Macro and Flows Update: July 2022 - e07
Summary
TLDRThe 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
- π Inflation is experiencing a secular increase, with a recent high reading of 99.1% on CPI.
- π The current inflation is believed to be driven by populism, fueled by income inequality resulting from 40 years of supply-side economics.
- πͺοΈ Populism is growing due to political shifts influenced by the younger generation, leading to increased focus on equality and justice in policy-making.
- π° The Federal Reserve's monetary policy is struggling to control inflation secularly, and the long-term outlook suggests a continued increase in inflation rates.
- π 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.
- π‘οΈ The Federal Reserve is attempting to dampen long-term inflation expectations to prevent demand pullforward and avoid an inflationary spiral.
- πΉ The cost of money is increasing, leading to market multiple contractions, margin compression, and a reverse Tina effect favoring bonds over stocks.
- π The market is currently in a state of reduced liquidity, particularly in interest rates and bond spaces, with equity volatility remaining relatively muted.
- π The US dollar has been strengthening, causing global market dislocations and increasing the risk of a debt crisis in dollar-denominated assets.
- π¨ The market is facing several risks including widening credit spreads, high yield and junk bond issues, and potential geopolitical tensions involving China and Taiwan.
- π 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
π 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.
πΉ 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.
π 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.
π¦ 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.
π 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.
Mindmap
Keywords
π‘Inflation
π‘FED (Federal Reserve)
π‘Populism
π‘Interest Rates
π‘Fiscal Policy
π‘Market Liquidation
π‘Dollar Strength
π‘Quantitative Tightening
π‘Volatility
π‘Supply and Demand
π‘Market Sentiment
π‘Earnings Season
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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