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.
