Global Macroeconomic Summer
is on the Horizon

Unraveling the Macro Map

G20 and Emerging Markets Entering Macroeconomic Summer

After more than two years of navigating through treacherous seas, marked by the tumult of financial maelstroms (regional bank crisis), the constriction of the credit currents (tighter lending), a worldwide downturn in the forges and foundries that fuel our industries (global industrial recession), one of the most enduring tempests ever to batter the cyclical activities of our homeland, and one of the longest spans under the shadow of diminished treasure (negative real income growth and cumulative loss of purchasing power), the cyclical seas of our economy are at last showing signs of calm (finally flashing stabilization).

Specifically, with the USA as the world exporter of its inflation, our domestic inflationary outlook has global implications, which, together with the bottoming of the global industrial recession, is powering the likelihood of twin tailwinds in growth and inflation (macroeconomic summer) for the balance of the year across a majority of foreign economies.

Effectively, both the G20 (the world’s largest economies) and emerging market economies are likely headed into macroeconomic summer.

Below, we shall map out the currents impacting our voyage as the macroeconomic summer sun climbs high, revisiting the ways we sail our long short long ship Drakkar through the swirling eddies of bottom up investment flows and amidst the top down macroeconomic weather conditions.

After all, the bottom up investment flows and the top down macro weather conditions can often interact at cross purposes.

We will assess the specters that loom: the softening strength of workers, the intensifying divide in the prosperity between the earls and the masses, and the cumulative/lagged bite of macroeconomic fall and winter’s frost that threatens to end the beginning of the current macroeconomic summer season.

Higher For Longer: Deficits, Debt, and Inflation

The tidal inflation forecast for 2024 is one coming in rather than going out which stands in stark contrast to what happened in most of 2023.

Specifically, the late-year resurgence of our longhouses' values (housing reflation), the violent escalation of voyage costs (global shipping costs), and a gradual end to the monetary gods’ lowering of the sea level (a slowing/end to Quantitative Tightening) will all constrain the ability for the inflation tides to keep retreating.

This results in a higher for longer interest rate weather pattern that is at the heart of our macroeconomic summer and fall outlook for most of 2024.

Interest rates are not the only macroeconomic force that is higher for longer.

The USA is keen on sailing its debt/deficit longship with oars all in and sails billowing (flank speed), heedless of caution. The earls in Washington, whether under the banner of an election year or not, seem as immovable as ever on this issue. After all, just look at the historical scrolls of the past 8 years on that front.

The Drakkar’s Portfolio Performance and Positioning

How We Sail

In order for the following assessment of the Drakkar’s investment performance to make the most sense, let us quickly summarize our risk management process for how we sail the Drakkar.

As a reminder, a long position (the most common type) means you make money when prices rise. A short position (far less common) means you make money when prices fall.

One of the biggest mistakes investors (both pros and amateurs) make is selling winners too soon and bag holding losers too long.

How many of you have stared at your cost basis (deep in the red) and just held the position hoping it comes back to breakeven?

Hope is not a strategy.

Our risk management process is designed to increase the odds we keep winners longer and exit losers sooner while minimizing one’s feelings about any given exposure so that staying calm and rational is easier for the commander, the crew, and the passengers.

In the simplest sense, we have two completely different risk assessment models that operate at very different altitudes of analysis:

1. Top Down Macro Fundamentals (#Macro: High Altitude and Slow Moving)

2. Bottom Up Quantitative Indicators (#Quant: Low Altitude and Fast Moving)

Green = All Clear

Red = Warning

Scenario A: #Macro and #Quant
When both the #Macro and the #Quant say green, then consider adding a long position or buying more of the existing long position up to the maximum size permitted. You are probably correct in your analysis and possibly more right than you realize.

Scenario B: #Macro and #Quant

When the #Macro says green but the #Quant says red, then don’t enter a long position. If you have an existing long position then exit (perhaps you started in Scenario A but it degraded to Scenario B). The macro weather might be changing adversely before the #Macro detects it. Additionally, you might be mistaken in your #Macro analysis and the #Quant is detecting adverse developments.

Scenario C: #Macro and #Quant

When the #Macro says red but the #Quant says green, then consider adding a long position but make it a minimum position. The weather might be changing favorably before the #Macro detects it. If the #Macro eventually concurs and says green, then increase the long position to levels fit for Scenario A. Conversely, if the #Quant then degrades and says red then exit as the weather conditions are likely transitioning to Scenario D.

Risk Scenario D: #Macro and #Quant

When the #Macro says red and the #Quant says red, then don’t take a long position. If you have an existing position then exit the entire position.

Summary

Effectively, the #Quant model serves as a “thesis validation check” because the input into the #Quant’s risk models are critically NOT from your own perspective.

It helps you exit losers sooner (or avoid buying into a loser) which is most valuable when YOU do not understand why the position is performing poorly.

It also helps you stick with winners longer (or avoid selling a winner too soon) which is also valuable when YOU do not understand why the position is performing so well.

Just because YOU don’t understand something does not mean it is therefore a mystery for EVERYONE else.

For some, their process attempts to buy the bottom akin to the axiom “the early bird gets the worm”.

Of course, no one talks about the cost of buying too early (it wasn’t the bottom that you thought it was) akin to the hawk preying upon the too eager early bird.

For us, the nature of our process means we will not likely buy the bottom but we also don’t ride the position to the bottom. Our axiom is more akin to “the second mouse gets the cheese”.

Finally, most other investors/allocators are only able and willing to express their investment positions (however they determine WHAT TO DO) in some combination of long equities and credit which is akin to a canoe with only two oars.

We on the other hand can go long or short across equities, credit, rates, currencies, and commodities along with options for all of the aforementioned.

Equities

Performance

Returns in our equity positions were materially positive for the quarter while most major equity indices posted modest gains.

We outperformed US Small Equities, Non-US Developed Equities, and Non-US Emerging Equities.

While we underperformed US Large Equities, it was a close second as we captured over 80% of the upside from US Large Equities. This is all the more pleasing given the far more diversified positions that we took and yet we captured the majority of the upside from this top performing index.

Our relative outperformance can be attributed to our overweight positions in US Large Equities with strong tilts to technology and growth as well as sector overweights in housing, defense, and insurance.

New Positions

• Countries

  • Sweden

  • Germany

  • South Korea

• Sectors

  • Carbon Based Energy (oil/gas)

  • Housing

  • Technology

• Factors

  • Large Cap Growth (large companies with strong growth characteristics)

  • Mid Cap Growth (mid companies with strong growth characteristics)

The incoming top down #Macro began to indicate favorable macro economic weather patterns for these exposures and the bottom up #Quant from Mr. Market began to incrementally concur.

Exited Positions

• Countries

  • Israel

  • Brazil

  • Colombia

• Sectors

  • Atomic Based Energy Miners (Uranium)

  • Physical Uranium U3O8 or “yellowcake”

  • Utilities

  • Gold Miners

We exited these positions as some of the incoming top down #Macro began to indicate unfavorable macro economic weather patterns for these exposures and all the bottom up #Quant from Mr. Market began to incrementally concur.

Maintained Positions

• Countries

  • India

  • Philippines

  • Netherlands

• Sectors

  • Healthcare

  • Insurance

  • Defense

The incoming top down #Macro continued to indicate favorable macro economic weather patterns for these exposures and the bottom up #Quant from Mr. Market continued to incrementally concur.

Bonds

Performance

Returns in our bond positions were materially positive for the quarter as most major bond indices posted slight losses.

Our relative outperformance can be attributed to our overweight positions in short duration US Treasury Bills and our selling of call/put spreads to harvest option income.

New Positions

None

Exited Positions

None

Maintained Positions

US Treasury Bills + Option Spread Selling Overlay

We currently are maintaining our positions to US Treasury Bills which provide an excellent base layer rate of return of approximately 5.4%. This combined with the overlay of option spread selling for option premium income further boosts this into the mid to high single digits.

As a reminder, selling call/put spreads is akin to selling fire insurance (collecting a premium of say $100) and then buying firestorm reinsurance (spending a premium of say $10) thus resulting in a net premium collection of $90 in a downside risk hedged manner.

As of this writing, the material call/put spread exposures are:

• Stocks

  • Russell 2000 (small US companies)

  • Biotech

  • Oil and Gas Exploration and Production

Newly Issued Agency Mortgage Back Securities (MBS)

As a reminder, Agency MBS effectively has no credit risk as they are backed by the US Federal Government.

Newly issued Agency MBS means mortgages that have just now been created with their associated interest rates of around 6% which stands in stark contrast to the majority of existing Agency MBS whose interest rates are 3% or lower. Moreover, the majority of Agency MBS exposures available to most investors is the older and inferior cohort of 3% or lower interest rates.

Relative to history, newly issued Agency MBS are paying substantially more than usual which is what attracted us to the space i.e. we love statistically high levels of compensation for a given unit of risk.

At a macro level, it is a powerful tailwind to those willing to lend for new mortgages when someone as large as the US Federal Reserve is no longer buying Agency MBS thru its quantitative easing (QE) programs. This means the largest price insensitive buyer (or lender to mortgage borrowers in this case) is no longer crowding out private capital.

The incoming top down #Macro continued to indicate favorable macro economic weather patterns for these exposures and the bottom up #Quant from Mr. Market continued to incrementally concur.

Alternatives

Performance

Returns in our alternative positions were materially positive for the quarter.

We outperformed US Small Equities, Non-US Developed Equities, Non-US Emerging Equities, and Global Bonds.

While we underperformed US Large Equities, it was a close second as we captured over 70% of the upside from US Large Equities. This is all the more pleasing given that the alternatives sleeve isn’t designed to outperform or compete with equities but rather to generate return sources that are low to negatively correlated to both equities and bonds.

Our outperformance can be attributed to our long positions in Bitcoin and Dry Bulk Shipping (think the cost to ship something via big oceanic container ship) and shorts in US 5 Year Treasuries, Natural Gas, Corn, and Wheat.

New Positions

Dry Bulk Shipping Futures

This is a pure-play exposure to the cost of dry bulk shipping.

Simply, if the cost to ship something via oceanic container ship goes up we then profit.

On a micro level, the geopolitical hot zone that is the Middle East and the global seaborne trade that is being interrupted by the Houthis attacking container ships means a large portion of those ships must sail around the continent of Africa (not a small detour) which of course means the cost of shipping has gone vertical.

This is in addition to drought levels at the Panama Canal preventing canal locks from functioning.

All of this is inflationary but it also means a hall of fame return experience for those who were long dry bulk shipping futures.

Silver

The incoming top down macro economic data began to indicate favorable macro economic weather patterns for these exposures and the bottom up quantitive indicators from Mr. Market began to incrementally concur.

Exited Positions

Diversified Quantitative Investment Strategies

These sets of strategies continue to behave as expected. The shifting macroeconomic weather patterns to some combination of summer and fall meant there were simply better opportunities to be had and as such the positions were exited.

Maintained Positions

Bitcoin + Option Spread Selling Overlay

To be clear, we are not laser eyed quasi religious zealots on Bitcoin (or any other asset). This asset is highly sensitive to the rate of change in real interest rates and global central bank balance sheet activity. Moreover, it typically performs best in macroeconomic fall (slowing economic growth rates and accelerating inflation rates).

This combined with the layering of selling call/put spreads for option premium income further boosts return potential.

As of this writing, the material call/put spread exposures are:

• Stocks

  • Russell 2000 (small companies)

  • Biotech

  • Oil and Gas Exploration and Production

As a reminder, we went long Bitcoin in Q1 2020 and exited in Q1 of 2022 which means we incurred the majority of the bull run for 2 years and exited largely before the substantial crash that occurred thru the rest of 2022. We then added the long position back in Q4 2023.

Trending Following Multi Asset Class Managed Futures

As a reminder, these strategies are trend followers in that they go long what is trending up and short what is trending down using price, volume, and volatility models. The scope of what trends can be harnessed spans all asset classes of equities, credit, rates, commodities, and currencies.

Moreover, it was these strategies that materially protected our capital in 2022 when virtually every long only vanilla stock and bond investor got crushed.

As of this writing, our positions are:

• Long

  • Commodities: Live Cattle, Crude Oil, Copper, Gold, Soybean Oil, Silver, Cotton

  • Rates: US 30 Year Treasuries

  • Currencies: None

  • Equities: S&P 500, MSCI EAFE

• Short

  • Commodities: Natural Gas, Corn, Wheat, Sugar

  • Rates: 3 Month CORRA, 3 Month SOFR, US 2 Year Treasuries, US 5 Year Treasuries, US 10 Year Treasuries, Canadian 10 Year Treasuries

  • Currencies: Japanese Yen, Euro

  • Equities: MSCI Emerging Markets

The incoming top down #Macro continued to indicate favorable macro economic weather patterns for these exposures and the bottom up #Quant from Mr. Market continued to incrementally concur.

The Top Down Macro Fundamentals

As a reminder, there are two key reasoning methods to our analytical framework:

1. The rate of change over time is more important than the level.

2. Bayesian Reasoning is superior to Frequentist Reasoning.

Rate of Change Over Time

For example, driving at 100 miles per hour is your speed.

If you maintain that speed your rate of change is 0.

If you go from 100 miles per hour to 0 miles per hour that is a negative rate of change or deceleration.

If you go from 100 miles per hour to 200 miles per hour that is a positive rate of change or acceleration.

Now, if you go from 100 miles per hour to 0 miles per hour in 60 seconds that is a leisurely pace to a full stop.

If you go from 100 miles per hour to 0 miles per hour in 0.1 seconds…well you are pink mist i.e. the rate of change is a life or death matter.

You might think that example is humorous but not applicable to markets or economies. If so, I invite you to go speak with the stockholders of Silicon Valley Bank, First Republic Bank, and Credit Suisse.

I will wait.

Bayesian Reasoning vs Frequentist Reasoning

Imagine you're trying to determine if the driver near you is drunk based on how they're driving.

Using a Frequentist Analytical Approach is like saying:

• A drunk driver is on the road near me on average 1% of the time.

• Therefore there is a 1% chance at any given moment a drunk driver is near me.

It's a static rule based on past observed behavior to inform one’s judgment.

On the other hand, using a Bayesian Analytical Approach is like saying:

• Given that the driver in front of me is driving erratically for no obvious reason, there is a higher chance he/she is drunk.

• Moreover, it is 1 AM in the morning after New Years Eve and I am driving by a lot of popular bars so there is even a higher chance he/she is drunk.

• Furthermore, the car in front of me is a specific car model that has a higher rate of DUIs relative to others.

• Therefore, there is a very high chance under these specific conditions at this specific moment in time that the driver near me is drunk and therefore I need to increase my distance and consider a different route home.

It's a dynamic approach based on continuous ingestion of new information to inform one’s judgement.

Naturally, frequentist analysis requires less work since there is minimal need to gather new data since it is largely fixed rule based.

Bayesian Reasoning is clearly more work since it constantly requires gathering new information and computing updated probabilities to inform action.

Ask your advisor if they use Frequentist or Bayesian reasoning in their investment process.

You decide what analytical approach you prefer for your wealth management.

With that established, let us proceed…

USA Sailing Into Macroeconomic Summer

Regional and National Surveys show things are getting less bad.

Less bad on Retail and Restaurant Traffic.

Cycles do not inflect at precise moments but rather are phase transitions. Think how water that is right at the freezing point can have portions that are still liquid and other portions becoming more solid ice. We think we are at that inflection phase transition.

Global Manufacturing PMIs suggest things are becoming less bad. Again, the correct question is asking if circumstances are getting better or worse (rate of change approach) as opposed to things being good or bad (level of things approach).

Specific nations that are very export centric are another good measuring point of where we are in the macroeconomic cycle. They are indicating macroeconomic spring and summer is here.

Domestic industrial production growth has been positive or accelerating in 3 of the past 4 months.

Manufacturing again looks less bad.

Cyclical Industries like trains and trucks concur.

Almost every leading indicator for ISM is signaling additional upside in the coming quarters.

Bank lending standards are loosening and loan growth is accelerating alongside business CAPEX growth.

CEO confidence is at 2 year highs in Q1 2024 while economic sentiment is in positive territory for the first time since 2021.

There is a broad acceleration in revenue and earnings revisions.

Housing and builder confidence has inflected. Domestic GDP is less likely, on the margin, to breakdown so long as housing/house prices remain solid. Housing/house prices will remain solid so long as labor doesn’t weaken and interest rates don’t increase too much. This also means an acceleration in Housing/Housing Prices is a primary catalyst for those higher interest rates.

Despite these indicators that macroeconomic summer is on the horizon, let us discuss some of the risks to this outlook.

For diffusion Indices like the ISM, mean reversion is simply an eventuality. While stabilization may be promised, a durable acceleration is not.

Let us take 2018 as a case study. Macroeconomic spring is generally but conditionally bullish. Measured and progressive rate increases often reflect a strong/strengthening economy and thus are typically absorbed.

Most of 2018 was characterized by a progressive rise in yields and positive returns for equities and housing unless a crescendo in inflation angst drives a jump in interest rate volatility and a “too high and too fast dynamic” in yields.

This results in equities having a bond problem i.e. correlations go to 1 and they both go down. So much for the 60/40 portfolio being diversified.

This is similar to what happened in Q3 2023. Here its macroeconomic spring instead of macroeconomic summer and we’re showing interest rate volatility vs high beta equities instead of the correlation.

The point is the same though.

It doesn’t matter if it’s inflation fear or angst around Treasury/Duration supply, too far and too fast in rates reverberates negatively across asset classes.

The risk of a (negative) overheating scenario is just higher in macroeconomic summer as inflation is already accelerating.

There are lagged impacts and there is a cumulative deterioration reality for many who are not in the top 20% whether it is the household or the business.

Higher for Longer means the pressure likely intensifies for many.

The bottom 50% of the US population exists in a totally different reality relative to the top 50% especially from the starting point of this most recent interest rate hiking cycle.

For the top 50%, their assets are earning more.

For the bottom 50%, their liabilities (debt) are more costly than ever and they have no assets to earn more on.

401k hardship withdrawals continue to accelerate as well as the percentage of workplace savers who are taking hardship withdrawals.

Rates moved from 0% to 5% at the fastest pace ever.

For households or small business vulnerable to rates who were viable at 0%-2% but are progressively bleeding out at 5.5%…well 1 or 2 or 4 cuts really will not make a difference as the number of interest rate cuts needed to make them a going concern is likely in the low teens.

For those in that situation, the bleed out is going to continue.

Interest payments will continue growing more than interest income and multiples of disposable income growth.

Still no green shoots for the consumer credit cycle yet.

Meanwhile in California, the world’s 5th largest economy just casually revises away all job gains in 2023.

The -277K revision takes employment gains over the September 2022-September 2023 period down to 50K from the initial estimate of 325K.

That is a whopping reduction by 85% of the original estimate.

The divergence between the Household and Establishment Surveys (different methods to measure employment) that opened up in March 2022 refuses to resolve.

In fact, it’s widening at a faster rate.

At face value we either added +794K jobs or lost -898K jobs over the past three months depending on your measuring tool of choice.

Moreover, the growth in part time job holders and multiple job holders grew faster than just full time job holders.

In its employment revision report, California is suggesting the more accurate employment data is more closely tracking the Household Survey data.

According to the Bureau of Labor Statistics (BLS), employment gains over the past 2 years are exclusively a function of an increase in foreign born workers.

Updated population and immigration numbers from the Congressional Budget Office (CBO) which were revised higher by more than 3 million from 2021-2023 offer a (partial) explanation.

The most leading components of the labor data continue to deteriorate i.e. it is NOT less bad yet.

Still no bottoming here in job losses but Jerome Powell says he sees NO evidence of labor market deterioration! Full-time employment is now negative Y/Y while permanent job loss continues to go up.

Overall, the conditional probabilities indicate intermittent macroeconomic summer with elevated risks of macroeconomic fall.

Sailing the very different sea conditions of macroeconomic summer versus macroeconomic fall are not a problem for the Drakkar.

Others, however, are simply paddling away in their canoe with the implicit requirement of macroeconomic spring or macroeconomic summer.

Higher For Longer: Rates, Deficits, and Debt

Rising levels of Debt-to-GDP do correlate with slower real economic growth, especially out on the tail. While there are countries with slower growth that also have lower levels of debt, there is a striking lack of growth among countries with the highest levels of debt. Japan, Greece, Italy are all in the 0%-1.5% growth range.

The CBO long-term projection has total federal debt held by the public growing to $146 Trillion by 2054, 30 years from now. That is nearly 6x the current outstanding debt. This assumes no wars, recessions, shocks of any kind.

The transition from Phase 1 to Phase 2 was extraordinary. The transition from Phase 2 to Phase 3 will be extraordinarily painful.

Liquidity will reemerge as an issue again in 2024. The Fed’s RRP is falling, the Fed is planning QT slowdown and Issuance will be rising. Janet Yellen will have to make another duration decision with the next Quarterly Refunding Annoucement.

The CBO projects net interest will exceed $5.5 trillion annually by 2054. That is more than 8x 2023 levels of $659B. Meanwhile, GDP is projected to be ~3x its 2023 level.

CBO average effective interest rate assumptions are that rates will remain in the 3-4% range over the next 30 years while debt-to-GDP grows to 170%. This is despite rates being almost 10% back when debt-to-GDP was a mere 25%.

After ~50 years of spending sobriety, the ZIRP party of the last 15 years ushered in a Modern Monetary Theory mentality (spend whatever we want without consequence).

Phase 3 (the next 30 years) is going to be a 30 year hangover.

Deficit spending has gone wild. Congress has no one to blame but itself. After running “tame” deficits averaging 2% of GDP per year from 1962-2007, deficits jumped to average 6% of GDP from 2008-2023 and are projected to average 7% from 2024-2054 with no tail risk assumptions.

Let us not forget that the CBO has tended to underestimate deficits. The CBO estimated the 2023 Fiscal Deficit would be $1.376T when it published its estimate in May 2023. They just published the Feb 2024 update and reported the 2023 Actual Deficit came in at $1.7T. Just a casual -$325B error.

At near maximum employment (unemployment: 3%-4%), Deficit-to-GDP should be 1%-2%.

Instead, it’s projected to run at 5%-9% annually for the next 30 years, levels more consistent with unemployment of 8%-12% or as high as unemployment was at the peak of the GFC.

As this chart shows, since 1948, there have only been 7 years with larger deficits as % of GDP.

Those seven years either saw titanic dislocations due to exogenous events/recessions (2020, 2021, 2009) OR were years marked by extremely high unemployment (1983, 2010-2012) (unemployment rates ranged from 8%-11%).

At the current level of unemployment, deficits should be ~1% of GDP, or ~$260 Billion, not $1.7 Trillion. This difference would shave 5%-6% off of GDP.

The February acceleration in diesel prices in rate of change terms (highlighted in the gray bar below) will exert upward pressure on March Headline CPI at the same time the easing base effects are more broadly pushing back against disinflation.

Looking ahead to April, March crude oil prices are accelerating on a rate of change basis, also portending higher for longer for April’s CPI.

After falling from $5 a gallon to $3, prices at the pump are poised to climb higher over the next 12 months.

Geopolitics are poised to reaccelerate inflation later this year.

Freight cost up +105% YoY is starting to look like November 2020.

The impact to CPI will start in Late 2024/Early 2025.

Are we sure inflation risk has been vanquished?

Headline Inflation is still above target, Core measures and Wage growth are still running ~2X target.

Home Price Growth is re-accelerating and a meaningful cross-section of price series are already reinflecting.

The risk of wages reacceleration is rising.

How about a scenario in which the Fed cuts rates aggressively into improving organic conditions like macroeconomic spring or summer?

2024 Deficits will again be YUGE! … but, as always, it’s about the rate of change and not the level.

Government acceleration in wage growth and percentage of new jobs continues.

The Fed has around 4-5 months before it needs to fully wind down quantitative tightening (QT), adding to the pro-inflationary backdrop later this year.

As a reminder, the Fed’s Reverse Repo Balance (RRP) is effectively like a checking account directly at the US Federal Reserve that pays a risk free rate of about 5.3%. These funds slosh around between the Fed and US Treasury Bills.

Once the RRP approaches a low balance, the US Federal Reserve and the US Treasury begin to compete with each other for funds which is the impetus for QT ending.

Foreign holdings of US Treasuries have declined from 32% to 28% in the last two years. Ex-China, foreign holdings have declined from 28% to 25%.

Falling foreign demand at a time when issuance is going to be in secular increase doesn’t bode well for a return to low rates.

At the same time foreign holdings of US Treasuries have been waning. Foreign central bank holdings of gold as a share of reserves have been climbing across every major economy.

G20 And Emerging Markets Moving Into Macroeconomic Summer

USA manufactures and exports its inflation to the rest of the world. The price of fiscal drunkenness is paid abroad via dollar-based system of global trade and finance.

Global shipping costs are materially accelerating.

A large part of this move is due to Asian vessels bound for the US East Coast diverting plans due to issues at the Panama and Suez Canals; however, there is a broader trend here.

Copper as the choice metal of highly cyclical industries like construction and industrial machinery manufacturing is breaking out.

Oil is also signaling macroeconomic summer.

China is coming out of an industrial recession.

China is having a rate of change improvement in industrial profits.

The broad metals complex is signaling macroeconomic summer.

Coal which powers 55% of Chinese energy consumption is moving in tandem with the Chinese industrial reactivation.

The Asia Pacific Region’s exports are being led by semiconductors with the US being the largest customer.

Expectedly, industrial electricity consumption in Taiwan is accelerating as seen in NSA units per person YoY.

The Bottom Up Quantitative Indicators

Today, much of daily trading is driven by rules based mechanical flow. Understanding the trigger levels and estimated magnitude of flows associated with Volatility Control Funds, Commodity Trading Advisors, Risk Parity Funds, and Passive Funds (think Vanguard Funds) is key in tactically risk managing the immediate term.

Moreover, we must always consider that the price of a thing is set on the margin i.e. the last trade for something has set the most recent price.

Finally, let us use the analogy of a water and a water pipe to illuminate in a tangible sense the following component (one of many) in our bottom up quantitative models.

Dealer Gamma

Simply, Dealer Gamma is a akin to the valve on a water pipe i.e it sets the intensity of water volume (investment flows) going thru the water pipe.

When Dealer Gamma is negative, it tends to amplify price and volatility movements. The valve opens up more investment flows in the same direction of the market’s price movements. This generally means that trend following strategies tend to work.

When Dealer Gamma is positive, it tends to suppress price and volatility movements. The valve opens up more investment flows in the opposite direction of the market’s price movements. This generally means that mean reversion strategies tend to work.

As of this writing, Dealer Gamma is likely slightly positive.

Volatility

If Dealer Gamma is the valve for investment flows, then volatility is the toggle for investment flows i.e. are we net buying or net selling.

As of this writing, Realized Volatility is low and the 3 month realized volatility level is likely the current determining toggle.

Generally, as realized volatility falls the toggle for investment flows is generally flipped up to “net buying”.

Conversely, as realized volatility increases the toggle for investment flows is generally flipped down to “net selling”.

While these flows have been beneficial in the short term for those with long positions, one key point to reiterate is that the systematic community is already near peak exposure levels, which means most of the supportive flow from these funds has already made its way into the market.

While we don't see any immediate catalysts that would make these strategies hit the panic button, should one occur, we suspect these funds would put a significant amount of selling pressure on the market.  

The information in this document is provided in good faith without any warranty and is intended for the recipient’s background information only. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations.