insurers are selling their 40-year bonds. I have read some suggestion that they’re getting out of the 40-year end, moving back to the 10-year. So, it hasn’t moved to the same degree or it could be that they’re investing overseas. I don’t know why you would do that if you can get a guaranteed, whatever it is, 2.5%, 3%, or it might even be 3.5% for the 40-year now. So, it would point to the point that you’re making that you would say, well, Japan doesn’t have to go overseas, that would be anti-positive, but it hasn’t played out.

And the other point is that we were all waiting for this big adjustment in Japanese yields, and the world was going to end when it happened. But it’s happened and nothing, you know, life moved on. So, I don’t know. Is this a delayed reaction or what? I mean, the reality is the BOJ bought a lot of the bonds ahead of the move.

So, I mean they effectively subsidized the private sector because the BOJ bought the bonds. Now the bonds are worth much less but the bank of Japan is where it’s lost. So, the private sector has dodged a bullet with the help of the BOJ.

[00:09:17] Niels

Yeah, a headline that I saw, which I think I knew about it, I’m just curious to see whether it actually will follow through because we’re only 12 days away, and that is, of course, as the Tesla is targeting June 12 for their Robotaxi service in Austin. I think there’s been a lot of, how should I say, I think Musk has put a lot of credibility on this launch. So, that would be interesting to see. We’ve had bitcoin, Alan, new highs this week, new all-time highs I should say this week.

And then I saw this and again I can’t verify it but I’m sure if this source wrote it, it’s right. It says BTC’s market cap stands at 2.1, 2 trillion higher than the market cap of Alphabet/Google. For the first time, Americans hold more bitcoin than gold. And experts predict BTC could explode, blah, blah, blah, to whatever number. But this thing about Americans hold more bitcoin than gold. That kind of… If that’s true, that’s kind of interesting.

[00:10:30] Alan

Yeah, yeah, I haven’t seen that. I haven’t looked at the numbers at all. So, nothing to add on that one.

[00:10:42] Niels

All right, so before we go to the usual trend update, we’re going to spend some time, and I think we’re going to spend quite a bit of time on your, as we normally do, your big global macro picture. A lot of the inspiration comes from your latest Substacks that people should go and read, of course, named, All Roads Lead To Higher Yields. So, I’m going to let you lead on this, Alan, and then I will try and keep up.

[00:11:12] Alan

Yeah, I’ll give you some… Feel free to jump in wherever. So, I just started writing on Substack lately. And the substack is called Beyond the Cycle. And this post is called All Roads Lead to Higher Yields.

And it’s interesting, sometimes when you start writing something, it’s only towards the end that the title becomes apparent or even what way you’re going with a piece becomes apparent. And that was the case writing this because I wanted to write something on the bond market because it’s so in focus at the moment.

And also I had a conversation with Barry Eichengreen this week, which will be coming out in the next few weeks. So, I had prepared for that. And of course, Barry Eichengreen presented a paper at Jackson Hole, two years ago, to all the good and the great in the central banking community about high debt levels and how they’re going to be here to stay. So, I was very curious to get his perspective.

And I think having had that conversation, it kind of cemented everything in my mind, as well, about the outlook. I think most people know this quote in markets about, you know, James Carville, he was Bill Clinton’s political advisor. And he made this comment back in the 1990s, it was 1993, that he said, oh, you know, if I died and it was reincarnation, and I had to come back, I used to think I’d come back as the Pope or the President, but actually I’d come back as the bond market because he can intimidate everybody. So, it’s kind of a famous quote that is often repeated and everybody kind of knows it.

And, as I said, that kind of came to mind as I was writing the piece and then it prompted me to go back and look at, well, what was the situation in the markets at that point in time? How intimidating was the bond market? And it’s very interesting when you look at it because you know, yields were not radically different from where we are today but actually the fiscal situation is way different. So, if you look at the 10-year yields, in 1993 they had come down to about 6%, so, marginally above 6%.

So we were still kind of in the midst of a disinflationary period, and yields were still in that big kind of long-term downtrend from what we’ve seen in the 1980s. But if you look at the deficit, it was a bit more than 4% of GDP. And the debt to GDP ratio was about 45% of GDP.

So you’re wondering, what was the bond market so worried about?

Now, if you compare it to the current day, we’ve got debt to GDP of 100%. It’s higher, it’s 120%, but you have to take out the bonds that are held by US agencies. So, it’s about 100%, and it’s forecasted to rise. And, obviously, we’ve got The Big Beautiful Bill going through Congress which is going to add another nearly 4 trillion to the deficit over the next 10 years.

So, it just struck me, wow, what a huge shift we’ve seen where back 32 years ago the bond market could still be an influence on politicians, on policy, even at much lower levels of debt and at lower levels of deficits. Because, actually what happened then, Carville was Bill Clinton’s political advisor and Clinton came in and one of the things he did was he raised taxes, he raised income taxes.

So, he knew that he needed to get interest rates down to stimulate the economy. The economy was still coming back after the recession of 1991, 1992, but it was a jobless recovery, it was known as, because the recovery was really slow. So, the perception was interest rates were still too high to stimulate the economy. Clinton knew he needed to get the rates down.

But again, a very interesting thing, he had a conversation with Greenspan early in his presidency, man-to-man, or whatever, not trying to influence him, but trying to understand the economic outlook. And Greenspan made it clear to him the best thing he could do, in terms of getting lower rates, would be to cut the deficit because that would make it easier for the Fed to Pursue an easier policy. You know, contrast that to the current day. The relations between the Presidency and the White House are very different.

You know, so you had a huge ideological shift, I suppose you say, you know, from the perspective of the 1990s, a period where people still thought, well, if you could control spending, you might actually get a positive outcome to the economy that would bring down interest rates and then that would help fuel investment. Which is effectively what happened.

Now, you did have Greenspan’s new economy, a new paradigm in the 1990s, big productivity boom, which helped as well. So, you had a confluence of positive factors, but certainly the Clinton tax hikes ultimately were not a headwind for the economy. You could say, arguably, they assisted that process of lower rates, the disinflationary trend, and it allowed for easier policy.

The Fed did hike in 1994, but then after that they were able to ease more and we did see lower yields. So, again, comparing that to today, very different. And obviously what we saw, on the back of the boom of the 1990s, was we actually went into surplus. US went to surplus by 2000, and all the talk was, oh, we need to retire or stop issuing long bonds. And I think they did for a while, I think till 2005 or so.

So, it just shows you, again, now we’re into a situation where they can’t term out. They had to issue bills because there’s concern about lack of demand for the long end. So, it’s kind of curious just to trace what happened along the way.

Obviously, we had Bush tax cuts in 2002 or so. And then, obviously, we had the financial crisis, which required a big fiscal response. But even that was tempered at the time. You know, they couldn’t… like the TARP was voted down the first time. And then, at the time, I think the advice from the likes of Larry Summers was like for a 1 trillion bailout, but they came in a little bit less than that.

And even after that, you know, even in the early 2010s, you remember, the ideology was still austerity. Okay, we’ve had this big fiscal splurge. We need to go back. We saw it in the UK, we saw it in the US. So, even by the mid 2010s, the deficits were still not that big. 3%, 4% or so back to more normal levels. But the real turning point, I think if you look back now, is 2017, when Trump came in, and the economy was doing okay. I suppose you’d had this period of secular Stagnation and, you know, a big tax cut in an economy that was already close to full employment. So, obviously that was in 2017, it worked through Congress, it came in in 2018. And then by 2019, you know, the deficit was back to like 4.5%, the same as the Clinton era, but this time for an economy at full employment. So, you would think that’s the time to be reining in the deficit. Instead, it was expanding.

And so that was, I think, the kind of the turning point from an ideological perspective. And, I guess, in the background in this period, you know, the second half of the 2010s, you had this idea of modern monetary theory. You know, do deficits really matter? We can have more spending. Come on, you know, the bond vigilantes – that’s a thing of the past.

So, all of that came in and, of course, interest rates were at zero. So, yes, of course you could do that. It didn’t really matter.

And then Covid, in 2020, obviously required a huge fiscal response. 15% of GDP, the deficit was. But then, after the fact, there was no appetite for kind of deficit reduction. Instead, Biden came in and got control of the Senate marginally and was able to bring through big spending plans. So, this was kind of… We had Gary Gerstle on before. He talked about the end of the neoliberal era. And this is kind of real evidence of it.

The idea of fiscal conservatism was gone, free markets gone. It’s all about, you know, making sure supply chains can’t be disrupted, investing in domestic manufacturing, encouraging that, investing in domestic infrastructure, but all at a huge cost in terms of debt and deficits. So, all the while, the debt to GDP ratio is creeping higher.

Now, the US did get the ‘benefit’ of higher inflation in the 2021 period – ‘21 to ‘22. So, higher inflation does kind of reduce the real value of debt. But now, as inflation’s coming down, the real value of debt is moving up again.

And obviously we’ve got Trump in now. And obviously, even though at the start of his presidency there was some hope. Scott Bessent’s 333 Plan, remember, a 3% deficit, and 3% growth. There’s no mention of that at the moment.

Doge was the great white hope. Doge was going to be instrumental in eliminating the deficit or at least cutting it significantly. And now Elon Musk is saying, well, The Big Beautiful Bill is going to undermine any progress they’ve made. So, hopes on that have diminished.

So, it’s kind of like there’s just no political appetite or ideological appetite to address this. You don’t hear much of that. And it’s just such a stark contrast to what we saw 30 years ago.

So, in the paper, you know, I talk about, you know, the other thing around this is the idea of it’s not just the level of debt, the debt GDP ratio, that’s not the key thing, it’s important. But the other thing is, you know, the relationship between interest rates and growth R minus G or R versus G.

So, when interest rates, when your debt servicing cost rises above your growth rate, that means more and more of your resources are going on servicing the debt then you are actually generating in tax revenue. So, at that point that becomes unsustainable.

So, if you’ll put some numbers on that, real GDP in the US, a reasonable expectation for it would be 2% over time. It could be 2.25%, might even be 2.5%. And if inflation is 2%, it could be 2.5%, you’re probably looking at nominal GDP growth of 4% to 4.5%. Maybe 4.5% is probably reasonable. That’s where 10-year yields at the moment. So that’s fine, it’s just about imbalance.

But the problem is, if yields spike up to 5% or above, then that shifts that relationship or exceeds your growth, and would negatively impact the growth outlook, but also the fiscal arithmetic. So, you quickly get into a period of investors then balking at buying more treasuries, and the higher yields go, it makes the debt less sustainable. So, you’re into a vicious cycle then of higher yields, a more pessimistic outlook.

So, the question is, are we at that point now? And that’s always a tough question because we’ve got a weak economic outlook.

So ironically, if we had a recession, it would probably bring yields back down because the Fed would probably ease. And that’s the pattern we’ve seen in the last two to three years. You get deficit concerns, but then you get weak economic activity. It brings it back down.

But the other thing is that if we get a recession now, then automatic stabilizers kick in, more people claim unemployment assistance, there could be another fiscal stimulus, so the deficit would get even bigger. So, it won’t solve the problem, it just pushes it down for the next recovery. So, that’s kind of one scenario.

Another scenario is the economy doesn’t weaken that much and maybe we see higher inflation in the near term and the Fed might have to actually respond to that. So that could be the trigger point for pushing yields up in the immediate term.

And I think even regardless of the two scenarios, I think a big focus is going to be kind of next year when Powell’s term is up and it’s going to be who will Trump replace him with? Probably, if you look at history, you’ve seen Nixon and Arthur Burns is a classic example of having a Fed chair who was sympathetic or at least under the influence of the administration. So, easy to see how we could see something like that.

Now, obviously, there are, whatever, 12 people on the FOMC. So, the Fed chair doesn’t dictate, but it is a significant seat and could influence policy. So, I think short term you can create paint different scenarios, but big picture, most of the scenarios point to scenarios where we see either financial repression (this idea of having to force institutions to buy bonds, whether it’s the Fed or the private sector) or having policy easier than otherwise you would want, and that’s kind of the idea of fiscal dominance. So yeah, I think there’s a classic quote from Rudi Dornbusch, who’s a famous economist.

He says, these crises take longer to evolve than you expect but when they happen, then they are much more dramatic and fast moving than you thought possible. So that’s the classic line with respect to the bond market.

I think all roads do lead to higher yields. Now, whether it’s this year or next year, that’s tough to say. But the big picture outlook, when you look at the trajectory of debt, deficits and policy over a three decade horizon, it’s very clear to see what is the direction of travel.

[00:24:25] Niels

I think what’s the most concerning about this, this is something that one of our former guests, Ben Hunt, put quite well in one of his recent writings. I’m not sure whether I’m actually quoting him correctly or not, but the point was that, you know, we live in this kind of narrative world, that’s his big thing. And it’s like, you know, that we’ve now across from the debt might be unsustainable to, obviously it is unsustainable, but the problem is nobody cares about it.

[00:25:00] Alan

Yeah.

[00:25:00] Niels

And it’s that mental shift that sounds kind of innocent, but it’s not. And we’ve seen that with so many things in recent years where you just think that that’s just unbelievable. And, I mean, similar to some of these meme coins, and all of that, and the people who get involved with them. So yeah, I mean it’s definitely worrying.

I kind of fall in your category in terms of that I see more risks, and have been saying that for quite a while, I see more risks to the upside in terms of interest rates. Although, I do remember, last year when we did our outrageous predictions, I said, well, maybe the Fed have to slash interest rates to 1% because there’s going to be an AI boom. So, I’m still hoping out for that. But you never know.

[00:25:51] Alan

Like an AI boom is part of the narrative here as well. I mean, because obviously if you can get stronger economic growth, it does solve things.

So after World War II, the debt level jumped up in the US and actually it was strong growth in the decades after it that helped pull down the US debt to GDP level. But the question is, how realistic is that now? And economic growth over long term is driven by the growth in the labor force and productivity.

Obviously, the US is now moving away from allowing immigrants, so that’s going to impact the labor force and obviously an aging population anyway. So, it’s hard to see a strong growth driven by labor. Then it’s productivity. And obviously, okay,

AI could be a huge transformation of the economy. But equally, there’s a huge range of estimates around this. And even with the Internet, the Internet came in the late ‘90s. It was maybe 10, 15 years later before the productivity gains were really seen.

Obviously, we had a productivity boom in the 1990s, but it wasn’t the Internet. It was the use of computers, which had been developed, I guess 10 years prior to that. So, there’s normally a lag.

So, I think you’re kind of been very hopeful that stronger economic growth is going to solve this. I mean, that was the idea of the Bessent Plan, you know, 3% growth, 3% deficit, that would definitely satisfy the markets.

But it comes back to this relationship between interest rates and growth. Yeah, if you can get the growth, that’s fine, but if you can’t, and interest rates are higher than the growth rate, then the market sees that and then you get into this vicious cycle.

And I think the other thing that’s really concerning is, if we did say, for whatever reason, yields jump up above 5% and then quickly go to 6% and are fast moving, now, how do you stop that? Well, you stop it by coming up with a credible policy to address the deficit.

I mean, how likely is that in the current political scenario? So hard to see that if an aggressive kind of deficit cutting policy was needed to be enacted quickly, that’s hard to see.

[00:28:02] Niels

There’s no votes in doing the right thing, unfortunately, in politics. So, we will be forced, I think we’ll have to hit the wall before something happens.

Speaking of AI, just completely random really. But just before we started recording today, I was just watching this little short, whatever you call it, program on Bloomberg about this new Stargate AI data center that they’re building in Texas. It’s just extraordinary.

And they were saying, I mean if we, and I’m sure we are getting, you know, a massive boost to AI, this one data center, not, albeit it’s a big one, they estimate it’s going to be using as much energy as 750,000 homes.

I mean, I think people in the rooting for the green transition, or not even the green transition, but you know, decarbonization, they must be just horrified by the thought of AI playing an even bigger role. I mean, that is incredible. Yeah, I didn’t realize there was that much.

[00:29:18] Alan

Interesting, yeah, well, I remember reading something about the size of those data centers that were planned. I think it was the big one that was announced and it was something like, you know, 20 kilometers long and 20 kilometers wide, that kind of size. So, that’s kind of the order of magnitude we’re talking about.

[00:29:35] Niels

Yeah. Now, a couple of things in terms of inflation in all of this. So, you talk about high yields. In terms of inflation, and I wanted to ask you, in a sense, it seems like inflation is becoming more of a political choice from the policies that they are pursuing. I also think that you have these… You talk about your Substack with the use of cycles. I mean, many, many years ago, and I didn’t think about it, I wasn’t, you know, that much into all these things back then.

But someone said to me, we go through cycles where you have either strong politicians and weak central banks or vice versa. So clearly right now we have strong politicians and weak central banks in a sense that they can’t really do much.

And then I read this headline today where I think someone from the ECB said, oh, they think they’ve defeated inflation. It’s not quite the same sense you get when you look at the US. So, are the interest rates going to decouple, or are bond yields going to decouple from inflation, to some extent? Meaning we’re just going to have higher real yields because investors demand that.

[00:30:51] Alan

Yeah, I think so. I mean that would be the implication of what I’m saying. I mean, obviously you can have a spike in yields driven by inflation. But even without that, we’ve seen a big jump in real yields already. And from negative, obvious, before Covid to, you know, real US yields of now 2%. But as I said back in 1993, they were, you know, over 3%. So, we’ve seen this, I suppose it’s this idea of rising term premia, you know.

And I guess, as well, you can think about it from an investor portfolio perspective as well. You know, as we’ve been saying, when you had that negative correlation between bonds and equities, bonds were quite valuable in your portfolio.

So, you might have been willing to tolerate a smaller term premium because there was a portfolio role, from an investment perspective. If that’s going to be more diminished and less certain that you will get kind of convexity and positive returns from bonds and an equity downturn, logically, you would say, it’s going to require a higher yield to encourage people to hold. So, I think it is. I mean, yeah, it’s an open book on the inflation debate. Is it tamed yet or not? I mean, who knows.

But I mean, what we’re seeing… We don’t know what the inflation impact is going to be from tariffs, I mean, in terms of the magnitude. We know the first order effects are pretty obvious. But, at the same time, if you think about what the Trump policy is all about, re-energizing US Manufacturing and re-industrializing the US economy, but it’s an economy already at full employment. So, where are the workers going to come from to do this, to build these cars, et cetera, or even for, you know, all of this new manufacturing.

So, you can see how that leads to bottlenecks, and skill shortages, and boosts to wage pressure in certain sectors which could spill over more broadly. So yeah, I don’t know. It’s not something that people can model with any conviction, I would say.

[00:33:01] Niels

I mean, if only Trump knew someone that was building robots at the moment.

Anyways, to leave this section on a positive note, you know, there wasn’t much of a prospect of the current government (and this is actually not political), no government right now really wants to raise taxes.

Then I read from this morning, on the FT, they said that we begin with the US where Wall Street is warning that a little publicized provision in Donald Trump’s budget bill that allows the government to raise taxes on foreign investments in the US could upend markets and hit American industry. So, apparently there is a little section, it’s section 899 for those who want to go and read it, it allows the US to impose additional taxes on companies and investors from countries deemed to have punitive tax policies. It would affect dividends, interest income, and U.S. stocks and bonds, and sovereign wealth funds holdings.

So, it may not be the US citizens that are going to pay higher taxes. It could be the rest of the world.

[00:34:14] Alan

Interesting. Yeah, I hadn’t seen that, but that’s certainly an interesting angle.

[00:34:17] Niels

Yeah, you have to get up early to follow my lead here, Alan.

You know, anyways, let’s say we’ve done enough for now on this super interesting topic. Let’s turn to something equally interesting, of course, the trend following update.

And since we are recording on the last day of the month of May, not an uninteresting month yet again, my own trend barometer finished yesterday at 30. That’s a low reading. That’s a weak reading.

So, I am expecting to see some losses, once again, across the industry, probably with some dispersion for sure, and obviously would love to hear your thoughts. From my vantage point I think things that have been tricky, for at least the longer term managers, could continue to be a little bit in the fixed income space. Long positions have probably been challenged during May, in particular in the short end. I think that they were particularly difficult.

And also, if you look at those who are diversified, who trade the commodities, we’ve seen some reasonable corrections in coffee so that’s going to be a negative impact. And even gold has taken a little bit of a breather in the month of May.

On the other side, I think a commodity market like live cattle actually, even though it sounds like a little bit obscure, but actually it’s been a pretty good market I think. And also equities for those who did not flip positions during the April period, which will be interesting to see, you know where model speed, how that impacted positions.

I do think though, overall, that risk levels have probably been caught in May. I think there’s this lack of strong signals across most markets and that generally leads to trend followers cutting risk.

And of course, it’s also interesting that with equities coming back to almost all-time highs again in some countries, we’re going to be seeing trend models basically adding risk to the long side once again.

What are your thoughts? And by the way, I’ll say one more thing, maybe. We talk a lot about model speed as being a differentiator between managers. It’s one of three or four differentiators for sure, but a little bit unusual. I think that the medium-term trend followers are probably the ones who’ve had the toughest time compared to being short-term or long-term.

So, those are my observations. I don’t know what your intelligence, when you speak with people, are telling you.

[00:37:08] Alan

Yeah, definitely the theme of reduced risk levels is definitely one, and even not just from a mechanical response to the vol but also to low signal levels across the portfolio. So, certainly would say a lack of conviction where, you know, I suppose if you look at what’s happened, we had a very sharp move up until maybe mid April and then a reversal since then.

So, as you say, things like FX as well, depending on how fast you were, did you. I would think most medium-term would have got on say the long euro trade and short dollar versus say the Swiss or the yen, and those have kind of been choppy and up and down in a range for now for four to six weeks. So, that’s been another one that could have been a bit trickier.

And then, obviously, as you say, on the equity side, I think, you know, managers may have got short in US equities but whether they maintain their longs in European and non US, as you say, it depends on speed but would be rebuilding that.

And then again, on the bonds I definitely was seeing kind of differentiated positioning there. Managers were more likely to be getting long the US short end which, as you say, has reversed. So, we haven’t seen anything.

Gold had been the most obvious sustained trend and that has paused in the last while and nothing really has come through. Obviously, equities have bounced back. I guess if you’re ultra slow and managed to not react much that was obviously the best thing.

But outside of that, as you say, no surprise to hear that your trend barometer is at the lower end of the range.

[00:38:43] Niels

No, and let me just quickly update on the numbers because they’ve just ticked in as of the 28th, yesterday. We don’t have them just yet but as of the 28th BTOP 50 index was down 1.55 in May, down 4.61 so far this year. SocGen CTA index down 1.61 for the month of May, down 8.34% year-to-date. The Trend index down 2% roughly 2.13%, down 11.25% for the year. And the Short Term Traders index down 1.14% in May, down now 2% for the year.

And I completely forgot, actually, to look up what the traditional markets have done. But I do have, I think, the S&P 500 just as a comparison as we normally do, and that it looks to have a decent month. Up 6.29% as of last night, up 1% for the year.

So yeah, interesting times. And of course with these drawdowns that we’re seeing, not that they are completely unusual, they’re a little bit large for some managers, they’re making new all-time max drawdowns so that’s worth following of course.

But generally speaking, these periods are not unusual. And you could argue, I know we’re going to actually be talking about it and maybe I’ll save that for in a few minutes because the next thing we were going to talk about is the latest report from SocGen. They have just released the SG Prime Spring 2025 Investor Sentiment Survey report.

It’s quite an interesting kind of a real-time snapshot. I think they survey 370 institutional investors or allocators managing trillions of dollars in terms of what they are looking at. So, it’s kind of a fascinating look into where people are focusing their efforts right now. Did you have a chance to look at it? What are your key takeaways?

[00:40:51] Alan

Yeah, I had a look at it. There’s nothing massively surprising, a couple of things that maybe you could ask about. So, they’re surveying over 300 investment firms and about three quarters of them are kind of fund of funds, family offices, consultants, and private wealth. And then the rest are asset owners and multi strats. And over half of these entities manage more than 5 billion. So, we’re talking about sizable investment firms.

Unsurprisingly I guess, you know, the strategy most likely to be increased was global macro. That doesn’t surprise me. We’re in a macro volatile world and certainly rich in opportunities, I would say, if you’re a discretionary macro or trader. Equity market neutral stat arb is the second one that is most likely to see increased allocations. I think that that area has done well. So, I don’t know if there’s an element of performance chasing or being influenced by good performance as of late.

The third one is commodities which did surprise me a little bit. I have to say that there is still interest in commodity strategies. You know, obviously, a couple of years ago that wouldn’t have been a surprise at all. But commodity markets have been generally rangy, you know, the major ones. We’re talking about copper, oil, etc. So, I was kind of interested to see that, and then equity, long/short.

About 30% of allocators were saying that they would consider allocating to CTA trend and a little bit less to CTA non trend. So still decent interest in it. Now, those numbers have come down by about two and a half percentage points from the fall of 2024.

So, you know, there’s certainly reduced interest in CTAs which certainly wouldn’t be shocked to hear that based on a tough year so far, but not massively down. The other ones that have seen less interest is quant macro, which again, it’s not really the flavor of the month given this kind of market environment that we’re seeing at the moment.

You know what I’ve mentioned at the outset, there’s a lot of choppiness in the macro data for a start, and hard to get a read on how that’s influencing the economy.

So, the other thing was declining interest in ESG, which is, you know, obviously the direction of travel in the US very much so. I’m sure there’s a big divergence between the US and Europe in that regard. But they were the highlights for me.

[00:43:21] Niels

Yeah, you know what I find interesting about this is, as you rightly say, discretionary global macro was the one that seems to have the highest level of interest from allocators. And I’m just thinking how on earth are you going to make sense of this world from a discretionary point of view?

I find it quite interesting because of course I’m massively biased here, but I’m kind of thinking kind of a non-predictive rules based, diversified approach might be quite useful in periods like this because otherwise it’s almost kind of flip of a coin or luck. Did you get the latest statement from the Oval Office about oh, it’s a good time to buy equities or not, it seems to be determining your returns.

And I know this is being a little bit facetious here, but still interesting. It’ll be interesting to see.

[00:44:16] Alan

Well, I think we’ve certainly seen big dispersion in macro. Obviously, we’ve seen big dispersion on the CTA side, but there has been big dispersion.

So, I mean, I just think it is an environment, it does offer big opportunities. Obviously, that doesn’t mean every discretionary macro manager will be on the right side of it, and that’s what we saw in April.

But you know, I guess the whole point is to kind of find asymmetric opportunities and capitalize when you can. But yeah, it’s not going to be across the board.

[00:44:44] Niels

No, pod shops have actually seemed to have done reasonably well through this period or these multi strat funds, as far as I can tell.

[00:44:55] Alan

Yeah, February, March seemed to be tough for them, you know, particularly the more equity focused ones with the unwind of the momentum kind of trade in that period. But April/May seems to have been okay.

[00:45:12] Niels

All right, well now we are back with your other topics where, again, I will try to, to keep up. We’re going in slightly different directions but obviously touching on some of the things we’ve talked about earlier.

So, what are these very interesting topics?

[00:45:32] Alan

Yeah, well, I think we’ve obviously had a very interesting year this year, so far, and it just strikes me a lot from kind of working with different investors and then going to a couple of investor events. I was in London last week at a couple of events.

So just kind of picking the mood across investor groups and then kind of bringing that together into what are the big themes that I’m seeing from investor groups to concerns, or how are people changing their asset allocation or even our asset allocation frameworks. Because that is in their topics that are coming up in some of the conversations. Maybe even starting with that one. Does the whole framework need to be reassessed? So that’s a question that an investor put to me.

And I mean, I think, obviously, you could take a kind of a mean variance optimization process but that would always have its shortcomings anyway. But I think one thing you have to be very aware of is not kind of anchoring to returns, volatility estimates, correlation estimates to a particular period.

So, obviously what we’re seeing now in markets is arguably quite different to what we saw say in the 1980-2020 period where we had a disinflation. As we said, falling bond yields, that was very positive for equity markets and financial assets. And then linked to that, ultimately, was the growth of private markets as well, less positive for commodities. But all of that is shifting now.

So, you wouldn’t want to put too much emphasis on the estimate of correlation between bonds and equities from that period. So how do you weight different scenarios and different kind of perspectives of the world?

So, I think that points to taking a more of a scenario-based approach to portfolio construction as opposed to just plugging in numbers based on average historical measures, and thinking about what are the different possible views of the world looking ahead?

So, a more scenario-based analysis would be one upshot of that from kind of an asset allocation perspective, and probably kind of making sure that your optimization or your allocation process isn’t overly sensitive to any assumption around volatility or correlation because the future could be quite different to the past.

[00:48:03] Niels

So sorry to interrupt you here. Just want to understand, how do you…

What’s the difference between scenario-based analysis and not having too strong opinion about, as you say, correlations and all of that? How do you put together a scenario without being influenced by what that means for correlations and stuff like that?

[00:48:21] Alan

What I mean is you could literally map out asset allocation plans for different macro scenarios as opposed to just having one base case, and then weighting according to maybe a subjective assessment of which type of environment you’re likely to be in. Because obviously if you were conducting this kind of analysis, say back in 2021, commodity markets wouldn’t have done great over that period. So, you probably would have ended up with quite a low allocation to commodities. Now that’s starting to shift. But how do you balance that versus the longer term?

So, rather than just doing a point estimate, it’s more mapping predictors scenarios and saying we’ll build a portfolio for more of a stagflationary scenario or an inflationary scenario and then weighting that based on the different probability.

So that would be one possible route which I think would tilt you away from financial assets, more to real assets, and it comes back to robustness. And that’s the merit of having a higher allocation to the pure diversifiers that we all advocate for. But also, probably, things like commodities would justify a higher allocation as well.

[00:49:38] Niels

I want to see if you remember, because I was intrigued by your conversation recently about the Annual Investment Return Yearbook where they look at real returns going back to 1900, so 125 years worth of data now. You probably will remember, from the conversation, more detail than I do, but what were their conclusions in terms of how do you best make use of the fact that you have all this data? And as you, as you say, yeah, we can make our own assumptions, and regimes, and all of that stuff, but can we completely ignore the past? I mean, where did they sit on that in the end?

[00:50:26] Alan

Yeah, it’s a good question. And it kind of links in with, there’s a couple of papers from AQR, recently, around the idea of how investors form return expectations and what’s the best way to do it.

So, it kind of links with that because in the conversation with the guys around the investment returns yearbook, they point out a couple of things, you know, long run equity returns. So, you know, if you were to go back to 2000, you would have said, and they said, returns are not going to be as strong going forward.

[00:51:01] Niels

I remember that, yes.

[00:51:03] Alan

So, they were right on that. But they would also have said don’t expect the US to continue to outperform the way it has. But they were wrong on that. So that has continued.

So again, if you’re forward looking now from that perspective, what would you say? Well, expect lower equity returns would be one thing if you’re purely taking a forward looking approach, and also expect less US exceptionalism.

So, notwithstanding the fact that that has been the case in the last 25 years and the last 125 years, and actually the AQR paper is around this too. So, they actually point out that if you look at the US, yes, it has outperformed over the last 15 years and the last 125 years, but we have had plenty of periods of underperformance like the 1980s was one and the early 2000s was another.

And actually, if you go back to 1990, because Japanese equities were so highly valued back then, if you look at the valuations of US versus non US markets, US markets were valued about a half in terms of just the price of earnings. But now they’ve gone from being half the non US to being double the non US.

So, a big part of the component of the US exceptionalism has just been a re ranking, a valuation change. Another interesting part of the conversation that I had with Elroy Jimson was, I made the point to him, well, investors are bullish on the US and they expect higher returns from the US because the narrative of US exceptionalism is it’s an entrepreneurial place, innovation, rule of law, you have all of these ingredients which are business friendly.

And he made a point, well, actually (and this is kind of the academic perspective on that), if that’s the case, that would mean the US is a safer place to invest. And your return would be lower. And actually, AQR draws this distinction in their paper that when we talk about expected returns, academics are talking about required returns. But market practitioners think of it differently. People in the market say where is earnings growth going to be strongest?

So that’s what they’re going to say. So even now, how many people would say… I mean loads of people I talked to say, oh, I’m going to say invest in the US. The US has always delivered. But, in theory, that should be priced in. So that means, to take Elroy’s point, that should mean that the required rate of return is less in the US so future returns would be lower. That’s what that means.

But actually, people are bullish on the US because of the expectation that what we’ve seen in the past is going to continue. But actually, what we’ve seen from the AQR paper is that a big chunk of that is just a re-rating. So, it’s just interesting how actual returns influence our thinking and the narrative. But there is an inconsistency there, I suppose, I’m trying to highlight between the kind of required return perspective and expected return perspective. The upshot is, based on all the evidence, you would expect some mean reversion. So that would point in favor of being less bullish on the US.

But it’s interesting as well, in one of the UK AQR papers they say, how do you form future return expectations? You can do it based on the past, say the average or the return in the last 10 years. Or else you can construct an estimate, say, based on a forward looking measures.

So, say if we were trying to say what’s a reasonable expectation for equities over the next 10 years? You could say, well, US equities have delivered 10% historically, so that’s our expectation. Or you could say, well let’s look at the dividend yield and earnings growth and see, well, what might happen to equity valuations. And that would probably tell you it’s going to be more like maybe 5% or 6%.

So, that kind of forward looking estimate has worked better over time. When you track that historically versus what was realized, that correlation is actually positive. Whereas, if you do it based in the past, it tends to be negative. So, that’s partially because you get mean reversion and partially because you get optimism around growth and that gets factored into returns.

But actually, what’s interesting is, what I notice that when you look at it is that when what you tend to get is when the forward looking measure is just below average, you tend to get much more negative actual realized returns. And when the forward looking measure of future returns is above average, it tends to be even better.

So, for example, if we’d gone back to 2010, the forward looking measure of equities returns would probably have pointed to maybe 8% to 10% equity returns, but they’ve actually delivered probably say 15% annualized. Whereas if you went back to 2000, it would have pointed to maybe annualized returns of 3% or 4%. But actually, over the next decade they were flat.

So, I think it is interesting that in the good times better returns tend to get accentuated and in the bad times it’s the same on the downside as well. And we’re at a point, at the moment, where future returns based on these more forward looking measures are pointing to lower than average returns for equities. So, that does highlight some downside risk.

I’m sorry, one other point I wanted to get in addition, he made the point as well about equity drawdowns. Equity drawdowns, big equity drawdowns tend to come following periods of great optimism, which makes sense. They don’t come out of the blue on the back of pessimism because obviously if the markets are very optimistic. That’s when valuations become very rich, like we saw in 2000. So, that was another kind of cautionary point to keep in mind. Yeah, what did you make of it?

[00:57:01] Niels

I mean, I thought it was very interesting. But I actually wanted just to briefly go back to the point you made about when you talk to investors and what should they do right now, and you talk about having more kind of regime based scenario analysis, and so on, and so forth. So, I’m not disputing that that’s probably what may happen, but I’m also thinking that in doing so, and maybe as you say, reimagining what frameworks we should be thinking of and using in our asset allocation, that there is a higher risk of them getting it wrong. Right. Because if you have three or four and you choose the wrong one, it could hurt.

And so I’m obviously trying to, as you know, I would do, trying to turn that back to say, well, that’s actually a really good argument for having more trend following. Because I always think that, and this is something that David Dredge talks a lot about and that is, you know, if you ask someone who is managing a portfolio, what are the risks that you’re considering, that you’re trying to accommodate for in your portfolio, they’ll have a list of that. And they will have answers to what they’re doing about those risks and that makes sense. But then if you’re asking them, so what are you doing about the risks that you haven’t thought about? There’s nothing on the list, of course, because they didn’t think about it. And I think, and I will continue to argue that our role in a portfolio, yes, some people say, oh, it’s crisis alpha. I’m not so sure it really is. But I think our role as trend followers is to play the role where we don’t have a specific plan or regime that we are planning for. We are planning for whatever comes towards us.

And so, as investors, having something in your portfolio that you’re not really allowed to have an opinion about, but where we will react accordingly regardless of what happens, I just think it’s going to be a more and more important and useful tool. Especially, as you said, and I think you used the word robust portfolios. I mean, how do you build these robust portfolios?

Well, I don’t think you build them by having too strong opinions about what’s going to happen in a world that seems to be changing in ways we can’t imagine. So that’s kind of my…

[00:59:32] Alan

I agree. I mean, it comes down to diversification, which is a fairly simple and maybe obvious, but diversification means being more balanced across different risk factors. And I’d really look into the portfolio and be saying, well, what diversification is not saying equities, private equity, credit, and private credit, and saying we’re diversified because, you know, obviously you’re picking up a lot of the same kind of risk there. And if you have a big negative tail, everything is going to go down. So, I think it’s, yeah, I mean, I think notwithstanding… So, I think what you’re saying is correct.

I think the challenge will be, and some people will say, oh, look at the environment, it’s Trump on/off, it’s choppy, that’s going to be difficult for trend following. You know, I don’t believe in that myself. I mean, I can understand people saying that, but what history has taught us is if you try and link, you know, a trend following allocation to a particular macro view like that, you might be right for a year but then something will happen, and it’ll surprise you. So, I agree, I agree with you.

[01:00:43] Niels

I mean, in a sense, this is actually, let me just as a parting point because I do think it’s an important one. If you look at track records for trend following, we’re not, by the way, I don’t think the SocGen Trend Index is at new or max drawdowns, by the way. It’s close, but it’s not quite there, I think. So anyways, if you just look at that track record and you look at just the drawdown profile, but you removed any knowledge that you might have about politics and who’s in the White House and who’s not in the White House and all of that, then you would say this is not unusual.

So, I know people talk a lot about the Trump effect and it’s difficult for us, as managers, but that’s not an excuse. Right? I mean, it doesn’t matter who’s in… It’s not about politics. I mean, it’s not about the person. It’s, yeah, politics change. Sometimes it’s good for us, sometimes it’s bad, but often it ends up breaking something that we can then latch onto as trend followers. So, I think it’s less about the person in the Oval Office and it’s just about yeah, this is one of these typical periods where markets are not trending. So, don’t expect trend followers to make money. End of story.

[01:01:55] Alan

Yeah.

[01:01:56] Niels

And so…

[01:01:58] Alan

But yeah, of course, all of these things change. Like, in 2019 there was a view that central banks can control the markets. You know, they will never have that again.

So, I mean, if you came up with that view in maybe 2016, you were right for a year or two. But then when do you change it? 2019, I think, was decent for trend following, 2020 was, while 2021 was fantastic. So, if you wait for it to be very obvious, it’s going to be…

I would say it was probably by 2022 when it was kind of mainstream. This is a great environment for trend following, but you’d already had four years, so that’s the nature of it. Don’t try and time it. You just have to stick with it.

[01:02:38] Niels

Yeah, absolutely. Alan, this was great. Thank you so much for all the prep you did and, yeah, really enjoyed the conversation as usual. If you also enjoyed the conversation, as I know a certain blind squirrel did, because he left a very nice rating and review that I picked up on this week. So, thank you very much for that. And he knows who he is, of course, and everybody else who follows him on Substack.

But you can, of course, express your appreciation to Alan and all the other co-hosts by going to your favorite podcast platform and leave a rating and review. As you can tell, I do read them, so we really appreciate that.

Next week, I’m kind of a little bit unsure who I’m with because I forgot to look it up in my schedule. Pretty sure it might be Rich. And in any case, whoever is going to be speaking with me next week, it’s going to be fantastic.

So, tune back in a week’s time. Make sure you have a fantastic weekend. As you can tell, Alan and I, we’re going to enjoy some sunshine. You’ve got babysitting duties, Alan, I know. I’ve got no babies to babysit anymore. They’re too big for that. So, I will enjoy the sunshine. In any event. from Alan and me, thanks so much for listening. We look forward to being back with you next week. And in the meantime, take care of yourself and take care of each other.

[01:04:03] Ending

Thanks for listening to the Systematic Investor Podcast series. If you enjoy 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.

And remember, all the discussion that we have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also, understand that there is a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Thanks for spending some of your valuable time with us and we’ll see you on the next episode of the Systematic Investor.