Macro and Flows Update: June 2022 - e06

Summary

The 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

00:00

📈 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.

05:01

💹 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.

10:01

🏠 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.

15:03

📊 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.

Keywords

💡Inflation

Inflation refers to the general increase in prices and fall in the purchasing value of money over time. In the context of the video, it is highlighted as a significant economic trend that has not been seen in 40 years and is affecting various aspects of the economy, including business behavior and consumer expectations.

💡Secular

Secular, in an economic context, refers to a long-term or persistent change or trend, as opposed to a cyclical one. The video emphasizes that the current inflation is secular, indicating that it is a sustained shift from previous economic conditions.

💡FED (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 regulate the economy. In the video, the FED is described as being in a difficult position, with limited power to control inflation.

💡Demand Forwarding

Demand forwarding is a strategy where businesses and individuals anticipate future price increases and thus bring forward their purchasing decisions to avoid higher costs. This behavior can contribute to inflationary pressures as it increases current demand.

💡Investment

Investment in this context refers to the act of allocating resources, usually money, with the expectation of generating an profit or return over time. The video discusses various investment strategies and sectors that could be beneficial in the current economic climate.

💡Liquidity

Liquidity refers to the ease with which assets can be converted into cash without affecting their market price. The video highlights that current market liquidity is poor, which can lead to increased market volatility and risk.

💡High Yield Spreads

High yield spreads refer to the difference in yield between high-yield bonds (often referred to as 'junk bonds') and more stable, lower-risk bonds like U.S. Treasury bonds. Wider spreads indicate greater perceived risk and lower credit quality.

💡Cryptocurrency

Cryptocurrency is a digital or virtual currency that uses cryptography for security and operates on decentralized networks, such as blockchain technology. In the video, the speaker discusses the instability in the cryptocurrency market and the potential for further decline.

💡Dollar Strength

Dollar strength refers to the value of the U.S. dollar relative to other currencies. A strong dollar can have various effects on global trade, investment flows, and economic stability. In the video, it is mentioned as a safe haven in times of economic uncertainty.

💡Options Markets

Options markets are financial markets where options, which are financial derivatives that give the buyer the right but not the obligation to buy or sell an underlying asset at a set price before a certain date, are traded. The video discusses the dynamics of options expiration and its impact on market positioning and volatility.

💡Counter-Trend Rallies

Counter-trend rallies refer to market movements where prices rebound from a general downward trend. These rallies can occur due to various factors, such as short covering or positive news, and are temporary reversals of the primary trend.

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

care

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