Macro Summer with Some Turbulence

Unraveling the Macro Map

The USA is Entering Macroeconomic Fall = Turbulence Ahead

The second half of the year is poised for a mathematical deceleration in year-over-year growth as the combination of labor deceleration, further cumulative deterioration for the “have nots”, and the higher for longer conditions of interest rates means constraints on acceleration in the cyclical economy and consumer credit growth.

All the aforementioned results in a collective rate-of-change drag.

Remember that macroeconomic fall (decelerating growth rates and accelerating inflation rates) and “recession” are not the same thing.

In fact, we see that nominal growth will remain non-recessionary (growing but slowing).

Moreover, we see a ping-ponging between macroeconomic fall (decelerating growth rates and accelerating inflation rates) and macroeconomic summer (accelerating growth rates and accelerating inflation rates) and macroeconomic spring (accelerating growth rates and decelerating inflation rates).

The rising geopolitical tensions around the world serve as an amplification of the turbulence associated with macroeconomic fall.

Higher For Longer Is At It Again

At the beginning of 2024, Wall Street estimates for CPI were for 2.9% and 2.8% for Q1 and Q2, respectively, down from the Q4 3.2% actual. Effectively, Wall Street estimated (or wished for) CPI rates to decelerate.

Our estimates at that time were for 3.1% and 3.2% respectively. The Street was calling for 2.8%. The actual? 3.3%. This matters.

The 2 Year US Treasury Yield at the start of this year was 4.25%. Today? 4.70%.

The inflationary forces today are largely unchanged from those that fueled our higher for longer view last quarter.

The Drakkar’s Performance and Positioning

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 marginally underperformed their RR benchmarks.

Year to date, 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 marginally underperformed their aggressive portfolio benchmarks.

Year to date, our managed aggressive portfolios marginally underperformed their aggressive portfolio benchmarks.

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Moderate Portfolios

Relative to the Required Return (RR)

For the quarter, our managed moderate portfolios marginally underperformed their RR benchmarks.

Year to date, 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 marginally underperformed their moderate portfolio benchmarks.

Year to date, our managed moderate portfolios 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 outperformed their cash reserve portfolio benchmarks.

Year to date, our managed enhanced cash reserve portfolios outperformed their cash reserve portfolio benchmarks.

The Drakkar’s Positioning: The Equities

Performance

Returns in our equity positions were negative for the quarter while most major stock indices were also negative for the quarter with the exception of Non-US Emerging Equities and US Large Equities.

New Positions

• Countries

  • Japan

• Sectors

  • Energy

• Factors

  • No change

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.

Countries: Japan

Generally, a macroeconomic spring weather pattern appears to be forming over Japan which bodes well for its equity markets.

On a longer term basis, there are several compelling factors:

• 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 market.

Furthermore, we have expressed this exposure thru a “feet on the street” Tokyo based investment manager. This shop has been around since the late 1980s and requires its companies to have the following criteria:

• A well-capitalized balance sheet with little debt.

• Durable competitive advantage.

• High return on equity.

• Above average earnings growth rate, which is sustainable and predictable.

• Strong cash flow generation.

• Value gap between intrinsic value and market price.

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

Sectors: Energy

Generally, energy performs well in a macroeconomic fall weather pattern which is our immediate view.

Furthermore, our exposure is expressed across approximately 900,000 acres of land in West Texas, primarily in the Permian Basin, which is one of the richest oil-producing regions in the United States. This extensive land ownership includes valuable mineral rights, providing significant revenue from oil and gas royalties as well as water royalties.

Moreover, this exposures comes with relatively low overhead costs, as it does 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. Additionally, the continued development and infrastructure improvements in West Texas can enhance the land’s value.

Exited Positions

• Countries

  • Sweden

  • South Korea

  • Germany

  • Philippines

  • Netherlands

• Sectors

  • Oil Pipelines

  • Oil/Gas Producers

  • Insurance

  • Health Care

  • Homebuilders

  • Atomic Based Energy Miners (Uranium)

  • Physical Uranium U3O8 or “yellowcake”

  • Gold Miners

• Factors

  • Non-US Emerging Stocks (ex-India)

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

• Sectors

  • Technology

  • Defense

• Factors

  • Select US Large Cap Growth Stocks

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.

Countries: India

Mr. Market remains bullish on India as its world-leading economic growth is set to hold at these levels, with probabilities pointing towards shallow accelerations in the second half of 2024. Additionally, a few of the macro tailwinds for India are as follows:

• India will be the global growth leader in 2024.

• India is outperforming the world and emerging markets as a whole.

• India PMIs are amongst the highest in the world.

• India missed the global industrial recession.

• Bank credit creation is very supportive.

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

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 India 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.

Source: Factset, S&P, Central Statistics Office of India, Reserve Bank of India, Hedgeye Risk Management

Sectors: Technology, Factors: Select US Large Cap Growth Stocks

As interest rates remain elevated and given our forward view that those interest rates will stay higher for longer, strategic avoidance of unprofitable firms should continue to be beneficial in favor of allocation towards firms that can self-finance profitable investment to create shareholder value or return capital to shareholders.

Defense

With the rising trend of deglobalization in play combined with a rising trend in nation state geopolitical conflicts while considering that defense 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.

Source: Department of Defense, Worldbank, Mark Harrison “Economics of WW2”, Hedgeye Risk Management

The Drakkar’s Positioning: The 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.

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.

The Drakkar’s Positioning: The Alternatives

Performance

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

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

While we underperformed US Large Equities and Non-US Emerging Equities, it was a close second as we captured between 50% and 80% of the upside.

This is all the more pleasing given that the alternatives sleeve isn’t designed to outperform or compete with equities and bonds but rather to generate return sources that are low to negatively correlated to both equities and bonds.

New Positions

None

Exited Positions

Dry Bulk Shipping Futures

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.

Silver

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

Bitcoin

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.

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, Gold, Sugar, Platinum, Cocoa, Coffee

  • Rates: None

  • Currencies: Euro

  • Equities: Non-US Developed Stocks, Non-US Emerging Stocks

• Short

  • Commodities: Wheat, Corn, Natural Gas, Cotton, Copper, Soybeans, Lean Hogs, Gasoline, Palladium

  • Rates: 3 Month SOFR, 3 Month CORRA, US 2 Year Treasuries, US 5 Year Treasuries, US 10 Year Treasuries, Canadian 10 Year Treasuries, US 20 Year Treasuries

  • Currencies: Japanese Yen

  • Equities: US Large Stocks

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.

Gold Bullion

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.

Gold performs exceptionally well in a macroeconomic fall weather pattern. Moreover, the relative increase in demand from global central banks which is occurring at the same time those same entities are reducing their US treasury holdings suggests a bright path forward for the curious element.

The Macro Situation Report

For a refresher on our analytical framework, click here.

Macro Summer with Some Turbulence

We dutifully rejected the willful consensus silliness that was 7-8 interest rate cuts for 2024 in January. Now the asymmetry has reversed with the pendulum having swung all the way in the other direction.

Then

Now

A measure of inflation that the Federal Reserve has said is important to them in determining interest rate policy is CPI Core Services Less Shelter, Y/Y % (NSA).

It is headed in the wrong direction.

Then

Now

Moreover, according to the CBO’s Baseline Projections they expect Quantitative Easing (QE) to resume starting in 2025 and effectively continue into the future.

We’re at a key phase in cycle risk management where early cyclical acceleration could be short-circuited by resurgent macroeconomic fall dynamics, potentially catalyzing a backslide.

On a global basis, it still looks like macroeconomic summer is the current weather pattern.

On the US front, similar positive cyclical forces appear to be present.

Liquidity is improving. The rate of change in M2 (the change in the money supply) just went positive after 16-months. If recent years and the Deficit trajectory are an indication, it is up for the rest of the year.

Bank loan growth is finally inflecting and accelerating.

Credit card delinquency rates are improving.

Housing and financial asset wealth effects remain a tailwind. Effectively, if investment assets and real estate assets increase in value then spending typically increases.

While interest rates and credit tightening have both been headwinds, wage income growth has remained the principal driver of nominal growth.

Below we profile a cross-section of the labor market and their associated wage growth trend. Aggregate Nominal Wage Income is running at +6% Y/Y.

If one begins to peak under the hood, the actual reality is very different between big business and small business as well as high income earners and median to low income earners.

In effect, a common reality has been split into the K reality.

The “Haves” are

• The Rich who disproportionately benefit from higher rates as they get paid on their excess liquidity.

• The Rich who disproportionately benefit from reflation in asset prices as they own a disproportionate share of financial assets.

• The Big Banks who consolidate share amidst banking stress and liquidity flight.

• The Big Businesses whose business and stock prices outperform amidst macroeconomic fall/winter uncertainty.

The “Have Nots” are

• The rest who get stuck with higher (cost of living) inflation while broadly missing out on the interest income upside associated with higher rates.

• The rest who lose discretionary consumption capacity as their wallet share goes to servicing higher debt costs.

• The rest who become increasingly vulnerable to income shocks (ie end of student loan moratoria) as any residual cash cushion is exhausted and the above play out in reflexive and compounding fashion.

For example, big business borrowed from capital markets (not banks) and locked in their debt at low fixed rates for long periods during the ZIRP (Zero Interest Rate Policy) era and have been net beneficiaries of rising rates (since their debt costs have NOT risen and yet their large cash balances are earning ever higher interest) while small businesses borrow from banks (not capital markets) whose interest rates are floating and thus their debt costs have soared and thus have become acutely hostage to interest rate policy.

In green we see the net interest payments for Big Business compared to the red where we see the net interest payments for Small Businesses.

In green we see the net income earned by the Magnificent 7 companies i.e. the biggest of the big businesses (Microsoft, Amazon, Facebook, Apple, Google, Nvidia, and Tesla) compared to the rest of the big businesses in the S&P 500.

In green, we see the stock performance of the Magnificent 7 compared to a basket of publicly traded small businesses as seen in red.

In green, we see that the top 1% of the population have increased their share of all assets while we see in red how the bottom 50% of the population have had a decrease in their share of all assets.

In green, we see that large companies have increased their share of all private sector employment while in red we see that small companies have decreased their share of all private sector employment.

In green, we can see that the top 10% of the population have cash reserves that exceed what they had prior to the global pandemic whereas in red we can see the bottom 40% of the population have cash reserves that are below what they had prior to the global pandemic.

In the aggregate, we can see that personal interest payments (debt costs) are growing faster than personal interest income (interest earned on cash reserves). As shown previously, your personal reality is very different depending on which part of the K you live on.

Below in green, we see that the cumulative net interest income MINUS cumulative net interest expense (interest on cash reserves - interest on debt) for the top 20% is materially positive and growing. This makes sense since that cohort owns the majority of the assets.

Below In red, we see that the cumulative net interest income MINUS cumulative net interest expense (interest on cash reserves - interest on debt) for the bottom 40% is materially negative and shrinking.

In essence, the global pandemic and more importantly the government responses to it materially accelerated the fortunes of the “Haves” and degraded the fortunes of the “Have Nots”.

Labor is progressively softening. Moreover, non farm payrolls which stands out as a positive indicator is increasingly alone relative to other measures of labor which show weakening. This represents the turbulence previously mentioned.

According to the BLS, employment gains over the past 2 years are exclusively a function of an increase in foreign born workers. Jerome Powell has pointed to immigration as a support to the labor market (supporting job gains/moderating wage inflation) but apparently fails to understand the implications for the (already tight) housing market.

“Immigration has supported job growth and has helped keep wage inflation tame”– Powell, 4/4/24

“Housing inflation has been a bit of a puzzle” – Powell, 5/14/24

Another source of inflationary pressure is from the downtrend in globalization and the uptrend in local reindustrialization.

Why is that?

When you shutter your industrial capacity.

Then decide to rebuild your industrial capacity.

But the industrial base has eroded and no one remembers how to do it.

You get a spike in manufacturing labor costs!

Higher For Longer Is At It Again!

Shanghai Freight Index levels are once again spiking which will drive inflation higher on a lag.

We expect shipping to account for a 2-point inflation reacceleration over the next twelve months.

Shelter inflation has another 5 months of disinflationary contribution but then it will reaccelerate in Q4 2024 and into 2025.

Moreover, the US Government keeps accelerating its spending. In fact, the CBO projected a 2024 Deficit of $1.5 trillion in February 2024.

Then in its June 2024 update, the CBO revised that to $1.9 trillion while revenue projections changed little.

Spending projections increased by $360 billion in just 4 months.

By the way, an incremental $360 billion in deficit spending in an election year equates to an incremental +1.3% lift to GDP growth ($360 billion / 2023 GDP of $26,974 billion)

Additionally, 88 countries are holding national elections this year, an unusually high number, and typically deficit spending exceeds projections by 0.40% of GDP in national election years. This often leads to macroeconomic summer weather conditions.

Starting now and likely for the foreseeable future, the Federal Reserve will be constrained by Fiscal Dominance. This will form the secular inflationary runway for the next decade or two.

Essentially, fiscal dominance is a theory in economics that describes a situation where a government’s fiscal policy decisions, particularly regarding spending and debt levels, significantly influence or constrain the central bank’s ability to conduct independent monetary policy aimed at controlling inflation.

This arises when a government accumulates high levels of debt and runs persistent budget deficits. This creates pressure on the central bank to monetize the debt (print money) to help finance the deficits, rather than focusing solely on inflation objectives.

In fact, this has happened several times in history.

The Federal Reserve is very aware of this potential as the St Louis Fed itself has cautioned against the dangers of Fiscal Dominance.

While the Federal Reserve vehemently denies the risks of Fiscal Dominance, one need look no further than the June Quantitative Tightening stepdown for evidence that it is already playing a role.

There is a growing aversion of foreigners holding US Treasury Debt. After generally rising for 40 years (1970-2008), foreign holdings of US Treasury Debt as a % of the total have been steadily trending lower since the great financial crisis of 2008.

In a 2024 survey, 13% of Central Banks report plans to hold significantly less USD reserves in 5 years time, up from just 5% last year.

Meanwhile, the share of Central Banks planning to hold a moderately higher share of reserves in gold in five years time increased from 59% in 2023 to 66% in 2024.

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.

Since the CBO began publishing decade-forward estimates in 2007, in comparing the period 2017-2023 to the original estimates issued in 2007-2013, the CBO has massively underestimated where Debt-to-GDP would land by an average of 32% over that time. This suggests treating the 172% Debt-to-GDP estimate for 2054 with extreme caution.

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.