Macro and Flows Update: June 2022 - e06
Summary
TLDRThe transcript discusses the current macroeconomic climate with a focus on inflation, which is at a 40-year high. It highlights the Federal Reserve's challenges in managing inflation expectations and the potential for a negative spiral. The speaker notes the impact on various markets, including bonds, cryptocurrencies, and equities, and suggests that despite the bleak outlook, there are investment opportunities in essential sectors. The importance of active management over passive strategies is emphasized, and the video ends with a disclaimer about investment advice.
Takeaways
- 📈 Inflation is a significant concern as it's the first instance of secular inflation in 40 years, impacting economic understanding and future risks.
- 🏦 The Federal Reserve is facing a challenging situation, being in a 'box' with limited tools to effectively control inflation.
- 💹 High long-term inflation expectations can lead to demand frontloading and increased spending, exacerbating inflation.
- 🛠️ If long-term inflation expectations remain high, investors may shift towards hard assets, driving up commodity prices and contributing to inflation.
- 🌪️ The Fed's definition of inflation as 'transitory' was an attempt to manage market expectations and prevent a negative inflationary spiral.
- 📉 The current market situation is complex, with high yield spreads and junk bond spreads nearing COVID-19 lows, indicating market stress.
- 🌐 Geopolitical tensions and economic strategies are influencing global markets, with Russia and China taking advantage of perceived weaknesses in other economies.
- 💲 The US dollar's strength is attracting safe-haven capital, but this can also lead to issues for countries with dollar-denominated debt.
- 📊 Despite market challenges, there are opportunities for investment in sectors like energy, healthcare, and consumer staples, emphasizing the importance of active management over passive strategies.
- 🔄 The June options expiration is a pivotal moment for market positioning, with dealer positioning potentially acting as a 'plug' against market pressures.
- 🚨 Early signs of market fragility are appearing, such as the skew pop before options expiration, indicating potential increased market volatility ahead.
Q & A
What is the primary theme of the June macro and flows update?
-The primary theme of the June macro and flows update is the significant impact of inflation and the challenges faced by the Federal Reserve in managing it, along with the potential risks and market reactions to this inflationary environment.
Why is the current inflation situation considered a major concern?
-The current inflation situation is a major concern because it is the first time in 40 years that the economy has experienced secular inflation. High inflation expectations can lead to demand frontloading, inventory building, and increased spending, which in turn can exacerbate inflation, creating a potentially harmful cycle.
What are the two main effects of high long-term inflation expectations?
-The two main effects of high long-term inflation expectations are: 1) entities, particularly businesses and individuals, start bringing demand forward and building inventories, leading to greater demand in the economy and increased inflationary pressure; 2) investors and entities confident in high future inflation will borrow at negative interest rates and invest in hard assets, driving up the prices of commodities and other tangible investments.
How does the Federal Reserve define its current stance on inflation?
-The Federal Reserve has defined inflation as 'transitory' in an attempt to manage market expectations and keep long-term inflation expectations down. However, the speaker suggests that this label doesn't necessarily reflect the permanence of the issue but is more about influencing market sentiment.
What are some of the risks associated with the current economic situation?
-The risks include high yield spreads and junk bond spreads increasing, potential existential crisis in Japan due to government bond issues, concerns about the stability of cryptocurrencies, and geopolitical tensions exacerbating economic crises, particularly in Italy and with Russia and China taking advantage of perceived weaknesses in the global economy.
How does the speaker view the potential for a recession?
-The speaker believes that while a technical recession might occur due to slight negative print in GDP, a major recession can be avoided. However, an 'earnings recession' is expected as margins normalize due to cost structure issues and inflationary pressures.
What is the speaker's advice for investors during this time?
-The speaker advises investors to focus on essentials, invest near central governments, and consider sectors like energy, healthcare, defense, infrastructure, consumer staples, food, and domestic manufacturing. They also emphasize the importance of active management over passive strategies.
What are the implications of the June options expiration for market positioning?
-The June options expiration is a significant structural moment that has been in high demand. Dealers have been short put out of the money, leading to a situation where they are decaying longer volatility and shorter Delta. This positioning has acted as a plug, holding back downside volatility and controlling move speed and convexity, but this plug is starting to weaken.
What does the speaker suggest about the future of volatility?
-The speaker suggests that as the current compressed volatility regime ends, there will be increased opportunities for long volatility strategies, especially in the latter half of the year. They anticipate tailwinds that should provide an incredible opportunity for investors.
What is the significance of the first skew pop observed before options expiration?
-The first skew pop observed before options expiration is an early warning sign of increasing market fragility and potential weakness ahead. While it doesn't necessarily mean an immediate market crack, it indicates that market participants should be prepared for more volatility and potential shifts in market dynamics.
What is the overall message of the June macro and flows update?
-The overall message is that despite the challenging macroeconomic environment and potential risks, there are still investment opportunities for those who are well-prepared and choose active management strategies over passive ones. The speaker emphasizes the importance of being dynamic, prepared, and positioned for a market environment where volatility is expected to increase.
Outlines
📈 Inflation and the Fed's Dilemma
This paragraph discusses the current inflationary environment, marking the first time in 40 years where secular inflation is observed. It emphasizes the importance of understanding this situation and its potential risks for the future. The Federal Reserve (Fed) is described as being in a precarious position, with limited tools to control inflation. The paragraph also explains the behavior of businesses and individuals in response to high inflation expectations, such as bringing demand forward and increasing spending, which can exacerbate inflation. The Fed's challenge lies in managing long-term inflation expectations to prevent a negative spiral of inflation and economic distress.
💹 Market Stress and Global Risks
The second paragraph focuses on various market stresses and global risks. It highlights the widening high yield spreads and junk bond spreads nearing the levels seen during the March 2020 COVID lows. The Japanese government bonds are also in crisis, and there are concerns about the stability of cryptocurrencies, particularly Tether. The paragraph discusses the tensions between Italy and Germany within the European Union, and geopolitical moves by Russia and China to exploit these weaknesses. Additionally, it covers the record dollar strength as a safe haven and its impact on emerging markets and the liquidity crunch affecting global markets.
🏠 Household Equity Allocation and Investment Strategies
This paragraph addresses the current household equity allocations, which, despite a nearly 10% drop, remain near record levels. It suggests that there is potential for further liquidation from households and offers investment advice for these uncertain times. The focus is on investing in essential sectors such as energy, healthcare, defense, infrastructure, consumer staples, food, and domestic manufacturing. The paragraph emphasizes the importance of fundamentals and active management over passive investment strategies, indicating a shift in the market dynamics favoring active investors with a structural edge.
📊 Options Market Analysis and Expectations
The final paragraph provides an analysis of the options market, particularly focusing on the June expiration and its significance as a structural moment. It discusses dealer positioning, including short put out of the money and long close expiration strategies, and the impact of the JP Morgan hedged equity trade on the market. The paragraph also highlights the demand and supply dynamics of options in the 3610 area and the effects of dealer positioning on market volatility. It concludes with expectations for increased market performance in the second half of the year, especially for long volatility strategies, and advises investors to be prepared for opportunities while remaining cautious of market fragility.
Mindmap
Keywords
💡Inflation
💡Secular
💡FED (Federal Reserve)
💡Demand Forwarding
💡Investment
💡Liquidity
💡High Yield Spreads
💡Cryptocurrency
💡Dollar Strength
💡Options Markets
💡Counter-Trend Rallies
Highlights
Inflation is the key economic theme of the moment, marking the first instance of secular inflation in 40 years.
The Federal Reserve is facing a unique challenge, being in a box it hasn't been in for 40 years, with real implications for economic policy.
High long-term inflation expectations can lead to demand frontloading and inventory accumulation, exacerbating inflation.
If long-term inflation expectations remain high, investors may shift towards hard assets, driving up commodity prices and potentially leading to an inflationary spiral.
The Fed's definition of inflation as 'transitory' was more about managing market expectations than a belief in its temporary nature.
Monetary policy has historically led to deflation, not inflation, and supply-side economics may inadvertently contribute to inflation.
The Fed's tools are limited in effectively controlling inflation, and extreme measures could lead to economic crises.
Market risks are increasing, with high yield spreads and junk bond spreads nearing COVID-19 lows.
Japan's government bonds are at risk of an existential crisis due to expanding spreads.
Cryptocurrencies, particularly those far out on the risk curve, are starting to implode, with concerns about Tether's stability.
The European Union is facing pressure from widening spreads between Italy and Germany, prompting intervention to secure debt.
Russia and China are exploiting perceived weaknesses in the global economy, with Russia cutting natural gas to Italy as an economic strategy.
Dollar strength is at a record high, as the US market and dollar-denominated assets are seen as safe havens.
Emerging market crises and risk spread expansion are expected due to dollar strength and rising interest rates.
Market liquidity is at a 15-year low, leading to increased risk and potential for more significant market swings.
Despite market declines, there are opportunities for counter-trend rallies due to historically bad sentiment and short interest.
Investment strategies should focus on essentials and active management over passive approaches in the current market environment.
Transcripts
hello and welcome to our June macro and
flows
update um I'm going to start this off uh
this month by talking about macro a
little bit um inflation obviously has
been the important Zeitgeist of the
moment um this is the first time in 40
years that we've had real secular
inflation and it's important to to note
how important that is um in
understanding where we stand and what
the risks are for what lies
ahead the FED is in a box for the first
time uh really in the last 40 years um
and arguably uh since it's been dominant
the first time
ever um what does that mean why is that
so um if inflation and long-term
expectations of inflation uh remain high
meaning one year two year threee
expectations of inflation remain high uh
two things happen one uh entities
particularly businesses but also
individuals start bringing demand
forward and they start building
inventories um purchasing things and
storing them and hoarding them uh they
start spending more actively uh now
knowing that things will be more
expensive later um that's relatively
well documented that helps Drive even
greater demand in the economy um and an
inflationary uh push to ex that
exacerbates the already high inflation
push two if long-term inflation
expectations remain
High um we end up uh getting a situation
where every investor every entity who
has confidence that inflation will be
high going forward will borrow at the
fence negative interest rates and buy
anything that is pinned down as a secur
uh against inflation investment that
will only drive prices of Commodities
and other hard assets higher ultimately
um so these two effects have very
powerful impacts that serve to
accelerate inflation once it takes hold
there is a negative uh inflationary
spiral uh a negative Doom Loop that
happens here the FED is very aware of
this this is why they uh Defined
inflation as transitory early on it
wasn't because they thought it was
transitory uh it was really to convince
markets um and and uh try and keep
long-term inflation expectations down
when that didn't work their next and
only tool is to try and get the market
to believe that they are going to do
whatever it takes um to uh lower
inflation the truth is the Fed has
little power to control in inflation um
they as we've talked about before
several times have used monetary policy
for 40 years particularly the last 20
years in in historic experimental
fashion and all they've got is deflation
so it doesn't really follow that pulling
uh assets of monetary policy back um
will in any way be um deflationary
actually it's supply side economics
you're moving money from corporations
you can
argue um that a major effect will be to
uh to reduce Supply and ultimately that
is itself somewhat
inflationary so at some point they can
kill the markets they can uh you know
really hurt uh the economy via killing
corporations and through creative
destruction and create an economic
crisis and that will be eventually
deflationary um but that's like akin to
dropping a nuclear bomb on uh you know a
forest to clear the underbrush um I
don't think that's what anybody wants
nor is it what the FED wants so the FED
finds itself in a very precarious
dilemma without a good solution at hand
so once we start there we realize where
we are and the um the ultimate problems
that that the markets in particular face
and that liquidity faces in the face of
this fairly unsolvable problem for the
feed you begin to realize the risks that
we're seeing we've been talking about
this obviously for quite some time but
some of the effects are just getting
started high yield spreads junk bond
spreads are blowing out uh we are now
near the March 2020 covid lows um in hyg
and
jnk um jgbs for the first time uh the
the Japanese government bonds um are
blowing out um and in serious risk of
having uh creating an existential crisis
in
Japan um crypto you know far out on the
rist curve is starting to implode um you
know many people believe that tether is
going to break the buck um and that
we're going to see significant greater
pain um in that
space uh we're seeing expansion and
spreads between Italy and Germany uh in
the European Union uh to such an extent
that
lagard and the European Union are being
forced to secure that debt to help um
tighten spreads Russia and China are
taking advantage of these presumed
weaknesses um you know and Russia has
cut amidst this expanding spreads and
and the crisis that they're seeing
beginning to see in Italy they've cut
energy um natural gas to Italy um so
they are trying to make this economic
crisis worse for the
West um all this while dollar strength
is at a
record because as a safe haven as one of
the few places is to hide the dollar and
the US market uh represents a safe haven
this dollar denominated this dollar
strength will cause thear dollar
denominated debt we've seen this uh many
times before throughout history in 1997
we saw the Asian financial crisis and
the Russian rubal crisis um ultimately
as a effect um as a result of um dollar
strength um and US U you know rising of
of interest rates um at that time so I
would expect uh more Emerging Market
crisises coming forward as well as
expansion of risk spreads um the world
over we are seeing this also in historic
uh poor liquidity uh top of the book
liquidity um is worse than it's been
really in the last 15 years and this
lack of liquidity means fatter tales for
markets and increasing risk risk more
leptokurtic distributions as we've
talked about now for over a year and a
half so I would expect more of the same
that doesn't mean we're not going to
have bounces back I don't mean to be all
doom and gloom this is a now almost 30%
decline uh you know in Broad markets
more than 35 uh percent in the NASDAQ so
this is not a time to be drumming the
table for um a a massive taale yet um
one is building um we will have counter
Trend rallies that we've as we've seen
in March um and again in May uh rallies
up greater than 10% because short
interest and bearishness and sentiment
are historically bad um but uh that is
for a fundamental reason and uh I would
expect that the secular Trend continues
quite a bit
lower amidst all of this um the good
news um is that we should see relative
Revenue strength increasing inflation
expectations ultimately does bring
demand forward price to sales which has
been at record levels um should be
slowly solved by this Revenue growth uh
we might get a technical recession here
um because of the slight negative print
last quarter um but it is our belief
that we are going to avoid any major um
recession um we are going to however
have an earnings recession margins which
have been at record levels for some time
now will begin to secularly normalize um
because of the costs structure problems
because of the inflationary push that we
are seeing at some point people will be
unwilling uh to uh allow uh
manufacturers
uh and and corporations to raise their
prices uh and corporations will have to
begin to digest some of the um the
inflationary
pressures um also good news as I
mentioned consumer sentiment is awful uh
investor sentiment is awful uh hedging
um and negative positioning is is at
record levels as we've seen for some
time this tends to mean that we're
likely to get um some major counter trun
moves and down moves are less likely to
be um continuingly
powerful um on that note however
household Equity allocations although
they've dropped Now by almost 10% are
still near record alltime allocation so
individuals even though institutions are
well positioned for this there is still
liquidation to come from households
so where do you invest in times like
this there are um you know it's a time
to invest in Essentials to uh invest
near um uh central government um to
invest in energy as we've talked about
before nuclear um for obvious reasons
healthc care uh defense infrastructure
Consumer Staples food Farmland domestic
manufacturing there are plenty of uh
bull Trends within this bare
Market it's important uh to think about
fundamentals for once um it's been a
long time since values have mattered
ultimately but we sit here at a moment
where DCFS active management will matter
again they will ultimately strike a put
in the valuations uh of of Corporations
going forward um passive is dead um
active is the new uh way to invest in
the decade to come so that's the macro
Outlook sounds pretty awful but the
reality is if well prepared um if
invested with entities with real
structural Edge and not just passively
dollar cost averaging into uh broad
passive markets as most Wealth Advisors
suggest if not trying to do the
6040 um risk parody
game um there are plenty of
opportunities in what has been a very
unbalanced market for some some time now
on to flows here we are at June
expiration um in the options markets um
it is a corly Opex generally very
important structural moments um there
are many moments so we can go back to
March of 2020 as a major turning point
um at expiration at the March covid lows
as one of many um the December of last
year um expiration as the beginning of
the final move that then rolled
over so here we sit at an important
Crossroads what does positioning look
like what do the dealer positioning and
flows look like at this
moment June expiration has been well
demanded um and in the context of um
high demand dealers have been short put
out of the money in that expiration um
and long and a very close expiration
behind it due to uh kind of an
idiosyncratic reason the June poly June
30th um uh options particularly in the
3610 area have been incredibly
incredibly well supplied because of this
JP Morgan hedged Equity trade we've
talked about this trade before the
bottom of that structure was the
3610 put that has provided massive index
ball um to dealers and uh to Broad
participants in the market having this
type of inverted structure where June
quarterly V has been very well supplied
where June monthly um several weeks
ahead of it has been very well demanded
has put dealers into a position where
they're decaying longer V uh and
decaying shorter Delta these VMA and vaa
effects um of of v as well as Vana and
charm effects of Delta have had a
massive pinning effect to V and a
massive compression of of v um V itself
that dealer positioning has served as a
plug in what we think of as a dyke
holding back the um building pressures
in a big macro World in a big macro
Market um with lots of stresses that
that we've talked about at the beginning
of this uh
conversation that plug which has pluged
big downside volatility and and speed
and convexity of moves that's controlled
the move at the index level um however
is starting to weaken a bit so as we
move past expiration and past towards
this June quarterly Opex those options
themselves will Decay and behind the end
of this quarter sit many short exposures
and much less well supplied um Vault um
this comes after a period of um
increasing uh disenchantment with
longall you know obviously our longall
strategies have performed incredibly
well but in the longall uh world there's
been massive underperformance puts uh
broadly V ETF f s have dramatically
underperformed what people hoped they
would do into these types of declines so
you're seeing Liquidation in a lot of
those products exactly at some of the
worst moments um and you're seeing a lot
of entities try and crowd into other
things that have performed incredibly
well that are much more shortfall or
synthetically shortfall like dispersion
so it's a time to be aware and to be
prepared for more um opportunity on the
index and Broad V
um longv side of
things um especially as we move into
August September October into the back
half of the year um we we broadly expect
much more performance from long
volatility at large and despite our
already great long Vault performance um
we expect Tailwinds um which should be
an incredible opportunity for our
investors so here we are um and and on
this day in particular this is Thursday
before tomorrow's op options expiration
we've actually seen the first skew pop
that we've seen from otherwise
incredibly depressed skew that is an
early warning sign so very shortterm
sign and doesn't mean that everything is
going to crack uh tomorrow or the next
day but it is a sign of increasing
fragility and weakness that may lie um
ahead so in GI times like this there's
really only only one thing to be
thoughtful of be water be dynamic head
on a swivel um try and be long gamma and
convexity in this lepto cured Market we
believe that the compressing of vult
ultimately um is uh by our next uh month
or the month afterward coming to an end
so um be prepared be water uh thanks for
listening take
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