Navigating the Islands of Macro with Andy Constan

[00:00:00] Welcome to Excess Returns where we focus on what works over the long term in the markets.

[00:00:04] Join us as we talk about the strategies and tactics that can help you become a better

[00:00:07] long-term investor. Justin Carbonneau and Jack Forehand are principals at the Lydia Capital

[00:00:10] Management. The opinions expressed in this podcast do not necessarily reflect the opinions of

[00:00:13] Lydia Capital. No information on this podcast should be construed as investment advice.

[00:00:16] Securities discussed in the podcast may be holdings of clients at the Lydia Capital.

[00:00:19] Hey guys, this is Justin. In this episode of Excess Returns, Jack and I welcome back Andy

[00:00:23] Constant of Damp Spring, a macroeconomic research firm to talk all things macro.

[00:00:27] Andy discusses how he's left the higher for a longer island, but doesn't yet know where he's

[00:00:32] going to land. He talks through the reasons for the changed outlook and the various economic

[00:00:36] forces, inflation, the Fed, the bond market that may impact his final decision and destination.

[00:00:41] We wrap up talking through his views on Alpha Beta and how he constructs portfolios to

[00:00:46] generate long-term returns. As always, thank you for listening. Please enjoy this discussion

[00:00:50] with Damp Springs and Andy Constant. And just one more thing before we start.

[00:00:54] We're very excited to announce our first ever charity podcast day in conjunction with our friends

[00:00:58] at Spot Gama. On April 30th, we will host an all-day live broadcast on our YouTube channel

[00:01:02] to benefit the Susan G. Komen Foundation. We will interview 24 guests from 8 a.m. to 8 p.m. Eastern

[00:01:07] Time. The guests will include many of the most popular guests we've had in the podcast, plus

[00:01:11] many other experts from the investing macro and options world. Our guest today, Andy Constant,

[00:01:15] will be kicking off a live stream with us as our first guest at 8 a.m. To be notified

[00:01:20] when we go live, go to the Access Returns channel on YouTube, click on the live link,

[00:01:24] and then click on notify me under the P&L for a purpose image. We hope you'll join us on 30th

[00:01:30] to support what is a great cause. Thank you so much.

[00:01:34] Andy, how are you? Thank you for coming back and joining us again.

[00:01:37] I'm great, Justin. Thanks for having me.

[00:01:40] Absolutely. Our audience always loves to hear your thoughts on the macro landscape,

[00:01:45] what you're thinking, I think the implications for investors and just people in general.

[00:01:54] Where you're at and how you're actually informing your subscribers with the research that you put

[00:02:00] out. But I think it would be good to start with how you think about the macro framework or

[00:02:08] landscape and this concept of islands that you often discuss on Twitter.

[00:02:15] It's become a meme. The way I look at the potential paths of the economy is one in which

[00:02:28] we're uncertain about growth, we're uncertain about inflation, and the Fed is working in its

[00:02:35] way as well as economic conditions just playing out like supply chains getting resolved, etc.

[00:02:41] To try to achieve a low inflation back down to target without significant job losses

[00:02:51] and without damaging the economy in any meaningful way. So not have it getting

[00:02:56] to basically to trend growth and target inflation, which is roughly one and a half percent growth,

[00:03:04] real growth and their two percent inflation target. And so to achieve that one does what the Fed has

[00:03:13] been doing and then follows the data and shifts there, uses their tools how they do to achieve

[00:03:23] that outcome. And so that's called a soft landing. And it would be ideal for the world,

[00:03:28] for the United States, for its citizens, for its, you know, the widest range of

[00:03:34] its participants to have all those things occur. And so that's the direction that the Fed is trying

[00:03:41] to pilot to the island that they're trying to pilot to. Now about that it's between 18 and

[00:03:50] 24 months ago when I came up with this idea, there was actually July of 22, I think, when the first

[00:04:01] hike was done about a month earlier. But there was a sort of a panic hike in, there was a small hike

[00:04:08] in May and then there was a panic hike in June. And then a July hike and, you know,

[00:04:15] rates had gone from 25 basis points to 150 basis points in three meetings. And so right at that

[00:04:23] point in time, people believed that and had begun pricing in the idea that the rate path was not

[00:04:32] going to be that steep and that the Fed was going to actually cause a recession. And then,

[00:04:40] and so that is typically what happens in a rate hike cycle is you're trying to curtail demand

[00:04:48] so that the economy will slow down. And you do it by increasing the cost of money,

[00:04:54] having the yield curve, long term bond yields go up. And what that typically does is slow the

[00:05:01] economy down and because the tools are rough, either they have to keep pressing on the brakes

[00:05:07] or and then sort of have an accident because they press too hard, maybe somebody rear ends them

[00:05:13] or they have to let off a little bit and then inflation and growth kick back in. And so then

[00:05:20] they have to tap the brakes again. So that's normally the path to the soft landing.

[00:05:26] And at the time, you know, everyone expected an imminent recession and pretty much

[00:05:31] I was alone in saying, you know, this supply chain thing is great. We all know that the supply chain

[00:05:37] is going to improve. It was in fact transitory for the reasons that they called it transitory

[00:05:43] because supply chains were resolved eventually. You're even seeing that today in the Panama canal

[00:05:48] being closed or significantly curtailed and the Red Sea having its issues with the Houthis.

[00:05:55] I think I pronounced that right. And all of those things get resolved either the cost goes up or

[00:06:04] ultimately the supply chain calms down. And so I expected that but at the same time I expected

[00:06:13] significant growth, real growth in the economy. I thought monetary conditions remained extremely

[00:06:21] easy. And that we weren't going to have a recession. In fact, it was going to be higher or for longer.

[00:06:29] And so I coined that higher for longer is a common term I call it coined the second thing and

[00:06:34] then made an island about it. And what happens on that island is real growth ends up being a well

[00:06:39] above trend for a long time. Inflation ends up falling less rapidly to target than desired.

[00:06:49] And so the Fed has to have interest deep interest rates high for long.

[00:06:55] And that's pretty much played out. And everyone there are some perma bears that continue to forecast

[00:07:02] doom recessions, etc. It perma bear but besides those types, the sort of normal players and

[00:07:10] markets have gotten all off of recession island and have now drifted over to either a soft

[00:07:17] landing or higher for longer. And so there's really it's really empty on recession island right now.

[00:07:23] There's nobody short equities, nobody short corporate bonds, credit spreads are tight, equity vol is

[00:07:32] low. And most importantly, what is priced in in terms of future cuts and interest rates

[00:07:41] is no longer a rapid, rapid cut cycle. But a cycle that is more consistent with what the Fed has been

[00:07:50] saying that their cut cut their their cut cycle is going to look like. And so at this stage, I consider

[00:07:58] a soft landing still is possible. But really what people are now expecting is that growth will

[00:08:03] continue to do very well for with and we will completely avoid a recession. And at the same time,

[00:08:13] people expect inflation to room to return to target. And to me that is now become my view

[00:08:23] has now become consensus. So I've left. So you've left the higher for longer island.

[00:08:29] And where, where are you do you think you're headed?

[00:08:34] Well, there's really for one, there's a possibility that I'm wrong and that in fact inflation does

[00:08:41] escalate. I just expect sticky. I don't expect it to ramp back up for any reason it could,

[00:08:49] but that's not my expectation. I'll be back at higher for longer island if that happens.

[00:08:54] But what I think and for that matter, I'll be back if the Fed cuts rapidly. But I don't think

[00:09:01] that's likely either. And so where I'm headed is even something that kills inflation. And it could

[00:09:11] be that it's a soft landing, or it could be a recession of some sort. And so what I've described

[00:09:19] today is that I'm in the economic slowdown sea. And I'm lashed to the

[00:09:29] the the mast of my boat with my crew with wax in their ears as we pass the sirens on

[00:09:37] soft landing island. And I'm doing everything I can to not land on soft landing island because

[00:09:43] I just think it's very unlikely. Now, what typically would happen is I'll end up at recession

[00:09:49] island, but I don't know yet. So that's why I'm out there. I do know that it's very unlikely

[00:09:54] that we'll end up soft landing island. But most importantly, pricing has no recession in it

[00:10:03] whatsoever. And high degree of and 50 50, call it whatever it is, of soft landing or,

[00:10:12] you know, higher for longer, sort of no landing. And so for me, when I'm thinking about trading

[00:10:20] markets and I'm looking at what's priced in, what's priced in is some is very low odds of a

[00:10:27] recession. And quite frankly, recessions happen frequently, and certainly can happen when you

[00:10:32] have so much. So such heavy winds going in so many directions from central bankers from the

[00:10:40] globe from geopolitics, from fiscal. And then we have an election coming, there's just, you know,

[00:10:46] with lots of winds. And so landing this plane softly is going to be a hell of a thing. And so

[00:10:53] I'm trying to avoid landing there. And you're not paid to land there either.

[00:10:59] I think we're flying and sailing. But if you do need to be rescue, Jack,

[00:11:03] Jack is a sailor, so he can he can come out and get you.

[00:11:06] I actually knew that for some reason.

[00:11:08] I think we talked about another podcast. I think you're a power voter, right? You're not a sailor.

[00:11:12] A wakeboarder, yeah. Yeah, okay. You'll get to whatever island a lot faster than I will.

[00:11:17] Depending where you're going. It's the engine on my boat, unfortunately.

[00:11:21] Oh, no. That's amazing. Yeah, I know that could be a major, major deal.

[00:11:25] Yep. I want to ask you about the bed cuts because you mentioned the more cuts were priced

[00:11:31] in than the Fed was indicating for a really long time. That's changed recently. What do

[00:11:35] you think the Fed is going to do here going forward? I mean, do you think we potentially get a cut in

[00:11:39] June and a few cuts this year or how do you think it might play out? It's going to be data dependent.

[00:11:45] It's a cop out. But again, I think that what we had in September and October was a significant

[00:11:52] tightening of financial conditions. And that was because both stocks fell and long-term

[00:11:59] interest rates rose to over 5%. And so we had a fairly tight environment for a couple of months.

[00:12:07] And what that did is it led to an economic slowdown in November, December, and maybe a little bit in

[00:12:16] January data, all the data that was released in January for December, certainly. And so inflation

[00:12:22] expectations came in. The Fed pivoted in December, markets priced seven cuts in December.

[00:12:30] Each of those tanks was a big easing and then financial markets took off in the first quarter.

[00:12:37] And so I think the environment is such that you're going to see warmer economy,

[00:12:43] warmer inflation, which would indicate that they're not going to cut in June.

[00:12:49] But I don't know. I'm not making a bet on that per se.

[00:12:54] Do you think, I'm just thinking about what they should do and I have friends who kind of go both

[00:12:58] the people I follow who kind of go both directions on this. Some people say things are really strong

[00:13:02] right now. There's no reason the Fed should even be discussing cutting at this point. There's

[00:13:06] just no point in that. And then other people would say the Fed, I don't know what the neutral

[00:13:10] rate is kind of this nebulous concept, but whatever it is, they're probably significantly

[00:13:14] above it right now. And if they want to stick to soft landing, they're going to want to

[00:13:18] incrementally get down there. So by cutting now, they'll still be significantly tight,

[00:13:22] but they'll be working their way down as inflation cools. I'm just wondering,

[00:13:26] like what do you think about those two arguments? Which one do you think makes more

[00:13:28] sense? I think they're both valid, but I also think they are not the point in our current

[00:13:34] economy. And the reason why I say that is I don't think the short rate is having

[00:13:38] much impact on the economy. I think what has impact on the economy is where

[00:13:45] long-term borrowers are able to finance. And so I saw today the 30-year mortgage is now at,

[00:13:55] I think it was 688 yield and that's not tight. 688 isn't a, it's not great. Let me tell you

[00:14:04] it's not like 3% or 2%, but it's livable given the level of GDP and inflation, real nominal GDP

[00:14:12] right now for people to begin to borrow at 6.88 mortgage for 30 years. And so that's not tight.

[00:14:24] And so what I think is important isn't so much what they do on the front end,

[00:14:29] but what happens on the back end. And so that depends more so on what the treasury does in terms

[00:14:36] of the composition of its debt and what the Fed does simply in terms of the short rate,

[00:14:43] the best thing they can do, well, in terms of the short rate, the best thing they can do is

[00:14:48] keep it high because that'll make the long rate less attractive. But at the same time,

[00:14:55] what they really can do is not taper quantitative tightening, not take off any of the pressure on

[00:15:01] the long end of the yield curve. But they are talking about tapering. So we'll have to see

[00:15:07] what happens in May. I expect them to announce either a specific plan that starts in June or

[00:15:14] a reason why not given the rhetoric they've put so far out so far, which has been

[00:15:22] their goal is to get reserves down by say a trillion dollars. And they can do it by running off

[00:15:29] 950 billion in a year, where they can do it by running off 950 billion in 18 months.

[00:15:36] And the difference is a taper. And so that's what I'm looking at the short rate,

[00:15:42] you know, pick them. The market wants animal spirits want the short rate to come in,

[00:15:50] for whatever reason. The real rate, the sort of myopic, what is the real restrictive short rate,

[00:15:58] the R star plus the inflation target that they believe they should have and what level of

[00:16:05] tightness relative to that they should have are all relevant things and something the Fed

[00:16:10] seems to be myopically focused on. Well, what I think has driven the economy, its peaks and

[00:16:16] valleys over the course of the last few years is the yields on long term bonds.

[00:16:21] So given that, do you think there was a case to be made that at the beginning of this,

[00:16:25] the Fed should have done more QT and maybe less increases on the short end? Like would that

[00:16:29] have been more impactful? That's what I was saying then. I was hoping they would actually

[00:16:34] make outright do outright sales of mortgages. You know, they had talked a big game about a

[00:16:39] desire to have no mortgages on their balance sheet in the future. And they said it relative

[00:16:45] to that okay target of $35 billion of runoff per year per month. But they weren't able to achieve

[00:16:52] that because rates rose so quickly, they drove rates up so quickly that all these mortgages stopped

[00:16:59] being re-financed. And so mortgage runoff has been running, you know, on average a little less

[00:17:06] than 20 a month. And that's nowhere near what they wanted. So I would have had them

[00:17:10] sell mortgages and some treasuries. But instead what they did is they said we're going to run off

[00:17:17] and they literally handed the monetary policy lever of QT to the treasury and treasury has

[00:17:24] a variety of very good reasons has in certain periods of time been forced to mute QT and in

[00:17:31] other times enhance QT and that has given you given QT a relatively mild influence because

[00:17:42] that you can see by what are very negative close to zero term premiums on long term bonds

[00:17:49] and a very inverted yield curve. You can see the short rates are much higher than long rates.

[00:17:54] And so it hasn't really worked very well, but that would have been my view still is my view that

[00:18:03] if you want to kill inflation the best way to do it is increase yields at the place where people

[00:18:09] actually borrow. Can you talk a little bit more about that treasury point you made because

[00:18:14] this is something I learned from you a while back. This idea that Janet Yellen may have more

[00:18:18] power here than the Fed actually does in terms of how she's setting the issuance. So

[00:18:21] can you talk about that a little bit and how impactful that is? Sure. So what happens when the

[00:18:26] Fed does QT and the way they've decided to do it, the Bank of England actually makes outright sales

[00:18:32] of bonds and so they have control. When the Fed does it, they let bonds mature. And so

[00:18:39] okay so the bond is mature now somebody has to pay them back and that is the US treasury has

[00:18:44] to pay them back as they would any investor who's bond mature. And so to get that money

[00:18:50] they have to ish the treasury has to issue some new obligation to some not the Fed,

[00:18:56] some private sector buyer. And if they chose to issue say for instance

[00:19:03] T-bills. Well there's a huge demand for T-bills. They're extremely low risk.

[00:19:09] There happened to have been also this excess savings in the form of the reverse repo program

[00:19:15] that is where most money market funds have a significant portion of their investment over the

[00:19:21] last few years. And so they were happy to move out of the RRP and into T-bills.

[00:19:29] And so that doesn't have any tightening effect on the market. It's just one

[00:19:35] short term interest rate exchanged for another and the Fed gets its money back.

[00:19:39] What does have an impact is if the treasury for instance, and this is obviously radical,

[00:19:44] if the treasury said we're going to issue an extra for QT at 60 billion per month,

[00:19:50] we're going to issue an extra 60 billion of 30 year bonds. Well 30 year bonds are somewhat more

[00:19:59] risky than a T-bill in that their price. Anyone who saw what happened in 2022 knows that

[00:20:06] the 30 year bond fell I think it was over 35%. So when people buy a 30 year bond they think

[00:20:13] of it very differently than buying a T-bill. And so they have to make room for it in their

[00:20:17] portfolio on a risk adjusted basis. And so by selling 30 years, if Janet had chosen to do that,

[00:20:25] that would have been an extreme tightening. So now she doesn't do either of those things.

[00:20:33] She sells some bills and she sells some coupons. But the more bills she sells,

[00:20:38] the less tightening. And by and large through the debt once the debt ceiling came into place in

[00:20:47] December of 2022, 22. Yeah. She basically reduced coupon issuance so significantly

[00:20:58] that because of the debt ceiling that at one point I believe it was the second quarter,

[00:21:04] she only issued $178 billion of net new coupons which is the lowest post COVID.

[00:21:12] And so markets loved that. There was no bonds for sale, so they bought stock, they bought meme stocks,

[00:21:18] they bought crypto, etc. And then in the third quarter she announced that the fourth quarter

[00:21:24] was going to see a doubling of that supply of coupons. And as soon as that was announced,

[00:21:31] bonds started selling off, equity started selling off and we fell 10% to Halloween.

[00:21:37] I think Russell's fell maybe 27% if I remember correctly in two and a half months.

[00:21:44] And then she blinked in October on Halloween and said, you know what? We're not going to

[00:21:49] increase coupons this time. And so it's very much her hand is on the tiller. Now she had

[00:21:57] good reasons. She wasn't allowed to issue bonds when there was a debt ceiling. So the first two

[00:22:04] quarters of this year, she didn't have any capacity to issue. But the third quarter,

[00:22:09] when she decided to issue mostly bills to rebuild her checking account, the TGA it's called,

[00:22:18] that was a significant easing and muting of QT which only until only by the announcement

[00:22:27] in August reversed. So do you think as we move forward here, do you think she'll issue

[00:22:33] more duration? Do you think she'll wait till the election's over and then do it or how do you

[00:22:36] think that might play out? Well on February 1st, yep, February 1st she'd had her next increase.

[00:22:43] And you know it went from 178 billion in Q2 to 338 billion of net new coupons in Q3

[00:22:52] to 348 billion in Q3 it was 178 and Q4 it was 338 and Q1 this year was 348. But in February she said

[00:23:06] we're going to issue 538 billion of net new coupons, which is by the way 1.1 trillion

[00:23:14] of gross coupons. And she said and the T-BAC, the Treasury Borrowing Advisory Committee and the

[00:23:22] members of the Treasury that are responsible for this wrote in their letter that they

[00:23:26] expected to keep that quantity of bonds on offer each quarter for many quarters to come.

[00:23:34] So it's a lot right now like it should be having a much bigger effect given that it's

[00:23:42] 4x or 3.5x what it was just a year ago and is 200 billion more per quarter than it was in Q3 and Q4

[00:23:56] and Q1. So it's a big slug of bonds that are being offered and I do expect it to have a meaningful

[00:24:03] impact. Why it hasn't had much of an impact yet, I think goes back to multiple times Janet has

[00:24:10] muted QT as a surprise and so she's now discouraged people from front running her supply

[00:24:20] by these actions. And so I think we're going to just actually have to see sort of a

[00:24:26] I've described it as a camel getting another piece of straw placed on its back until bond yields

[00:24:31] actually start moving in a meaningful way and then you get the dynamic that can slow the economy

[00:24:38] enough to either land us softly or cause a recession. I'm curious when you think about the

[00:24:44] election like do you think people overstate that you hear that all the time right now you hear like

[00:24:47] she's influenced by the election then you hear the Fed who is independent is influenced by the

[00:24:51] election and they're going to you know they're going to do things because the election's upcoming

[00:24:54] I mean do you think there's political influence in all that or do you think they're they're

[00:24:58] kind of just doing their job and they're they're outside of that? Well I mean there's the

[00:25:02] staff and then there's the elected officials that are responsible for the treasury and let's

[00:25:09] be clear about this. The elected officials are trying to get reelected there's no doubt about

[00:25:16] no doubt about it let's not be naive. Now the question becomes what levers do they have

[00:25:21] and what do they actually want? So I'd be open to hearing what would be the best outcome for

[00:25:30] I think I could well let me describe what I think would be the best outcome for the

[00:25:34] current administration. I believe what would be best is for gasoline prices to be three dollars at

[00:25:41] the pump for food prices to be back to where they were or at least not going up anymore at all

[00:25:50] home prices being more affordable mortgage rates being lower and what else?

[00:26:02] Oh and everybody having jobs and that's what they want. Now you know some of those things don't go

[00:26:09] together and so the question becomes what do you think they want like which one's more

[00:26:14] important is inflation more important? Well one might say that the gas pump is a pretty

[00:26:19] important place for a majority of voters a gross gross majority of voters and the financial asset

[00:26:26] market is not necessarily their constituency. I'm not sure it's anyone's constituency but it's certainly

[00:26:32] not the Democrats historical constituency so that brings us to jobs and so now it's a question

[00:26:41] of would they sacrifice jobs given how many jobs have been created and how tight the labor

[00:26:47] market is for lower prices at the pump or lower consumer goods prices or lower cost of a haircut or

[00:26:56] a nice meal or even a crappy meal at a you know a fast casual restaurant which has

[00:27:05] gotten silly and flayed it? What would they want and honestly I don't know. I wish I did know

[00:27:11] but they're not making it obvious what they would want and then the question is what

[00:27:16] levers do they have to make it happen? Now let's just dig into that very quickly which is the Secretary

[00:27:23] of the Treasury has the lever I described which she can decide to issue more or less coupon bonds.

[00:27:30] She has stated that she intends to issue the same amount this next quarter as she issued in Q3 as

[00:27:37] she's issuing in Q2. We'll see she'll tell us on May 1st so I'm going to pay attention to that

[00:27:43] when she tells us. The other thing she can do and this is a it's a discussion for another time but I

[00:27:52] will tee it up there's this thing called the Treasury General Account which currently has

[00:27:57] 750 billion dollars of money in it and that's the money that what happens is when we pay our

[00:28:05] taxes that goes into that account when we buy a bond from the Treasury that goes into that

[00:28:12] account and what comes out of that account is the expenditures that the Treasury makes in the

[00:28:19] to the real economy both interest and spending, interest being an increasing largely large portion

[00:28:25] of that seven trillion dollar number and tax refunds and maturity payoffs and so

[00:28:38] why is it 750 billion? Well it turns out there's a really good reason why it's that large and the

[00:28:44] reason is is back on September 11th in 2001 for five or six days markets were completely closed

[00:28:53] like and that meant that the Treasury could not issue anything no bills no nothing

[00:29:01] and so they decided to implement a policy that is on the Treasury's website regarding you know keeping

[00:29:07] money in the bank just in case they can't issue bills to create new funding and that number is

[00:29:14] five days worth of net expenditures plus redemptions of existing bonds and bills they

[00:29:20] don't want to go bankrupt they don't want to not honor their maturing obligations they

[00:29:24] expect to collect taxes and they expect to spend their expenditures but it assumes they are not able

[00:29:29] to raise new money and so that's a number that tends to run somewhere between seven or 50 billion

[00:29:36] and a little bit more over the course of the next 12 months and so to take it below that amount

[00:29:44] and so to take it below that amount would be risking a potential market disruption event where they

[00:29:55] would not be able to meet their obligations and so that's a pretty that's a pretty meaningful standard

[00:30:02] at the same time they could they have many times said well we're in a debt ceiling so

[00:30:10] we can't raise new money so we have to spend down the money and so last year we all we were

[00:30:17] talking about is when was the ex-state when was the government going to run out of money and shut

[00:30:22] down well the running out of money is taking that Treasury general account spending it

[00:30:30] down to zero and so they came close to that and the Treasury general account

[00:30:37] has been rebuilt now remember they only took the risk of the September 11th market disruption event

[00:30:46] because there was a debt ceiling they didn't do it voluntarily they just said hey we don't

[00:30:52] have we have a debt ceiling we have to spend we have to meet our obligations so they spent

[00:30:56] their savings their Treasury general account and so that's a dangerous thing to do but

[00:31:01] but conceptually that if Janet wanted to reduce the amount of issuance in the economy while still

[00:31:08] spending which would tend to be a thing that would inject money into the financial into the

[00:31:15] real economy without demanding that money being invested in government obligations

[00:31:22] that tends to be stimulative of financial assets and so they could spend down the TGA

[00:31:28] take that risk as a political maneuver to goose the stock market and the bond market not

[00:31:38] necessarily the economy and it's they couldn't may or may not be inflationary so and it may

[00:31:43] not or may or may not save anyone any jobs but they could do that so that's one lever

[00:31:48] now there's an interesting dynamic based on the the financial fiscal responsibility act

[00:31:56] which was the thing that resolved the debt ceiling that there are some interpretations and this is again

[00:32:02] for July they'll tell us in July um that says that the government has to spend down the TGA

[00:32:11] by January 2nd to the level it was on June 2nd of 2023 if they were to do that the

[00:32:19] Treasuries can say yeah we're going to follow the letter of the law and spend that money

[00:32:25] and they may get the outcome that they want which is a pumped up equity market

[00:32:29] or they're going to say well the way we interpret the law and the law isn't clear

[00:32:34] the way we interpret clause 2b is that we're supposed to keep a normal amount of money in our TGA

[00:32:42] in that case we're not going to spend it down so it's an interesting dynamic one worth very

[00:32:48] that one should follow very carefully understand the why's and the house but that's the real lever

[00:32:54] that Janet has but again it's a financial market juicing it's not an inflation fighting in fact

[00:33:01] it's arguably inflation causing and it's not a job saver because it doesn't change the amount

[00:33:09] of real spending that the government does it's interesting when you were answering that I

[00:33:14] was just thinking about like we're in a new world of trade-offs now like in past elections and past

[00:33:18] years when we had no inflation if the government wanted to you know if they wanted to get reelected

[00:33:22] if the Fed wanted to help them and if all that wanted to happen it was more clear what they

[00:33:26] should do um now now it's a little less clear what they should do right because they're

[00:33:30] they potentially could have inflationary consequences of doing the things they could do before

[00:33:34] yeah I honestly well you know it's funny it's I don't have a political view generally

[00:33:41] I vote my conscience and who vote who are vote for but um it is interesting that not only that we also

[00:33:48] have to focus on how maybe four or five states and maybe within those four or five states two or

[00:33:55] three counties in each of those states and so that's who you're planning for if you're pulling

[00:34:01] on levers if you're manipulating now the the media will manipulate as well but if you're

[00:34:07] pulling on those levers you're really only targeting 11 counties in the united states

[00:34:14] to win your election because all the other counties are either blue or red and there's

[00:34:19] nothing you're gonna do that's going to change that so I so what I basically say is uh they're

[00:34:28] going to tell us certain things they're going to do we don't know what that is let's assume

[00:34:32] that politics is going to be playing a role but until you can tell me how they win those 11

[00:34:38] counties with their actions I'm gonna say I'm just gonna wait and watch and if they do something crazy

[00:34:44] like spend down the tga or shift out of coupons into bills again I know what I'll do and you have

[00:34:51] time to get in position when they do it I want to ask you about long-term structural inflation

[00:34:56] because before all this happened you sort of had three deflationary forces everybody was talking

[00:35:00] about they were talking about technology demographics and globalization and those are the

[00:35:04] things that kept inflation very very low for a long time and I'm just wondering how you think

[00:35:08] about those going forward I mean I would think globalization may be shifting in the other direction

[00:35:12] but then people say with with AI technology is going to be even more deflationary than it has

[00:35:16] been like how do you think about long-term structural inflation in the context of those

[00:35:20] things I think about it at some level as it relates to what I do pro-living I think

[00:35:26] about it as a fairly well-informed person but really as useful to me as any other cocktail party chatter

[00:35:34] it doesn't really have any impact on how I think of markets in the next year so for instance you

[00:35:40] mentioned AI as a deflationary force and I agree it has great potential for increased productivity

[00:35:49] it does have a and it has a second order impact not only will we be able to create

[00:35:54] more goods and services cheaper but we'll also be able to fire a lot of people and their demand

[00:36:02] for goods and services will come down and so spending on goods and services will come down

[00:36:08] unless that income that is lost by these people getting fired is made up for by some

[00:36:15] government spending like a UBI or something like that

[00:36:22] and so it could be extremely deflationary if both the demand side because of the fired workers

[00:36:29] and the supply side because of the greater quantity able to be of goods and services able

[00:36:34] to be produced could be extremely deflationary but who cares today nothing but spending is

[00:36:41] happening there is except for the chip sellers and some of maybe the rack sellers or you know some

[00:36:48] the cooling tower sellers or anything that makes the picks and shovels of AI

[00:36:56] no one's make a penny on this stuff no one's seeing the benefit of no one has turned their

[00:37:03] operation no one has fired a single worker because of AI no one is seeing increased

[00:37:11] manufacturing capacity because of AI yet and so what I look at it is it's wildly inflationary

[00:37:18] at the in the near term and in the longer term like the inflation reduction act the ironically

[00:37:26] named inflation and reduction act was a spending bill today to get the benefits of deflationary

[00:37:34] investment in the future I don't know when that's coming around but right now I know what is happening

[00:37:40] and you're getting inflation from these efforts and that applies broadly speaking to most things

[00:37:47] including the things you mentioned like on shoring um and uh you know even if not on

[00:37:53] shoring bringing our creating duplicate supply chains with partners that are more aligned with us

[00:38:02] you know geopolitically or simply closer versus importing from China and so

[00:38:10] those to me are meaningful structural inflation at the same at the moment and

[00:38:17] are deflationary over time and I just not going to hold my breath

[00:38:22] I guess we should call this segment before I switch back to Justin here that my last two

[00:38:25] questions maybe should Jack be worried about these things because there's two things you've been seeing

[00:38:30] people very concerned about on Twitter and I would ask you about each one individually

[00:38:34] and see what your level of concern is and the first one is this idea that you know the

[00:38:37] national debt is is very high right now and you know many people see a situation that could

[00:38:42] spiral out of control you know they see all kinds of you know second order effects to that

[00:38:46] how worried are you about the level of the national debt right now

[00:38:49] not very much at all um the level of debt is um is uh high no doubt about it the

[00:39:01] interest payments are high but also not significant relative to GDP yet

[00:39:09] um and it appears that we are uh the deficits which is the important thing that's what creates

[00:39:20] additional debt the deficits are not likely to go up in the near term now I am worried

[00:39:28] in a recession if we were to have a recession what would happen to the deficits as the

[00:39:34] government typically in a recession counteracts uh declining private sector incomes with public

[00:39:42] sector spending so I am concerned about austerity in a recession causing a bigger problem

[00:39:50] but you know I have faith in our politicians to act in exactly the way they always act

[00:39:57] which is bipartisan deficit increasing they

[00:40:07] both always spend more than they take in there is and that politically it's a pie splitting thing where

[00:40:16] one party may um tax less and another party may spend more but both are deficit creating so

[00:40:24] I have confidence there's going to be deficits the question are they going to escalate instead of

[00:40:29] staying high and if they stay at you know 1.4 or 1.5 trillion for a while eventually our debt is

[00:40:37] going to get to a tipping point um but it's nowhere near where a tipping point today just

[00:40:43] in this as an aside do you ever think we'll return to like what we saw in 2019 you know

[00:40:47] zero percent feds rate fed funds rate um three percent mortgages do you think that's something

[00:40:51] we see again in our lifetime or do you think that's over I would like to say it's over but

[00:40:59] I would never say never I think that experiment uh by and large failed and what I mean by that is

[00:41:10] if you look at the 2010 through 2019 time frame we got very little asset inflation and

[00:41:18] pretty subpar growth certainly subpar NGDP nominal GDP um and so it didn't really do the

[00:41:26] sort of stimulative thing that you would have you would have hoped for and that's precisely

[00:41:32] because the government you know every I I watched uh Greenspan Bernanke and Yellen and then Powell

[00:41:41] um go up to the hill and say we're doing our part you need to do yours or else we're going to have

[00:41:49] subpar growth and they never never really did except all at once in 2010 20 and 2021

[00:41:58] then they got with the picture and so I think that

[00:42:02] that

[00:42:04] my prior um from one of my prior firms that I worked

[00:42:08] um for calls it mp3 which is monetary policy three and it's not mmt per se

[00:42:16] month um that is a popular version but it's not dissimilar in that I think that that the

[00:42:22] response to a significant slowdown significant meaningful slowdown you know like a 3000 s and p

[00:42:30] and a negative 2 growth for six months will be something like that instead of single handed

[00:42:39] action by the the Fed to lower rates to zero and to be doing QE because that doesn't work they need

[00:42:47] spending and so that's what I think the first try will be first there's going to be

[00:42:54] in a recession first the first action is always austerity the second if it's a slow grinding

[00:43:00] recession if it's a sudden one like 2000 something breaks um you can see um the fiscal side act

[00:43:07] quickly but by and large there's austerity and then it's followed by spending and if that

[00:43:13] spending is essentially financed by QE at positive interest rates I think that's a more

[00:43:19] likely outcome than a you know the Fed trying to lift the economy all on its own because

[00:43:27] it created a lot of bad behaviors and it created a lot of um of unsustainable conditions that

[00:43:33] we're still living with the last thing I want to ask you before I hand it back to Justin is

[00:43:37] this idea of the refinancing wall so a lot of people have this idea that a lot of the

[00:43:40] court there's a lot of corporate debt that has to be refinanced it hasn't been refinanced yet

[00:43:45] you know so we haven't seen the impact of these rates and when it comes we've got a

[00:43:48] coming catastrophe like what do you think about that uh so credit spreads are extremely tight and

[00:43:54] interest rates are very low and everybody knows that and so there is not a single treasure or

[00:44:01] CFO on the planet who is not looking at their maturity wall and addressing it they have deep

[00:44:09] liquidity they have low credit spreads and they have higher interest rates but they could

[00:44:16] hedge them if they want if they want to make that bet but they also have high nominal GDP so by

[00:44:22] and large that thing that tends to work itself out now the commercial real estate market is probably

[00:44:28] one narrow section of that and within commercial real estate it's certain subsections of that I

[00:44:35] don't want to get into the weeds on that but I assume there's going to be some difficulty

[00:44:38] in some of those for those some of those banking institutions that have made those loans

[00:44:43] and certainly for the equity holders that own the equity in those properties

[00:44:51] we uh wanted to sort of talk about how some of these ideas manifest themselves in actual portfolios

[00:45:00] and strategies um but before sort of maybe we get into that a little bit just can you explain

[00:45:09] how you sort of differentiate alpha and beta and how you would define those things because

[00:45:14] because on your you know as part of what you offer subscribers is these alpha and beta

[00:45:19] portfolios which maybe we'll talk about in a few minutes but you know how would you explain this

[00:45:24] to investors and your your way of defining alpha and beta yeah so I think that one of the

[00:45:30] only places where investors have essentially free money is by buying securities that allow a real

[00:45:40] economy participant whether it's a corporation a mortgagee or a government to spend in the

[00:45:49] real economy to buy a factory to buy a home or to provide to buy a uh aircraft carrier um and so

[00:46:00] when those seekers of money offer their securities as um as uh as payment for the money

[00:46:12] um they offer a positive expected return through time and that positive or expected return is

[00:46:21] often called the risk premium that's what I like to call it and it's basically saying that if a somebody

[00:46:26] somebody is a sabre somebody has cash and they're willing to lend it um that um it's not dissimilar

[00:46:33] for you and I playing a game of dice you walking up to me and saying do you want to bet uh

[00:46:39] a hundred dollars on a coin flip and I'm gonna say and you're very motivated to do this for

[00:46:45] whatever reason and I'm gonna say uh no that has zero expected value to me why would I take on risk

[00:46:55] for no reason and then you say well I'll pay you 101 and you only have to pay me 100

[00:47:02] and I'm gonna say okay well that has a positive 50 cent expected value to me

[00:47:07] I'll do that or I won't do that um financial assets have that characteristic of the

[00:47:17] a motivated seller a corporation a mortgagee or the government wanting your money to spend

[00:47:24] in the real economy and you sitting back and choosing amongst all the possible places to

[00:47:29] invest including holding cash all of which have some risk and you assess that and say

[00:47:36] yeah I'll do it and so what I think happens is that through time it's been shown that

[00:47:43] if you hold cash reinvested overnight for five 10 15 25 years a century compared to owning a

[00:47:52] diversified asset portfolio you'll find that you are on excess returns in owning assets

[00:47:59] that's what I call beta that's free money that all you have to do is buy and hold

[00:48:08] and you should earn excess returns versus cat and so I think beta's you know the greatest thing

[00:48:14] in the world and everyone should own most have shouldn't have most of their assets in

[00:48:20] that type of strategy now um what type of portfolio it should be balanced I happen to like portfolios like

[00:48:29] a qr's risk parity the there's ETFs that are called Alpar for instance that has a portfolio I like

[00:48:41] and bridgewater's all-weather portfolio I have a portfolio that's similar to those things and

[00:48:46] that it probably has more gold more commodities and more bonds than most people's portfolio but

[00:48:53] it still has plenty equity and I like that because it tends to work better in a broader range of

[00:49:00] possible outcomes particularly ones like we've seen lately um and so I like that but any portfolios

[00:49:08] fine most portfolios even 60 40s not awful they're gonna earn a positive return on cash through

[00:49:16] if you hold them long enough and so again for your listeners that's what I'd have you in

[00:49:24] then down a level

[00:49:30] there's this game of outperformance that people do you give a investor

[00:49:38] money and they outperform something a benchmark so the long only active manager typically might be

[00:49:45] benchmarked against the s and p 500 to put it simply and that active manager is supposed to

[00:49:51] beat the s and p 500 the return of the s and p 500 is all beta the outperformance or

[00:50:01] underperformance is alpha and how do you generate outperformance well if the world is invested in

[00:50:10] all the assets on the planet which they are you have to take it from somebody else

[00:50:18] to get outperformance you have to be smarter than somebody else you have to pick better

[00:50:23] stocks well if you pick these better stocks that means somebody else had to sell those

[00:50:29] better stocks and buy worse stocks because as I said every stock is owned so you're buying them

[00:50:36] from somebody who thinks they're good and selling and they're then buying and so that whole thing

[00:50:42] works in a way that it's zero sum and so I think of alpha as the zero sum way of timing the market

[00:50:51] so that you're buying something that is going to outperform what you're selling

[00:50:59] and that's alpha now that alpha can be expressed in many many different ways it can be a it can be

[00:51:07] macro like what I do which is changing you know I go long and short assets and because I go

[00:51:14] long and short assets equally and I don't particularly care whether I'm long or short

[00:51:19] on average I have I'm neutral and because I do that my benchmark is cash and that's okay a cash

[00:51:28] benchmark is no big deal because as I said most of my wealth is in long only beta so I get the

[00:51:33] market return and my alpha just gives me extra money versus cash and so that's how

[00:51:42] I think about investing and I think that the question then becomes do you have alpha as an investor

[00:51:51] or if you're giving your money to somebody else to invest who is trying to outperfian

[00:51:59] do they have alpha and those are hard questions to answer.

[00:52:03] You had mentioned in the the beta portfolio that you own probably more gold than you know

[00:52:10] some other strategies but that's been I would imagine that's been good because gold's kind of

[00:52:14] woken up here lately right you know gold actually is an interesting asset it really hasn't done very

[00:52:22] well when measured against most things certainly you know if you bought gold at 800 in the

[00:52:30] when it first became legal it owned gold in America in the 1970s you made awful returns

[00:52:41] and so it's really important when you buy it if you bought it recently that's good you did well

[00:52:46] but that's alpha not HEDA so I like gold because it offers properties that nothing else does which

[00:52:54] is the potential for monetary hedge monetary inflation now bitcoin may do the same thing or

[00:53:01] crypto may do the same thing broadly speaking I think other assets do the same thing broadly

[00:53:06] speaking so real assets so gold is interesting and it's like money and you know I think it's

[00:53:14] it should be in somewhat sport polio are you considering any crypto assets for the beta side

[00:53:22] I like to do things I understand fully and I feel like everyone else has much more edge than

[00:53:27] I do in crypto I also think that it's volatility you know when I was really liking crypto there

[00:53:34] was a period of time and it's gone up that doesn't matter there was a period of time in which it I guess

[00:53:40] it was probably about six months ago when it was just stuck at 30 000 might have gone to 26 and then

[00:53:45] up to 30 and then down to 26 and it was just stuck and I was like yes the speculative pump

[00:53:53] and dump nature of that asset had sort of retreated and it actually became instead of correlated to

[00:54:00] meme stocks or qqqs it became correlated to gold I'd like to buy crypto when it's like that

[00:54:09] and the question is is there alpha between today when it's not like that and one day when it is

[00:54:17] like that there may be I just am gonna miss it because I'm not gonna be able to understand it

[00:54:23] can you just I want to go back to the island thing for a minute and the fact that you

[00:54:29] you know you left the island and you're you're sort of going to you know some island but

[00:54:34] just let's talk about decision-making for a minute because you know how do you just walk through like

[00:54:45] an example or how you think about changing your mind on something or not you know we were we

[00:54:54] did a podcast the other day and we were talking about Daniel Klaneman and all of his

[00:54:58] contributions to behavioral economics and decision-making and you know there's this idea of the

[00:55:02] sunk cost fallacy um and you know and we gave an example of Jason Schwagger an article about him

[00:55:09] and it was our article about how they sat down one day him and Conan and wrote this big long

[00:55:14] article and in the next morning Jason woke up and the article was completely different like he

[00:55:19] had rewritten the whole thing and Jason was like how could you do that and he's like I have no

[00:55:24] sunk costs so I mean I would I would imagine you know as someone that's been investing uh

[00:55:33] using these macro strategies for as long as you have you know you you might have a somewhat

[00:55:38] similar principle but just kind of talk talk about that decision-making process and how

[00:55:42] you think about that yeah number one i'm far from perfect number two um I've seen the way people

[00:55:49] tend to go about that and um that is either discretionarily which is something in your

[00:55:57] head that you bring together um to create a signal um or systematically in which you get

[00:56:05] a machine to do that for you um I'm a single person operator I have as many things as I

[00:56:12] as I could systemize systemized um I would like to systemize everything I do and I don't have the

[00:56:19] resources to do so I have to make compromises and part of that is being discretionary I saw the

[00:56:26] a discretionary macro from you know of the top quality when I worked at Brevin Howard and I

[00:56:33] saw um Bridgewater do systematic trading and throughout my Wall Street career both as a

[00:56:38] hedge fund manager and as a broke as a broker dealer at Solomon Brothers a derivatives professional

[00:56:44] at Solomon Brothers um I tried to systemize everything and so I continue to favor that to

[00:56:51] deal with the sunk costs um that you described um and uh but then the other thing is um just

[00:57:00] constantly um exploring where I could be wrong like spending way way more time on how I could be

[00:57:08] wrong than how I could be right so uh final sort of question here um when you are looking out

[00:57:20] over the next 12 18 months what are the things that you're most worried about and what are

[00:57:25] the things that you're most optimistic about I think that thing I'm most worried about how the

[00:57:29] one I think the um the the combination of the uh uh various forces there that are winds that are

[00:57:40] blowing across the economy and the geopolitical landscape that we could have a meaningful

[00:57:47] dislocation and that could be social it could be economic it could be markets and all of these

[00:57:53] things so I do think there's some rough waters ahead in that regard but in particular the thing

[00:57:59] I'm most concerned about financial markets is that we uh that the um uh that we don't kill inflation

[00:58:07] that's the number one thing I think is most that most important for society right now

[00:58:12] is killing inflation and I am um while I um I'm sympathetic and don't want to see anyone

[00:58:20] feel pain I think the pain that the overall populace will feel uh even in a shallow recession is much

[00:58:29] versus what an individual class would feel in us in a or set of people will feel in a in a um

[00:58:37] a shallow recession I'd take the um pain of the recession over inflation so that's the

[00:58:44] number one thing in terms of optimism I think the experience I've had meeting guys like you too and

[00:58:50] meeting everybody out that I've met um over the course of the last two years the the conversations I

[00:58:58] have uh the the learning I'm doing is astounding it's just astounding what a community of people

[00:59:08] that are looking to try to help each other and educate each other can do and so when I think about

[00:59:15] all the great things that our society can do that gives me the greatest optimism that we now

[00:59:21] have a way that you can connect with subject matter experts that generously offer their time

[00:59:30] and pay it forward in a way that pretty much everyone has access to I think that's

[00:59:38] that's so different than 20 years ago that's awesome thank you very much Andy we uh we really

[00:59:46] appreciate your time and we look forward to seeing you uh in a couple weeks here on the live

[00:59:52] it's gonna be fun thanks this is Justin again thanks so much for tuning into this episode

[00:59:57] of excess returns you can follow jack on twitter at app practical quant and follow me on twitter at

[01:00:03] at JJ carbonell if you found this discussion interesting and valuable please subscribe in either

[01:00:09] itunes or on youtube or leave a review or a comment we appreciate Justin carbonell and jack

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