USA Economic Winter
is Here

Unraveling the Macro Map

USA Entering Economic Winter

After 25 months of a trending slowdown off the business cycle peak in November 2021, the business cycle will slouch into its final phase. The combination of further and organic deterioration combined with the hardest comparisons of the business cycle will conspire to drive another material deceleration in Q1 2024. We will detail the macroeconomic winter weather pattern and its rate of change asymmetry that will characterize the first part of 2024. We’ll dissect the probability and risk associated with the consumer, business capital expenditures, and the manufacturing-industrial economies hitting a cumulative tipping point. We will also discuss the implications associated with the policy pivot, the prospect for and cross-asset class implications of reemergent global divergences and the risk management strategy as the distribution of macro outcomes broadens and a potential business cycle inflection comes into view as we push past Q1 2024.

The Big G Says Pucker Up

Government spending growth accelerated in each of the last four quarters, coming in at a brisk +4.9% YoY rate in Q3 2023 based on the final revision (up from the already-hot earlier estimate of +4.5%). In the last two quarters of 2023, it has grown at more than twice the rate of personal consumption expenditures in the private sector. Despite it being a) an election year and b) a year with uncapped commitments to green energy spending, total government spending’s contribution to GDP growth in 2024 will face among the steepest comparisons in years. We’ll review the setup here quarter by quarter looking out across 2024.

Macroeconomic Gravity Doesn’t Care About Narratives

While we are bearish broadly on the US Economy and many (not all) of the investment opportunities embedded therein at this time, we are sailing The Drakkar, our multi asset class long short viking warship, to more favorable waters and macroeconomic weather patterns.

After all, we like to live optimistically and risk manage realistically.

Such as….

Long India and Gold; Short Japan

We remain bullish on India as shallow economic decelerations are overlooked for the shine and "relative" acceleration of its world leading economic growth powered by buoyant domestic demand, government spending, moderated commodity prices, and strong credit growth.

We also remain bullish on gold as real yields are down and gold is up with the added long term secular tailwind of fiat debasement and real asset supremacy in the age of fiscally drunk sovereigns. We expect real yields to experience downside pressure from the two most probable outcomes: nominal yield declines on slowing growth or a reacceleration in inflation due to a premature Federal Reserve pivot into easy comparisons.

Lastly, Japan is past its peak with returns from accommodative monetary policy, a weaker yen, and heightened external demand due to exports and the wave of post pandemic tourism diminishing. Accordingly, Japan is poised for back to back macro economic winter weather patterns thru the first half of 2024.

The Drakkar’s Portfolio Performance and Positioning

Equities

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.

Performance

Returns in our equity positions were positive for the quarter with most major equity indices posting substantial gains. Our relative underperformance can be attributed to our overweight positions in non US equities and more defensive US sectors. Funny enough, our equity performance was positive in the last quarter when nearly every major equity index was negative so having positive performance back to back is quite encouraging.

New Positions

Long

• Countries

  • Israel

  • Brazil

  • Philippines

  • Colombia

  • Netherlands

• Sectors

  • Utilities

  • Health Care

  • Gold Miners

  • Defense

The incoming macro economic data began to indicate favorable macro economic weather patterns for these exposures and Mr. Market began to incrementally concur.

Exited Positions

Long

• Countries

  • Japan

• Sectors

  • Carbon Based Energy (oil/gas)

• Factors

  • Market Neutral Long/Short

We removed these positions as both the incoming macroeconomic data indicated growing probabilities of headwinds which Mr. Market began pricing in. We don’t want to overstay our welcome which can result in small losses becoming even becoming bigger losses.

Maintained Positions

Long

• Countries

  • India

• Sectors

  • Physical Uranium U3O8 or “yellowcake”

  • Uranium Miners

  • Insurance

The incoming macro economic data continues to indicate favorable macro economic weather patterns for these exposures while Mr. Market continues to concur and thus reward these positions.

Bonds

Performance

Returns in our bond positions were positive for the quarter as most major bond indices posting substantial gains. Our relative underperformance can be attributed to our overweight positions in defensive short duration US Treasury Bills and our selling of call/put spreads to harvest option income. Funny enough, our bond performance was positive in the last quarter when nearly every major bond index was negative so having positive performance back to back is quite encouraging.

New Positions

Long

• Sectors

  • 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 programs. This means the largest price insensitive buyer (or lender to mortgage borrowers in this case) is no longer crowding out private capital.

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:

• 20 Year US Treasury Bonds

• S&P 500

• Bitcoin

Alternatives

Performance

Returns in our alternative positions were negative for the quarter as most major asset classes posted substantial gains. Our underperformance can be attributed to our short positions in US Treasury Bonds. This underperformance was primarily concentrated in Q4 2023 as Mr. Market got incredibly excited that the US Federal Reserve would begin to aggressively cut interest rates in 2024 thus resulting in a massive bond rally (which results in losses if you are short). While we are not pleased with the returns, it is these same positions that rewarded us handsomely in 2022 and thus prevented the portfolios from incurring the large double digit losses that everyone else largely incurred.

New 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. The incoming macroeconomic data began to suggest the weather patterns were changing to be favorable for this asset and Mr. Market’s assessment thru prices began to concur with this assessment.

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:

• 20 Year US Treasury Bonds

• S&P 500

• Bitcoin

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 occured thru the rest of 2022.

Exited Positions

None

Maintained Positions

Quantitative Investment Strategies

These quantitative investment strategies run four distinct strategies of carry, volatility, technicals, and liquidity across the five asset classes of equity, credit, rates, commodities, and currencies.

Each systematic strategy is designed to capture proven market return premiums which when added all up is designed to provide absolute returns in a highly portfolio diversifying manner.

Managed Futures

We continue to hold a managed futures position.

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, Natural Gas, Gold

  • Rates: US 30 Year Treasuries

  • Currencies: Euro

  • Equities: S&P 500

• Short

  • Commodities: Corn, Cotton, Crude Oil, Soybean Oil, Wheat, Sugar,

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

  • Currencies: Japanese Yen

  • Equities: MSCI Emerging Markets

The Market Weather Report

What a difference a year makes!

In 2022, high inflation and the Fed’s commitment to tame it led to sharply rising interest rates and negative returns for virtually all long only vanilla traditional asset classes.

In 2023, much to the surprise of many, global equity and bond markets ignored widespread expectations that we were headed for a recession and were able to shake off a host of uncertainties to post strong gains for the year.

Aided by a powerful year-end rally, U.S. stocks (S&P 500 Index) jumped nearly 12% in the fourth quarter to finish up 26% for the year, and end within a whisper of its all-time high. Smaller-cap stocks (Russell 2000 Index), which lagged their larger counterparts for most of the year, also rallied sharply in the fourth quarter (+14%) to end the year with a respectable gain of 17%. In an encouraging sign, during the year-end rally we saw a shift in market leadership and equity gains broaden out beyond the “magnificent 7” stocks (Apple, Microsoft, Nvidia, Facebook, Alphabet, Netflix, Amazon) which had been responsible for much of the U.S. equity markets returns prior to the fourth quarter.

Developed International and emerging-market stocks also posted solid gains but weren’t able to keep pace with U.S. markets. Developed International stocks (MSCI EAFE) gained a very respectable 18%, while emerging-market stocks (MSCI EM Index) posted a nearly 10% return.

Bonds also rallied sharply in the fourth quarter aided by a significant drop in US Treasury yields. The benchmark 10 year Treasury yield declined over 100bps in the fourth quarter resulting in a 6.8% return for the Bloomberg U.S. Aggregate Bond Index. Interestingly, despite massive intra-year volatility, the 10 year Treasury yield ended the year exactly where it started. For the year, U.S. core bonds (Bloomberg U.S. Aggregate Bond Index) finished up 5.5%. Credit was a standout performer both in fourth quarter and for the full year. Junk bonds (ICE BofA High Yield Index) were up 7% in the quarter, finishing up 13.4% for the year.

The sharp fourth quarter rally was driven in large part by US Federal Reserve policy and falling inflation. The US Federal Reserve made it clear they believe the end of the war on inflation is near, and not only are they preparing to take their foot off the brake in terms of future rate hikes, but they anticipate interest rate cuts in 2024.

Looking ahead to 2024, all eyes will be on the US Federal Reserve. When will they start to cut, by how much, and why?

With US Federal Reserve policy top of mind, a key question will be whether they cuts rates because of restrictive policy in the form of high real yields (lower inflation and unchanged Fed Funds) or because economic growth slows more than anticipated.

While this question will be in focus, monetary policy is just one of many factors that will influence markets.

Geopolitical risk, the U.S. presidential election, labor markets, and inflation will likely fill the headlines and all could be sources of volatility.

Equity Markets

In November, the US Federal Reserve made it clear they believe the end of the war on inflation is near, and not only are they preparing to take their foot off the brake, they are anticipating interest rate cuts in 2024. At the same time, the US Federal Reserve also said it foresees the economy remaining relatively healthy with steady growth and modest levels of unemployment. Historically, the end of the US Federal Reserve’s hiking cycle usually serves as a tailwind for stocks.

Within the U.S. market, performance in 2023 was driven by the handful of mega cap growth stocks (dubbed the “Magnificent Seven”) and the concentration in these names at the top of the index remains at historic levels. These stocks had an average return in excess of 100% for 2023 and now represent a combined weight of more than 28% in the S&P 500 and 47% in the Russell 1000 Growth Index.

Heading into 2024, the valuation discount for developed international and emerging market stocks versus the U.S. is the widest it’s been in decades. From 2006 through 2016, the U.S. and developed markets traded within one multiple point of each other. The average forward P/E for the S&P 500 over the period was 14x compared to 13x for MSCI EAFE. Since 2016, the valuation gap has widened substantially. The S&P 500 now trades at nearly 20x forward earnings while the MSCI EAFE remains close to 13x. The story can be seen in the chart below. US stocks trade toward the top end of their valuation range while other regions offer up better relative values. Most other markets are trading roughly in line or slightly below their historic averages. All else equal, lower starting valuations imply better long term returns and provide more of a valuation cushion should multiples contract in a stock market sell off.

Earnings in the US have largely recovered from their lull in 2022. Low double digit earnings growth is the current consensus expectation for the S&P 500 in 2024. With revenue growth estimates for 2024 currently at 5.5%, the expectation is for profit margins to expand back towards all time highs. While margin expansion can’t be fully ruled out, we think it’s unlikely they’ll reach peak levels because we don’t believe companies will benefit from the same level of pricing power as they did in 2021 and 2022. Moreover, with interest costs having risen substantially over the past year, it would be a headwind to any company needing to refinance or take on new/additional debt.

Emerging markets have the highest earnings growth expectations for 2024 at over 17%. Emerging markets earnings have yet to recover following their contraction in 2022—and remain about 16% below their peak level (in local currency terms).

The main culprit for the suppressed earnings picture is China.

A strong earnings recovery was expected following the removal of their zero COVID policy in late 2022. But after an initial bounce in early 2023, earnings in China have not moved meaningfully higher. While the Chinese economy has stabilized in the second half of 2023, it has not recovered like many had expected. The COVID reopening playbook that worked for investors in the US and Europe did not provide the proper roadmap for Chinese equities.

The problems facing China are well documented at this point: a struggling real estate sector, a regulatory crackdown on the tech sector, deteriorating demographics, and heightened geopolitical tensions (to name a few). Economic optimism in China has taken a significant hit and Chinese consumer confidence is depressed.

Bonds

Looking to 2024, inflation and US Federal Reserve policy will continue to be major drivers of bond market returns.

If we rewind the clock two years to the end of 2021, rates were 0% and the market forecasted three 0.25% hikes. Instead, there were effectively 17 quarter point hikes. The market got it wrong again in 2022, when two or three 25bps hikes were expected to be followed by two rate cuts. There were four hikes, and no cuts.

The Market’s Hyper Local Weather Report

In our unending quest to improve our analysis for our client’s benefit, we began incorporating into our analysis the metaphorical equivalent of a hyper local weather analysis. In other words, market microstructure analysis.

Market microstructure refers to the study of the processes, mechanisms, and structures through which securities are traded, and how these influence the formation and evolution of asset prices. It delves into how specific trading mechanisms, like the arrangement of orders and transactions, affect price formation, liquidity, transaction costs, and information dissemination in financial markets.

In essence, while traditional finance theories might consider markets as abstract mechanisms for price determination, market microstructure examines the "nuts and bolts" of the marketplace.

Why might you ask is that even worth the effort?

In the chart below, we show how a single $1 invested in the S&P 500 compounded from 1926 to today. This covers over 25,200 trading days. Just missing the 10 best days, 10 worst days, or 10 best AND 10 worst days (all very short term time frames) makes a massive difference in the long term result of compounding capital despite being 0.039% to 0.079% of the entire timeline.

Understanding market microstructure is a powerful framework in risk managing the super short term and as demonstrated above, the super short term (a handful of days) can make a large difference in the long term when the magnitude of those key days are material.

It is NOT the average of things that matter but the specific thing that happens at the specific time.

Grasping this idea means you understand how the 6 foot man drowned in the pool that was 5 feet deep on average.

Flow dynamics (can) sit independent of fundamental trends and increasingly influence/dominate short term price action. Short term dislocations (positive or negative) might not have a fundamental reason but that doesn’t mean it didn’t happen.

With the table set, let us begin.

Current Hyper Local Market Weather Conditions

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.

When Dealer Gamma is negative, it amplifies price and volatility movements. When Dealer Gamma is positive, it suppresses price and volatility movements.

Volatility remains the primary exposure toggle – directly for Volatility Sensitive Strategies and indirectly for everyone else (even if they don’t conceptualize it that way).

Understanding the trigger levels and estimated magnitude of flows associated with Volatility Control Funds, Commodity Trading Advisors, Risk Parity Funds, and Passive Funds is key in tactically risk managing the short term which as previously illustrated can make a material impact to one’s long term wealth.

As of this writing, dealers remain in negative gamma and intraday volatility on both sides remains firmly the story of the day. The high degree of market distortion suggests that futures and index ETFs are the preferred trading vehicles and strong outperformance by higher quality large caps is indicative of stock investors rotating (when they can) into defensive positioning. That this defensive positioning tends to correlate with buying the largest stocks in the S&P 500 leads to confusing market behavior – occasionally big stock prices UP is risk off!

Longer term context for the implications of Negative Gamma Environments helps illustrate the utility of this analysis more clearly.

Notice that when dealers are in positive gamma (green), S&P 500 (equities) has a tendency to drift up smoothly and thus “buy the dip” i.e. mean reversion strategies tend to work. For most investors, this is indirectly all they know and thus assume that is all that matters.

Conversely, when dealers are in negative gamma (red), S&P 500 (equities) has a tendency to move swiftly and thus “buy the rip” or “sell the dip” i.e. trend following strategies tend to work.

The switch from negative gamma which was most of Q3 2023 (we were positive for that quarter when every long only vanilla investor was down) to positive gamma around the end of October was likely a material part of the vicious rally in stocks and bonds from October until end of December.

Despite this switch in gamma regime, we also were up for Q4 2023 after being up for the prior quarter as well. This back to back positive performance compares favorably to those who were long only vanilla investors who were materially down in Q3 2023 and then up materially in Q4 2023.

Part of how we were able to post back to back positive performance quarters was due to our analysis of the market microstructure which pointed us in the direction of reducing equity hedges once the gamma regime flipped to positive.

The Global Economic Weather Report

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

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

2. Bayesian Reasoning is superior to Deterministic 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 Deterministic Reasoning

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

Using a Deterministic 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 approach 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, deterministic 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.

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

With that established, let us proceed…

Here is a quick illustration of how different global macro weather patterns impact long only vanilla exposure to the S&P 500.

We continue to see deceleration in Net Income Growth for both US Large Stocks and US Small Stocks.

As stated earlier, Big Government came in with big guns blazing stimulus which can be seen both in its contribution to GDP Growth Rates and Employment Growth Rates.

The distortions between GDP and GDI are layering upon each other which of course occurs during critical inflection points in the business cycle.

Non Farm Payrolls (NFP) had 10 negative revisions out of the past 11. Cumulative negative revisions are now -443K for the period and have represented 15% of the original estimate, on average. In effect, NFP has been overstated 90.9% of the time for the past 11 months by a magnitude of 15%.

The services portion of the US economy makes up most of the US economy. The ISM Services Employment index has gone sub 50 (breakeven level between expansion and contraction) which is clearly contractionary evidence.

Hiring announcements are at all time lows and hiring rates are speeding toward the ground.

The average weekly hours worked which is a powerful leading indicator continues to be negative.

The “birth death adjustment” has accounted for 40% of the employment gains over the past year.

This adjustment is an imputed calculation and attempts to model how many businesses were born and died over the period and therefore how many net jobs were created or eliminated from it.

The spike that occurred during the pandemic ran parallel with $200 billion in fraudulent loans as people were incentivized to form “businesses” to receive stimulus funds.

Has the underlying reason for the anomalous spike in business formation (which informs the birth death adjustment) and the associated follow on distortion to the employment data been adequately vetted?

Temp staffing and overtime hours continue to make new lows.

Permanent job losses and duration of unemployment continue to rise.

FLOWS ≠ FUNDAMENTALS but they are intimately and increasingly linked via employment.

Passive flows (think automatic 401k contributions buying Vanguard/Blackrock/etc target date funds whose algorithms are the world’s simplest of “you give me cash and I buy the index or you request cash and I sell the index”) and the autopilot bid to assets (intimated tied to equity indexes that are often market capitalization weighted which means they are heavily weighted to you guessed it the Magnificent 7 of Apple, Microsoft, Google parent Alphabet, Amazon.com, Nvidia, Meta Platforms and Tesla) tethered to employment is roughly $60 billion per month!

The end of cycle labor capitulation and potential reverse of those flows is what hard landings and nonlinear market outcomes are made of.

This collection of impacts cluster and crescendo at the very (very) end of the business cycle.

January 2023 Cost of Living Adjustments (COLA) and Social Security Income Payments = +9% M/M, +11.5% Y/Y. The COLA Increase for 2024 will decelerate to +3.2% and represents a notable drag with respect to growth in consumption capacity.

The Employee Retention Tax Credit (ERTC) was a pandemic tax credit available to small businesses and non profits as an incentive to keep works employed and allowed small businesses to receive up to $26,000 per employee.

It’s been fraught with fraud and abuse which is why the IRS shut it down in September 2023.

In fact, Danielle DiMartino Booth who used to work at the Dallas Federal Reserve and is apart of our team was instrumental in this analysis and her work was read by the IRS which was a huge part of why this program was shut down.

The spending associated with this $250 billion in cash payments (with a LOT of embedded fraud) paid for by the US taxpayer into bank accounts of the already relatively rich cohort of business owners will have a tail but it will continue to be a drag on discretionary consumption growth.

It is easy to weather resumption of student loan payments when you don’t actual pay them.

Business CAPEX spending plans continue to decelerate.

Manufacturing orders by businesses continue to decelerate.

Diffusion Indices inherently and eventually mean revert, but ISM New Orders remains stubbornly sub 50 (contraction territory). New Orders have now been in contraction for 16 consecutive months.

The Goods Economy is more cyclical and interest rate sensitive and Goods Activity and employment leads the Services Economy.

This time is not proving different as Goods Employment deceleration continues to outpace Services and ISM Manufacturing continues to Lead ISM Services.

Industrial production growth remains negative, even exclusive of the United Auto Workers distortions.

Global trade volumes and freight shipments continue their decelerating trends.

Small business revenue is down and cost of capital is up.

Small business earnings are down.

Do we think US Real GDP growth is divorced from the main street reality of small businesses? Nope!

But but but the excess savings is dry powder that can be used to keep growth accelerating!

Perhaps but the levels of savings for the majority of US Citizens is back to where it was at the end of 2019.

In fact for the bottom 50% of Americans, their balance sheets have weakened since the start of the interest rate hiking cycle in 2022.

Food scarcity and food insecurity continues to trend upward.

401k hardship withdrawals continue their upward trend.

Credit card balances and credit card interest rates are both increasing again.

Either consumers continued to borrow more as interest rates rose further in an attempt to smooth consumption or the increase is due to accrued interest, in which case those balances will continue to compound.

Interest payments are growing faster than interest income and at multiples of disposable income growth, taking the servicing burden back up towards prior credit cycle peaks.

Consumer foreclosures and bankruptcies continue to trend upward while real wage growth continues to trend downward.

Consumer delinquencies and credit card balances continue to trend upward.

Consumer credit availability is trending downward.

Lending tightness will continue to roll through the consumer economy on a lag.

The commodities market continues to signal demand destruction.

Geopolitical friction and supply inflation is now back on the table.

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 reaccelerating and a meaningful cross section of price series are already reinflecting.

The risk of wage reacceleration is rising.

How about a scenario in which the Federal Reserve cuts rates aggressively into improving organic conditions, easier CPI/Consumption comparisons and a multi-quarter macro economic weather pattern of spring and summer?

Given the increasingly relative importance of government activity, let us measure and map what Big Government has been up to.

While Government spending accounts for 17% of GDP, it has contributed closer to 30% of the growth in GDP for 2023.

Let us look at Real Government GDP Growth YoY.

At the end of Shocktober where most investors had incurred material losses starting in July of 2023 (incidentally our managed portfolios were positive), the Big J’s of Janet Yellen and Jerome Powell both contributed to the revival of animal spirits.

With deficit spending and US Treasury Issuance panic in full crescendo, Janet’s shift to issue more US Treasury Bills (akin to financing debt with credit cards) instead of US Treasury Bonds (akin to financing debt with long term debt like a mortgage) was probably the biggest event of Q4 2023.

It came as the angst around deficits and duration supply (demand at treasury auctions was tanking), nominal yields were going vertical, the term premium had ramped dramatically, and equities were having an acute bond problem.

She went full Bill-nado and saved Christmas.

Yields fell, Interest Rate Volatility fell, Financial Conditions eased, the US Treasury Bond supply problem evaporated, and stock markets got the green light to restart the party.

The Federal Reserve’s Reverse Repo Facility (akin to having a checking account at the US Federal Reserve itself) is falling (akin to withdrawing from Federal Reserve Checking account and using proceeds to buy US Treasuries), the Federal Reserve is floating the idea out loud that the pace of Quantitative Tightening might decrease, and US Treasury issuance will be rising.

Janet Yellen will have to make another funding decision in January 2024 (increasing debt financing on credit cards or long term debt).

The deficit is projected by the Congressional Budget Office (CBO) to grow every year over the coming decade, exceeding $2.5 trillion annually in just 8 years.

The Deficit as a % of GDP in 2022 and 2023 was 5.3% and 6.3%, respectively.

This is in spite of unemployment being in the 3%-4% range during that period. This is unprecedented. 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.

Public sector jobs tend to average 5% of total payroll growth over time.

2023 has seen almost a quarter of all payroll growth come from the public sector.

The origin of Big G’s nickname of Uncle Sugar isn’t a mystery.

Zooming in to the monthly data, the trend over the last 24 months is quite clear.

Interestingly, the back half of 2023 saw government jobs account for fully 31% of total new jobs added.

This compares with 21% of total jobs added in the first half of 2023.

For broader context, looking back over the period from 2008-2022, government jobs have contributed, on average, just 1% of new jobs added over that 15 year period.

So, accounting for 31% of jobs added in the second half of 2024 really is quite remarkable.

The Federal Reserve’s Reverse Repo Balances (RRP) have been falling quickly, at a pace of roughly $7 Billion per day since late May 2023.

Extrapolating that rate of runoff, the RRP would hit zero in 100 days, or by roughly mid April 2024.

Once the RRP has been drawn down, the next domino to fall will be bank reserves. What’s unclear is what amount of reserves the Federal Reserve considers adequate.

Mid April seems like a decent starting point for talk around the timing of Quantitative Tightening’s endpoint, leaving the tightening regime in place throughout Q1 2024.

The Global Economic Opportunity Report

Long India

India’s Real GDP Growth is relatively stronger than virtually every other G20 country.

Industrial production continues to trend up.

Domestic demand is powering reacceleration of India’s manufacturing sector.

The services economy is still expanding.

India’s bank loan growth continues to trend upward.

India is sitting below its pre-pandemic level of core inflation.

Long Gold

Gold’s absolute returns in macro economic winter have been solid historically and relatively the strongest compared to the S&P 500.

Gold’s returns hold up as a safe haven asset in higher volatility environments.

A VIX level (a measure of equity volatility) shows that as volatility increases (going to the right on the charts) the forward gold return increases across multiple time horizons.

Gold produces asymmetrically positive returns in and following periods of sharply rising equity volatility.

Gold moves inversely to real interest rates (interest rates adjusted for inflation).

On a longer term basis, gold broadly tracks the increase in the US money stock (a measure of money in circulation).

Abuse and weaponization of USD has global central banks increasingly favoring hard money without counterparty risk.

Short Japan

Japanese retail sales have plateaued.

Real housing spending is negative.

Fading noise around the local peak in consumer confidence.

Japanese industrial production running into slowing global demand as seen in industrial production YoY.

Global manufacturing and CAPEX recession apparent in Japan machine tool orders YoY.

Japanese goods economy becoming steadily more contractionary as seen in Japan manufacturing PMI.

Services economy in downtrend trend towards contraction territory as seen in Japan services PMI.

Japanese credit creation in downtrend as seen by Japan bank lending and deposits growth (YoY).

Real GDP Has diverged from exports.

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