Coal Mine, Meet Canary

Jay Powell announced today that the Fed would expand their balance sheet “organically”, meaning that the “temporary” expansion of overnight repo operations is about to become not-so-temporary. Rather than continue to treat the recent spike in demand for cash as an anomaly, the Fed will satisfy that demand going forward as an ongoing, more-or-less permanent adjustment to the Fed’s balance sheet.

“It’s a feature, not a bug.” That’s what Powell said yesterday.

Powell went to great lengths to explain that, in his mind at least, this balance sheet expansion was NOT Quantitative Easing, because the intention here was NOT to provide stimulus for the real economy or any impact on longer-term interest rates, but rather to “maintain a firm grip” over short-term rates. In Powell’s mind, balance sheet expansion is a rectangle and QE is a square … all QE is balance sheet expansion, but not all balance sheet expansion is QE. Whatever.

I say whatever because I don’t think the question I hear people asking – is this QE or isn’t this QE? – is particularly helpful. Why not? Because the engine that makes QE “work” (and by work I mean its impact in pumping up financial asset prices, not any supposed impact on the real economy) is not so much the mechanistic effect of balance sheet expansion per se, but is the narrative of monetary policy support in the form of associated forward guidance. And that narrative ain’t happening here.

So yes, this is balance sheet expansion. It’s more than just a “reverse-twist”, where the average duration of the Fed’s holdings are shortened but the size of those holdings remain the same. And if your definition of QE is balance sheet expansion, then you’re right in saying this is QE. What I’m saying, though, is that a mechanistic, balance sheet approach to the meaning of QE for markets is weak sauce. The WHY of balance sheet expansion matters a lot more for market impact than the FACT of balance sheet expansion.

But that doesn’t mean that Powell’s announcement yesterday is no big deal. It’s a huge deal. I think it’s a dead canary in the coal mine of monetary policy.

I think these emergency actions in the repo market – and to be sure, these ARE emergency actions – and now the expansion of the balance sheet to get more cash into the system, are the clearest indications yet that the Fed has lost its fundamental credibility with Mr. Market.

What do I mean by fundamental credibility? I mean the belief that the Fed sets the price of money on the basis of its legal mandate – full employment and price stability. Not to weaken the dollar. Not to juice the market. Not to influence the 2020 election. Not as a negotiating chip in a China “trade war”. Not as an overtly political entity.

It’s not possible to see recent Fed easing actions as anything but a non-mandated political reaction to external pressures.

It’s not possible because They’re. Not. Even. Pretending. Anymore. It’s not possible because Jay Powell TOLD US this is why they are easing. It’s not possible because Jay Powell TOLD US that the Fed is concerned about “maintaining a firm grip” on short-term interest rates.


As they say in the twitterverse, let that sink in.

Are these emergency actions in the repo market a problem for the market? No, not at all. The Fed can literally paper over this doubt in the overnight repo market by shoveling limitless money at the doubters. And they will. (see The Right Price of Money for more thoughts on this) But this is a disturbance in the Force. This is a dead canary.

What I’m trying to figure out is where this failure of credibility – this mistrust in the stated price of money – will bubble up next.

I think it shows up next in HY corporate credit. Unlike the overnight repo market, this will be a slow-motion train wreck. But I do think it will be a train wreck. And I don’t see how this gets papered over so easily.

As always, I’d love to hear your thoughts on all this. Still trying to figure it out. But I think I’m on the right track.

The Wages of Populism

I wrote a brief note today about the narratives surrounding emerging market investing, particularly what I call EM Investing™ – the business of EM as an asset class. The skinny of that note is that I believe there are two necessary narratives for EM Investing™ to work: EM Growth! and EM Property Rights!. Unfortunately, the former has been under siege for close to a decade, and the latter has suffered what I think is a mortal blow from the Argentina/IMF debacle. Can investment in idiosyncratic or even country-specific emerging market opportunities work in the absence of a supportive narrative structure? Absolutely. Will institutional flows into the asset class of EM work under these conditions? I don’t see how.

As you’ll see from the text of the EM note (reprinted below), I’m not unsympathetic to Argentina’s populist political movement (now with a healthy lead in the polls) seeking to defeat Macri and undo the IMF accords that provided loans of $57 billion in exchange for the usual IMF “structural reforms” enshrining the primacy of global capital. But regardless of what you or I may think about the merits of all this, I don’t think there’s any disputing that property rights (in this case those of foreign investors) are under assault in Argentina, and that it’s an intrinsic plank of that country’s populist movement.

“Assault” is probably too strong of a word. Let’s call it a subordination of property rights … a political reconfiguration of the meaning and primacy of property rights in relation to other political rights. But if you’re a foreign holder of Argentine sovereign debt, it probably feels like a physical assault.

My larger point is this: the subordination of property rights to other political initiatives and good things isn’t limited to Argentina. It’s everywhere a populist political movement exists, including the United States. I think the way it will present itself in the US is through massive changes in tax policy following the 2020 election, regardless of who wins. I think that no one is talking about this, much less preparing for this. I think that I’m not sure how to prepare for this.

As always, I’d be keen to hear your thoughts.

Yes, Deadwood is the greatest HBO series ever. Don’t @ me. I’m not having it. David Milch is MY President.

And while Al Swearengen is the greatest character of that greatest show, the fact is that it’s another character – George Hearst – who drives the narrative arc for the entire series (and movie). Distant oligarch George wants the gold. He wants the timber. He wants the land. He goes to great lengths and great expense over a period of several years to acquire those assets, and then, by God, he is prepared to go to even greater lengths and greater expense to keep those assets. Because once acquired, by hook or by crook, those assets are HIS.

You see, Deadwood is a show about property rights.

So is the Argentina – IMF show.

IMF not saying when Argentina could get last disbursement  [Associated Press]

The International Monetary Fund refused to say Thursday when it will disburse the last $5.4 billion of a massive loan to Argentina that was originally planned for mid-September.

IMF spokesperson Gerry Rice said at a news conference that he didn’t “have specific information on timing.”

Reporters had asked him whether the organization will wait for the winner of the October presidential elections to take office on December 10 before releasing the funds.

Over the years, I’ve written a lot about Emerging Markets (EM) and the narrative here in the US and other developed markets about EM Investing ™. Here’s the note from six years ago that started this thread, “It Was Barzini All Along“.

Six years later, and I wouldn’t change a word. What is the core narrative for thinking of emerging markets as an asset class? What is the line you hear over and over and over again?

“EM is where the growth is.”

Or in the Epsilon Theory lingo, Yay, EM growth!

Except it’s not working. Or at least it’s not the emerging market-ness of a country that has driven its economic growth (or lack thereof) over the past decade, but rather that country’s sensitivity and vulnerability to DM monetary policy in general and US monetary policy in particular.

Is there a meaningful secular growth reality in emerging markets? Of course there is. But that and $2.75 will get you a subway token. It’s not that the secular growth story in emerging markets is a lie or doesn’t exist. It’s that it hasn’t mattered. In the same way that value and quality and smarts and careful fundamental analysis haven’t mattered. For a decade now. You know … Three-Body Problem and all that.

But the growth narrative for EM as an asset class is just the public core narrative for EM Investing ™. There’s a non-public core narrative, too. A much more foundational narrative.

“Your property rights as a foreign investor will be preserved.”

Or in the Epsilon Theory lingo, Yay, EM property rights!

Christine Lagarde and Mauricio Macri in happier days

This is why the IMF exists. This is what the IMF does. This is what the IMF means.

To protect the property rights of foreign investors in emerging markets.

Now don’t get me wrong. I believe that the property rights of foreign investors SHOULD be protected. I believe that everyone – but most of all the citizens of emerging markets – benefit from the free flow of global capital, and global capital ain’t gonna flow freely to you if there’s a risk it gets stolen.

But I also believe that the local returns on global capital access are almost always hijacked by the local oligarchs, and even if they’re not hijacked completely, it is entirely appropriate for local governments to negotiate and renegotiate those returns on capital. I also believe that there’s nothing sacred about foreign investor property rights, as those rights are not at all the same as the rights of citizens. I also believe that a nation should be free to burn itself on the hot stove of nationalizing assets or defaulting on debt or otherwise choosing an antagonistic stance towards global capital.

And to be sure, it’s not like the IMF rides into town like George Hearst rides into Deadwood, surrounded by Pinkertons and committed to preserving his “rights” through the barrel of a gun.

But it’s not that different, either.

I know, I know … here I go getting all political again.

Look, you don’t have to agree with me about whether the subordination of foreign investor property rights is a good thing or a bad thing to agree with me that this subordination IS … that foreign investor property rights are, in fact, under a withering political assault in Argentina today, and that this isn’t just an idiosyncratic Argentina thing.

Why am I so down on investing in emerging markets AS AN ASSET CLASS?

Because I think you need two functioning narratives for EM Investing ™ to work.

  • Yay, EM growth!
  • Yay, EM property rights!

Today those narratives are broken. And until they’re somehow patched together again, I don’t think it’s possible to have the systemic narrative support required for institutional capital flows into emerging markets as an asset class.

It’s not just the Argentina narrative that’s broken. It’s not just the IMF narrative that’s broken.

It’s the entire EM Zeitgeist that’s broken.

What’s a Zeitgeist? It’s the water in which we swim.

Can idiosyncratic investments in emerging market opportunities work while the EM Zeitgeist is broken? Sure!

But can the business of EM Investing ™ work while the EM Zeitgeist is broken? I don’t think so.

The Old Man and the Sea

I’m late with this note because I was in Paris for a BAML conference. I wanted to see what European allocators thought about Draghi and the most recent ECB monetary policy “stimulus”. I wanted to see if their narrative was the same as the narrative I’m hearing in the US about the Fed. It is.

The line between the anchor and the ship has been cut. The line between the fisherman and the fish has been cut.

Monetary policy – at its core the setting of the price of money – is no longer connected to the real economy. I mean, of course interest rates are connected to the real economy. But the setting of those rates, by both the Fed and the ECB, is no longer connected. The setting of those rates is now a disembodied symbol of governmental will, all-important to the market economy and utterly … utterly! … ignored and immaterial to the real economy.

My catch phrase these days is They’re. Not. Even. Pretending. Anymore. and that’s still totally in play. Draghi and Powell and the rest of the mandarin crew hardly even give lip service to the idea that cutting rates or expanding the balance sheet do anything helpful in the real economy. It’s really quite remarkable. There’s more talk about “fixing” the yield curve – as if the yield curve were a real thing – than about fixing corporate investment in property, plant and equipment.

But what I didn’t realize until this week is that it’s not just the central bankers who have cut the cord here. It’s everyone else, too. No one on either side of the Atlantic believes that central bank actions have ANY efficacy or connection to real economic outcomes. Worse, everyone knows that everyone knows that central bank actions have no connection to real economic outcomes. THIS is the new common knowledge, and I don’t know how or where or when, but I think it changes everything.  

For example, I think this cutting of the line between interest rate-setting and interest rate-using is the underlying reason for the bizarro-world we are experiencing in overnight repo, where $75 billion is not enough to satisfy the demands of the financial “system” for cold, hard cash, but maybe $100 billion is. Maybe.

Overnight repo is a rope between anchor and ship. It is where the interest rates that central banks SET meet the interest rates that real economic actors USE. What we are seeing with this huge spike in demand for overnight financing is, I believe, a direct result of real economic actors trying to figure out what it MEANS when the interest rates are a symbolic communication to markets rather than a clearing price of money in the real world.

I know what it would mean to me. It would mean that I want the cash, not the securities, and I’d be willing to pay up to have that cash. Because if the price of that real-world cash isn’t connected to monetary policy, then it can trade … anywhere.

I think there are a lot of these dislocations happening today, and I don’t think it’s an accident that they are happening in places where the real world meets the symbolic world. The WeWorks IPO would be another example.

I have no idea where this ends, and I’d be keen to get your thoughts on all this. But where I have a very clear idea is that the common knowledge around central banks has shifted dramatically. Everyone now knows that everyone now knows that central banks are powerless to impact the real economy (but are still the only thing that matters in the market economy). We’re adrift in a way that we haven’t been before.

Hello Darkness My Old Friend

There are a couple of tectonic plates moving in narrative-world of late, just like there have been a couple of tectonic plates moving in market-world. The market-world tectonic plates are factors like momentum and value, and lots of people are talking about them. The narrative-world tectonic plates are inflation and central banks, and that’s what I’m going to talk about.

Our most impactful structural attribute of narrative is Attention – the level of “drum-beating” for a certain narrative relative to all of the OTHER narratives taking place. It’s not just an increase or decrease in the number of articles that drives an increase or decrease in narrative Attention … it’s much more an increase or decrease in the centrality and the connectivity of the articles.

These measures of centrality and connectivity within a giant multi-dimensional data matrix don’t lend themselves to two-dimensional visualizations very well, at least not nearly as well as other attributes like Cohesion and Sentiment, so I won’t be showing those visualizations here (although you can see them in the attached data packet). But just to reiterate … I believe Attention is the most important measurement we take in the Narrative Machine.

So I think it matters that the Inflation narrative is close to all-time lows in its Attention score coming into September, while both the Central Bank narrative AND the Trade & Tariff narrative are at all-time highs in their Attention scores coming into September.

Our rule of thumb regarding Attention (and this is true whether you’re talking about single stocks or sectors or macro issues) is pretty simple: fade high Attention and accumulate low Attention.

More specifically, I’ve got the following takes from these narrative Attention scores:

  • There is enormous market complacency around inflation. Just enormous.
  • Markets are far more likely to be disappointed by Central Banks today than encouraged.
  • The all-China-all-the-time news cycle is at a peak.

How does this play out? I dunno. If there were any signs of the US Recession narrative actually taking root in domestic US issues, then I’d say that it’s time to study up on the stagflation playbook. But as I described in last week’s letter, there’s nothing about the US in the US Recession narrative … it’s all non-US issues. Still, even if it’s not an all-out stagflationary world, we’re going to have some whiffs of that stagflationary odor. Gold? I don’t think you get hurt with all this complacency on inflation, but it’s hard for gold to work so long as Central Banks are front and center. Keep in mind that I think markets are likely to be disappointed in Central Bank action, not that they’ve lost faith in the ability of Central Banks to control market outcomes.

My best take at putting all this together? The back-up we’ve seen in rates over the past two weeks has the narrative legs to back up more. Maybe a lot more. And that’s not going to make anyone happy. Especially the guy in the White House.

The US Recession That Wasn’t

Before I get into the planned subject for this week’s note, I thought I would take a minute to describe what we’re seeing from a narrative perspective in the under-the-market-surface dislocations that have occurred over the past few days. As you’re probably aware, Value stocks (financials and energy listings, for the most part) have outperformed Growth stocks (tech listings, for the most part) to a degree that we haven’t seen in years.

None of this shows up in the specific financial sector, energy sector, and tech sector narrative data. On the contrary, the specific sector narratives are wrong-footed for these sharp shifts. This isn’t a financials story per se, or an energy story per se, or a tech story per se.

I think it’s a Value narrative in general that is playing out here (for how long is anyone’s guess), and a yield curve / negative interest rates story in particular. The “negative interest rates are inexorably coming to the US” story got a lot of play last month, as did “the ECB is going to go crazy with new policy” … both of which were terrible narratives for financials and the yield curve and value stocks in general. We’ll see what the ECB actually does on Thursday, but the narrative of the last week or two has been “well maybe we were being overly optimistic about ECB boldness” and you’ve seen the yield curve on both Bunds and USTs steepen a lot, with a commensurate move in financials and value stocks in general. The last few days have been a magnified version of that, playing out across everything that touches the “value complex”.

On a personal note – and I certainly don’t have any narrative analysis to back this up – the past few days (and the past six weeks, really) have felt like long periods of 2008 and 2009, where the only thing that mattered for markets was risk-on/risk-off, and that “factor” swamped whatever else you were doing in your investment process. This isn’t as all-pervasive as risk-on/risk-off, but whatever it is (rates-on/rates-off?), it’s as impactful in the value/growth context.

And now our regularly scheduled note.

We’re pleased to announce a sixth standing narrative Monitor – US Recession – to join our roster of Central Bank Omnipotence, Inflation, Trade & Tariffs, Credit Cycle, and US Fiscal Policy. We’ve produced historical values for the Recession Monitor through January of this year, and we can speak to the 2018 narrative patterns here.

You can see the full write-up for all six narrative Monitors here, but thought I’d speak directly to the Recession findings today.

Here’s a copy of the Recession narrative map for August.

The first thing you’ll notice is how many narrative sub-clusters there are for non-US issues … in a US Recession narrative map! Yes, most of these non-US clusters are outside of the narrative center of this map, but not all … German stimulus and ECB stimulus are at the heart of this map, and Chinese economic data is not far out from the center.

I’ve never seen a US-oriented macro query that yielded more non-US narrative clusters!

Moreover, the largest (and most central) narrative cluster has nothing to do with the real economy in the US, but is focused on the inverted yield curve and its “signal” of recession. Again, nothing to do with an actual recession in the US real economy.

Finally, as Rusty notes in the attached commentary, the cohesion of this August Recession narrative map is quite low, meaning that the sub-clusters tend to be spread apart and relatively unconnected with a common narrative theme.

Put it all together and here’s my conclusion: there is quite a lot of narrative attention being paid to the concept of a US recession … everyone is falling over themselves looking for a US recession. But it doesn’t exist. At least it doesn’t exist in the US real economy.

These recession fears should be faded.

Two Things I Think I Think

Peter King (the sportswriter, not the Congressman) writes a football column where he makes a distinction between the things he thinks and the things he thinks he thinks. The latter being less certain in his own mind, I guess. It always struck me as a strange conceit to use as the framework for a regular column that dates back … decades … but I’m adopting it in this note to make a slightly different distinction.

I think I think that there have been two tectonic shifts in major narrative patterns over the past few weeks. I put it this way because I don’t have any strong evidence from our Narrative Machine measurements that this is the case. Not yet, anyway … these are both recent developments.  If I did, then I’d say that I think these things. As it stands, I’m telling you that my views are based on my subjective and personal narrative antennae for this stuff. I’m less certain than if I had Narrative Machine data to back it up. But I think I think this is true nonetheless.

The first tectonic shift concerns the market narrative around central banks in general and the Fed in particular. For the past decade, the “cover story” for market-supporting or financial asset-supporting monetary policy has been that it helps the real economy, too. That cover story has evaporated. More and more, I am seeing and hearing prominent media Missionaries (in the game theoretic sense of the word) question the idea that cutting interest rates from these low levels does anything for the real economy, particularly for corporate investment in productive economic activities.

To be clear, no one is saying that more and more accommodative monetary policy would be unhelpful for *markets*, so I do NOT think I think that this shift in the central bank narrative foreshadows some big down move in financial asset prices. No, no … when the Fed cuts (not if but when) two or three or four or five more times, financial asset prices will react as they always react. Oooh, that feels good! More drugs, please! But losing the cover story of accommodative monetary policy helping the real economy and the little guy has an enormous impact, I think I think, on *politics*.

Hold that thought.

The second tectonic shift that I am seeing and hearing is only a few days old. I think I think that the market narrative around Donald Trump changed dramatically last Friday, between “hereby ordered” and “enemy Powell” and those tariff numbers thrown around like confetti. I think I think that Donald Trump lost the Wall Street Journal and CNBC on Friday with his conduct of the China Trade War, in exactly the same way that Lyndon Johnson lost Walter Cronkite with his conduct of the Vietnam War, and with ultimately the same *political* effect.

I think I think that the financial media has been the strongest media force for the normalization of Trump, as the near-universal subtext (if not overt text) of financial media Missionaries has been “I don’t like his style, but he’s done some good things.” Like a stock market that’s gone up, up, up since his election. Like tax cuts. That normalization narrative stopped on a dime last Friday, and has been replaced by a narrative that Donald Trump IS “macro risk”.

Putting these two tectonic narrative shifts together, I think I think we are rapidly approaching a moment of political nihilism, where NOTHING is believed on its merits and ALL of our pleasant fictions that support cooperative gameplay in our domestic political institutions are dashed.

Again, I do NOT think I think that all this puts us on the cusp of some market breakdown, as the narrative of “the Fed has got the market’s back” is still going strong. But I DO think I think that the widening gyre of American politics is now poised to “take another leg down”, as we’d say in a market context. How that manifests itself … I don’t know. But I think I think it’s coming.

I Was Shook

I learned the distinction between excuses and reasons when I was 12 years old and had failed to do some sort of chore at home. As my father told me before grounding me, “Ben, you have lots of good excuses, but no good reasons.”

So I’m late with this week’s ET Pro email, and my excuse is that I was up in the wilds of Maine from last Thursday through Monday for a Team Elite fishing camp experience that David Kotok graciously hosts every year. Internet connectivity was pretty non-existent, the fish were biting … yada, yada, yada.

But I also have a *reason* for being late with the email this week. The news about Jeffrey Epstein’s death on Saturday hit me hard, as did the escalation in the Hong Kong protests over the weekend, as did the collapse in Argentina’s currency and stock market on Monday. As the kids would say, I was shook. And I’m still trying to figure out what I think about all this, both as a citizen and as an investor.

Of the three events, I’m most settled in my views on Epstein. I think it’s possible to be outraged (beyond outraged, really) at his death without succumbing to any conspiracy theory at all, much less the way out-there theories, and that’s what I’ve tried to capture in “I’m a Superstitious Man”, published yesterday on the website and attached as a PDF here. It’s a feeling that I haven’t experienced since October 2008, when the US Treasury put the full faith and credit of the United States behind the unsecured debt of Goldman Sachs, Morgan Stanley, JP Morgan and Bank of America … a feeling that the pleasant skin of American democracy has been peeled away to reveal the naked sinews of power, wealth and violence beneath. Does anything about the Epstein case impact markets and investing? Nah. Not so far as I can see, anyway. But this was the event that shook me the most.

I’m still not settled on my views on Hong Kong, but Rusty made a big contribution in helping me frame those views with a wonderful note he published yesterday, “Does It Make a Sound?”. The answer to that question – what is the Hong Kong Resistance narrative in the US mainstream media? – is pretty resounding: it does not exist. Rusty presents the empirical evidence from the Narrative Machine. As we like to say (cribbing the old George Soros line), we’re observing, not predicting. What I’m wrestling with now is the WHY … why is the HK Resistance narrative so muted in American media? Is it a conscious effort by status quo elites to downplay what’s happening? Is it a structural element of a domestic widening gyre? I’m still wrestling.

If any HK-resident ET Pro subscribers (of which there are several) are able to share their thoughts, I’d be grateful to hear them. Your privacy and anonymity are my greatest concern, and unless you explicitly tell me otherwise, NOTHING you email will be shared with ANYONE.

I’m also not settled on my views on Argentina specifically and EM more generally, other than what I’ve been saying for a while now … with the exception of China and its insulated domestic currency, EM monetary policy is just a shadow of DM monetary policy.

Macri embraced that shadowy semi-sovereign existence, as it allowed the IMF support package of all IMF support packages. Foreign investors (and local oligarchs) rejoiced, of course, as the cornerstone of any IMF support package is preserving the property rights of those foreign investors. Now Fernandez and Kirchner want to break that shadow existence and chart a (much) more independent monetary policy path, which means that the IMF support package and its associated property right protections for foreign investors will evaporate like a winter rain on the pampas. Good times.

Is Argentina an idiosyncratic outcome for EM investors, or is Argentina indicative of a structural risk for EM investors? Yes. Not trying to be flippant with that answer, but in truth that is the answer. If you’re thinking about EM as a thing – as a discrete asset class – then this is absolutely indicative of a structural risk. It’s a manifestation of what I think is the category error you’ve made in thinking about EM as a thing. If you’re not thinking about EM as a thing, then this is absolutely an idiosyncratic outcome. But it’s also an idiosyncratic outcome that can easily be duplicated in a lot of countries … so maybe not so idiosyncratic after all. Either way, I don’t think there is any more difficult job in finance today than being an EM investor. And it’s not going to get easier.

Two last points to call your attention to before closing this belated email.

First, if you haven’t reviewed the ET Pro Monitors, they were updated earlier this month and I’ve attached that PDF here. Frankly, no big breaks or changes in the macro narrative structures we measure, but we’re watching the Central Bank Omnipotence narrative carefully for any signs of it being replaced by a coherent “central banks are impotent” counter-narrative.

Second, we recently put out an In Focus piece for ET Pro subscribers with our analysis of “Big Tech Anti-Trust Narratives: Deteriorating but Disconnected”. The skinny here is that while we think this could be a powerful thematic short, you’re VERY early from a narrative perspective if you’re acting on this now.

The Second Horseman

Last October I wrote “Things Fall Apart (Part 3) – Markets”, focused on the three big deflationary shocks that could hit markets, and the one big inflationary shock that would ride in on a pale horse after the deflationary shocks had their way with us.

The Three Horsemen of the Investing Semi-Apocalypse

  • The Fed keeps on raising interest rates and shrinking its balance sheet, ultimately causing a nasty recession in the US and an outright depression in emerging markets.
  • China drops a trade war atom bomb by letting the yuan devalue sharply, sparking a global credit freeze that makes the 1997 Asian crisis look like a mild autumn day.
  • Italy and its populist government play hardball with Germany and the ECB in a way that Greece could not, leading to a Euro crisis that dwarfs the 2012 crisis.

Markets suffered through the deflationary shock of the First Horseman in Q4 of last year, but then recovered nicely after Jay Powell’s monetary policy independence was taken out into the street and shot in the head on Christmas Eve.

Markets are now suffering through the Second Horseman riding into town, as China “surprised” markets with a sharp devaluation of the yuan last night in response to higher/broader tariffs that Trump threatened to impose last week.

Here are the questions Rusty and I are asking now, along with our answers …

Could the tit-for-tat of a trade war escalation into a currency war and a global credit freeze result in as painful a market decline as Q4 last year?


Will the Second Horseman ultimately be vanquished like the First Horseman?

I very much think so. I can’t tell you which equilibrium in a game of Chicken will prevail, but there will be an equilibrium reached, probably one where both China and the US declare victory domestically.

When will the Second Horseman be vanquished?

No idea. It’s a core ET precept, taking from an old George Soros line … we’re observing, not predicting.

How will we know if we’re wrong, and the Second Horseman is here to stay?

Two ways: a) if the Trump administration turns the trade/currency narrative into a full-blown national security narrative (i.e., this is a new “Cold War” against a new “Evil Empire”), or b) if common knowledge around the Central Bank Omnipotence narrative weakens dramatically (i.e., the Fed and ECB are “powerless” to do anything about the ongoing deflationary shock).

So that’s what we’re going to be watching closely – any shift in the Trade & Tariff narrative towards a national security narrative, and any shift in the Central Bank Omnipotence narrative towards an impotence narrative – and that’s what we’ll be reporting back to you.

In real-world, as opposed to narrative-world, I think you should be looking for signs of a credit freeze in trade finance to get a sense of how bad this trade/currency war can get.

As in 1997 (and to a lesser extent 2015), this is a credit freeze that will start in Asia and then spread globally. It will be levered to trade finance, but will hit ANY sector or subsector where the narrative is based on trade and growth. In other words, EM currencies and markets get absolutely gob-smacked, DM rates continue to plumb uncharted depths in the negative-rates abyss, and financials have no support.

It’s that last piece – shorting non-obvious financials that have secondary exposure to trade finance woes, at least in narrative-world – where I think there’s a trade that hasn’t already been priced in after the last few days. For me, that go-to trade is buying CDS protection on the iTraxx Senior European Financial index, a trade I’ve written about before for ET Professional subscribers, as recently as this May (“In the Flow – Chef’s Knives”).

Here’s the one year chart for the SNRFIN, wider by 5 bps today but only in the low 70s …

And the five year chart …

If the yuan devaluation sparks a credit freeze in global trade finance, which I think is more likely than not, then we could see these spreads widen to 120 bps in very short order, which would be … something. The next ECB policy meeting isn’t until Sept 12, so unless Mario and Christine start jawboning pretty hard and pretty fast from wherever they are vacationing, I don’t see how the blisteringly negative narrative around European financials changes course for the next four weeks.

Like I say, this is a trade and not an investment, and a CDS contract is a chef’s knife – they’re sharp and you need to know what you’re doing. But these are exchange-traded instruments and can be an effective tool in any professional investor’s kitchen.

Yours in service to the Pack,


The Dog That Didn’t Bark

The dog that didn’t bark is the punchline to a famous Sherlock Holmes story, Silver Blaze, where our man Sherl deduces that the killer was a familiar presence at the murder scene because of the absence of a clue – the watchdog who barked not at all as the murderer came and went.

It’s the same thing with US fiscal policy … it’s the absence of a clue that tells me the market is extremely complacent about what is coming down the pike here.

That clue is, of course, the market narrative, and when I say that a market narrative is absent from US Fiscal Policy, I mean that there is no connection between the occasional financial media article about budget votes or fiscal policy and ANYTHING written about markets per se. This was the point of an ET Zeitgeist note I published last Friday, titled We’re All MMT’ers Now. It’s a quick read and worth your time.

In this email, I want to show you the Narrative Monitor we maintain on US Fiscal Policy so that you can understand why we think this is a big deal.

Here’s the page on the ET Professional site where you can access this Monitor data, and here’s what Rusty had to say about our results:

  • As in prior months, there is very little attention being paid to fiscal policy/budgetary topics, and practically no linguistic connection between them and financial markets narratives.
  • Cohesion and Fiat News, too, remain at floor levels.
  • We counsel some awareness of the scale of policy proposals, especially those being promoted by leading Democratic candidates. The market is paying zero attention with zero cohesion, which we observe as a complacent structure.
  • A sufficiently credible candidate with a GND/MMT-style approach could be a significant surprise to a market that could not care less about debt ceiling negotiations, government shutdowns, debt levels or budget deficits.

And here’s the narrative map itself:

What Rusty is focused on is the peripheral position of market-related narrative clusters (what’s moving the US market, why are China stocks rallying/falling, etc.) all found at the top of the narrative map, and the distance and empty space between these clusters and the center of the narrative – the record US budget deficit – as well as the distance and empty space between these clusters and the bottom of the narrative map – the fiscal policies proposed by Democratic candidates.

Up/down/left/right means nothing in these narrative maps. You can turn them 90 degrees or upside-down and nothing changes in their meaning. What is meaningful is centrality and distance and the connective links between clusters.

When Rusty and I see a narrative map like this, we immediately look at the narrative core of anything written about US fiscal policy – the record deficit shown as a bright red cluster – and how linguistically divorced those articles are from ALL other articles that show up when you do a search on “fiscal policy”. None of these peripheral articles are really about fiscal policy. They use that phrase in the article, but the article is about something else.

We also see that the articles about markets are as far apart from articles on Democratic candidate policies, like student debt forgiveness, as it is possible to be on this map. In other words, even though all of these articles share the phrase “fiscal policy” somewhere in their text, there is ZERO linguistic connection between an article about markets and an article about what a Democratic president would do about student debt. THAT is what we mean by a complacent narrative structure.

Will the market go up or down as it becomes less complacent over fiscal policies over time? Yes. And I’m not trying to be cute with that answer.

I don’t know what the market reaction will be as (or if) fiscal policies and proposals become biting (or pleasing) realities. All I know is that the market is unprepared for this. All I know is that fiscal policy is NOT in the price of financial assets today.

Yours in service to the Pack,


They’re. Not. Even. Pretending. Anymore.

Yesterday I published a brief note called “I’m Not a Raccoon! I’m the Lone Ranger!” about the hucksters and the con men in the crypto space. The point was that the obvious frauds reveal themselves pretty easily, but there are less obvious – yet no less fraudulent –narratives for Bitcoin being made by prominent people who live at the intersection of Wall Street and Bitcoin. These are people who should (and I think do) know better, but promote these false narratives anyway because it makes them money.

The false narrative I was referring to specifically in that note was the idea that ‘network effects’ or Metcalfe’s Law or some other description of transaction volumes was a source of intrinsic value in Bitcoin. This is nonsense. There are no ‘network effects’ for a non-cash-flowing, non-productive thing. There is no ‘tipping-point’ in the transactional network around a non-cash-flowing, non-productive thing beyond which it becomes ‘too big to fail’ or becomes ‘an accepted store of value’.

Are there non-fraudulent arguments for buying-and-holding Bitcoin? Sure! There’s an inflation hedge / fiat debasement argument. There’s a security / privacy argument. There’s a fashion / expression of identity argument. But my raccoon-radar starts beeping like crazy whenever I hear someone make a network effects argument for buying-and-holding anything, much less a non-cash-flowing, non-productive thing.

I had the same raccoon-radar reaction yesterday to the FT article by Rick Rieder (Blackrock’s global fixed income CIO) and the CNBC appearance by Larry Fink in support of that article: “ECB can boost growth across Europe by buying stocks”.

The money quote:

“Lowering the cost of equity would stimulate growth through organic channels of investment, including research and development, which can provide durable economic gains.”


I mean … I like to think of myself as something of a connoisseur of trickle-down economic arguments. I get the joke. But this is INSANE. The ECB is going to spur growth in the real economy because publicly traded corporations are going to spend more on R&D if their stock price goes up? WHAT?

I’ve met Rieder and Fink a couple of times, but I don’t know them. At all. Maybe they’re decent guys. Maybe they really believe in their heart of hearts that this is wise public policy. I truly don’t know.

But if it talks like a raccoon and walks like a raccoon …

Get Up and Dance

– Chuck Prince, Citigroup CEO (2007)

As long as the music is playing, you’ve got to get up and dance. We’re still dancing.

Chuck Prince made his infamous get-up-and-dance quote to the FT in reference to Citi’s levered loans business, although it was later taken to refer to subprime lending. No matter, it’s the perfect quote for any age and any asset class where institutions intentionally take risks they know are foolish, but risks they believe are manageable because there’s a greater fool looking to get on the dance floor after them.

The greater fool theory is the driving force behind the bid for negative-yielding debt, whether it’s European government bonds or European investment grade corporate debt.

Sure, it would seem that I’m the fool for paying the German government 25 bps per year for the privilege of giving them my capital for ten years, but if there’s someone down the road willing to pay me a nice premium over what I paid for this Bund because the 10-year rate is now -35 bps … well, take my money now, Ms. Merkel!

The rationale for buying negative-yielding debt securities is capital appreciation and gain-on-sale, not (obviously enough) the expected return of the coupon as the security is held to maturity. In other words, the get-up-and-dance game is always a return ON capital game, not a return OF capital game.

But playing for capital appreciation in a (supposedly) risk-free rates portfolio or an IG debt portfolio is a VERY different game than playing for capital appreciation in an equity portfolio or a distressed debt portfolio.

Who is managing these negative-yielding IG and rates portfolios? The same portfolio manager who has made a career out of honing a hold-to-maturity mentality? Or did they parachute a distressed guy into this world of macro carry trades and monetary policy analysis? Either way, it’s a prescription for massive error. Either way, it’s the management of the now $13+ trillion in negative-yielding debt securities that I think is the catalyst for a blow-up here.

Let’s leave aside the distressed guy parachuting in to manage this portfolio. Because that’s not what’s going on. What’s going on is that there are a lot of hold-to-maturity IG and rates guys who now fancy themselves as momo traders. I mean … that’s not really how they think of themselves. They think of themselves exactly as Chuck Prince thought of himself – the true heir to Sandy Weill, master of the deal and the pivot, a man who knew how to hoof it – when really he was just another lawyer who couldn’t dance to save his life.

Bull markets make everyone think they’re a freakin’ genius. While bear markets doth make cowards of us all. And that last part is the problem.

In my experience, hold-to-maturity guys – and here I’m talking about both hold-to-maturity bond guys and their equivalent in equity-world, the put-it-in-a-drawer-and-never-sell-a-share guys – always get two things wrong when they decide to play the get-up-and-dance game.

  1. They vastly overestimate the liquidity in their market, and they are paralyzed by the absence of bids when the shit hits the fan.
  2. Their sell-discipline muscles have atrophied (if they ever existed), so they hang on waaay too long before making the first sale, and then they panic and puke out the rest into an illiquid market.

This is why I think the negative-yielding bond bubble ends in tears.

Not because bond managers are wrong about the intentions of central bankers and the direction of monetary policy for the foreseeable future. But because they overestimate their ability to trade this portfolio and they underestimate the mad rush off the dance floor when nobody sees a greater fool waiting in the wings.

You Are Here, June 2019

We’ve published the updated ET Pro Narrative Monitors for June:


Central Bank Omnipotence

Trade and Tariffs

US Fiscal Policy

I’ll discuss in more detail over next few weeks, but here’s the skinny: Yes, we’re still in a zeitgeist of Central Bank Omnipotence, where deflationary shocks simply can’t take the market down for much or for long. That said, the Cohesion measure of both Trade & Tariffs and Central Bank Omnipotence is really breaking down, meaning that there is enormous narrative confusion over how the rate cut trajectory plays out … far more confusion than the 100% implied market odds of a cut would imply.

ETNA Research Update

Updated ETNA Research Deck (PDF)

Rusty and I have updated our research deck for the sector rotation Epsilon Theory Narrative Alpha (ETNA) project, and I wanted to highlight those additions in this email. As described in the full-length notes “The Epsilon Strategy” and “After All, We Are Not Communists”, this research deck is only available to Professional subscribers, and we would welcome your direct inquiry if you have questions or if you’d like to walk through the deck on a call.

The major update in today’s research deck is a simulation of a market neutral / absolute return strategy using our narrative-driven S&P 500 sector underweight/overweight signals. Prior to this we had presented simulations of an unconstrained “Beta1” portfolio (always 100% net long, but allowing leverage and short positions, roughly the equivalent of a 150/50 portfolio) and a constrained “Long-only” portfolio (always 100% net long AND 100% gross long, so no leverage and no short positions). Both of these strategies were designed to test for an excess return versus the S&P 500, essentially as generic long-equity replacements for S&P 500 exposure.

Today’s simulation is designed to test for absolute return by fixing the net market exposure to zero, along with an efficient application of gross exposure and a targeted volatility (8%). We also evaluated the six individual narrative strategies for their Sharpe-additive potential, which led to our dropping one of the strategies here, even though it met our standalone backtest threshold (positive excess return, information ratio >= 0.6). As with the Beta1 and Long-only research simulations, the remaining individual strategies were equally-weighted with no data-fitting or optimization effort.

I’ve attached the full research deck to this note, and copied the new slide below. We will continue to press forward with our research efforts, both in this US equity framework and within/across other asset classes, and keep you apprised of our efforts and findings.

Thanks again for being a Professional subscriber, and please don’t hesitate to contact me directly for a more in-depth conversation!

In the Flow – Chef’s Knives

Two weeks ago, in both the weekly ET Professional email and the ET Live! webcast, I mentioned European Senior Financial Index Credit Default Swaps (CDS) as my favorite way to set up a trade against what we see as a very complacent market narrative regarding US-China trade conflict. In this email I want to dig into that trade a little deeper.

Credit default swaps are like chef knives. They are precision instruments and a necessary tool for so many tasks in the professional kitchen. Sure, they are also sharp as hell and will give you a nasty cut if you don’t know what you’re doing, but the truth in the kitchen and the market is that a sharp knife is actually safer than a dull knife. Even if you don’t cook or trade a portfolio professionally, you’ll want to own a good knife and you’ll want to know the mechanics and the rationale of a CDS trade.

What we’re talking about today is buying protection through CDS. To use the insurance analogy that is typically used in explaining how CDS works, we are buying a “policy” that pays off in full if the referent credit issuance defaults over the term of the swap, typically 5 years.

But hold on, you say. I thought this was a Senior Financial Index CDS. How can an entire index default? Answer: it can’t. This index is composed of 25 individual financial issuers, and if all of them default, then the world has ended and you should be worried about stockpiling ammo and seeds, not managing an investment portfolio. Even if one or two of these individual issuers default, they will be replaced by other issuers and you will never get a full default pay-out. Index CDS is a very different animal than single-name CDS … it’s a synthetic creature with no direct “insurance policy” usefulness.

You are not buying index CDS protection as an actual insurance policy against an actual default. You are buying index CDS protection for the change in value of that aggregated insurance policy as the component values of the component insurance policies change over time. As such, index CDS protection is a trading instrument, pure and simple. It is NOT a buy-and-hold investment or insurance policy or anything of the sort. In fact, the worst thing you can do with an index CDS is buy it, stick it in a drawer somewhere and forget about it, as you might do with an insurance policy.

But if you have an edge on the timing of an event that you believe is systemic … ie, an event that will impact the entire financial system rather than just an idiosyncratic company or sector … then there is no more powerful or asymmetric trade you can put on than with index credit default swaps, precisely because it ONLY reacts to systemic stress. Your counterparties selling you the swap don’t have to worry much about idiosyncratic corporate credit risk, and so the price of the derivative security is typically very cheap, particularly on investment grade or senior debt insurance policies. And because it’s going to be a 5-year contract, there’s a tremendous amount of leverage embedded within the term structure itself … again, if you have an edge on the timing here.

Back in the day, CDS trades were the Wild West. There was no standardization on these contracts, and certainly nothing traded on an exchange. Everything was bespoke, and counterparty risk was a very real worry. Maybe my greatest moment as a PM was novating my CDS away from Lehman, eliminating rehypothecation in the portfolio, and switching my prime brokerage away from Bear Stearns in late 2007 and early 2008. Three big bullets dodged!

Today the CDS world is a lot safer. Starting in 2011, ISDA standardized all CDS trades on two common templates (one for Investment Grade pricing and one for High Yield pricing) and set up a clearinghouse to backstop all member banks’ trades and reduce counterparty risk. Once the clearinghouse was established, it was just a matter of time before the more liquid trades could be moved over to an exchange and eliminate the need for ISDAs altogether, and that’s exactly what happened with the major credit indices. If you can buy and sell commodity contracts on ICE, you can buy and sell index CDS.

Anyone can own a chef’s knife today.

Here’s the core Bloomberg screen (CDSW) for any standardized CDS contract today, with the major pricing elements marked by the yellow boxes, cash settlement marked by the blue box, and P&L marked by the red box:

The top yellow box is what you’re buying – in this case 5 years of protection against default in $10 million worth of the Itraxx European Senior Financial Index. The left-hand yellow box just below is the market price (the “spread”) to take on this contract – in this case 81.5 basis points on the $10 million notional exposure, or $81,500. That right-hand yellow box is the obligation you are agreeing to in this contract – in this case paying 100 basis points per year on a quarterly schedule, so $25,000 to the protection seller every 3 months for the 5-year term.

With a market price of 81.5 basis points, the market is saying that an “insurance premium” of 100 basis points per year is too expensive. In other words, if this contract were not standardized, the market clearing premium would be 81.5 basis points per year. So when this contract is settled, your counterparty pays YOU that difference in premium (18.5 bps) over the course of the remainin term of the contract (4.8 years or thereabouts), plus the accrued premium so far in this quarter. So what you see in the blue box is that you are receiving $104,000 today for the obligation to pay the seller $25,000 at the end of this quarter and every other quarter for which you hold the contract.

Finally, the red box shows you the change in value for this contract for every single basis point that the market price (the spread) moves up or down. So if tomorrow the spread widens from 81.5 bps to 82.5 bps, the value of the contract would increase by $4,742 in your favor. Vice versa if the spread narrows by a basis point.

Since I took this snapshot last week, the spread has widened 8 basis points … call it $38,000 in value … to a market priced spread of 89.5 bps. If I wanted to sell this contract and realize my gains, then, I would pay the new owner of protection $49,000 in principal (10.5 bps x 4.7 yrs) plus $18,500 in accrued premium (the $16,900 accrued when I bought the contract plus $1,600 for the week I’ve held the contract), for a total of $67,500. Since I received $104,000 from the seller I bought the contract from, that’s $36,500 remaining for me.

It’s a weird instrument, right? You have to post some margin to cover your potential P&L losses, but it’s a very small margin requirement if you’re buying protection (significantly more if you’re selling protection) because the asymmetry of how much the spread can narrow versus how much it can widen is so pronounced. I mean, at one point you could buy protection from GS with a 2% margin on notional, so potentially a 50x leverage on a cash account. That would be nuts, of course, but it’s indicative of how easy it is to buy a lot more insurance than you have assets to “insure”.

Here’s the price history of the spread since these contracts were standardized in 2011. I’ve circled in red the last two times we had a sharply strengthening dollar and a sharply weakening yuan, because that’s what I think is highly likely here … not a blowing out of spreads to 300 bps wide like in the full-blown Euro crisis of 2001 and 2012, but a spiking of spreads to 120 – 140 bps wide as systemic concerns of a yuan devaluation and/or a credit freeze around trade finance take hold.

Here’s the first of those red circle periods (Q1 2016), showing how the blue yuan spikes (weakens) before the yellow iTraxx Senior Fin’l CDS spikes.

And here’s the second of those red circle periods (Q4 2018), showing the same thing … and how the yuan has spiked (weakened) again here in May. I think the SnrFin CDS will follow suit. Again.

As always, happy to discuss this instrument and this trade in more detail if you like. I realize this discussion is old hat for some and way in the weeds for others, but I hope you found this primer useful!

In the Flow – You Are Here, May 2019

We updated our five narrative Monitors last week with financial media tracking through April 30, so I wanted to focus today on our findings from that update, particularly as it relates to the recent re-escalation of trade tensions. The data can be accessed as a PDF file here, a Powerpoint file here and as an Excel file here.

For each of the five Monitors I’ve highlighted the finding that I think is most interesting. Put it all together and here’s the skinny – there’s a tremendous amount of narrative complacency out there, particularly on Trade and Tariffs, which means this market has a long way down if the narrative focuses on negotiation failure. It’s not focusing there yet, but that’s what you want to watch for. We’ll keep watching for any changes of that sort in narrative-world, and in market-world you should keep your eye on USDCNY and iTraxx European senior financial CDS spreads. A quick move over 7.0 in the former or 100 bps wide in the latter is a sign that China is considering a currency float/devaluation. That’s how China will declare these negotiations have failed.


  • Inflation language remains at a low-to-moderate level, but outside of central bank policy discussions and discussions of health care and education (esp. student loans), attention – its influence on broader narratives – is limited.
  • Consistent with prior updates – and despite our belief in the long-term shift in Zeitgeist toward inflation – we do not think there is a coherent short-term inflation narrative at this time.
  • Inflation discussions persist with somewhat higher intensity than usual in the usual pockets in emerging markets. Latin America and Middle East have become more central to EM inflationary narratives.
  • We found it noteworthy in April that the language used in media to describe US inflation and central banking is most similar to language used to describe BOJ (relative to BOE/ECB/EM banks).

Central Bank Omnipotence

  • Our measures of both attention and cohesion of central bank omnipotence narratives flagged slightly in April.
  • We think this is generally the result of (1) increasing separation in policy imperatives within the narratives surrounding the major central banks and (2) the brief emergence of a new (and separate) view on a potential rate cut in the US.
  • Regardless, we continue to think that Central Bank Omnipotence is the primary governing narrative of risky asset markets in the US – with Trade and Tariffs emerging from complacency much more recently.
  • We also note the recent emergence of a central cluster relating to inequality, ‘failures of capitalism’, student loan debt and other issues making the rounds in US election politics. These are surprisingly well connected across articles in the CBO dataset. We think shifting political pressures on central bank narratives are worthy of long-term monitoring.

Trade and Tariffs

  • For much of April, cohesion continued to drift downward, as trade and tariffs discussions splintered further into distinct Europe, North America, China and now US/Japan trade clusters.
  • Meanwhile, sentiment remained noticeably more positive than in the recent past, leading us to believe that the narrative structure is still highly complacent.
  • In early May, a couple well-placed tweets from President Trump very briefly showed some measure of the volatility-inducing potential of negative surprises on this complacent narrative structure.
  • We suspect that focus will return to China/US trade discussions in May, and we would not be surprised to see sentiment retreat somewhat.
  • Will the complacency about a positive outcome stick around? We think it will be heavily influenced by whether the additional tariff threat is a true negative surprise or a manufactured “wall of worry.” We lean toward the latter, but that is opinion and not something we necessarily see in the narrative data.

US Fiscal Policy

  • Rising sentiment and cratering cohesion in US Fiscal Policy narratives appear to be the result of electoral politics: wide-ranging, optimistic plans in popular areas (e.g. student loan debt retirement, medicare-for-all, infrastructure)
  • There is, however, no central governing narrative, and financial market attention on fiscal policy narratives remains below historical levels. We don’t think it’s an overstatement to say that financial markets simply do not care about US fiscal policy at this time.
  • Of interest: as covered elsewhere on Epsilon Theory, language used in articles about student loan debt continues to be among the most well-connected in the US Fiscal Policy dataset.
  • While you may note a cluster of articles focused on the ‘US Federal Debt Crisis’ topic, we note that most refer to it as a non-existent crisis. It includes many pro-MMT style opinion and analysis pieces.

Credit Cycle

  • We are now comfortable characterizing the credit market narrative structure as complacent.
  • There is very little overall structure to any one narrative about risks to credit markets, defaults or liquidity, and general coverage continues to be quite positive in sentiment about lending.
  • In addition, each of the notable credit events large enough to merit a cluster of articles is visibly separate from the core of financial journalism.
  • In other words, the only people talking about Canadian Banks, China Debt Traps in the Philippines, or HNA’s CWT International are people talking about those specific issues; they are NOT being pulled into broader discussions of fixed income and credit markets.
  • As noted elsewhere, the student debt market continues to be central to most coverage of credit markets.

In the Flow – Wage Growth, Groucho Marx Edition

The Secret of life is honesty and fair dealing. If you can fake that you’ve got it made.

These are my principles, and if you don’t like them … well, I’ve got others.

I’m not crazy about reality, but it’s still the only place to get a decent meal.

A child of five could understand this. Send me someone to fetch a child of five.

Last March, I wrote a long note on the cartoon that labor statistics present, called The Icarus Moment. To set the scene:

Once you start looking for these cartoons, you will see them EVERYWHERE.

It’s not a Karl Marx world of alienation. It’s a Groucho Marx world of alienation.

The cartoon of our monthly theater regarding labor statistics, particularly wage growth, rests in the fact that they are reported as hourly wages. Even though the majority of wages in 2019 America are paid biweekly against an annual salary, the Bureau of Labor Statistics (BLS) reports ALL of our wages as if they were paid hourly. Why? Because in 1915 America, when the theater of labor statistics began, this was how most people got paid. Even today, the abstracted idea of hourly wages connects with people more effectively than the abstracted idea of weekly wages. Put that together with bureaucratic inertia, and that’s why this cartoon exists.

But here’s the problem with the hourly wage abstraction. It requires introducing a new data estimation into the mix, one that has nothing (or at least very little) to do with the real-world concept we’re trying to represent, which is whether you’re taking home more money today than you did this time last year. That additional layer of abstraction is the average length of the work week.

The root data collected by the BLS consists of the weekly wages paid by US businesses to their employees. That number is then divided by the total number of people being paid, and the result is the average weekly wage for Americans. Here is that abstracted data for the past 7+ years.

source: Bureau of Labor Statistics

But instead of reporting the annual percentage change on a month-to-month basis, the BLS also calculates the “average work week” so that they can maintain the cartoon of hourly rather than weekly wage reporting. Here is that abstracted data.

source: Bureau of Labor Statistics

For the past 7+ years, the average work week has averaged 34.45 hours, with a range from 34.3 hours to 34.6 hours. That’s 2,067 minutes, ranging from 2,058 minutes to 2,076 minutes. Here’s a graph of that.

source: Bureau of Labor Statistics, Epsilon Theory

This is not a variable. This is a constant.

From a statistical perspective, given the inherent errors of measurement, any month-to-month difference of 6 minutes here or 6 minutes there is a totally random event.

Measured changes in the average work week are not real.

And yet they have very real effects on the narrative.

Here’s the year-over-year wage growth data from the singly-abstracted measure of weekly wages:

source: Bureau of Labor Statistics

These are the “true” results, or at least the most basic abstraction of what we’re after.

And now here’s the year-over-year wage growth data from the doubly-abstracted measure of hourly wages:

source: Bureau of Labor Statistics

These are the results that are reported to us and create the political and investment narrative.

And now here’s the difference in the two data series, with weekly wage increases subtracted from hourly wage increases. The numbers here are how much the reported wage growth result overstates or understates the actual wage growth result.

source: Bureau of Labor Statistics, Epsilon Theory

In 2016, reported wage growth massively overstated actual wage growth. Wage stagnation going into the 2016 election was actually much worse than you were told. Did this make a difference in the Midwestern states that swung the election, in that actual labor conditions were worse than everyone thought they were? I think yes.

In 2018, reported wage growth massively understated actual wage growth. Wage growth all last year was actually much better than you were told. Did this make a difference in the current Fed/Wall Street/White House narrative that inflation is dead and the easy money punchbowl can be maintained without consequence? I think yes.

What does all this mean for our investments? Here’s the money quote from The Icarus Moment:

Honestly, I still don’t have a good answer to this question.

Do I invest on the basis of what I can see happening in real-world or do I invest on the basis of what I can see happening in narrative-world?

Ultimately, I STILL think that real-world ultimately wins out.

But the path for that … the timing of that … it’s utterly narrative dependent.

Groucho would understand.

In the Flow – It’s Toasted

There’s a great scene in Mad Men, when Don Draper and the gang are trying to figure out how to sell Lucky Strike cigarettes. The tobacco exec is walking the ad team through the cigarette-making process, and he mentions that they toast the tobacco leaves. Don stops him. That’s it. That’s the slogan. “Lucky Strike: It’s toasted.”

The corporate exec scoffs. Everyone toasts their tobacco!

No, no, Don responds. Everyone else’s tobacco is poisonous. Lucky Strike … it’s toasted.

See, Don Draper recognized that when the Surgeon General made it illegal to claim health benefits for cigarettes, this wasn’t a defeat … this was an opportunity. It was an opportunity to redefine the meaning of tobacco and cigarettes, if only the execs were bold enough to abandon their defensiveness and embrace a winning narrative, no matter how divorced from reality or nonsensical that narrative might be.

This is the current Missionary narrative on inflation and monetary policy … it’s toasted.

Here’s what we’re seeing in narrative-world …

  1. Wage inflation consistently above 3%, something that would have rocked the world 12 months ago? We are told this is “muted wage inflation”.
  2. Q1 GDP growth above 3%, when only 3 months ago we were told that we were on the verge of a global recession? We are told this is “low quality” growth, with core inflation “disappointing”.
  3. Unemployment rate at 50-year lows to go with robust growth? Two weeks ago, we are told by former Minneapolis Fed president Narayana Kocherlakota that the Fed should cut rates prophylactically, that they should “fight the next recession now.” This opinion piece gets a ton of play.
  4. German inflation surprises to the upside today, well over 2%, an unthinkable number just a few weeks ago? Crickets. No one says anything at all about this.
  5. Gasoline prices set a new high for the year yesterday, at $2.88, just as the US is reinstating full sanctions on Iranian oil exports? Again, crickets.
  6. Goldman Sachs reverses ALL of their commodity trading recommendations from December, going from uber-bears to uber-bulls (h/t ET Pro reader Alex Vugman), because there’s “far less perceived macro risk as evidenced by stable physical commodity demand”? Orphan article in the FT.
  7. A $2 trillion infrastructure spending program proposed today? Over the past month, Democrat candidates proposing, by my rough estimate, $4 trillion in new unfunded expenditures? No connection is made to inflation.
  8. I mean … we had a Republican president say today that the Fed should cut rates by 100 bps and restart QE. Why? Why not! Everyone knows that everyone knows that inflation is dead.

And when Donald Trump tells you that there’s no inflation, that up is down and black is white, that monetary policy … It’s toasted! … you’ve gotta believe him, right? Right?

Actually, for investment purposes, you do. When everyone knows that everyone knows that inflation is dead, that IS the common knowledge. And the common knowledge must be respected. CPI-based inflation-sensitive investments – like TIPS – will not work until this common knowledge shifts. They’ll get cheaper. You can accumulate them. But don’t expect them to work until this common knowledge shifts. Non-CPI-based inflation-sensitive investments – like commodities – well, they can work. Because in order to maintain the toasted fiction, the definition of what inflation IS must get narrower and narrower. Today inflation has been narrowly defined as CPI and its first cousins like PCE deflator and other central banker doubleplusgood words. Everything else? Go ahead. Inflate away. If we don’t call it inflation, then it’s not.

But here’s my question. Why am I seeing this NOW? Why is this narrative effort – and it IS an effort – happening now? I think it goes back to what I wrote about in “The Silver Age of Central Bankers” – we are smackdab in the middle of increasingly competitive AND increasingly ineffective central bank actions. This is what a race to the currency bottom looks like. Everyone wants to ease. Everyone knows they’re pushing on a string. You might think that leads to cooperation and caution. But no. It accelerates your time table. You gotta do what others would do unto you … but do it first.

So long as you can sell it.

And the Missionaries are selling this hard.

All the best, Ben

PS. This chart is courtesy of TS Lombard. Stock buybacks are now outpacing capex. What is financialization? THIS.

In the Flow – Adventures in Valuation Land

First, a big thank you to the ET Pro subscribers who read and commented on an early version of This Is Water. It’s now the most widely read note over the same post-release time frame ever for ET. I will definitely be doing this crowd-sourced ET Pro editing experiment again!

Second, I want to highlight the S&P 500 valuation analysis in that note, as well as bring in some supporting analysis from our friends over at Bridgewater.

My conclusion in This Is Water is that in the absence of financialization – profit margin expansion without labor productivity expansion – the S&P 500 P/E ratio would be 28 instead of 19, essentially matching the S&P 500 P/Sales level. Expressed differently (in price levels rather than valuation multiples), in the absence of financialization, US equity prices would be about 35% lower, all other things being equal.

source: Bloomberg

Bridgewater’s conclusion in Peak Profit Margins: a Global Perspective is that in the absence of globalization – profit margin expansion driven by easy trade in capital and goods, plus labor arbitrage – US equity prices would be about 40% lower, all other things being equal.

I find it really interesting that we get to almost exactly the same place from different directions.

Actually, not that different.

The transformation of globalization to nationalization/balkanization is a manifestation of what I call the shift from cooperative multi-play games to competitive single-play games.

The swing of the labor/capital pendulum away from a near-historic favoring of capital and back towards labor is a manifestation of what I call the shift in capital markets to becoming political utilities.

We are both making Zeitgeist arguments.

Where do we differ?

I think that the structural drivers of profit margin expansion used to be all of these globalization and labor arbitrage factors that Bridgewater notes. But in the past decade of ZIRP, we are NOT getting more goods and services out of an hour of labor. Sure, we ALSO aren’t paying labor (much) more for that time, but we are NOT getting the same juice from globalization and labor arbitrage in the past ten years as the prior fifteen. AND YET the growth in S&P 500 earnings-to-sales ratio has been faster and sharper in the past ten years than the prior fifteen.

source: Bloomberg

Like everything else in macroeconomics, corporate profit margin expansion is overdetermined. I think that Bridgewater is right to point to globalization and labor arbitrage as important drivers of margin expansion … drivers that I agree look likely to dissipate in the years to come. AND I think that these globalization drivers have been less “driving” over the past decade. AND I think that tax arbitrage and balance sheet arbitrage have been much more important drivers over that span.

Why is this differentiation important?

Because central banks can drive financialization – i.e., continue to create balance sheet arbitrage opportunities for earnings margin expansion – regardless of nationalization/balkanization and regardless of improved labor conditions.

Will they? I don’t know. But if we’re mistaking primary drivers for secondary drivers, and vice versa, we will zig when we should have zagged if they do.

In the Flow – Risk Management with ET Pro

PDF Download: Risk Management with ET Pro

There are plenty of “use cases”, to employ some marketing jargon, for the financial media narrative research that we report in ET Professional. If you’re a slow-twitch macro trader, and who isn’t these days in one form or another, our research can identify specific macro trades with an appropriate time frame. If you’re a value investor with a specific view on a stock or sector, our research can identify when your view (or an opposing view) begins to get narrative traction.

The universal use case for ET Pro research, though, is portfolio risk management.

Whether you’re a trader or a portfolio manager or a financial advisor or an allocator, we can help you identify both the inflection points and the trajectory of the market Zeitgeist – particularly the question that any long-term portfolio owner MUST get roughly right in order to succeed: are we in an inflationary or deflationary world, and how quickly (if at all) and in what ways is that world changing?

There’s no single trade we can recommend off this research that will be useful for all of our subscribers … probably not even a majority of subscribers. But every subscriber cares about the way their individual investment exposures work with each other to create (or not) a coherent and understandable investment whole, and we CAN help you with that.

Every ET Pro subscriber cares about the WHY of their portfolio. If I’m down this month, why am I down? If I’m up this month, why am I up? Are the components of my portfolio acting the way I would expect them to act given what’s happening in the world? We can talk about this in terms of covariance matrices and correlations and volatility skews and any number of ten-dollar words if you like, but those words are all getting at one simple question: do I understand why my portfolio is doing what it is doing?

Understanding the WHY of your portfolio is the fundamental purpose and meaning of risk management.

Unfortunately, all of our risk management heuristics – another ten-dollar word that means our “rules of thumb” or our basic sense of the WHY of portfolio construction – have been developed in a deflationary Zeitgeist. We’ve had 40 years of declining interest rates, and more recently we’ve had a solid decade of central banks doing anything and everything – literally, “whatever it takes” – to support financial assets against deflationary outcomes. We are all well and truly trained in deflationary risk management of portfolios, regardless of what type of portfolio we work with, and we are all well and truly defended by central bankers against deflationary threats.

That’s why I think the biggest practical investment risk for everyone reading this note is a shift from a deflationary Zeitgeist to an inflationary Zeitgeist. Sure, that shift will affect a trader’s trades differently than it affects an investor’s investments and differently than it affects an advisor’s advice and differently than it affects an allocator’s allocations.

But it will affect everyone – trader, investor, advisor, and allocator alike – differently in the same way.

None of these portfolios will work the way “they’re supposed to” in a shift from deflationary expectations to inflationary expectations. The WHY of these portfolios – whatever that WHY might be – will no longer make as much sense.

The solution? To start exercising a new set of risk management muscles now, well before you need those muscles to carry a heavy load. 

How? By learning how to “see” the shift in the Zeitgeist and tracking the WHY of your portfolio as that shift occurs.

Here’s how ET Professional can help you see a change in the Zeitgeist …

I’m going to call your attention to a couple of charts that you can find in the Monitors section of the ET Pro website. When you click on any of the five Monitors for a given month – Inflation, Central Bank Omnipotence, Trade & Tariffs, US Fiscal Policy, and Credit Cycle – you’ll arrive at a page that gives a quick summary of our research on that specific narrative topic for that specific month. What you’ll also see at the top of each page is a link to a Powerpoint deck, a PDF version of that same deck, and the underlying data for the deck in Excel. Those decks and that Excel file contain all historical data and charts for all five Monitors. In other words, you don’t have to make five separate downloads for five separate Monitors to get the most recent data and charts … one will do.

In this note on a Zeitgeist shift from deflation to inflation, I’m going to focus on two narrative Monitors – Inflation and Trade & Tariffs. Inflation is an obvious choice, because its narrative context in any queries we set up is a direct match for what we’re trying to measure. If narrative Missionaries want to talk about inflationary impulses and expectations, they use the word “inflation” a lot. With deflationary impulses and expectations, though, it’s a little different. People use many different phrases to mean deflation, but they rarely use the word itself. So when people talk about “slowing global growth”, they mean deflation. When people talk about “credit freeze” or “banking crisis”, they mean deflation. When people talk about “trade war” or “tariffs”, they mean deflation. For the past year or so, ever since the Trump White House launched this as its primary foreign policy initiative, financial media about Trade & Tariffs has been the dominant narrative context for HOW people talk about deflation.

For both Inflation and Trade & Tariffs, I’m going to focus on the patterns we’ve observed in Narrative Attention. To recap (and you can read more on this in The Epsilon Strategy note from the other week), Narrative Attention measures the persistence and prevalence of a given financial narrative topic within the larger universe of ALL financial narrative topics over time. It’s a measure of how central the Inflation-relevant articles or Trade & Tariff-relevant articles are to ALL financial media articles over time. We think it’s a good measure of how much “drum-beating” the financial media and Wall Street are doing on a given topic, and we calibrate its measurement by how much more or less active the given month’s drum-beating is relative to the average level of drum-beating for that topic.

Here’s Inflation:

So in February, March and April of 2018, the level of financial media and Wall Street effort to call attention to inflation spiked well above average. That effort largely collapsed in May 2018, climbed back to “average” in the fall, saw another spike in December, and then has fallen again sharply so far in 2019.

In contrast, here’s the Narrative Attention timeline for Trade & Tariffs over the same timespan.

For all practical purposes, there was no Trade & Tariffs narrative before March 2018, but once it was introduced by the Trump Administration it became an enormously powerful narrative from a media drum-beating perspective. By August the Trade & Tariffs Attention score is much higher than the Inflation Attention score was at its peak, and stayed that way through December. In January of this year, however, Trade & Tariffs Attention started a sharp decline, and March took us back to levels not seen since the narrative was launched.

For both Inflation and Trade & Tariffs, these measurements ring true for our subjective experience with these narratives. The spike in the Inflation drum-beating was very noticeable to us last spring, and we wrote about it then, as was the incessant Trade War! narrative and meme of last fall.

So now let’s put these Attention charts together in one graph, and let’s include the Central Bank Omnipotence Attention data for good measure.

I’d draw two conclusions from this chart:

  1. December was an INSANE month for narrative drum-beating and Attention scores. All three of these core macro narratives show above-average media Attention effort, and I don’t think it’s an accident that December was an insanely bad month for global risk assets, culminating in a shocking (to me, anyway) about-face in Fed policy and guidance at the very end of the month. I don’t think that was a coincidence. I think that the end-of-month reversal in Fed policy was the intended and successfully executed result of all of that end-of-world Wall Street drum-beating.
  2. In general, though, and to quote the Highlander catch phrase, there can be only one! One dominant narrative that draws the lion’s share of market attention, that is. Last spring a strong narrative emerged that inflation was starting to bite. That narrative collapsed as a deflationary narrative of a global trade slowdown emerged out of nowhere, taking center stage and dominating financial media (and crushing risk assets), until that narrative was in turn vanquished by a resurgent Fed Omnipotence story. Notably, both the deflationary Trade & Tariffs narrative AND the Inflation narrative have diminished as the Fed Omnipotence narrative has surged.

So what’s next? This, too, shall pass. Meaning that the Fed Omnipotence narrative will lose its dominant position in a couple of months, to be replaced by … drumroll, please … either a resurgent and deflationary Trade & Tariffs narrative OR a deflationary Euro Crisis narrative OR a resurgent Inflation narrative.

This is the narrative playbook I laid out in Things Fall Apart, Part 3.

It’s all happening.

I think there are 3 deflationary narratives in the world today – a Fed-tightening recession, a China-trade recession, and an Italy-euro crisis/recession – what I called the Three Horsemen of the Investment Semi-Apocalypse in that note.

Of the three, the Fed-tightening recession is now off the table. We’re done with that one, and Trump won’t allow it to return. One deflationary Horseman down, two to go.

Could we have a resurgence of the deflationary China Trade War narrative? Could it evolve into some sort of deflationary Europe Trade/Currency narrative. Absolutely. But even if these narratives spike for a couple of months, they will ultimately be defeated by the Central Bank Omnipotence narrative, just as they were in December.

Inflation, on the other hand, what I call the Fourth Horseman of the Investment (True) Apocalypse … there’s no taking that off the table. There’s no Omnipotence narrative that’s geared to deal with THAT, because all the central bankers have told us that they’re not going to deal with THAT, that they’re more than happy to let inflation ride back into town. And so it will. Just like it did last spring, only this time it will stay for a while longer. Sure, it will eventually get beaten back for a bit by a deflationary story, but each time it will come back stronger than before.

That’s how a Zeitgeist shifts. Not in one fell swoop, but in an ebb and flow. Just more flow than ebb. All taking place most clearly in narrative-world.

Until one day you’re swimming in an entirely new ocean of water.

ET Professional is here to help you see that ebb and flow in narrative-world and help you prepare for it.

Because whether you’re a trader or an investor or an advisor or an allocator, we all have one shared directive: Don’t Drown!

PDF Download: Risk Management with ET Pro