Observations by David Robertson, 4/21/23
Well I’m back in the saddle and feel as if I missed … almost nothing. I’ll touch on some things that I think will become very important, but there hasn’t been a lot day-to-day news.
On a housekeeping note, you may have heard Twitter started blocking links in Substack posts. While it is still possible to link to a tweet, the link takes you to Twitter rather than displaying the tweet in Substack. As a result, the letter will contain less graphics, at least for the time being, but retain all the same content.
As always, if you want to follow up on anything in more detail, just let me know at email@example.com.
T1 Alpha Sit-Rep: Monday, April 17th
Keeping this in mind, our volatility term structure model envisions clearer skies ahead. Even with the sound of economic thunder in the distance, equity volatility has been steadily approaching 52-week lows across the board. It's quite an impressive accomplishment, all things considered, and serves to emphasize the crucial intersection of fundamentals and flows.
A couple of important points here. First, volatility has crashed over the last few weeks. Second, it is easy to assume this is a signal of “all clear” for markets. However, a better interpretation is, “the recent decline in volatility stems more from strategic equity positioning than any widespread economic optimism”. As long as the flows keep coming in, most of the fundamentals just don’t matter that much.
The US dollar (USD) has also been weak this year which has been somewhat surprising to me. Given the liquidity tailwind late last year it is understandable. Given the response to bank failures and declining growth estimates it is even more so.
Nonetheless, forces for a strong USD have not dissipated. After the debt ceiling is resolved huge amounts of debt will need to be issued and that will cause a big drain on liquidity. Further, a strong USD remains advantageous in the conflict with Russia and China. The Biden administration has just over a year to make headway on that front before the presidential election heats up. In short, the weak USD story appears overdone to me.
An AI in the City of God ($)
The great gift of generative AI like ChatGPT is that it takes the ideas of search and discovery away from the petty Tech Principalities and returns them into the individual hands of those with faith in the Spirit of Man.
And that’s the most hopeful sentence I have ever written.
To tap into the discovery-librarian superpower of GPT-4, you should talk to to it exactly as you would a human knowledge-work assistant who wants desperately to please you with its responses but has none of the cues and context an actual human knowledge-work assistant would possess insofar as what responses would actually please you the most. The secret to good GPT4 prompting is the same secret as good management of a human knowledge-work assistant – you must provide the cues and context for what is pleasing and what is not. It’s really as simple as that.
As I continue check out AI and ChatGPT, I am becoming progressively more optimistic about what it can do. Part of this is based on the positive assessments by people whom I trust, like Ben Hunt in the commentary quoted above. Part of this is based on my own observations experimenting with the tools.
Part is also due to the different business model. ChatGPT runs on mostly a subscription basis. In contrast, many tech tools of the past fifteen years have run on ad-based revenue models. As a result, although the services were “free”, the user (and user data) was the valued product. That means any received value came with some kind of cost - whether immediately perceived or not.
Of course, there is certainly potential for misuse and harm. Hunt highlights the ability of generative AI to destabilize common knowledge structures like “your money is safe in the bank” or “the announced election results are legitimate”. True enough. Also, you need to be careful putting in confidential or sensitive information. Finally, you need to establish clear context in order to get useful results. But most of these things are true with any service.
One of the phenomena I have noticed over time is that I (and most other people I observe) develop habits around things that aren’t easily doable. It is easier to avoid them than sinking huge amounts of time and energy into projects with little estimated payoff.
Since ChatGPT makes so many tasks possible now, it opens the door to not only a different and improved workflow, but an entirely new and bigger universe of research projects! As a result, it presents both a challenge and an opportunity to think deeply and strategically about its potential applications.
Finally, I think one of the most obvious use cases is for work that is fairly pedestrian, but potentially time consuming. This is where ChatGPT has a comparative advantage. While I do think there are interesting creative applications as well, that’s not where the real strengths are. So the good news is a lot of things can get better. The bad news is much of the opportunity will be wasted on “pie in the sky” cool tech tricks.
The new Washington consensus ($)
The new Washington consensus is different to the old in three key respects. First, Washington is no longer the uncontested Rome of today’s world. It has competition from Beijing … Second, the new consensus is geopolitical. It does have economic tools, such as reshoring supply chains, prioritising resilience over efficiency, and industrial policy. But these are largely means to a national security end, which is to contain China … The third difference is that the new consensus is as pessimistic as the old one was optimistic … Washington has lost faith in economic multilateralism.
Ed Luce at the FT finally says out loud what has been quietly confounding investors for a several years now: The old Washington consensus has died. This has been confounding because that consensus consisted of “free market maxims”, a language economists could appreciate. It was also a “positive sum game; if one country got richer others did too”. It was sort of a big, global, kumbaya moment.
No longer. the new consensus, as Luce describes, “is zero sum; one country’s growth comes at the expense of another’s”. This seems harsh at first but is a natural outcome of slowing global growth. If the overall pie isn’t growing, the only way to get ahead is to compete for a bigger share. Aging demographics and high levels of debt are major causes of the slowdown and hence, the evolving approach to it.
As a result, many analysts today have trouble really understanding government behavior. Raised on free market ideals, they get frustrated when governments consistently intervene. Grounded in the notion that good economics is good public policy, they don’t see the motivations of geopolitics and national security as clearly as they could. While it certainly cannot be said the Biden administration has set a clear or completely cohesive foreign policy agenda, it can be said the old Washington consensus has virtually nothing to do with it.
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One of the dominant inflation themes has been the expectation that once inflation turns down, it will quickly and sustainably reach the desired 2% level. As Lyn Alden correctly highlights in a recent thread, inflation has a nasty habit of both hanging around and bouncing around. This also happens whether the Fed is actively fighting it or not.
The expectation of rapidly vanishing inflation, then, is not well supported by history. Nor is the occasion of inflation being easily tamed by monetary policy. Alden concludes, “the 2020s are likely to be characterized by recurring bouts of large monetized fiscal deficits, and tight energy/commodity markets. And war as an ongoing wildcard.” In other words, a quick and sustainable return to 2% inflation looks like a long shot.
In other inflation news, short-term expectations popped up considerably while longer-term expectations have remained unchanged. This doesn’t seem to reflect any kind of game-changing event but it does appear as if an adjustment has been made to shorter-term expectations. The notion of a quick return to 2% got overdone.
One of the things I always try to do in Observations is highlight stories that are important for long-term investors to understand but are under-followed and/or under-appreciated. As a result, I am somewhat reluctant to post on “De-dollarization” because it is showing up everywhere. Most of the discussions I have seen, however, miss the main points. They tend to be emotionally evocative but substantively vacuous. This means there is space to dig in deeper.
There is no single person better to inform on the topic of currencies and international trade than Michael Pettis. A good place to start is his 2019 essay for Carnegie Endowment for International Peace, “Should the US Run a Trade Surplus?”. In it he not only reveals the key drivers of trade differentials, but also identifies where conventional economic thinking misses the mark:
So the answer to the original question of why the United States isn’t a trade surplus country is that it should be, but because of its deep, flexible, well-governed, and completely open capital markets, in a world of excess savings and insufficient demand, the United States absorbs a substantial share of excess savings from abroad. These savings, in turn, create distortions in the domestic economy, which in turn force down U.S. savings and cause the United States to run the largest trade deficits in the world.
What is more, these U.S. trade deficits force the United States into accepting either higher unemployment or a more rapid increase in debt.
This is fascinating! Whereas persistent US trade deficits are commonly portrayed as a function of either policy incompetence or cultural proclivity for profligacy, Pettis shows these deficits are largely a function of excess savings outside of the US. These excess savings frequently seek the stability and governance of US capital markets, and as a result, are largely outside the control of US policymakers.
Politicians on both side of the debate complain, but mostly about the wrong things. For example, Pettis explains in a recent tweet thread why the redenomination of trade between Brazil and China would be pointless: “What matters are the assets in which exporters want to accumulate the proceeds of their exports.” Other countries can redenominate all they want but it will do nothing to change the US capital account surplus.
In yet another thread, Pettis addresses another misconception: “Foreigners don't acquire dollar bills in exchange for the cars and televisions they sell Americans, and they certainly don't consume those dollar bills.” Rather, he explains,
all the dollars foreigners earn from exporting to the US can directly or indirectly be used for either of only two things. They can use those dollars to buy goods and services produced by Americans, thus giving Americans productive jobs, or they can use those dollars to acquire real American assets.
A final point Pettis makes is that “de-dollarization,” in the sense of smaller global trade imbalances, is very much in the interests of the US. While the strength of the dollar affords the country some luxury in negotiating geopolitical squabbles, it also comes with plenty of domestic downside. Namely, persistent trade deficits forces the US into accepting “either higher unemployment or a more rapid increase in debt”.
It is interesting that the bulk of “de-dollarization” talk carries a negative connotation. The implication is the US is losing status somehow. This is associated with the beliefs that fiscal deficits and trade deficits are primarily caused by policy incompetence. Conversely, excess savings abroad is frequently viewed as evidence of superior economic functioning.
Both views are wrong. As Pettis points out, the fiscal and trade deficits are primarily a function of excess savings from the rest of the world which in turn is caused by low demand due to economic inequality. If China’s working population received fair compensation for their efforts, consumer demand would increase and there would be no need to export so much and no excess savings. What many view as a strength is actually a weakness.
A proper diagnosis of the problem significantly changes the policy calculus. Mainly, there is little the US can do. Tariffs and protectionism are misguided. The one thing that would address the underlying problem is to limit capital inflows, perhaps through taxation. Anything else, from the US, China, Brazil or whoever, is just political bluster.
T1 Alpha Sit-Rep: Friday, March 31st
The steepness of the vol [volatility] surface is rapidly attracting volatility sellers as the one month "yield" on VIX futures roll-down now exceeds 5% monthly, placing it in the top quintile over the last year. Replace the pennies in front of the steamroller with dimes and you'll get more takers. While a very attractive yield, remember that this is roughly average over the life of the VIX futures contracts (back to 2005) and selling vol in the teens with geopolitical tensions and an imminent recession dead ahead feels more "50 First Dates" than "An Affair to Remember" (lack of memory vs triumph over adversity).
Tier1 Alpha remarked at the rapidness of the decline in volatility at the end of March (and immediately after the bank failures). Already sub-20 at the time, VIX has continued to decline in April.
One tempting explanation for the significant decline in volatility is reduced uncertainty. As Tier1 points out, however, “geopolitical tensions and an imminent recession dead ahead” makes this highly unlikely if not outright implausible.
Rather, our old friend, the carry regime, seems to be poking its head up again. The practice of selling volatility, figuratively picking up nickels (or dimes) in front of a steam roller seems to be back in style. This works when traders correctly guess the central bank will intervene in any market mayhem in order to prevent destabilizing events. As it turns out, the Fed’s effort at “controlled demolition” also facilitates the bets of volatility sellers.
This dynamic has some important implications. First, the process is self-reinforcing. Lower vol means more profitable trades means more volatility selling means lower vol. It doesn’t imply anything for general market uncertainty. As a result, large stocks tend to benefit most. Finally, the dynamic does not resolve peacefully. It keeps pushing vol lower until eventually something breaks or until central bankers change the rules of the game.
The recent spate of low and declining volatility presents a superficially placid perspective of capital markets. Unfortunately, the calm belies significant risks that long-term investors should keep in mind.
One of the risks is the impending debt ceiling. Lower than expected tax collections suggest the Treasury may run out of money in June as opposed to prior estimates of late summer. While I seriously doubt there will be any Treasury holders who do not get paid eventually, a government shutdown and potential default would certainly be disruptive and lends itself to a wide range of unintended consequences. It would be less concerning if Washington were run by adults, but that is not the case.
Regardless, the most likely medium-term outcome is the debt ceiling gets resolved and the Treasury starts to issue unholy amounts debt. The massive drain of liquidity will create an enormous headwind for financial assets.
Interest rates also remain a risk. Even though rates took a toll on financial assets in the first half of last year, stocks and bonds have largely brushed off further increases since then, even though the risk has become greater and more immediate. The reality, however, is the noose is continuing to tighten on over-leveraged businesses. It takes some time, but commercial real estate, venture capital, private equity, and various securitizations are all feeling the pain.
Finally, the geopolitical risk that reared its head so visibly when Russia invaded Ukraine has not gone away either. Though it remains mostly out of the limelight, the risks have probably actually increased since then. The risk now is of persistent, chronic tension from which higher intensity conflicts can easily emerge.
In sum, several powerful forces are converging over the next few months to create an exceptionally negative environment for stocks and bonds. The best chance of avoiding the storm is to steer clear of it while you have a chance.
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