Fourth Quarter 2024 Investment Commentary
USA Macro Summer and Global Macro Fall
Unraveling the Macro Map
The USA is in Macroeconomic Summer
Macroeconomic summer is defined as accelerating economic growth rates and accelerating inflation rates.
Macroeconomic fall is defined as decelerating economic growth rates and accelerating inflation rates which of course is not the same thing as recession.
As previously stated, we expect the USA to oscillate between macroeconomic summer and macroeconomic fall for the first half of 2025.
More importantly, the USA’s probable macroeconomic weather is materially more positive relative to the rest of the world (RoW) which appears to be mostly in macroeconomic fall.
Furthermore, we will discuss our approach to risk managing the administration change and the growing constellation of known-unknowns. We will also dissect the fundamental dynamics supporting a mostly macroeconomic summer forecast in the USA for most of 2025.
Finally, rising geopolitical tensions around the world serve as an amplification of the turbulence and divergences between the USA and the RoW.
Top Trump Trades
First, we’ll discuss the most likely impacts of policy changes, focusing on tax reforms, deregulation initiatives, immigration dynamics, and shifts in trade policies.
Second, we’ll examine the implications for the US Dollar (USD) and long-term US Treasury (UST) Bonds within the broader backdrop of our macroeconomic and quantitative frameworks.
Third, we’ll look at sector exposures that are highly sensitive to interest rates and how sectors such as Utilities, Real Estate, and Staples may react to rising interest rates.
Fourth, we’ll explore the potential ramifications for the Healthcare sector, considering both the impact of policy uncertainty and the possibility of significant reforms that could reshape the industry.
The Drakkar’s Performance and Positioning
The Drakkar: Our Multi Asset Class Long Short Longship
For a refresher on how we sail our managed portfolios, click here.
The Drakkar’s Performance
As a reminder, investing is just a means to an end.
That end is accomplishing your financial goals which are measured and mapped via your custom financial plan.
Every financial plan has inside of it a required return (RR) that must be earned over the long term for the portfolio to do its part in making the financial plan successful.
As such, we will compare how the managed portfolios have performed relative to their respective required return.
We will also compare the managed portfolios to a comparable diversified portfolio.
Aggressive Portfolios
Relative to the Required Return (RR)
For the quarter, our managed aggressive portfolios materially outperformed their RR benchmarks.
For the full year 2024, our managed aggressive portfolios materially outperformed their RR benchmarks.
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Relative to Comparable Portfolio Benchmarks
For the quarter, our managed aggressive portfolios materially outperformed their aggressive portfolio benchmarks.
For the full year 2024, our managed aggressive portfolios materially outperformed their aggressive portfolio benchmarks.
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Moderate Portfolios
Relative to the Required Return (RR)
For the quarter, our managed moderate portfolios materially outperformed their RR benchmarks.
For the full year 2024, our managed moderate portfolios materially outperformed their RR benchmarks.
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Relative to Comparable Portfolio Benchmarks
For the quarter, our managed moderate portfolios materially outperformed their moderate portfolio benchmarks.
For the full year 2024, our managed moderate portfolios materially outperformed their moderate portfolio benchmarks.
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Enhanced Cash Reserve Portfolios
Relative to Comparable Portfolio Benchmarks
For the quarter, our managed enhanced cash reserve portfolios materially outperformed their cash reserve portfolio benchmarks.
For the full year 2024, our managed enhanced cash reserve portfolios were in line with their cash reserve portfolio benchmarks.
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Traditional Cash Reserve Portfolios
Relative to Comparable Portfolio Benchmarks
For the quarter, our managed traditional cash reserve portfolios marginally outperformed their cash reserve portfolio benchmarks.
For the full year 2024, our managed traditional cash reserve portfolios marginally outperformed their cash reserve portfolio benchmarks.
The Drakkar’s Positioning: The Equities
Performance
For the quarter, our equity returns were materially positive and materially outperformed the world equity benchmark.
The primary contributors to this outperformance were our exposures to
West Texas Real Estate where we own the oil, gas, and water rights.
Bitcoin.
Japanese small companies that are currency hedged. This means the exposure is NOT impacted by the exchange rate between USD and Japanese Yen (JPY).
US large companies where we filter out overvalued low quality companies run by poor management teams.
Moreover, much of the outperformance came from having low to no exposures to Europe and Emerging Markets which performed very poorly over the period. Incidentally, the weather pattern in those areas were various forms of macroeconomic fall and macroeconomic winter which are generally headwinds to equities.
New Positions
No new positions.
Exited Positions
None
Maintained Positions
US Large Company Equity Exposure
Our US Large Company Equity exposure is one that seeks to earn superior long term returns with lower downside risk by quantitatively removing overvalued low quality companies run by poor management teams. For example, these negative factors that we filter out include:
High External Financing: companies that are over reliant on external capital through high debt or stock sales.
Wealth Destroyers: companies that reinvest but generate economic returns below their cost of capital.
Value Traps: companies where intrinsic value is lower than book value; we avoid these potential value traps.
For the quarter, this position materially outperformed the world equity benchmark. The top three contributors to this outperformance came from
Armaments
With the rising trend of deglobalization in play combined with a rising trend in nation state geopolitical conflicts while considering that armaments spending has largely fallen to such lows implying that nation state conflict was over, the potential growth path forward is far more likely than not.
The entire western world has been living in the delusion that the post-Cold War 1 era would never end. In other words, in the debate between Guns vs Butter, the choice has been more butter and Germany loves it the most.
For the quarter, this position materially outperformed the world equity benchmark. The top three contributors to this outperformance came from
Source: Department of Defense, Worldbank, Marzian and Trebesch (2024), Hedgeye Risk Management
Japan Small Company Equity Exposures
We updated this exposure to one that still focuses on high quality and profitable small Japanese companies but now includes active currency hedging. This means the fluctuations in the exchange rate between USD and JPY is neutralized. The primary motivation is based on our view that USD is likely to stay strong and gain strength relative to many other currencies which includes JPY.
As US investors, our currency is the USD. This means if we own an asset denominated in another currency (like JPY) and if the USD gets stronger relative to the JPY that means the foreign asset we own has lost value all else equal purely due to the change in the exchange rate.
Moreover, the top down and longer term positive attributes that we see include:
Demographic Shifts and Wealth Transfer: We expect a significant wealth transfer as Japan’s older generation passes on their savings to younger generations. This transfer, amounting to approximately $5-$6 trillion, is anticipated to boost domestic demand and economic activity as younger generations inherit and spend this wealth.
Labor Market Changes: The shift from seniority-based to merit-based pay is transforming Japan’s labor market. As the war for talent intensifies, companies are increasingly offering better pay and career opportunities to attract and retain employees. This shift is expected to enhance productivity and increase incomes, further stimulating domestic demand.
Corporate Efficiency and Profitability: Japanese companies, especially under the leadership of so-called “salaryman CEOs,” have demonstrated remarkable efficiency and profitability. Despite stagnant top-line sales since the mid-1990s, these companies have managed to significantly increase profits. This indicates strong internal management and cost-cutting capabilities, positioning them well for future growth when combined with potential new investments in technology and human capital.
These factors among many more collectively create a compelling case for the continued growth and potential of Japan’s equities.
For the quarter, this position materially outperformed the world equity benchmark. The top three contributors to this outperformance came from
Currency Hedging
Source: Jesper Koll, UBS Global Wealth Report 2023, Wilkinson & Pickett & The Equality Trust, OECD, Bank of Japan, US Federal Reserve, Japan Labor Force Survey, Tokyo Stock Exchange, Bloomberg, Census Bureau, METI, Ministry of Finance, Milken Institute
India
Mr. Market has gone from bullish to neutral on India with probabilities pointing towards macroeconomic fall and macroeconomic winter in the first half of 2025.
Furthermore, we have expressed this exposure thru a “feet on the street” India based investment manager who has been around for over a decade. Their team consists of over 70 employees of which most live and work in India across Mumbai, Chennai, New Delhi, and Kolkata.
The underlying portfolio is tilted toward exposures that benefit from the growth of the domestic Indian market (as opposed to external markets via exports) and the underlying companies must meet stringent screens for management quality, business moat, growth drivers, and future potential.
For the quarter, this position materially underperformed the world equity benchmark but outperformed relative to the broad Indian equity market.
The primary reasons were rising bond yields and a strengthening USD which often puts stress on all emerging markets. Moreover, there was material foreign investor selling and growing concerns about downward revisions to growth expectations.
West Texas Real Estate Exposures
We held our exposures to West Texas Real Estate which is specifically in the highly energy productive Permian Basin where we own the real estate as well as the oil, gas, and water rights.
One of our exposures consists of approximately 870,000 acres of surface land and 2.4 million acres of mineral interests in West Texas, with a checkerboard pattern of land holdings that are effective for capturing tangential activity such as power lines, pipelines, and roadways. Moreover, this exposure is located in District 8 which is responsible for about 20% of all oil and gas production in the U.S.
Another exposure includes an additional 220,000 surface acres and 8,000 gross mineral acres in the Permian Basin, with a focus on contiguous land holdings that are ideal for large-scale water management and data center operations.
This offers unique advantages for data center operations (especially for AI focused workloads), including abundant and cheap natural gas for power generation, extensive water resources for cooling, an unregulated power grid, and low existing populations so there is little to no competition between citizens and business for access to said resources.
Finally, these exposures come with relatively low overhead costs, as these businesses do not engage directly in oil and gas production. Instead, it leases its land to producers, ensuring a steady flow of royalty income without the associated expenses and risks of production. An additional benefit is the potential for significant appreciation in the real estate itself over time, particularly as the value of energy resources increases. Furthermore, the continued development and infrastructure improvements in West Texas can enhance the land’s value.
For the quarter, this position materially outperformed the world equity benchmark. The top contributors to this outperformance came from
Digital Asset: Bitcoin
Yes we are aware Bitcoin is not an equity but we assign it to the risk sleeve for risk management and portfolio management reasons.
Given the scarcity value of Bitcoin which has a maximum supply of 21 million coins of which almost 95% is already mined means it has some common characteristics to Gold (to be clear we own both) and as such it should resist fiat debasement over the long term.
Additionally, it often has low to negative correlations with equities and bonds which enhances its diversification value.
Moreover, given its digitally native and decentralized nature there is potential value in its exposure for those who are at risk from financial repression by their sovereign.
For example, if you are a Chinese citizen who wants to get their wealth out of China for fear of the Chinese Communist Party (CCP) it is not feasible to cross the border with backpacks full of gold bullion but it is very possible to leave with your wealth in Bitcoin via self custody. The larger point is it can be seen as a release valve for those wanting to leave financial repression which of course creates buying pressure all else equal.
Furthermore, it is difficult to overstate the regime shift that his occurred from a political and regulatory perspective. Trump promised a Strategic Bitcoin Reserve while speaking at the national BTC conference and then went on to launch a Defi token/protocol. Every key member of the incoming admin is pro-crypto and owns significant amounts of BTC. Stand With Crypto/Fairshake was one of the biggest PACs in the 2024 election, helping 276 pro-crypto candidates elected in the House and 20 in the Senate. Gensler from the SEC announced his resignation, Pennsylvania and Texas are competing to launch the first state-level BTC reserves (with up to 10 more states allegedly in queue).
Longer term, digital asset ownership skews younger and towards digitally native generations. Cohorts that are disenfranchised with current institutions and are set to fill leadership roles and make decisions into and after the sunsetting of the Baby Boomers. This is highly relevant given the size of inheritances coming down the pike.
Source: standwithcrypto, cointelegraph, Bitcoin Magazine, Glassnode, Hedgeye Risk Management
For the quarter, this position materially outperformed the world equity benchmark.
The Drakkar’s Positioning: The Bonds
Performance
For the quarter, returns in our bond positions were marginally negative as most major bond indices posted material losses.
Our relative outperformance can be attributed to our overweight positions in short duration US Treasury Bills and our selling of put spreads to harvest option income as well as our exposure to newly issued agency mortgages.
This is especially important as interest rates materially increased over the period which meant those with longer duration bonds would have incurred material losses.
Moreover, we exited all of our strategic allocations to bonds in early November which further reduced losses as the rest of the quarter continued to inflict losses in bonds all else equal.
New Positions
None
Exited Positions
US Treasury Bills + Option Income Harvesting
Newly Issued Agency Mortgage Back Securities (MBS)
We effectively sold all of our strategic allocations to bonds over the period.
At a 50 foot view, we still expect these exposures to do well relative to their bond benchmarks.
At a 50,000 foot view combined with a deeper look at the past, we came to the conclusion that holding bonds long term more often than not failed to provide positive real returns and just as importantly did not provide the diversification value to equities that is often permanently assumed when in fact the historical record says it is conditional. This is especially true in a more geopolitically stressed environment.
For example, let us examine a period of time during the first age of globalization and what happened between its hegemon Great Britain and its challenger Germany.
Notice the material percentage increases in defense spending that also coincided with large increases in government borrowing relative to GDP. Then notice over this buildup period before the start of World War 1 that those who held their sovereign’s bonds had losses between 23% and 30%.
Source: Niall Ferguson in Pity of War
This of course bodes poorly for bond exposures during the build up period. Now let us examine what happens after the war starts.
Notice the massive increase in the money supply across all participants from 110% for the UK all the way to 1,102% for Russia. This all took place over just six short years and thus shows the absolute decimation of one’s purchasing power over the period. A similar conclusion can be seen in cost of living indices as well. This should not be a shocking result when one sees the magnitude of deficit spending over the war period and the cumulative amount of debt incurred to fight it.
Conceptionally, it was not just men’s bodies that were conscripted to fight with the obvious truth that preserving one’s own life was NOT the priority but rather to be used for collective victory.
It was also the population’s collective purchasing power and wealth that was conscripted to fight with the obvious truth that preserving let alone growing one’s own wealth was NOT the priority but rather to be used for collective victory.
Source: Niall Ferguson in Pity of War
However, it is false to say that performing your patriotic financial duty means you must accept being debased and rendered poorer. There were plenty of other investments that you could have deployed your capital into that provided immense value to the war effort and also resulted in your wealth growing at the same time.
Assuming you were limited to being a long only investor (you could not short which is not a limitation for us) select equities and certain commodities would have done the job.
Clearly, such observations are not readable visible without doing the historical research.
Source: Niall Ferguson
Overall, our conclusion was that there are better ways to build portfolios in the context of a wider aperture of potential conditions that are only visible if one looks deeper into the historical past and thus perceives the conditional factors that favor or disfavor certain exposures.
To be clear, we will still have exposure to bonds but it will be one that is rented as opposed to permanently owned and more importantly we will be taking both long (making money when prices rise) and short (making money when prices fall) exposures as deemed appropriate.
Maintained Positions
None
The Drakkar’s Positioning: The Alternatives
Performance
Our alternative positions were marginally positive for the quarter while world equities were marginally negative and broad bonds were materially negative.
As a reminder, the alternatives are designed to generate returns that are low to negatively correlated to both equities and bonds. For this quarter, they did exactly what they were supposed to do.
New Positions
Quantitative Investment Strategies (QIS)
These strategies are designed to generate non-correlated absolute returns. They rely heavily on data analysis, statistical modeling, and algorithms to identify and exploit these market patterns. They are classified into two buckets.
Defensive Bucket
Designed to generate returns during both fast and slow severe market downturns while allowing for some participation in upside gains in normal conditions. Think of fast drawdowns like 2008 and 2020 and slow drawdowns like 2022.
Carry Bucket
Designed to capitalize on structural/market inefficiencies targeting exposures beyond long only vanilla stocks and bonds.
The dozens of strategies underneath are diversified across four asset classes: equities, interest rates, commodities, and currencies.
The return drivers are also diversified across three types: carry, trend, and volatility harvesting.
What is Carry?
Carry is about profiting from the "cost of holding" an asset over time. It's like collecting rent on a property. For example:
Fixed Income: Buying a bond with a higher yield than its funding cost (e.g., borrowing rate).
Currencies: Going long a currency with a high interest rate and shorting one with a low interest rate.
Commodities: Holding a commodity in storage and profiting from the difference between the spot price and the expected future price (accounting for storage costs).
Carry exploits the tendency for certain assets to offer a return simply for holding them, often as compensation for taking on some form of risk (like credit risk or interest rate risk).
What is Trend Following?
Trend following is based on the observation that assets that have performed well recently tend to continue performing well in the short to medium term. Conversely, assets that have performed poorly tend to continue underperforming.
Thus, buy assets with upward trends ("go long") and sell assets with downward trends ("go short").
Trend following exploits the tendencies of behavioral biases (like herding) and delayed reactions to new information.
What is Volatility Harvesting?
Volatility harvesting aims to profit from the difference between implied volatility and realized volatility. Essentially, you profit from the difference between what people expect and what actually happens. For example:
Selling Options: One common approach is to sell options spreads. Option sellers receive a premium upfront, and they profit if the actual volatility is lower than what was implied in the option price.
Volatility Risk Premium: This strategy relies on the existence of a "volatility risk premium," which suggests that implied volatility tends to be higher than realized volatility on average.
Volatility harvesting exploits the tendencies that people will overpay a premium for protection against large price swings.
Exited Positions
None
Maintained Positions
Trending Following Multi Asset Class Managed Futures
As a reminder, being “long” means you make money when prices rise and conversely being “short” means you make money when prices fall.
These strategies long what is trending up and short what is trending down using price, volume, and volatility models.
The trends that can be harnessed include all the major asset classes of equities, bonds, commodities, and currencies.
Moreover, it was these strategies that materially protected our capital in 2022 when virtually every long only vanilla stock and bond investors got crushed.
The beauty of this investment style is the ruthless execution of its quantitive rules which means there is no psychological barriers to changing one’s mind and thus positions when the data says the world is changing.
For the quarter, this position materially outperformed both world equity and broad bond benchmarks. The top contributors to this outperformance came from
Long positions in Cocoa due to weather-related supply chain concerns.
Long positions Cattle due to reduced herd sizes, droughts, and potential weakness from tariffs and immigration reform in 2025.
Short positions in US and Canadian Bonds due to rising concerns about uncontrolled deficit spending and less buying from foreign central banks.
As of this writing, our updated positions are:
Long
Commodities: Live Cattle, Heating Oil, Crude Oil, Natural Gas, Soybeans, Gold, Cocoa, Corn, Coffee, Gasoline, Platinum, Lean Hogs, and Silver
Bonds: None
Currencies: None
Equities: None
Short
Commodities: Sugar, Soybean Oil, Cotton, Copper, Wheat, Canola Oil, and Palladium
Bonds: US 2 Year Treasuries, Canadian 10 Year Treasuries, Canadian 5 Year Treasuries, Canadian 2 Year Treasuries, US 30 Year Treasuries, US 5 Year Treasuries, and 3 Month SOFR, and 3 Month CORRA.
Currencies: None
Equities: None
Furthermore, there is asymmetric value in these types of strategies in the context of rising geopolitical tensions.
Let us examine how such exposures in equities, bonds, and commodities performed in multiple global kinetic conflicts like WW1, WW2, and the Korean War.
Equities
There are a mix of equity markets that did well (naturally those countries who won) and those that did not do well (naturally those countries who lost).
For bonus points, if your equity exposure was tied to producers of key war time materials (like US Steel which produced steel or Anglo-Iranian which produced oil) you performed exceptionally well. This highlights the importance of being macro and historically aware when determining where to allocate equity capital.
Bonds
As previously discussed, the vast majority of cases show that bonds lose material value leading and into the conflict period.
This is absolutely true for the loser in the conflict and is often the case even for the victor.
If you think about it, the sovereign not only drafts its people for the conflict but often drafts your money (thru inflation and debasement) to be used in the marshaling of its military so that victory can be attained.
This highlights the importance of being macro and historically aware when determining where to allocate bond capital.
Thus a strategy that quantitatively determines when to go long (making money when prices rise) and when to go short (making money when prices fall) is key.
Commodities
There are dramatic commodity price moves thru the entire lifecycle of the kinetic conflict (start, middle, end).
Again, a strategy that quantitatively determines when to go long (making money when prices rise) and when to go short (making money when prices fall) is key.
Source: Global Financial Data, Niall Ferguson
Gold Bullion
We updated our gold exposure to one that we are proud to say was one that we helped create.
This exposure combines two different exposures:
First, we get 1.5X exposure to the price of gold. For example, if the gold price goes up 10% then this exposure would be up 15%. Effectively, it buys $10 of gold with cash and then borrows the remaining $5 to buy the remaining gold position which results in a total exposure of $15. By borrowing funds as institutional investors in global capital markets, we are able to borrow at an interest rate in the low single digits.
Second, we layer on the selling of put spreads to generate option income. This is akin to selling a fire insurance policy that lasts for 2 weeks before it expires for a price of $10 and then buying firestorm reinsurance for $1 thus pocketing $9 for the two week period. By renewing this “fire insurance policy” every two weeks we expect over the long term to generate a modest amount of additional income in a very prudent manner.
When these positions are combined we have effectively created a gold exposure that generates income which is boosted by prudently borrowing some rapidly debasing fiat to buy more debasement resistant gold.
In effect, we observed that Gresham’s Law states “bad money drives out good money” i.e. people rapidly spend the less valuable money and hoard the most valuable money.
We took that long established historical observation and concluded we could benefit from it by borrowing “bad money” to buy more of the “good money”.
At the 50,000 ft altitude of analysis, you will see that
Gold demand from global central banks is accelerating at the same time US Treasuries are being reduced.
Gold demand from global central banks intensely accelerated after the start of Russia’s invasion of Ukraine.
Gold exposure is being specifically expressed via physical deliveries which highlights growing mistrust.
The top global fiat currencies (USD, EUR, GBP, CHF, JPY, etc) have all lost material value relative to gold over the past several decades with the best performing fiat of the Swiss Franc (CHF) “only” losing 93% of its value.
Over the past 109 years, the gold supply has increased from 38,387 tones in 1914 to 212,582 tonnes in 2023 which is an annualized increase of 1.59% per year which favorably compares to the USD supply of 26 billion in 1914 to 212,582 billion in 2023 which is an annualized increase of 8.61%.
Source: World Gold Council, Incrementum AG, Reuters Eikon, USGS, Federal Reserve St Louis
For the quarter, our returns in our gold positions were flat while the world equity benchmark was marginally negative and broad bonds were materially negative.
The Macro Situation Report
For a refresher on our analytical framework, click here.
USA In Macro Summer
When we look at global growth rates, we see the USA is primarily responsible for global growth. Within the USA and specifically within Large Companies, we see that high tech industries are driving the growth.
Source: Factset, Bloomberg, Hedgeye Risk Management
The speed and scale of direct and AI adjacent capital expenditure has been legitimately exceptional. This is clearly connected to the observation that US business investment has outpaced other economies because of its high tech centric economy.
Source: Bloomberg, Hedgeye Risk Management
With the change in USA’s management, the small business community has grown materially optimistic.
Source: Bloomberg, Hedgeye Risk Management
However, the emerging concern is one of tariff uncertainty. It has resulted in an increase in postponing, scaling down, or delaying indefinitely business investment plans.
Source: Bloomberg, Hedgeye Risk Management
The question now remains if we are transitioning into an expansionary phase as several indicators like the LEI, Fed Service Sector Survey, ISM New Orders, ISM Services, S&P Services PMI, etc all appear to be on the ascendant.
Source: Bloomberg, Factset, Hedgeye Risk Management
On the household side, we see material financial position improvements like interest income growing faster than interest payments as well as assets growing faster than liabilities. This aligns with increases in household sentiment and increases in retail spending as well.
Source: Bloomberg, Factset, Census Bureau, Hedgeye Risk Management
Small businesses (who generally borrow from the banks) continue to pay relatively high interest rates combined with spending less on business expansion relative to the past few decades.
However, there have been recent improvements in these domains over the past few quarters. Nevertheless, big business continues to have low and falling net interest payments.
After all, they generally do not borrow from banks but rather capital markets (where interest rates are lower) and they generally have large cash balances which of course earn more interest income with rising interest rates.
Despite the sharpest rate hiking cycle in history, big business has seen a decline in their net interest payments which is absolutely astonishing.
Source: Bloomberg, Factset, Census Bureau, Hedgeye Risk Management
There is growing evidence the credit cycle may be inflecting.
Credit availability is improving and household leverage has fallen. Credit continues to progressively loosen, bank loan growth has begun to accelerate, CEO confidence remains near cycle peak and commerical/industrial loan growth should begin to accelerate sometime around now based on historical lags.
Source: Census Bureau, Hedgeye Risk Management
On the labor side, unit labor costs i.e. worker pay has been revised up. This is showing up across a widening constellation of data which suggests acceleration in wage growth.
Source: Census Bureau, Hedgeye Risk Management
Trump Trades
We think the most likely five big policy moves are
Tax Cuts
Tariffs
Deregulation
Immigration
Deficit/Debt
Tax Cuts
$4.6 trillion is the estimated cost to extend the Tax Cut and Jobs Act (TCJA) from 2025-2034. Additionally, the extension of TCJA would increase the projected fiscal deficit by $400B-$500B annually from 2027-2034. For reference, $450B/year would add 1.1%-1.4% to the deficit. This would be in addition to the baseline for 6%-7% deficits.
Source: CBO, bipartisanpolicy.org, Peter Peterson Foundation, Hedgeye Risk Management
Tariffs
America’s new management team aims to combine these huge tax cuts with new revenue primarily thru tariffs.
This is not without historical precedent as tariffs were once the primary funding system for the US Government.
For roughly half of the country’s history, tariffs accounted for half or more of total federal revenue.
Interestingly, the Second Industrial Revolution occurred during 1870-1914, a period during which Tariffs accounted for about half of US Federal Revenue.
The Second Industrial Revolution was a period of rapid industrialization that occurred between 1870 and 1914. It marked a significant advancement in technology, industry, and society, building upon the foundation of the First Industrial Revolution (which had primarily focused on steam power and textile production).
Technological Advancements:
Electricity: The widespread use of electricity revolutionized daily life.
Steel Production: Innovations like the Bessemer Process allowed for mass production of steel, leading to stronger buildings, bridges, and railways.
Chemicals: Advances in chemistry led to the development of synthetic dyes, fertilizers, and explosives.
Internal Combustion Engine: This enabled the creation of automobiles and airplanes.
Communication and Transportation:
The invention of the telephone (Alexander Graham Bell, 1876) and the expansion of the telegraph revolutionized communication.
Railroads expanded dramatically, and the advent of automobiles and airplanes transformed transportation.
Industrial Expansion:
Large-scale industries like steel, oil, and electricity dominated economies.
Corporations and monopolies grew, such as Standard Oil (John D. Rockefeller) and U.S. Steel (Andrew Carnegie).
Urbanization and Labor:
Urban centers expanded as people moved from rural areas to work in factories.
Labor movements emerged to advocate for workers' rights, fair wages, and safer working conditions.
The Second Industrial Revolution laid the groundwork for the modern economy, fostering technological innovation, globalization, and economic growth.
It also contributed to significant social changes, including the rise of the middle class, shifts in gender roles, and the growth of consumer culture. The revolution came to a halt with the outbreak of World War I in 1914, which shifted global priorities toward wartime production.
Additionally, Trump’s belief in tariffs goes back 40+ years. It starts when he lost an auction in 1988 for a 58 key piano used in the classic film “Casablanca” to a Japanese trading company who represented a collector.
Overall, tariffs could solve a big portion of the tax cut math. But we must bear in mind that tariffs are regressive in that the impact of a 10% across the board tariff would impact the bottom quintile earners by 4x-5x more than the top 1% earners.
This would continue to widen the gap between the “haves” (like the wealthy and big business) and the “have nots” (the non-wealthy and small business).
Source: Council of Economic Advisors, NYTimes, Tax Foundation, Hedgeye Risk Management
As a reminder, the characteristics of the "haves” and the “have nots” are as follows.
The Haves
The wealthy materially benefit from higher rates as they get paid on their excess cash.
The wealthy materially benefit from reflation in asset prices as they own a material share of financial assets.
Big banks consolidate share amidst banking stress and liquidity flight.
Big business generally outperforms amidst macroeconomic winter when it arrives.
The Have Nots
The non-wealthy don’t benefit from higher rates as they don’t get paid on their excess cash (they don’t have any).
The non-wealthy get higher (cost of living) inflation.
The non-wealthy lose discretionary consumption capacity as more wallet share goes to service higher debt costs.
The non-wealthy are more vulnerable to income shocks as any residual cash cushion is exhausted and the above factors compound the problem.
Since big business locked in low interest rates from global capital markets in 2021 and earlier, they have been net beneficiaries of rising rates.
Since small business borrowed at floating interest rates from banks, they are been net victims of rising rates.
The charts below illustrate these points quite vividly.
Source: BEA, Factset, NFIB, Hedgeye Risk Management
Deregulation
Trump 2.0 aims to outdo himself in his second term by replacing his “Two-Out” rule with “Ten-Out”.
Trump 1.0 pursued one of the most aggressive deregulatory agendas in recent U.S. history, drawing comparisons with Ronald Reagan's in the 1980s.
Regulatory "Two-Out" Rule:
Trump issued Executive Order 13771, requiring agencies to eliminate two regulations for every new one introduced.
The administration claimed to have exceeded its goals, reporting the removal or rollback of 8 regulations for each new one added.
Economic and Environmental Focus:
Significant rollbacks were aimed at environmental protections, such as revising the Clean Power Plan and loosening fuel efficiency standards.
The administration also reduced regulations on industries like energy, banking, and manufacturing to boost economic growth.
Speed and Breadth:
The focus was on rapid deregulation across a wide array of sectors, including healthcare, telecommunications, and labor.
Judicial Strategy:
Appointing judges sympathetic to a limited regulatory state helped bolster deregulatory efforts by increasing the likelihood that regulatory rollbacks would be upheld in court.
As such, the most regulated industries that stand to benefit most are likely oil/gas, autos, banks, nonbanks, airlines, and pharmaceuticals.
Source: National Archives, Lisam, RegData’s Industry Regulation Index, Hedgeye Risk Management
Immigration
Immigration remains the biggest known-unknowns in recent memory. No one has a clean read on the impact but its pervasively distorting all manner of BLS labor data.
On Labor
“IMMIGRATION HAS SUPPORTED JOB GROWTH AND HAS HELPED KEEP WAGE INFLATION TAME” - POWELL, 4/4/24
On Housing
“HOUSING INFLATION HAS BEEN A BIT OF A PUZZLE” – POWELL, 5/14/24
US Labor Force growth is projected to be driven primarily by immigration in the next decade. Sectors like Agriculture, Hospitality, and Construction are especially dependent on undocumented immigrants.
Source: BLS, CBO, Census Bureau, Pew Research Center, Hedgeye Risk Management
Deficit/Debt
As strange as this sounds, this bodes well for a long position in USD and a short position in long maturity UST Bonds.
At the US Treasury, prior management (Janet Yellen) is a former central banker and academic whose approach was activist government and global stability.
Going forward, new management (Scott Bessent) is a legendary practitioner in capital markets whose approach is USA primacy. The question now remains if he can help tame the Debt-to-GDP path.
Source: CBO, Hedgeye Risk Management
The post-election breakout in the USD is likely to be sustained by growth and inflation differentials between the USA and RoW.
The American first policies are unlikely to dampen this positive differential.
The USD has enjoyed a steady floor of support from its global leadership in real GDP growth.
Thus these policies are likely to fuel global monetary policy divergences.
Source: Factset, Federal Reserve, Hedgeye Risk Management
When one is the sovereign that controls the world reserve currency you then face the Triffin Dilemma.
The Dilemma:
Domestic vs. Global Demand:
To meet the world’s demand for a reserve currency, the country issuing it (USA) must run a trade deficit. This ensures there’s enough of its currency circulating globally to facilitate global trade.
However, running persistent trade deficits undermines confidence in the currency's stability and value over time.
Global Liquidity vs. Stability:
Global trade and investment require a steady supply of the reserve currency, which means the issuer must provide liquidity by running deficits.
But these deficits can erode the currency's value, potentially leading to inflation, loss of confidence, and financial instability.
Implications:
For the U.S. (under the USD global system):
A strong USD facilitates international trade and investment.
Persistent deficits to supply USD globally can increase U.S. debt and reduce long-term confidence in the USD’s value.
For the World
The global economy becomes reliant on the economic policies of the reserve currency issuer, creating systemic risks if the issuing country faces economic challenges.
In other words, it is a very delicate balancing act between the national interests of the issuer (USA) and the global interests of those who use it for trade (RoW).
What can history show us regarding the Triffin Dilemma?
Dynamics resembling the Triffin Dilemma contributed to the collapse or significant restructuring of reserve currency systems in the past.
The British Pound as a Reserve Currency (19th–20th Century)
Background:
In the 19th and early 20th centuries, the British pound sterling was the dominant global reserve currency, backed by gold under the gold standard.
Triffin-Like Dynamics:
Britain maintained trade surpluses and financed global trade by lending abroad. However, during World War I and later World War II, Britain incurred significant debts and faced economic challenges. The strain on Britain’s economy led to doubts about the pound’s stability.
Outcome:
After World War II, the pound was no longer able to sustain its role as the dominant reserve currency. The USD, supported by the Bretton Woods system, replaced it.
Britain faced currency crises and devaluations, such as the devaluation of the pound in 1949.
The Roman Empire and Denarius Devaluation
Background:
While not a reserve currency in the modern sense, the Roman Empire's silver denarius served as a widely used currency across the empire.
Triffin-Like Dynamics:
As the empire expanded, it needed more currency to facilitate trade and pay for its military and administrative costs.
This led to the debasement of the denarius (reducing its silver content), causing inflation and a loss of confidence in the currency.
Outcome:
Over time, the loss of confidence in Roman currency contributed to economic instability and the eventual decline of the empire.
Thus given our view that we are likely to see a rising interest rate environment, what does history show to be equity sectors that did relatively well and relatively worse when long term UST rates increased?
Source: Factset, Hedgeye Risk Management
Moreover, healthcare typically underperforms in this type of environment which is uniquely vulnerable to the change in USA’s management.
There are three areas that are likely to see a withdrawal of federal largess: Medicaid, Affordable Care Act health plans, and biotech funding. Funding for Medicare is likely to be less affected.
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