Macro and Flows Update: January 2022 - e01

Summary

The video script discusses the current macroeconomic environment, highlighting the challenges faced by the Federal Reserve in managing inflation through monetary policy. It emphasizes the deflationary impact of increased supply due to technology and globalization, and suggests that tightening monetary policy could lead to stagflation. The script also notes the market's vulnerability to structural changes and the potential for increased volatility, advising investors to prepare for a difficult period ahead while remaining vigilant for opportunities in market rallies and a widening distribution of outcomes.

Takeaways

• 📉 The Federal Reserve is under political pressure to respond to inflation, which is increasingly difficult due to the inapplicability of old monetary policy models.
• 🔄 Monetary policy has shifted from being deflationary to potentially inflationary due to changes in supply mechanisms over the past 43 years.
• 💹 Tightening monetary policy is expected to decrease supply, potentially leading to a stagflationary environment.
• ⏳ The Fed faces a challenging task of managing inflation within a reasonable timeframe, as the current situation is different from previous cycles.
• 📊 Market breadth has been poor, signaling a warning sign for the economy and investment markets.
• 📈 Despite weak market flows, markets have been supported by high levels of liquidity, particularly during positive flow periods.
• 📉 The S&P has experienced a significant drop, indicating a market pullback and increased stress.
• 🔮 Market indicators suggest a potential near-term turning point, with signs of market capitulation and increased implied volatility.
• 📊 The speaker draws parallels between the current market situation and past economic cycles, noting the difficulty of predicting market movements.
• 🚀 Opportunities exist in the market for active management and leveraging specific dealer positioning and relative value strategies to generate returns.

Q & A

What is the main theme of the macro markets and flows update presented in the transcript?

The main theme is the current challenges faced by the Federal Reserve in managing inflation and the potential for a stagflationary environment due to tightening monetary policy in a context of decreasing supply.

How has monetary policy historically affected inflation according to the transcript?

Historically, monetary policy has not been inflationary but deflationary, as it has increased supply through better technology and globalization.

What does the speaker believe will be the outcome of the Federal Reserve's tightening monetary policy in the current economic climate?

The speaker believes that tightening monetary policy will not be deflationary as it has been in the past, but will instead decrease supply at a time of lower supply, potentially leading to a stagflationary environment.

What factors have contributed to the decrease in market breadth and the warning signs mentioned in the transcript?

Factors contributing to the decrease in market breadth include the response to sticky inflation, growth names and duration rolling over, and poor market flows despite positive reinvestments and shortened calendars.

How did the market perform after the rally in October mentioned in the transcript?

After the rally in October, the market was able to maintain a sideways pattern to slight new highs primarily due to V supply. However, the momentum was lost and the market has since experienced a significant pullback.

What is the significance of the January 19th expiration mentioned in the transcript?

January 19th expiration is significant because it was expected to be an important turning point for the market, and the market's weakness since then has been a major warning sign.

What are the 'fat tail' events that the speaker refers to in the context of the market?

The 'fat tail' events refer to the possibility of extreme market outcomes or major macro issues in the economy that could result in a significant shift in market dynamics and investment opportunities.

What historical period does the speaker compare the current market situation to?

The speaker compares the current market situation to the period of Long-Term Capital Management and the tech bubble, which occurred from 1998 to 2000.

What is the speaker's outlook on the opportunities in the market despite the challenges?

The speaker sees opportunities in taking advantage of strong rallies to monetize, as well as benefiting from the increasing volatility and potential for a widening distribution in the market.

What advice does the speaker give to investors regarding navigating the turbulent market conditions?

The speaker advises investors to rely on active management and specific strategies such as dealer positioning and relative value yield creation to generate returns and real Alpha for portfolios.

What disclaimer is provided at the end of the transcript regarding the content and advice presented?

The disclaimer states that the content does not constitute an offer to sell or buy any security or service, and is not intended to provide tax, legal, or investment advice. It also clarifies that the securities or services discussed may not be suitable for all investors, and individuals should consult their advisors before making any investment decisions.

Outlines

00:00

📉 Economic Crossroads and Fed's Response

The first paragraph discusses the current economic situation, focusing on the Federal Reserve's challenge in managing inflation. It highlights that traditional models of inflation management by the Fed are outdated, as monetary policy has become deflationary due to increased supply from technological advancements and globalization. The speaker predicts that tightening monetary policy will lead to a stagflationary environment, making it difficult to handle inflation within a reasonable timeframe. The Fed's dual mandate of maximum employment and inflation control is expected to be more challenging than previous cycles, with the speaker noting that the current situation is not like the easy management of cycles in the past.

05:02

📈 Market Volatility and Supply Dynamics

The second paragraph delves into the market's supply and demand dynamics, particularly the role of V (volatility) supply in supporting markets during positive flows at year-end. It notes that the market has been able to maintain a sideways pattern to slight new highs due to this V supply. However, as the supply slows down, the market is expected to face headwinds. The speaker mentions that January 19th options expiration was anticipated to be a turning point, and the subsequent market weakness is not surprising. The current market stress is seen as a continuation of structural effects that are expected to persist in the coming months, with the speaker warning of potential major market stress due to a combination of factors including the Fed's tapering, leverage in the system, and market dynamics.

10:02

🚀 Market Cycles and Strategic Opportunities

The third paragraph provides insights into the long-term market cycles and strategic opportunities for investors. It emphasizes that the current market decline is part of the last kicks of a 13-year bull market driven by monetary policy. The speaker suggests that implied volatility is likely to rise, presenting opportunities to bet on a widening distribution. Drawing parallels with the NASDAQ's final rally in 1999-2000, the speaker highlights the potential for profit in long implied volatility positions. The paragraph concludes with a reminder that the market is entering a more challenging phase, and active management and specific investment strategies will be crucial for generating returns. The speaker encourages viewers to reach out for further discussion and reiterates that the content is not investment advice.

Keywords

💡Macro markets

Macro markets refer to the large-scale economic environments and trends that influence the overall performance and direction of financial markets. In the context of the video, it is used to discuss the broader economic factors such as inflation, monetary policy, and the Federal Reserve's actions that have significant impacts on investor decisions and market flows.

💡Volatility

Volatility is a measure of the variation in the price of a security over time, often used as an indicator of the risk associated with trading or investing in a particular market or security. In the video, it is highlighted as a key factor that investors need to consider, especially in the current environment where the Federal Reserve's actions and fiscal policies are creating a complex market landscape.

💡Federal Reserve

The Federal Reserve, often referred to as the Fed, is the central banking system of the United States, responsible for implementing monetary policy to promote economic stability. In the video, the Fed's role is discussed in relation to its response to inflation and its influence on the financial markets, including its use of tools like interest rates and quantitative easing.

💡Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. In the video, inflation is portrayed as a significant challenge that the Federal Reserve is trying to manage through its monetary policy, with the speaker noting that the traditional methods for controlling inflation may not be as effective in the current economic climate.

💡Monetary policy

Monetary policy refers to the actions taken by a central bank, like the Federal Reserve, to influence the economy by adjusting the cost and availability of money and credit. In the context of the video, monetary policy is being scrutinized for its effectiveness in managing inflation and its potential to impact the supply and demand dynamics in the market.

💡Stagflation

Stagflation is an economic situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high. In the video, the term is used to describe a potential economic scenario where the Federal Reserve's tightening of monetary policy leads to a decrease in supply, which, combined with existing inflation, could result in a challenging economic environment for investors.

💡Capital markets

Capital markets are markets in which savings are converted into investment in financial instruments. They include stock markets, bond markets, and other venues where businesses and governments can raise long-term funds. In the video, the capital markets are discussed as a channel through which the Fed's monetary policy actions can influence economic activity, particularly in terms of how they affect the availability of capital for corporations and individuals.

💡Wealth effect

The wealth effect refers to the economic phenomenon where the perceived increase in personal wealth, such as from an increase in stock prices or house values, influences economic behavior, leading to increased spending and consumption. In the video, the concept is used to explain how changes in the capital markets can impact consumer behavior and, by extension, the economy.

💡Market flows

Market flows refer to the movement of money into and out of various financial instruments or markets. These flows can be influenced by a variety of factors, including investor sentiment, economic indicators, and policy changes. In the video, market flows are analyzed to understand the potential impact on asset prices and market trends.

💡Supply and demand

Supply and demand are fundamental economic concepts that describe the relationship between the quantity of a commodity that producers wish to sell at various prices and the quantity that consumers wish to buy. In the context of the video, the balance between supply and demand is discussed in relation to the impact of monetary policy and technological advancements on the economy.

💡Leverage

Leverage in finance refers to the use of borrowed funds to increase the potential return of an investment. It can amplify gains but also amplify losses if the investment does not perform as expected. In the video, leverage is mentioned as a factor that contributes to the complexity and potential stress in financial markets, especially when combined with macroeconomic challenges.

💡Fat tail

In finance, a fat tail refers to a statistical distribution that has more extreme outcomes than a normal distribution, indicating a higher likelihood of rare events with large impacts. In the video, the concept of a fat tail is used to describe the potential for significant market movements or events that are outside the typical range of expectations.

Highlights

The update discusses the changing role of the Federal Reserve in managing inflation, which is no longer as effective as in the past due to the deflationary effects of technological advancements and globalization.

Monetary policy is now seen as deflationary when it should be tightening supply, which could lead to a stagflationary environment.

The Fed's challenge is to handle inflation, which is primarily a fiscal policy issue, through capital markets and demand reduction.

The current economic situation is expected to be more difficult for the Fed compared to previous cycles due to dual mandates of maximum employment and inflation control.

The market's momentum has been weakening since February 2022, with growth names and duration rolling over.

The rally in October was in preparation for major structural flows, but the market's inability to maintain momentum was a warning sign.

The market has experienced a significant pullback, the biggest in almost two years, indicating real stress.

The current market situation is compared to the period of Long-Term Capital and the tech bubble, suggesting a potential market top and change in cycle.

Implied volatility is expected to rise as the market cycle reaches its end, presenting opportunities for trading strategies.

The distribution of the market is expected to widen, with fatter tails, similar to the period from October 1999 to March 2000.

Active management and specific strategies are emphasized as ways to generate returns in the challenging market environment.

The transcript warns of the potential for difficult times in the market, with a shift towards lower returns for investors.

The historical comparison to 1968-1982 suggests a potential market stagnation in real terms due to increasing interest rates.

The update concludes by encouraging investors to reach out for feedback and reiterates that the content is not investment advice.

Transcripts

good afternoon and Welcome to our first

macro markets and flows updates here at

Kai volatility for investors uh we look

forward to doing these once a month

going forward in the year to come uh I'm

going to start out this update uh as as

we said a very important Crossroads uh

talking about macro where do we see

things the FED uh is being forced to uh

politically to respond to inflation as

most of us know uh unfortunately the old

models of how inflation can be managed

by the Federal Reserve um are broadly no

longer pertinent um as we've seen for

the last 43 years now monetary policy uh

when used is not inflationary it is

deflationary it has been increasing

Supply through better technology

globalization among other things right

so that that Supply uh increase like I

said has been deflationary it therefore

follows that uh in in tightening uh and

and giving less Capital ultimately um to

corporations via monetary policy that

the response will not be deflationary if

anything it will be decreasing Supply at

a time of lower Supply We Believe here

at K volatility that that will create a

stagflationary environment there is a

decreasing uh likelihood of of being

able to handle this inflation with any

manageable time frame the only way that

the FED can ultimately respond to this

inflation that's been really truly

created by fiscal policy not the

monetary policy at hand ultimately this

is going to slow uh inflation only by

slowing via the capital markets route uh

demand um this will happen via

reductions in the wealth effect uh to

individuals as well as less um dollars

uh ultimately to corporations to invest

the real question going forward will be

uh is this what uh the populace wants uh

there is a lot of clamoring for handling

inflation first and foremost but as a as

markets decline as a recession is likely

to build um you know what how will the

FED respond to their dual Mandate of

Maximum employment and inflation it will

be much tougher than previous Cycles uh

before it was there was no problem uh

with managing price stability uh and and

it made it very easy for the FED

reaction functioning to to Simply um

involve more monetary policy uh that is

why the cyle has lasted 42 years um this

will be a much more difficult uh Road

this is not

2018 uh here in

2022 the the FED will struggle against

both growth and inflation this has been

a growing uh problem and we've seen uh

therefore big macro effects

um honestly this started back in

February when uh it became clear that

the Federal Reserve would have to

respond to uh sticky

inflation uh we started to see a lot of

growth names and duration uh begin

rolling over even before that but uh

it's been pretty clear under the surface

that breadth has been very poor uh that

breadth and a lot of other uh factors

that we look at here at Kai volatility

have been a major warning

sign uh after the rally we got in

October uh in preparation for major

structural flows that come at that time

of the year as we've talked about in our

investor letter uh throughout November

December and January particularly in a

big up year um we get lots of positive

flows that of reinvestment going into

the end of the year we also have a

shortened calendar uh and time very much

matters to these strong Vana and charm

flows we had big on that 5.2 2% pullback

in September we had a significant

increase in volatility the vanana and

charm flows paired with the structural

flows with a shortened calendar

throughout the holiday period should

have led to increased momentum if this

Market was going to continue its strong

March higher from the year before

however the rally ultimately petered out

um that was a that loss of momentum as

long as well as breath during this

period has been a major warning sign

that we've talked about um through

various mediums during this time the

markets were still able to maintain kind

of a sideways pattern to slight new

highs primarily due to V Supply there's

been a tremendous supply of V uh in

these markets as time and volumes uh Eed

during a time of great positive Flows at

the end of the year this implied V

Supply ultimately um has has helped

support the markets in the context of

otherwise incredibly weak um Market uh

flows that ball Supply as expected um

has come to a a slowing there is less

ball Supply um and this was expected

after the the first week or so of of

January um and not a surprise here that

that we've seen a topping out since that

period we expected and highlighted for

some time now that January 19th of

expiration uh would be an important

Turning Point Market somewhat front ran

that a little bit but you've seen

considerable uh weakness uh since then

we are now amidst the biggest pullback

we've seen in in almost two years since

the March Feb March covid crash um at

almost 9% now and and drop in the S&P

and much bigger throughout rest of the

market obviously the markets are

beginning to experience real stress

again this is not a surprise this these

flows have been uh under underneath the

surface bringing down major um kind of

overextended momentum names for some

time now we believe these structural

effects will continue um not in the

short term as much as secularly in the

next month or two um this period is a

seasonally weak period because there is

a lack of flows um there are no major

holidays or shortened time frames a lot

of the positive flows that came in

January have been uh are now having to

be given

back add to that the accelerating uh

taper that's happening with the FED um

the uh considerable uh leverage in the

system and lepto kurtic nature of

markets and it is a recipe for um major

potential stress in the markets that

said these macro Cycles are big long

Cycles they don't go in a straight line

um this 9% decline that we've had

already is definitely reaching oversold

territory today Friday the day of op

options expiration uh we saw um kind of

historically steep put call Equity

ratios a significant demand for puts

increase in implied volatility that was

significant given the size of the move

and increases in skew across the market

these are signs that tend to mean that

we are reaching near a capitulation

Point we've also seen significant volume

um on call speculation from entities

that tend to have a good track record

positioning has reached a point um in

its extreme where it is uh likely that

we start to see um some type of of major

turning point in the short

term this uh coming turn when it happens

may come from a little bit lower in the

market but should be

significant with the FED ahead here on

this coming Wednesday um we expect that

in the next week we will see some

significant B moves as well as moves in

the market um a reversal which uh could

have again come from lower but is likely

to come in the short

term um we'll have to maintain some very

strong momentum um in the couple of

weeks to come in order to be

sustained after all like we mentioned

the macro flows are in trouble there are

bigger issues ahead so we stand prepared

here to not only benefit from a a coming

bounce in the market but also uh as we

model the distributions are very much

aware of a fat tail that sits out in

this market uh in terms of major macro

um issues in the economy uh we also

looking to to take advantage of of

strong rallies here to monetize given

these ebbing momentum and flows um here

in the long term as a student who

started a you know a student of these

Market who started in 1998 and really uh

began his career uh during long-term

capital and the tech bubble this period

reminds me a lot of of what we went

through then there's likely to be uh not

an easy time to to to short this Market

or or to play directly from the short

side um but what one thing is clear

towards the end of these Cycles even

though they tend to last longer than you

expect um implied volatility should

continue to rise there are opportunities

to bet on a widening distribution um

this lepto kurtic Market as I've

mentioned is likely to grow uh with

wider and fatter tails in October of 99

through March of 2000 the NASDAQ rallied

110% in its final um kicks and and uh

fits as it attempted to find the top

during that period implied volatility R

Rose dramatically although you would

have really gotten hurt trying to short

the market into that period before

making a lot of money taking the road of

more long implied volatility

particularly to the upside into those

final moments was one of the most

profitable ways to take advantage of the

widening distribution this is a a big

part of what we're seeing in our

distributions and how we we hope to take

advantage um in the months to come both

taking advantage of of an increasing um

volatility that that's going to exist in

this market as well as an eventual

decline this is the end of a 13-year

bull market it can last for a year maybe

even longer but the reality is these are

the last kicks and pads of a market

driven by monetary policy lower interest

rates Ates more liquidity um ultimately

that has been threatened by increasing

inflation and a need uh for for higher

interest rates uh there is too much

demand uh and not enough Supply at the

end of the day the FED must lower uh the

monetary policy uh response uh relative

to its historic average uh given where

multiples sit given where uh at this

point of the cyle margin set given the

amount of Leverage in the system this

will ultimately lead to difficult

outcomes in the market as I mentioned

before 1968 to 1982 was the last period

that we saw interest rates increase over

that 14-year period in nominal terms

markets went nowhere in inflation

adjusted terms markets lost about 70% of

their

value this may sound really bearish may

sound scary but the reality is everybody

is use to over uh expecting the returns

in these markets and there's payback

there's a time where it will be much

more difficult to make the returns that

people are used to is during those times

that we hope to lean on active

management uh and our specific edge of

dealer positioning as well as relative

value yield creation to generate returns

and real Alpha for portfolios hopefully

you found this update helpful as you

navigate the turbulent water Waters

ahead please don't hesitate to reach out

we look forward to hearing your feedback

take care be

[Music]

water this does not constitute an offer

to sell a solicitation of an offer to

buy or a recommendation of any security

or any other product or service by Kai

or any other third party regardless of

whether sub security product or service

is referenced in this video furthermore

nothing in this video is intended to

provide tax legal or investment advice

and nothing in this video should be

construed as a recommendation to buy

sell or hold any investment or security

or to engage in any investment strategy

or transaction Kai does not represent

that the Securities products or Services

discussed in this video are suitable for

any particular investor you are solely

responsible for determining whether any

investment investment Strate stry

security or related transaction is

appropriate for you based on your

personal investment objectives Financial

circumstances and risk tolerance you

should consult your business advisor

attorney or tax and accounting advisor

regarding your specific business legal

or tax

situation