Volatility Risk, Demographics as Destiny and Generational Change

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• Why is populism such a force in U.S. politics — and in much of the rest of the world?
• My co-host Cem Karsan sees it as a generational trend in reaction to economic inequality.
• How will shifting demographics, volatility markets, the Fed’s actions impact the markets?...keep reading to find out.

Most weeks on Top Traders Unplugged, we welcome a guest who shares their views on the markets, the best investment strategies and the world at large. A recent episode of our Global Macro series, however, featured just Cem Karsan and me — but of course, we both have plenty of opinions. 

It was a great way to warm up for the next Global Macro show, featuring the one and only MacroAlf (aka Alfonso Peccatiello), who has plenty of strong views of his own. 

For now, I’m curious to hear about Cem’s big-picture view of macroeconomics and geopolitics in Q2 2023, after what can only be described as, shall we say, an eventful start to the year.  

“Underneath everything right now, there is a generational populist push,” he says. “I think that’s important to keep front and center. There have been 40 years of monetary policy that created inequality at a historic scale.”

That’s optimal for maximizing GDP, but it’s not without consequences. In 1980, interest rates were around 20%. Roughly 30 years later, they were down to 0% (in late 2008, as a reaction to the global financial crisis). The Fed kept rates at zero for roughly six years. 

Fast forward about 14 years to now: Are we paying the price?

“We’re now a fiat-driven world, allowing for almost an unlimited amount [of control] by the U.S. Federal Reserve as the reserve currency of the world,” Cem continues. “That said, there was always a cost to this and inequality is that cost. … Ultimately, there’s a limit to how far people will allow inequality to go. And we’ve reached a bound. It’s not just a bound in terms of stratification. It’s a bound in terms of generation.”

Monetary policy = growing inequality?

When these low-interest monetary policies began, “the younger generation was the working class, and as they have gone through this for 40 years — that’s why it took this long — they have now grown into political dominance … those beliefs of unfairness, of inequality, of an unjust kind of stratification, have come front and center.”

This phenomenon isn’t restricted to the U.S. It’s a global trend. 

As he talks to people across the country and the world, Cem has observed that people are slowly coming to terms with the idea that “things are fundamentally different than they were for the last 30 or 40 years, in the sense that that inequality is now becoming more and more dominant.” 

That’s why populism continues to drive political action, particularly elections. So many people crave a rebalancing of that inequality — “and that that can take the shape of more progressive taxation … [or] the shape of more fiscal policy and money flowing to the bottom from straight payments or other types of credits. But it also takes the shape of populism by protectionism and nationalism,” he adds.

Demographic reality and generational change

Demographics are destiny. We’ve heard that before. But the reason Cem believes it with such conviction is because each younger generation, almost by definition, is the labor class. 

“They are defined by how they grew up … and the way they see the world. There is always a conversation — this next generation thinks differently. But they really do. There is a generational shift here, because monetary policy has taken us to such an extreme over such an extended period of time.”

He also thinks that “demographic reality is a function of time,” in the sense that each generation eventually becomes the primary voting class. Right now, Millennials represent “a bubble, much like the Baby Boomers did.” 

Meanwhile, the youngest Baby Boomers are close to retiring, and the oldest are 77 years old. 

“So we’re getting a dramatic reduction in the amount of people working … and at the same time, that there’s a massive new voting bubble coming in, with a new view of how things should work and what is fair.”

Arguably, that massive voting bubble isn’t totally new (the oldest Millennials are about 43, and the youngest are 27), but they do seem to have different priorities. 

When the focus is not on maximizing GDP, but instead maximizing median outcomes, “that dramatically changes the relationship between inflation, and maximum employment,” Cem notes. “And that is really putting the Fed in a box.”

Is the Fed playing three-dimensional chess? 

“Nobody talks about the Phillips curve anymore, and the role of labor, and inflation,” Cem says. “Guess what? That’s going to become central again, because ultimately, these political forces are back front and center … What kind of lag does it operate on? Not quarters, not years — decades. This is a structural secular force.”

(For those whose Econ 101 days are a bit hazy, the Phillips curve is the concept that inflation and unemployment have an inverse relationship. Higher inflation is associated with lower unemployment, and vice versa.)

For 40 years, those of us in the finance world have “played in two dimensions,” Cem argues. “Everything is, What cycle are we in? Where’s the Fed in this cycle, and how is it going to react?” 

That’s because the Fed has been in control — and had a controlled environment, one in which it could “very easily come back in and stimulate, reinflate the bubble; and reinflate the market — reinflate assets,” he says.

But that’s because the Fed “didn’t have a countervailing force that forced it into a box,” Cem adds. “Now there’s a countervailing force, which is inflation, and essentially, fiscal stimulus coming in to rebalance this inequality. Ultimately, that means we’re no longer playing in two dimensions; we’re playing in a much less controlled environment where the Fed has less control. … There are many more dimensions that things can move in.” 

Volatility risks and nonlinear events

I very much agree with Cem. What we shouldn’t forget, but what is very easy to forget, is that the Fed may act exactly the same as it has done over the last 40 years. When the economy slows down, it could enact quantitative easing (QE), for example. But I think many people will be surprised about how little effect the Fed may have. 

The other thing about downturns and recessions is that they often coincide with nonlinear events, much more so than when everything is going well. This tendency makes it much more difficult, not just for investors, but for policymakers, to choose the best path forward. I really do think we are in for something we cannot imagine right now.

Speaking of the Fed and the consequences of its actions, I’m curious to learn what Cem thinks about why volume is so low right now. I’ve heard him talk about the Fed “selling puts,” but recently it’s “selling calls.” What does that mean, and how does that contribute to the current vol environment?

“To start with the metaphor of selling puts and selling calls, the Federal Reserve can provide liquidity to the market in several ways. It can do it by just flooding liquidity in the market with a straight QE … at a certain decline in the market and kind of project a ‘put’ in the sense that we’re going to provide this. They can do what they’ve done recently, which is just secure depositors. And that’s not QE as in going straight to equity markets or bond markets. It’s protection of a liquidity event on the tail.”

Put, push and bounce

However, the Fed is ultimately still backstopping by providing capital to the market in that circumstance. That’s a positive thing, Cem argues, in the sense that the Fed is pushing money into the system — “but they’re pushing it into different parts of the distribution … and markets are relatively quick to react to these things.” 

That’s why he likens the Fed’s actions to put in the market. 

“If somebody comes in and sells a put to the market, like the Fed has done, in reality, dealers are going to buy that put and buy stock back. So automatically, you’re going to get a push as the dealers buy that stock back and convert it to a change in expected value of the distribution.”

But that doesn’t mean the market should go up, he adds. 

“Those puts are still going to go out worthless if the market goes down, just not enough [to make a difference].”

So that’s what the Fed did: The Fed sold puts. That lowers volatility, but more importantly, it changed direction. It took the tail off the market and reduced volatility. That created a short-term bounce in the market. 

“We can argue whether or not it should or not, or whether it’s going to matter in the long run,” Cem says. 

At the same time, the Fed is giving out real liquidity in the form of higher interest rates, essentially “talking the market down, because they don’t want this wealth effect. They don’t want interest rates lower and stimulating the economy. So the Fed is essentially playing both sides of the market.” Straddle up, folks. The second half of 2023 will likely be a bumpy ride.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.