Risk Management Strategies: How To Avoid Losing It All

Darius joined our friend Andreas Steno Larsen on Real Vision last week to discuss inflation, what 42 Macro’s quantitative asset allocation process is signaling, where we are in the positioning and liquidity cycles, and more.

If you missed the interview, here are the three most important takeaways from the conversation that have significant implications for your portfolio: 

1. We Believe Inflation Is Likely To Slow, But Bottom Above 2%

We have maintained for nearly two years that the Fed would need to revise its inflation target to be higher, as their policies since early 2022 suggest they will allow the economy to run hotter for longer. 

Moreover, we believe inflation is likely to slow over the medium term. However, given the current era of fiscal dominance and other structural factors, we do not foresee a durable return to the Fed’s mandate of 2%. 

We believe the Fed’s decision to perpetuate a higher nominal GDP growth economy is structurally bullish for risk assets like stocks, credit, commodities, and crypto, and bearish for defensive assets such as Treasury bonds and the US dollar. Investors will still have to manage cyclical risks along the way, however. 

2. Our Discretionary Risk Management Overlay aka “Dr. Mo” Is Responsible For Keeping 42 Macro Clients On The Right Side Of Market Risk

We utilize our Discretionary Risk Management Overlay as the primary tool to advise our clients on the appropriate trades and position sizes across every major asset class, sector, and factor. 

At the time of the recording, we were in a risk-on REFLATION Market Regime, and our Discretionary Risk Management Overlay aka “Dr. Mo” recommended maximum long positions in many risk assets across equity, credit, and macro markets — recommendations it has maintained since November. 

The recommendation logic is based on the interplay between an asset’s Volatility-Adjusted Momentum Signal (VAMS) and its historical performance within the current Market Regime. These trade recommendations are updated six times a week for our clients at 42 Macro and only change if the Market Regime or VAMS for a particular asset changes. 

3. Our Analysis On Liquidity Cycle Upturns Suggests Risk Assets May Have A Larger Drawdown Ahead

Investors should focus on both the liquidity and positioning cycles to better understand how exogenous shocks, like geopolitical events or crises, can influence asset market behavior.

We have analyzed the various liquidity cycles since Mar-09 to aid our clients in predicting expected asset market performance and potential drawdowns during these cycles. Currently, we are in a liquidity cycle upturn that began in October 2022, lasting for 19 months—shorter than the median duration of nearly two years typically seen in past cycles. Despite this shorter duration, the performance has been greater than the median 37% return of other cycles, with the S&P 500 up 40% since the current liquidity cycle upturn began.

However, a concern for us is that we have not reached the median maximum drawdowns observed in past liquidity cycle upturns. In this cycle, the maximum drawdowns have been -10% for the S&P, -11% for the NASDAQ, -27% for Bitcoin, and -34% for Ethereum. These figures are significantly milder compared to the median drawdowns of -14%, -16%, -61%, and -51% for these assets, respectively. This analysis leads us to caution that, despite the strong performance and the persistence of the liquidity cycle upturn, there remains a potential for significant corrections in asset markets.

That’s a wrap! If you found this blog post helpful, go to www.42macro.com/research to gain access to 42 Macro’s proprietary trading signals, asset allocation recommendations, and portfolio construction pivots.

How To Navigate The Fourth Turning

Darius hosted our friend Kris Sidial on this month’s Pro to Pro Live to discuss the 42 Macro Positioning Model, inflation, the Fourth Turning, and more.

If you missed the interview, here are the three most important takeaways from the conversation that have significant implications for your portfolio: 

1. Our Positioning Model Suggests Vulnerability In Equities

Our 42 Macro Positioning Model monitors 14 indices relative to their historical time series. By identifying the thresholds of each indicator that correspond to major bull market peaks and troughs, we can determine whether we are approaching cyclical tops or bottoms in asset markets.

Currently, six of the seven indicators related to equities are flashing red. Specifically, the AAII stock allocation, AAII bond allocation, AAII cash allocation survey, S&P 500 realized volatility, S&P 500 implied volatility correlations, and the S&P 500’s valuation have all breached historical thresholds observed at bull market peaks.

The positioning cycle is not ever the cause of breakdowns and breakouts in stock market momentum, but it does act as an accelerant once a catalyst(s) has triggered. That means investors should be on higher alert than normal for signs of rapidly deteriorating fundamentals. A better process would be to trust proven risk management signals that will help you book gains closer to the top than waiting for or even attempting to [oft-erroneously] predict those catalysts. 

2. Is 3% Inflation The New 2%?

At 42 Macro, we have conducted an in-depth analysis of the economic dynamics surrounding the Fourth Turning. 

Our findings suggest that over the next decade, investors should anticipate significant upside surprises in the growth of public debt relative to current projections and a marked increase in inflation compared to the pre-Fourth Turning baseline.

This conclusion aligns with a report we published in January 2022 featuring our secular inflation model. Our analysis revealed that the Core PCE trend from 2010-2019 was 1.6%. However, our models project that the trend for 2020-2029 is likely to be between 2.6% and 3.0%.

3. A Higher Inflation Trend Will Have Important Implications For Investors’ Portfolios

The inflation outlook during the Fourth Turning has significant implications for the stock-bond correlation and investors’ portfolios. 

In periods of 1-2% Headline CPI, as experienced over the past decade, the stock-bond correlation tends to be negative. Conversely, in periods of 2-3% Headline CPI, the correlation becomes positive, and increasingly positive beyond those levels. 

If our Fourth Turning thesis holds true, a traditional 60/40 portfolio is likely to underperform more thoughtful asset allocation strategies over the next decade. Investors will need to consider alternative instruments, such as volatility products, to hedge their portfolios effectively. Investors should consider the 42 Macro KISS Portfolio Construction Process, which is already being relied upon to deliver superior investment performance for thousands of investors around the world. 

That’s a wrap! 

If you found this blog post helpful, explore our research for exclusive, hedge-fund-caliber investment insights you can act on today.

How Will The Election Year Impact Asset Markets?

Darius joined Victor Jones this week to discuss the impact of the PBOC’s policies, inflation, the election year, and more.

If you missed the interview, here are the three most important takeaways from the conversation that have significant implications for your portfolio: 

1. Policies Coming Out Of The PBOC Have Had A Meaningful Impact On Asset Markets This Year

Since December of last year, we have called for Beijing to implement front-loaded policy support as we entered 2024. 

That is what we have witnessed, and that front-loaded policy support has had two significant impacts on global financial markets:

1. It has contributed to the uptrend in global liquidity, as evidenced by our 42 Macro Global Liquidity Proxy, an estimate for global liquidity calculated by summing the Global Central Bank Balance Sheet, Global Broad Money Supply, and Global Foreign Exchange Reserves ex-Gold. 
2. It has supported a rebound in Chinese PMI, suggesting the narrative around the Chinese economy being a black hole is changing at the margins. 

2. The “Immaculate Disinflation” Theme Is Likely to Persist For Another Quarter Or Two

Over the past two months, we have seen Headline PCE, Core PCE, and Sepercore PCE Deflator accelerate to well above trend rates on a three-month annualized basis.

However, investors do not need to be highly concerned about those increases at the current juncture because:

• Productivity growth remains above trend.
• Leading indicators such as the “Prices” and “Supply Chain” components of PMIs continue to indicate a likely deceleration in inflation.
• The “Shelter” component of inflation has not meaningfully decelerated despite ample housing price disinflation in the pipeline. 

We believe the “Immaculate Disinflation” theme may persist for another quarter or two before inflation bottoms at an unpalatable level relative to the Fed’s mandate. At that point, we believe the narrative around inflation is likely to change, and asset markets are likely to be impacted.

3. Fiscal Policy Is Likely To Continue Supporting Asset Markets Heading Into The Election

One reason we have been bullish on risk assets is that we believed President Biden and Treasury Secretary Yellen would implement favorable fiscal and net financing policies this year, supporting our “Resilient US Economy” theme and US liquidity. 

We believe the election remains a risk-on catalyst for now. However, asset markets are likely to face headwinds after the election. 

Sometime in Q4, we anticipate the RRP balance to have declined to at or near zero and the TGA balance to have decreased by $250B from current levels. Those estimates represent dangerous starting points ahead of another round of debt ceiling negotiations on the horizon is poised to induce volatility in asset markets.

That’s a wrap! 

If you found this blog post helpful:

1. Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.

2. RT this thread and follow @DariusDale42 and @42Macro.

3. Have a great day!

Navigating Shifts In Global Liquidity

Darius sat down with Gordon Johnson last week to discuss the macro outlook for asset markets, the fourth turning, China, and more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio: 

1. US Liquidity Is Likely to Peak Around Midyear 

The Federal Reserve has significantly increased the supply of Treasury bills, accounting for 69% of the total net marketable borrowing on a TTM basis through the first quarter. 

This has led to a reduction in the RRP and an injection of liquidity into the financial system, supporting asset markets. However, this trend is likely to shift in Q2, with the proportion of Treasury bills in net marketable borrowing dropping to 49% on a TTM basis. 

As a result, the drain on RRP will likely be halted, potentially impacting the favorable liquidity conditions supporting the stock market’s recent positive performance.

2. During The Fourth Turning Regime, Inflation Is Likely to Remain Elevated

Our research indicates that Headline CPI typically exhibits faster growth during Fourth Turning regimes, averaging 2.1%, in contrast to the 1.2% observed during the First, Second, and Third Turnings. 

As a result, we anticipate a shift towards a more inflationary climate over the next decade, diverging from the relatively stable price levels experienced in recent decades.

Consequently, this evolving landscape is likely to prompt the Federal Reserve to engage more actively in debt and deficit monetization, a trend we believe is likely to intensify over the coming decade.

3. China’s Structural Liquidity Trap

China is currently facing a structural liquidity trap, similar to the situation Japan encountered starting in the early 1990s. In this structural liquidity trap, additional credit growth in China is not effectively fueling economic expansion. Instead, it is primarily being used to roll over existing debt, allowing them to refinance current obligations.

Moreover, the expansion of the PBOC’s balance sheet has been largely driven by China’s foreign exchange reserves, a trend that halted in 2015. That said, incremental policy adjustments such as reducing the reserve requirement ratio (RRR), cutting loan prime rates, and bolstering medium-term financing are creating positive global liquidity conditions. 

These policy measures have had a positive impact on asset markets and have been contributing to the current GOLDILOCKS Market Regime. 

That’s a wrap! 

If you found this blog post helpful:

1. Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.

2. RT this thread and follow @DariusDale42 and @42Macro.

3. Have a great day!

A Glimpse Into How 42 Macro Models Work

Darius sat down with Markets Policy Partners last week to discuss the details behind a number of 42 Macro models, inflation, and more.  

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio: 

1. A Look Into How 42 Macro Nowcasts The Current Macro Regime

Our Global Macro Risk Matrix is designed to provide a current snapshot of the market regime from a top-down perspective.

This is important for investors because in order to be consistently profitable, they should align their positioning with prevailing market conditions.

Our process evaluates 42 distinct markets, including broad baskets of assets such as equities, volatility instruments, commodities, currencies, and various fixed-income measures like rates, spreads, and yields, and incorporates a volatility-adjusted momentum signal to assess each market’s performance.

We update the data daily and aggregate the scores for each market. 

Finally, the regime that accumulates the highest total score is identified as the prevailing top-down market regime.

2. Our Macro Weather Model Systematically Nowcasts Momentum Across The Principal Components of Macro

Understanding the current macro regime is just the starting point. 

To be successful, investors must also anticipate the duration of the current market regime and anticipate the transition to the subsequent market regime – especially when a “RORO” phase transition (i.e., risk-on-to-risk-off or vice versa) is increasingly likely. 

The Macro Weather Model is our process for analyzing several principal components of macro and translating those components into a 3-month outlook for major asset classes, including stocks, bonds, the dollar, commodities, and bitcoin.

This model monitors indicators that reflect both the real economy cycles and financial economy cycles:

• Real economy cycles: Growth, inflation, employment, corporate profits, and fiscal policy
• Financial economy cycles: Liquidity, credit, interest rates, and market sentiment indicators ‘fear’ and ‘greed.’

3. Our Models Indicate Inflation Will Likely Trend 100 to 140 Basis Points Higher This Decade Compared to The Previous One

Since 2020, most forecasting models used on Wall Street, including DSGE and auto-regressive models, faced significant challenges in predicting inflation due to such an unprecedented surge in various economic indicators stemming from the COVID-19 pandemic.

During the decade from 2010 to 2019, core PCE maintained an underlying trend of approximately 1.6%. 

However, our models predict that Core PCE will likely average somewhere between 2.6% to 3.0% throughout the 2020-2029 decade. 

An increase to those levels is likely to cause concern for the Fed and may lead to structural policy adjustments in the future.

That’s a wrap! 

If you found this blog post helpful:

1. Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.

2. RT this thread and follow @DariusDale42 and @42Macro.

3. Have a great day!

Is Bitcoin Data Giving The Green Light?

Darius sat down with Anthony Pompliano last week to discuss global liquidity, the Macro Weather Model, Bitcoin, and more.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio: 

1. Our 42 Macro Weather Model Is Suggesting A Less Bullish Outlook Over The Medium Term

In our previous appearance on The Pomp Podcast, our Macro Weather Model signaled a bullish 3-month outlook for risk assets. 

However, as of last week, the model has signaled neutral outlooks for both the stock market and Bitcoin over a three-month timeframe. 

While these signals are not explicitly bearish, they indicate a shift toward a more bearish environment. 

This change is primarily driven by the Sovereign Fiscal Balance to Nominal GDP Ratio, which has recently inflected to a positive trend. 

This implies a lower fiscal impulse compared to 2023, potentially leading to a less favorable environment for risk assets.

2. We Believe Global Liquidity Is Likely To Continue Trending Higher Over The Next Quarter or Two

Our 42 Macro Net Liquidity Model, which is calculated by taking the Federal Reserve Balance Sheet and subtracting the Treasury General Account (TGA) Balance and the Reverse Repo Program (RRP) Balance, is trending higher.

Similarly, our 42 Macro Global Liquidity Proxy, which is calculated by summing the Global Central Bank Balance Sheet, Global Broad Money Supply, and Global Foreign Exchange Reserves ex-Gold, is also trending higher.

Furthermore, leading indicators for both the Net Liquidity Model and Global Liquidity Proxy suggest a sustained positive trend in liquidity for at least the next two quarters.

3. We Expect Bitcoin Will Perform Well Over The Long Term

We recommend investors view Bitcoin simply as an additional asset class to maintain a rational perspective and avoid becoming too emotionally invested in the asset. 

That said, it is important to note that the introduction of the ETF is a structurally positive fundamental, likely to boost inflows into this asset class over the long term. 

Additionally, our research into the Fourth Turning indicates we will likely experience well-above-trend inflation over the next decade. 

As a result, the traditional 60/40 investment portfolio is unlikely to yield the same returns it did in the past decade. 

This scenario is likely to prompt investors to seek alternative investment opportunities, and we anticipate a significant portion of this capital redirection towards alternative assets, with Bitcoin being a favored destination among millennial, gen-z, and tech-focused investors.

That’s a wrap! 

If you found this blog post helpful:

1. Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.

2. RT this thread and follow @DariusDale42 and @42Macro.

3. Have a great day!

Macro Market Outlook

Darius sat down with Andy Constan last week on 42 Macro’s Pro to Pro discussion to explore the US Treasury, fiscal stimulus, and the US dollar.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio: 

1. While The US Treasury Has Been Capitalizing on Strong Demand for Short-Term T-Bills, It Is Also Considering Issuing Longer-Term Coupon Bonds

Although the US Treasury has continued to flood the market with T-bills over the past three quarters to tap into excess demand via the Fed’s Reverse Repo Facility, they may begin to issue longer-term coupons.

The decision to issue more long-term debt is influenced by the current low or negative term premium, which makes issuing longer-term bonds cheaper for the Treasury. 

2. Fiscal Stimulus, Which Has Been A Major Contributing Factor to The Resiliency of Household Income, Has Peaked

In 2023, the US economy featured a record non-war, non-recession budget deficit. 

However, the impulse peaked earlier in 2023 and has shown signs of moderation: the budget deficit on a YTD, YoY basis was up $834 billion in June, $535 billion in August, and now only $255 billion in October. 

As a result of the slowing impulse, we believe we will return to more typical levels of government spending and budget deficits. 

The challenges faced by investors due to the previously high levels of Treasury debt issuance are likely behind us… for now.

3. Is The US Dollar Entering A Bear Market?

We expect the US Dollar to decline if we continue to get data that supports a soft landing.

Additionally, our research suggests the US dollar is overvalued on a real effective exchange rate basis and relative to current inflation dynamics and that the path of least resistance for the dollar is down.

However, the Fed is currently adopting a more restrictive policy than the rest of many central banks worldwide, supporting the dollar. 

This approach tends to attract foreign investment seeking higher returns, which increases the demand for and drives up the value of the U.S. dollar. 

While there is a push-pull between these dynamics, we believe there is a credible path to a bear market for the US dollar. 

That’s a wrap! 

If you found this blog post helpful:

1. Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.

2. RT this thread and follow @DariusDale42 and @42Macro.

3. Have a great day!

What’s Driving Global Liquidity?

Darius sat down with Maggie Lake last week on Real Vision’s Daily Briefing to discuss all things Global Liquidity.

If you missed the interview, here are three takeaways from the conversation that have significant implications for your portfolio: 

1. The Recent Surge In The Dollar Has Negatively Impacted Global Liquidity

Our 42 Macro Global Liquidity proxy, a sum of global central bank balance sheets, global broad money supply, and global FX reserves minus gold, is a key driver of risk assets like equities and bitcoin.

Since mid-July, the US Dollar has rallied aggressively. This rally weighed on global liquidity because the Dollar and FX volatility are negatively correlated to global liquidity.

If we see a breakout in currency volatility, which is in the process of occurring according to our Volatility-Adjusted Momentum Signal, the negative global liquidity impulse could continue to decline, negatively impacting risk assets. 

2. Currency And Interest Rate Volatility Have Hampered Private Sector Liquidity

Most retail investors think of liquidity solely in terms of whether or not central banks are supplying liquidity to the global financial system. 

Private sector agents like commercial banks and non-bank lenders – primarily from net international investment surplus economies like Europe and Japan – also supply liquidity, referred to as “private sector liquidity.”

Recent currency and interest rate volatility have made it difficult for these private sector agents to supply liquidity to the system, impeding the overall global liquidity supply.

3. The Dollar Could Reach Its Highs From Last October If It Slows Its Trajectory

If the dollar continues its aggressive trend over the next few months, the Fed may have to step in and intervene because it will likely coincide with something “breaking” in the Treasury market. 

But, if the dollar slows its trajectory and grinds its way higher, we believe it may reach its highs of $113 from October of last year in DXY terms.

That’s a wrap! 

If you found this blog post helpful:

1. Go to www.42macro.com to unlock actionable, hedge-fund-caliber investment insights.
2. RT this thread and follow @DariusDale42 and @42Macro.
3. Have a great day!

US-Global Growth Divergence

Last week, Composite PMIs came in below expectations across continental Europe and in China. Stagflation is the fear in Europe, while deflation is the fear in China. Neither public sector appears ready to supply the liquidity required to ignite animal spirits within their respective economies and financial markets. Regarding the Composite PMI data specifically, only four (Japan, Russia, Brazil, and US) of the 13 economies that have reported thus far posted MoM accelerations in August. Only Japan, China, India, Russia, Brazil, and the US reported figures greater than 50, indicating expansion. Europe was a noteworthy laggard with Spain, Italy, France, Germany, Eurozone, and UK all slowing sequentially to sub-50 readings, indicating contraction.

It is now fashionable to make the short-USA/long-RoW (rest of world) call, citing valuation differentials, but we disagree with that view. Valuation is not a catalyst for market developments, Rather, valuation merely acts as an accelerant when flows reverse. FWIW, we do not believe valuations matter all the time; in fact, most of the time valuation is irrelevant because the overwhelming majority of investors cannot take risk in accordance the time horizons (3, 5, 10 years) that valuation metrics are most instructive on. Retail investors generally operate on short to medium-term time horizons because of FEAR and FOMO; institutional investors generally operate on short to medium-term time horizons because of career risk.

The US Economy Remains As Resilient As Ever

Last week’s +1.8pt MoM advance in the ISM Services PMI (54.5 = 6mo high) was adequately presaged by the New York Fed’s Services Survey a couple of weeks ago. The New Orders PMI hit a 6mo high as well alongside the highest reading in the Employment PMI since Nov-21.

The probability of a near-term recession continues to dwindle because the services sector accounts for 86% of Total Nonfarm Payrolls.

Offsetting the positivity was the 4mo high in the Prices PMI, which is now trending higher again. If the inflation narrative devolves sooner than our qualitative research views anticipate, we could be in the early innings of a market crash.

China’s Crude Oil Imports accelerated to 30.9% YoY in August, fanning the flames of an ill-timed, hazardous breakout in energy prices.

All eyes on Wednesday’s August CPI report to confirm or disconfirm the prevailing “immaculate disinflation” theme, which itself is one-half of the “transitory GOLDILOCKS” theme we co-authored in mid-January (with the other being “resilient US economy”).