Macro and Flows Update: July 2022 - e07

Summary

The video discusses the current macroeconomic situation, highlighting the secular increase in inflation driven by populism and income inequality. It predicts a short-term peak in inflation but expects it to rise again. The Fed's struggle to control inflation and the increasing importance of equality in politics are noted. The video also forecasts multiple contraction due to higher interest rates and a potential decline in markets, with fiscal policy responses likely to continue. It warns of a bearish outlook in the long to medium term, with potential risks including a dollar debt crisis and widening credit spreads. However, short-term market complacency is expected due to poor positioning and sentiment, but this is anticipated to be temporary.

Takeaways

• 📈 Inflation is experiencing a secular increase, with a recent high reading of 99.1% on CPI.
• 🔄 The current inflation is believed to be driven by populism, fueled by income inequality resulting from 40 years of supply-side economics.
• 🌪️ Populism is growing due to political shifts influenced by the younger generation, leading to increased focus on equality and justice in policy-making.
• 💰 The Federal Reserve's monetary policy is struggling to control inflation secularly, and the long-term outlook suggests a continued increase in inflation rates.
• 📉 Expectations for a short-term pullback in inflation to 5.5-6% followed by a rise in secular inflation due to the populist-driven economic policies.
• 🛡️ The Federal Reserve is attempting to dampen long-term inflation expectations to prevent demand pullforward and avoid an inflationary spiral.
• 💹 The cost of money is increasing, leading to market multiple contractions, margin compression, and a reverse Tina effect favoring bonds over stocks.
• 📊 The market is currently in a state of reduced liquidity, particularly in interest rates and bond spaces, with equity volatility remaining relatively muted.
• 🌐 The US dollar has been strengthening, causing global market dislocations and increasing the risk of a debt crisis in dollar-denominated assets.
• 🚨 The market is facing several risks including widening credit spreads, high yield and junk bond issues, and potential geopolitical tensions involving China and Taiwan.
• 📆 Upcoming events like earnings season and Federal Reserve decisions are expected to introduce more market volatility and potential downward pressure.

Q & A

What is the main theme of the macroeconomic update discussed in the transcript?

The main theme is the increasing secular inflation, driven by populist movements and the consequences it has on various financial markets and policies.

What recent inflation reading was mentioned in the transcript?

A 99.1% inflation reading on CPI was mentioned in the transcript.

Why is the Federal Reserve unable to control inflation secularly according to the transcript?

The Federal Reserve is unable to control inflation secularly because it is driven by populism, which was created by the Fed's own monetary policies and has led to massive inequality over 40 years.

How does the transcript link fiscal policy to inflation?

The transcript links fiscal policy to inflation by explaining that fiscal policies, which involve distributing money to people, provoke demand-side economics, ultimately causing inflation.

What are the implications of long-term inflation expectations taking hold, as per the transcript?

If long-term inflation expectations take hold, demand gets pulled forward, inventories build up, and anyone can borrow at low rates, increasing inflation and creating an inflationary spiral.

What does the transcript suggest about the future of interest rates?

The transcript suggests that interest rates will secularly increase due to the need to control long-term inflation expectations and prevent an inflationary spiral.

What does the transcript indicate about the impact of inflation on the poor population?

Inflation, being a flat tax, disproportionately hurts the poor and drives even greater populism.

What financial market trends are expected in the short term according to the transcript?

In the short term, the transcript expects more pain in the equity market, vault, and compression due to poor positioning and sentiment, as well as reduced demand from put and Vol liquidation.

What are the potential risks mentioned in the transcript for the upcoming months?

The potential risks mentioned include a dollar denominating debt crisis, widening credit spreads, high yield and junk bonds issues, liquidations in crypto, and a possible Chinese invasion of Taiwan.

How does the transcript describe the current state of liquidity in various financial markets?

The transcript describes the current state of liquidity as decreasing, with top of book liquidity in the fifth percentile and reducing day by day. There is no liquidity in the interest rate and bond space, and FX has lost all liquidity.

What advice is given in the transcript regarding investment strategies in the current market conditions?

The advice given is to be cautious and avoid being short-skeptic, as there is a significant payout sitting on the left tail that is expected in the next 3 to six months. Investors should be vigilant and aware of the potential risks and market developments.

Outlines

00:00

📈 Inflation and Fiscal Policy

This paragraph discusses the current state of inflation and its secular increase, with a recent 99.1% inflation reading on CPI. It highlights the expectation of a short-term peak but a long-term continuation of inflation, driven by populism created by the Fed's monetary policy over 40 years, leading to inequality. The discussion extends to the political impact, with figures like Donald Trump and Bernie Sanders responding to public demand for equality, and the understanding that fiscal policy drives inflation. The paragraph also touches on the Fed's struggle to control long-term inflation expectations and the consequences of low interest rates, such as demand pull-forward and an inflationary spiral.

05:00

💹 Market Decline and Fiscal Response

The focus here is on the anticipated market decline and the fiscal policy responses to economic challenges, such as gas tax holidays and first-time home buyer tax credits. It suggests an increase in such policies as political cycles heat up, leading to a cost of money increase and multiple contraction for markets. The impact on various sectors like bonds, volatility risk premium, and the reverse Tina effect are discussed, along with the potential for a dollar denominating debt crisis globally due to the Euro and dollar parity.

10:02

📉 Equity Market and Liquidity Concerns

This paragraph examines the equity market's performance and liquidity concerns amidst a backdrop of increasing interest rates and quantitative tightening. It discusses the impact on investment opportunities, the illiquidity in various sectors, and the potential for greater market problems. The paragraph also touches on the hedging strategies employed by funds and the illiquid market conditions, emphasizing the importance of equity volatility as a place of liquidity that could change if it breaks.

15:04

🏦 Earnings Season and Economic Challenges

The upcoming earnings season is discussed, with expectations of poor performance due to margin compression, the impact of inflation on earnings, a strong dollar affecting multinational companies, and a slowdown in demand. The paragraph also highlights the issue of inventory whipsaw and its effects on retail and corporate entities, particularly during buyback blackout periods. The potential for the Fed to take aggressive action and the political implications of the midterm elections are also considered, with a warning to be cautious in the short term due to potential market tail risks.

20:08

📝 Disclaimer and Investor Guidance

The final paragraph serves as a disclaimer, clarifying that the content does not constitute an offer to sell or buy any security or service, nor is it intended to provide tax, legal, or investment advice. It emphasizes the viewer's responsibility to determine the suitability of any investment strategy based on personal circumstances and the importance of consulting with business, legal, or tax advisors for specific situations.

Keywords

💡Inflation

Inflation refers to the rate at which the general level of prices for goods and services is rising, and subsequently, purchasing power is falling. In the video, it is mentioned that inflation is secularly increasing, with a recent 99.1% inflation reading on CPI, indicating a significant rise in prices over time. This increase in inflation is linked to various factors, including monetary policy and inequality, and is expected to continue despite short-term fluctuations.

💡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 maintain economic stability. In the context of the video, the FED's role is discussed in relation to its inability to control inflation secularly. The speakers argue that the FED's monetary policies over 40 years have contributed to the current inflationary pressures by creating inequality and populism, which in turn drive political demands for more equitable economic policies.

💡Populism

Populism is a political approach that strives to appeal to ordinary people who feel that their concerns are disregarded by established elite groups. In the video, populism is described as a driver of inflation, fueled by economic inequality and the demands of various social groups, including the working poor and younger generations, for more equitable economic policies. This populist sentiment is seen as a reaction to the concentration of wealth among the top 1% of the population and is influencing political discourse and policy-making.

💡Interest Rates

Interest rates are the percentage at which borrowers can borrow money, or the rate at which savers receive interest on their deposits. In the video, the discussion around interest rates focuses on the necessity for them to increase in response to long-term inflation expectations. The speakers argue that if these expectations become entrenched, it can lead to demand being pulled forward and a build-up of inventories, which can exacerbate inflation. The FED is trying to prevent this scenario by increasing interest rates to dampen long-term inflation expectations.

💡Fiscal Policy

Fiscal policy refers to the use of government revenue collection (taxation) and expenditure (spending) to influence a country's economy. In the video, it is argued that fiscal policy, by provoking demand-side economics, ultimately causes inflation. The speakers suggest that the understanding that fiscal policy drives inflation has been evident in historical examples such as the Great Society programs of the 1960s and the New Deal policies of the 1930s. The current populist sentiment is seen as a reaction to the effects of fiscal policy over time.

💡Market Liquidation

Market liquidation refers to the process of selling off assets, such as stocks or bonds, in the market, often due to financial stress or to meet margin calls. In the video, the concept is discussed in the context of an expected decline in markets and the subsequent impact on various asset classes. The speakers suggest that the cost of money is going up, leading to multiple contraction and margin compression, which historically results in reduced demand for stocks and market liquidation.

💡Dollar Strength

Dollar strength refers to the increase in value of the U.S. dollar relative to other currencies. In the video, the speakers discuss the secular increase in the strength of the dollar, which has been accelerating and has significant implications for global markets. A strong dollar can impact trade balances, investment flows, and can lead to debt crises in countries with dollar-denominated debt.

💡Quantitative Tightening

Quantitative tightening is the process of reducing the size of a central bank's balance sheet, typically by selling assets that the central bank has previously purchased, in order to tighten monetary policy. In the video, it is mentioned that quantitative tightening is just beginning and is expected to increase, which will lead to a decrease in liquidity in the market, potentially impacting asset prices and market dynamics.

💡Volatility

Volatility refers to the degree of variation of a trading price series over time as measured by the standard deviation of returns. In finance, volatility is often associated with the risk of price changes. In the video, the speakers discuss the impact of increasing volatility on various markets, including stocks, bonds, and currencies. They note that while equity volatility has been relatively muted, it is expected to increase as market conditions evolve.

💡Supply and Demand

Supply and demand is a fundamental concept in economics that describes 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 video, the concept is discussed in the context of market dynamics and the impact of geopolitical events, such as a potential Chinese invasion of Taiwan, on global supply and demand.

💡Market Sentiment

Market sentiment refers to the overall attitude or feeling of investors towards a particular security or financial market. It can influence investment decisions and impact market behavior. In the video, the speakers discuss how current market sentiment is quite negative, with hedge funds and retail investors positioned for poor outcomes, which is expected to contribute to further market declines.

💡Earnings Season

Earnings season refers to the period when publicly traded companies release their financial results for a given quarter. It is a critical time for investors as these reports can significantly impact stock prices and market trends. In the video, the speakers suggest that the upcoming earnings season is expected to show disappointing results due to factors such as margin compression, inflation, and a strong dollar.

Highlights

Inflation is secularly increasing, with a recent 99.1% inflation reading on CPI.

The short-term peak in inflation is expected, but a secular increase in inflation is anticipated.

Populism, driven by income inequality, is believed to be the primary driver of inflation.

The FED's monetary policy over 40 years has contributed to the rise of populism.

The younger generation's growing political dominance is influencing the focus on equality and justice.

Fiscal policy drives inflation, as seen in historical examples from the 60s and 30s.

Inflation is a flat tax that disproportionately affects the poor, leading to increased populism.

Interest rates are expected to increase to combat long-term inflation expectations.

The FED is trying to prevent a demand pull forward and an inflationary spiral by increasing interest rates.

Markets are expected to face multiple contraction due to reduced demand for stocks.

The cost of money is going up, leading to margin compression and higher discount rates.

Dollar strength has been accelerating, with the Euro and dollar reaching parity.

Market dislocations are occurring, with the JGB hitting its lowest levels in 30 years.

There is a one in three probability of a Chinese invasion of Taiwan in the next year or two.

Market liquidity is decreasing, with the equity market being in the fifth percentile of book liquidity.

Quantitative tightening is just beginning and is set to double in a month and a half.

Earnings season is expected to bring challenges due to margin compression and a strong dollar.

Inventory whipsaw is causing significant write-offs for retail and corporate entities.

Buyback blackouts are coinciding with earnings risk, reducing demand for stocks.

Despite a bearish macro outlook, positioning and sentiment are expected to dampen downside.

Transcripts

hello and welcome back to our monthly

macro and flows update

here in July uh we sit at a

precarious uh fork in the

road from a long-term macro

perspective um the most important thing

is that inflation is secularly

increasing um obviously recently we had

a

99.1% inflation reading um on CPI this

last

Wednesday and um we've been calling for

this for um about a year and a half uh

we expect that to probably be the

short-term

Peak um but broadly expect inflation to

secularly be increasing we would expect

a a pull back to five and a half um

percent maybe even six um in the next

year but that will only be a shortterm

um uh Valley into what is otherwise an

increasing uh secular inflationary push

what gives us that confidence why do we

believe that why can the FED not control

inflation

secularly our view is that this

inflation is driven primarily by

populism that popul populism uh was

created by the FED Itself by 40 Years of

secular monetary policy supply side

economics which drove massive

inequality um over 40 years as we've

discussed the top 1% has taken the Lion

Share of GDP um growth that populism is

being driven not just by the poor um and

the ex middle class which is now in the

Working Poor but importantly by the

younger generation by the Millennials on

down which are now growing after two

generations to political dominance

slowly in the system as this happens

over election cycle and election cycle

you see an increasing importance to

equality

Justice these forces will continue to

drive politicians whether from the right

like Donald Trump or the left like

Bernie Sanders to attempt to give these

populace here in the United States what

they want this is not just an American

phenomenon D we're seeing it broadly

globally and we've seen it um really

starting in the last decade as the word

inequality became more and more in

Vogue ironically people broadly

understand that fiscal policy drives

inflation we saw it with a great society

um uh of of lb J in the 60s uh and

70s um we saw it with uh FDR in the 30s

um

unfortunately that policy of fiscal um

money going helicopter money going to to

people and provoking demand side

economics um ultimately uh causes

inflation that inflation itself which is

a flat tax disproportionately hurts the

poor and drives even greater populace

populism so this populism Loop is

increasing this long-term effect

we'll see to it that interest rates

secularly increase why do interest rates

have to increase most people understand

this but important to understand if

long-term inflation expectations take

hold and this is what the FED is

desperately trying to avoid two factors

happen one demand gets pulled forward uh

inventories build that corporations

individuals choose to buy now as opposed

to in the future this creates greater

and greater demand which drives even

more inflation two if interest rates are

kept low at the end of the day anybody

can borrow at a low rate and and buy

anything pinned down because inflation

will continue to increase in their views

that happens that also increases

inflation and creates an inflationary

spiral so the FED is desperately trying

to dampen long-term inflation

expectations in the short term it seems

to be working

um but important to understand that it's

likely to not work secularly um the next

decline in markets We Believe will be

met with even more fiscal policy we're

already seeing fiscal responses globally

and here in the US as well responses to

uh gas tax you know gas taxes with gas

tax holidays uh responses to increases

um in home uh prices with uh firsttime

home buyer tax credits we're seeing

these things in the west and in States

across the United States we're likely to

see more and more of this as the

political cycle heats up here in the

fall um so the cost of money is going up

what does that mean for markets that

means multiple contraction historically

due to reduced demand for stocks um this

means margin compression uh earnings

being hit by higher costs um also by

stronger currency and developed markets

um we see a reverse Tina effect there is

now an alternative to stocks it's called

bonds um you see volatility risk premum

going up we're seeing this broadly in

the move index um as well as FX ball

lately dramatic increases there even

though Equity Vol still uh is the one

place where it Still Remains relatively

muted we think that will

change um and the discount rate

importantly goes up killing investment

opportunities and creating creative dis

ruction um uh to Mal investment in other

places where uh investment has been

overreaching uh low yield

Investments so the Outlook is not good

secularly in the midterm what are we

seeing as we mentioned dollar strength

has been uh not only secular since this

inflation started but has been

accelerating dramatically the Euro and

dollar have reached parity for the first

time in over 20 years uh we are seeing

uh pockets of the market where um you're

seeing dramatic

dislocations um in the jgb for example

uh it's hitting its lowest levels in 30

years um and this is likely to cause

dollar denominating debt crisis is

globally again last time we referenced

this last month but the last time we saw

this kind of strength um in the 1990s

which was not even close to this we saw

um Chinese

sorry Asian financial crisis paired with

a Russian rubal crisis which eventually

sewed the scenes of long-term Capital

Management and a few other

crisises um we're also seeing other

risks as I mentioned jgbs um uh causing

major issues in Japan credit spreads

widening high yield and junk bonds are

um starting to really widen at uh at

increasing speeds uh Liquidation in uh

crypto

risk to the breaking of of tether

potentially uh we've already seen

liquidations and big funds like three

arrows um as well as other recent

lenders um commercial real estate

starting to crack uh private equity

which is a much more slow moving entity

um after last quarter's first slow

moving quarter reports I'm starting to

see major write Downs in that in that

space all while we have the tail RIS of

a Chinese potential invasion of Taiwan

again many have called that highly

unlikely we believe it's a one in three

probability uh in the next year or two

um that probability alone if it were to

happen would create a massive Fork

between um

both um the East and West the supply and

demand in the markets all pretty bearish

right so why isn't thisk Market

particularly on the equity side

liquidated more as I mentioned we've

seen the move index Spike uh which is

interest rate B fxv Spike but Equity B

has been incredibly

muted um the reality is uh we are amidst

incredible hedging that we saw um at the

peak in the market we've talked about

this vocally we expected the market to

be down and B down in the equity space

and that's what we've received as that

pain has been uh hit on on the

liquidation of long equities um the

henges uh have probably had to be

liquidated as well so we've seen massive

put and Vol liquidation if you look at

the equity all space the majority of

Equity allall Funds um have had negative

returns hard to imagine into what was at

Max of 25% draw down in the market but

again most Equity Vol uh has has VA

funds have experienced a historic uh fix

strike Vol compression we have done

incredibly well in our funds obviously

due to a lot of the alfha edge that we

have um in terms of Vault positioning um

but those funds have seen dramatic

liquidation um for the most part that

liquidation is leading to even greater V

Supply um into this decline this is in

the midst a incredibly illiquid Market

top of book liquidity is in the fifth

percentile

um and reducing day by day that's

meaning positioning ultimately is

driving um a compression of Vault and

that's ultimately the pain trade and the

one place in the market where people

have been

hedged that's changing and it's

important to note that's the last

Bastion of liquidity in the market there

is no liquidity in the interest rate and

bond space anymore FX has lost all

liquidity we're seeing that in the move

invol there obviously Tech uh crypto uh

across the market credit spreads um are

also CDs are also widening dramatically

so watch Equity Evol this month and in

the coming quarter that is the one place

of liquidity and the one place that if

it breaks we're likely to see greater

and greater problems we're beginning to

see higher correlation in the market as

well places to hide in the last several

months are now starting to break energy

has seen massive liquidation this month

um a lot of banks um and other defensive

are also beginning to see Liquidation in

the

midterm um quantitative tightening is

just getting started this started in

June so it's only really been a month um

and a lot of the MBS effects take a

month or so to to pass through the

system so we are seeing decreasing

liquidity right as September 1st really

in another month and a half right now is

going to see a doubling of quanti ated

tightening from 475 billion runoff to um

95

billion so all in all a pretty bearish

picture in the long to medium term what

about the short term well in the short

term um there's a couple of uh things

that are are leading to a bit more

complacency and we expect that probably

in the next month we'll see a bit more

pain in the vault Equity Vault trade and

a bit more compression but that's

ultimately we believe the eighth or

ninth inning here um that again is

because ball is dramatically

oversupplied in the equity

space um also positioning and and

sentiment are are quite awful right now

um they are in the uh 15th per uh for

hedge funds as I mentioned retail is

still relatively high at the 80th

percentile um but dramatically reducing

so we believe in the short term um that

there'll be some continued pinning in

the market invol under performance um

but again that's probably just about a

month or two uh as we come into the fall

we expect much greater

opportunities the next two weeks in

particular are particularly interesting

tomorrow is July Opex after all we are

going into a five week cycle what do I

mean by that there's five weeks between

this monthly July Opex in August why is

that relevant why does that matter so

much well I've talked about these before

but positioning wise there are these

things called vaa and charm flows these

flows are uh are are flows that

ultimately as options involve decays as

risk Premier decays in the market um

Drive significant buyback of stock by

dealers given how uh low V has been

compressed recently those are decreasing

and as we come to the end of the Opex

cycle really in the next 24 hours we

would expect that the primary last charm

flows of that period um come off um the

come off the calendar the five-week

cycle means there's an extra week so a

25% increase um right at the beginning

of the cycle when there's almost no V

and charm flows to speak of the those

flows have been critical in this window

and the removal of those flows doesn't

necessarily mean weakness we've referred

to this window as a as a as a window of

weakness um in the reality it's it's a

window of non strength not as exciting

not as interesting to call it a window

of non- strength but it's a window of

non- strength where demand comes off the

table it doesn't mean Supply comes on

but upside is significantly Limited in

this

window um on top of that we're entering

earnings season we just had uh awful

Bank earnings from JB Morgan and Morgan

Stanley um we broadly expect that Trend

to continue why why is earnings likely

to be U bad several reasons one margin

compression as I referenced earlier the

inflation that we're seeing is is

beginning to really hit um uh earnings

early on in the cycle that inflation me

entities could raise their um raise

their prices um why because demand was

that strong but as demand really begins

to slow a bit here due to Federal

Reserve activity and markets coming down

uh the inflation will have to go to the

bottom line for corporations the strong

dollar um about 40% of earnings for us

corporations come from the dollar uh

that dollar strength which has been

historic is going to take a significant

bite out of earnings for a lot of

multinational companies on top of that

we have a slowing of demand

um that uh is ultimately going to create

some Revenue slowdown from historic

levels um and lastly this was referenced

by Target this month but it's also

likely to be seen by much broader array

of entities entities are experiencing an

inventory whipsaw um in order to both

hedge inventory costs as well as get out

in front of of inflation entities have

built inventory dramatically and now the

significant reduction in demand is

seeing massive inventory gluts that is

going to cause a shortterm write off on

from a lot of retail entities um and

even um corporate

entities this all happens during a

period of buyback uh blackouts so as we

go into earnings here many corporations

can't um Drive the the demand for stocks

that they have been uh for the last uh

two months we've seen record BuyBacks

and that's been a major source

of of demand so right now um we are not

only losing vet and charm flows but

we're losing buyback flows right as

there's earnings risk in markets um

lastly at the end of this two week

period on the 27th we expect um the fed

the FED is coming in and at a period

right after a really hot cbii with a lot

of uncertainty right as the move index

and interest rate ball is increasing

this a particularly dangerous time where

risk is going up in the market um fed

credibility is also at stake and it's

important to note that we're also at a

period where the election will be coming

in November for

midterms and ultimately the FED does not

want to be incredibly active come

November so there's a shortening window

where the FED needs to be agressive we

believe that even despite some of the

comments that we heard today that we

still think think we'll get likely a 1%

increase now that CPI was hot um and

even though the market is saying 5050 we

believe uh that we'll continue to see an

aggressive

fed um now again the contrary argument

important to understand because

everything I've said to this point is

incredibly bearish is that positioning

particularly at hedge funds is expecting

um kind of poor outcomes um sentiment is

awful um put call equities have also

been lately in the very short term

normalizing um and VA again is

dramatically over suppli so we believe

those effects will ultimately help to

dampen downside despite what is

otherwise a very very um beish macro

Outlook any real convexity that comes to

the market and real risk that comes to

the market from other parts of the

market could really break Equity Vol and

that's what's important to look at again

that come from uh something in China

private Equity news commercial real

estate jgbs credit spreads crypto um

there's all kinds of sources that could

really create that tail and if they can

push Equity ball enough um the thing uh

there's very little liquidity outside of

S&P at Equity index

ball so here we are right at this window

um you know the Vol compression is

supportive but getting close to

short-term lows uh less Von and charm

flows less demand from BuyBacks uh less

uh demands from those V and charm uh you

know flows so window of non- strength uh

calls um are to be written in this

window much like the FED is doing um be

careful being short skewed given the

tail um and be much more cautious as we

head in what into what we believe is the

ninth eighth or ninth inning um for all

there is a significant payout sitting on

the lepton CTIC left tail that we

believe is coming in the next 3 to six

months um so head on a swivel uh as

always I wish you to be water and look

forward to chatting next month thank

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