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To cut straight to the chase, the origin for this pivotal moment is the Iran conflict, and in particular the blockade of the Strait of Hormuz, through which c. 20% of global oil traffic and many other essential inputs such as fertilizer, LNG or helium flow. This creates a setup akin to a ticking bomb, where every shut day causes gradually more damage, until a large rupture occurs

To illustrate this dynamic, please follow me on the below simple math, focussed solely on oil for now:

• Daily global oil demand is ~105m barrels per day. Most of the oil produced in Iraq, Kuweit, Bahrein, Saudi, UAE and Iran, 21mbd in total, is shipped to global markets via the Strait of Hormuz

• Oil is an inelastic good i.e. we really need it irrespective of the price. It is mainly used transportation (cars, trucks & planes) and industrial purposes (plastics, energy production)

• The current flow of ships through the Strait has decline from ~140 to 3-6 per day. Thus, Hormuz oil volume has collapsed to c. 2mbd (mostly Iranian ships to China) vs the 21mbd pre-conflict. In other words, a 18mbd deficit is now at hand

• However, a range of offsetting measures has been introduced. A pipeline that cuts through Saudi with spare capacity is now fully utilised (+4mbd), and more oil now flows from Iraq to Turkey (+0.5mbd) and from UAE to Oman bypassing the Strait (+1mbd). A globally coordinated release of strategic oil reserves (“SPR”) adds ~2mbd

This leaves a daily deficit of ~10mbd if counted generously. For an inelastic good this is a huge gap. Economic theory stipulates that to balance the market, the oil price would have to go high enough for 10% of consumers to give up, i.e. not use their car, halt the factory assembly line, not take that long haul flight etc. The price to do this would be very high, in particular on the industrial demand side ($200-300bbl?)

For obvious reasons, this scenario would crush the world economy and lead it into a deep recession. So why is the oil price not there yet? Three reasons:

1. The main reason is that there is still a lot of inventory that gets eaten into first

2. A secondary reason is a disconnect between paper and physical markets, and the focus on US benchmark WTI. Many refined oil products as well as oil originating in the Middle East (e.g. Dubai/Oman) are already at nosebleed levels

3. Markets are pricing in some odds that the conflict ends shortly

The current commercial inventory both held on tankers at sea and onshore inventories is ~260mbbl excluding China, which has its own strategic interests in opposition to the West, and still receives some Iranian oil. A 10mbbl/day deficit eats through that in 26 days (please note the SPR is already accounted for in the daily deficit number)

• Now, many additional levers will be pulled and human ingenuity always goes above and beyond in crisis. Also please note these are back-of-the-envelope calculations to just give a directional sense. So this number of days could also be twice as high

Either way, it is not many days, and once the inventory is absorbed and if the conflict is still ongoing, another aggresive leg higher in oil prices as well as fuel shortages are in the cards. This may sounds hyperbolic, but consider the following: Inventory is not distributed evenly, so in many countries fuel shortages have already started, incl. Japan, Australia, Korea, India, Indonesia, the Philipines etc.

In Europe, Italy would be next in line, as it receives 30% of its natural gas imports from Qatar, which has currently shut down entirely, and where 17% of production has been damaged for 3-5 years

Summary: If the Strait of Hormuz is not opened very shortly, enormous damage will be inflicted on the world economy

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How likely is this to happen? First of all, geopolitical conflicts are unpredictable, so all of the below thoughts come with a wide margin of error. Either way, this is how I see it:

• At the moment, Iran has full control of the Strait of Hormuz. Since the start of the war, this has not weakened. In fact, over the past week Drone and missile attacks increased again and strikes over the past days occured in a precise manner (e.g. Qatar LNG, Kuweit refineries, Saudi Red Sea refinery), which suggests that despite all the decapitation strikes leadership coordination still occurs. I also assume Russia and China provide significant aerial intelligence help

• This makes Iran the new de-facto OPEC. By deciding which ships can go through the Straits they can set the price of oil. This situation is absolutely unacceptable not only to the US and Israel, but to the entire West, against which Iran is aligned

It is highly unlikely that Iran will give up this new found power voluntarily. It also seems implausible that the Strait can be made secure from the air. After all, it only takes a kid with a drone to disrupt it, and that can occur from far away as the drone strike on the Saudi Red Sea refinery 1500km away demonstrates. This leaves the following three options from here:

1. The US and Israel take control of the Strait by force, on the ground

2. The US and Israel manage to destabilise the regime from within in short enough time before global oil inventories run out

3. The warring parties make a deal that ends the war, likely involving considerable concessions to Iran (e.g. sanctions relief)

Today’s reporting suggests that 1. is the most likely, and preparations for it are under way. This would be a high-risk path with many challenges, and likely considerable time and possibly casualties involved. At its end however I would think Hormuz control is achieved. Again, keep in mind geopolitical events are very fluid, and I also leave some probability assigned to 3., as unlikely as it looks today

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What Does that Mean for Markets?

The following section is for professional investors only. It reflects my own strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please always note, I may be entirely wrong and/or may have changed my mind even by the time you read this. This is not investment advice, please do your own due diligence

Short Run:

In the very short-run, anything that prolonges the Strait closure is cryptonite for equity markets, as it increases the odds of the “off-the-cliff” scenario I outlined above. Even if that case may be 2-6 weeks out depending on the calculation, markets will very likely front run it

This also aligns with the technical picture, which shows the S&P 500 in a lengthy consolidation pattern since the fall (cf. Wyckoff distribution pattern), that now has a fundamental reason to be resolved to the downside

More so, while positioning has certainly cleared a fair amount, it is not at levels that are so one-sided that it is no brainer to go long. Many pockets remain with considerable net length (below for systematic hedge funds)

However, as I mentioned above, geopolitical events are both unpredictable and very fluid. Further, the outcome I describe above is undesirable for almost everyone including China, so all possible forces will work against it happening. Thus, a resolution, or a step towards it may be announced at any time. Equally, there will be many attempts to jawbone markets higher with reassuring words. I have closed out equity shorts today, and will be flat into the weekend. If the news context does not change, it will use risk rallies to re-enter these. It is not my base case (see above), but at the same time, if the news context provides a light at the end of the tunnel I will go long. As always, I may be wrong in direction, time or both, and am ready to change my views on a dime should new information warrant it

Long Run:

Equities broadly My base case assumption is that markets see a sharp correction over the coming weeks as the world moves closer to the brink. In turn, that could be the catalyst putting sense into everyone and an off-ramp is found, which may coincide with positioning so washed out that no one is left to sell, providing much fuel for an upside move I am looking to go long risk into that low

Looking at sectors and asset classes in more detail, I see the following as long-term winners from this situation:

US LNG - Mideast natural gas supplies are likely both damaged in output and reputation, with main demand sources Europe and Asia needing to turn to other sources. US LNG is the most obvious and I would expect this sector to do well

Renewables & EVs - Substantial progress has been made in partiular in Solar power generation, as well as in battery storage. This is another obvious winner for me, as well as electronic vehicles, which are more attractive again at higher gas prices while autonomous driving makes big progress

Coal - left for dead many times over the past decade, coal remains a go-to energy source for higher short term demand

Defense, in particular drones and lasers - After Ukraine, the Iran conflict has once again re-affirmed that future conflicts will be assymetric and drones are a key component in them. The flipside is laser-based air defences against them, which are much cheaper than e.g. existing Patriot systems

AI - Iran is another proxy war between the West and China/Russia. Global tensions rise, and with it the urgent need to win the AI race. Expect more government support. Focus on whatever the bottleneck is and the highest beta to it (memory, photonics today, what’s next?)

Gold & Bitcoin - While either in the short run are tied to risk-on/risk-off, in the long run war is inflationary as more defence spending requires more money printing, and the worries on governmental confiscation rise, which benefits store of value proxies

Commodities - The conflict accelerates the breakdown of the world into competing spheres. This weakens global supply chains and increases the need to hold more strategic inventory of key primary inputs

These will have difficulties:

Japan - The land of the rising sun imports most of its energy and food. It has also embarked on a highly inflationary policy mix just before the war broke out. It will have to hit the inflation breaks hard or risk a Turkey-style outcome

Germany & Europe - The old continent is facing another inflation wave as its vulnerability to energy shocks has not diminished since the Ukraine war. The silver lining could be that this creates the impetus for lasting positive change, as Europe realises it needs to rely on itself

Fantasy stocks and financial concepts - A hallmark of the late 2010s and early 2020s easy money period, it is hard to see a return to 100x EV/sales ratios for gaga-stocks and fantasy coins when liquidity is needed for commodities and defence

I’ve share my views much more closely on X, and continue to trade along the Dominant Driver Theory introduced last year. Performance continues to be good (below as before since 17th Oct ‘24) and is composed almost entirely of hyperliquid global macro instruments (ES, UB, CL, GC futures etc.)

• Rather than adding to these gains, my main personal challenge from here is not to give them up, as human psychology incl. mine will work against me to induce carelessness and excessive risk taking. The FK Terminal Claude Opus let me build helps a lot in that regard, a small data excerpt below. I still intend to make an open-source version available when I get the chance for it (please note that all it does is give you structure and process, you’ll still have to do the hard work yourself of filling it with life :)

• Finally: there have been some imposters and spam accounts in my name that X is slow to get rid of, please note I do not run any paid service or investment opportunity and will never contact you via whatsapp or otherwise for it

The world is in a difficult place today. I genuinly hope that further escalation is avoided, I would much rather be wrong on my short-term view than see it continue down an increasingly difficult path. My thoughts are with all those affected by the war one way or another

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DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, the author does not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

Around 1440 in Strassburg, Johannes Gutenberg invented the printing press. This greatly facilited the proliferation of documents which before had to be copied by hand. In my view, the release of Claude Opus 4.5 late last year marks a similar moment, where the ability to generate software moved from costly, labor & time-intensive to cheap, effortless & quick, thus enabling a dramatic shift in access and proliferation akin to the printing press at the time

This opens the door to some major changes to the fabric of our economies and markets, which this post walks through, as always along the lines of the Dominant Driver Theory

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Perhaps the best way to illustrate the significance of this moment is through personal experience: I know as much about coding as I do about cooking, to my wife’s great lamentation

• Yet, since downloading Claude Opus 4.5 in early January, I have managed to create an investment terminal ideally tailored to my needs. It now replaces my Bloomberg account for most tasks and, more importantly, performs many other tasks that were previously not accessible

• More so, having worked with developers before, I was used to lengthy feedback loops between the idea and implementation and a big bill at the end. The work with Claude on the other hand was as effortless as conversing with a developer, but cheap and with immediate results, as coded files are returned within minutes

Thus, in the space of a few weeks I was able to build software that (at least for me personally) has huge value and even 6 months ago would have taken several months and hundreds of thousands of USD to create. Here are some more details on the “FK Terminal”, starting with some screenshots below:

The column on the left with the light blue fields is the main menu. Each button opens a tab as some of them are shown on the right. Each tab in turn fulfils a function supporting the Dominant Driver Theory investment approach I pursue, let’s briefly walk through them:

• Dominant Driver Tab: This logs the current and past market moving themes with accompanying analytics

• Technicals: The charting module (more below)

• Daily Assessment: A key part of my investing approach is “radical journaling”, the process of noting down every possible detail around a trade, from technical and fundamental elements to personal observations suchs as mood or sleep quality. This module allows me to do that in a structured way, with daily and all-time learnings extracted every day

• Trade Log: This files all my trades including their reasoning across multiple vectors. The adjacent trade statistics allow me to sort for each of these vectors to easily detect what worked over time and what did not - a key improvement engine

• Trade Heuristics: Here I store all the conceptual market relationships that have shown valid time and again (e.g. “Staples and Energy rallies often precede market downside”, see more in market section)

• Trade Mistakes: Macro investing is akin to trying to make a thoughtful decision while you are getting punched in the face, so very error prone. I file and dissect every error here diligently as another improvement flywheel component

• Research: I could never read all of the my over 70 email subscriptions which I all rate for one reason or another, and many other sources on top. This module summarises all incoming information in a digestible way

• Setup Tracker: I track every trade setup I see and the reasoning around why I take it or not. This is a great and objective way to tease out behavioral biases

• Visual Examples: I often come across the same technical pattern, whether it is on an intraday, daily or weekly chart. Here I save images of what I feel frequently repeats, which over time creates a library of patterns I can use for comparison

Now, as you can already tell, this all resembles an external brain/memory/ knowledge storage - whatever you want to call it

• As my biggest investing bottleneck is bandwidth and information absorbtion, this is of course very useful, yet nothing groundbreaking on its own

However, what takes it to another level is that AI introduces the recursive learning ability. With enought input, the machine can learn my investment style, and start to proactively assist, and eventually perhaps even replace me :) A good example is the technical analysis component:

• This is a key part of my investment process as I rate very highly the information the market provides us via price action. I apply classic pattern analysis on it. However that takes time, and I can only look at so many assets until my bandwidth is maxxed out

• In order to expand, I am training the terminal to read charts like me. The red box at the bottom with the arrow counts the # of samples the machine needs to replicate my technique both (1) via standard coordinate settings and (2) via image recognition, i.e. a neural network. So over time, the machine will have seen enough examples from me to read them the same way, and I can have it go through 1000s of assets instead of the currently 120 I scan every day

Given the very high number of datapoints involved in the Dominant Driver Theory approach, there are many other AI feedback loops that eventually apply

• These range from a co-pilot that highlights possible mistakes before they occur to trade recommendations or automated overnight trading (I also need to sleep…)

Important: I intend to the make the FK Terminal, or parts of it, available either as a download or opensource for free. Please give me some time with that as that involves more steps than just getting it to run on my computers. It also requires some API connections that can be set up easily

To come back to the introduction- I was able to do all this with no coding experience, no developer team, little money spent and only limited time avaible. It did this with an AI app that is already outdated (Claude Opus 4.6 came out yesterday, and recent Kimi 2.5 performs better in many tasks). I have not taken advantage of the latest AI agentic bleeding edge developments

Now, imagine what all these possibilites mean for the real economy. Let’s have a look at that in the next section

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Current Dominant Drivers for Markets

Enterprise AI

It is hard to overstate the implications of what I illustrated above. Here are some that come to mind:

• Business formation will likely go through the roof. Never has it been easier to create something that can be useful for others. We can see that already in growth rate for iOS apps which has exploded over the past 12 months

• The AI cost saving curve for traditional businesses I discussed in several past posts goes on an even steeper leg, and the pressure to implement these will be VERY high - never has the first mover advantage been greater as so much difference can be achieved in so little time

However, the code and agentic breakthroughs open the door to a new, possibly even larger dynamic:

It has now likely also never been easier to attack an existing business

What do I mean by that?

• The US economy in particular is shaped by oligopolistic structures across many sectors. Many incumbents sport very high margins, but their customers have long been less than excited about the product and service, often with no alternative to turn to. From FICO to Expedia, from Salesforce.com to Microsoft Office, from LexisNexis to Bloomberg in my example above

While the market for the past months has focussed on the “AI Winner” trade, a new dynamic is now in its early innings and will likely stay with us for some time - “AI Creative Destructuion”

AI Capex

The initital read from all this is that AI compute demand from here only goes up. So the US Tech Megacaps have once again hiked their capex forecasts, e.g. Google from $91bn (FY25) to $185bn (FY26) or Amazon from $125bn to $200bn

• However, as model competition remains intense and cheap and compute-efficient Chinese open-source alternatives pour into the market (e.g Alibaba’s Qwen 2.5-VL that runs on your phone), investors continue to doubt the ability to monetise these gargantuan numbers

• A comparison with the US shale boom comes to mind, where US oil companies invested hundreds of billions into accessing more complex US onshore oil deposits from ~2010-2020 which ended up great for the consumer as it depressed the oil price, but left equity and debt investors with negative returns

• At the same time, Megacap capex comes at the expense of their buybacks which until now had been a significant demand source for US equities

AI capex remains a headwind for US Tech Megacap, with some growing risk that low-cost models open source models bring return potential down even further

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What Does that Mean for Politics and the Economy?

The fast AI advancements pose tremendous opportunity and challenge. We may be very close to some incredible scientific breakthroughs, from curing cancer to slowing or reversing aging. At the same time, the risks are high that economic change occurs too fast. Job cuts this January were the highest since 2009 and Job Openings (JOLTS) are dropping like a rock, with AI cost savings no doubt playing a role. The following two scenarios cover both bookends of the range of possible outcomes:

1. Business formation creates many new employment opportunities. AI wealth gains are spread enough to create societal discontent. Scientific breakthroughs lead to significant deflation, bringing down the cost to access high value services and products The historical equivalent of this is the post WWII period and the producivity boom enabled by better transport, refridgeration and industrial tools

2. AI-related employment losses happen too fast to be absorbed elsewhere. AI wealth gains are highly concentrated while AI costs (e.g. energy) are socialised. Societal discontent rises, and with it populism, inflation and ultimately conflict The historical equivalent are the 1920/30s

We need to remain open-minded to either outcome. Perhaps most likely is a combination of all of the above

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What Does that Mean for Markets?

The following section is for professional investors only. It reflects my own strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please always note, I may be entirely wrong and/or may have changed my mind even by the time you read this. This is not investment advice, please do your own due diligence

Let’s tie the themes together for their investment implications

In my last post, I suggested that equities would see weakness early in the year, ROW and Europe would outperform the US, oil should be traded from the long side, volatility would go up a lot and the low in crypto would not be in yet, the CHF could be the safe haven from USD debasement and bonds should be traded from the long side

I’ve also shared this on precious metals the day Platinum, two days before SIlver and three days before Gold peaked:

• These views largely turned out to be correct, which of course may also just be coincidence as I have been wrong many times before, e.g. earlier this week with calling for a low in Software too early. Further, bonds have gone nowhere

• Either way, I have traded these view within the Dominant Driver Theory which continues to work (below as before since 17-10-24). You can see quite well on the equity curve when I started using the “FK Terminal” in mid-January. I would say one of the biggest benefits so far is higher trade discipline and broader trade implementation

My updated views by asset class:

Equities

On the one hand, it appears that many active market participants have turned quite bearish this week, as levered ETF selling has been the highest since April ‘25 and Bitcoin went through a collosal sell off which looks like it may have found a local low at 60k last night. On the other hand, there is a long list of technical observations that usually occur before major drawdowns, with the extreme outperformance of Energy and Staples (XLP) as in the chart below as one example

As of writing this, I am currently still long some residual US equities index positions set up yesterday (see here), but I believe we must be open to the posibility that if we get a bit of a rally here it may just be short cover, and we reverse lower again once that is done. Retail, CTAs and vol control are still very long, and the market has turned on US mega cap capex spend, now perceiving it as an issue rather than a positive. Thus I plan to exit these soon and initiate downside bets again if/when that short cover squeeze is done, for a more climatic low perhaps later this year Please keep in mind as always this may change, or simply be the wrong read and something totally different may occur

Given the reflexivity between the US stock market and the US economy (“wealth effect”) as well as a weakening labor market, it would not be a huge surprise if economic data eventually also gets hit, which could then trigger a very aggressive and thus bullish policy response

Precious Metals

Big picture, the supportive structural trends remain in place. However, volume was very extreme at the highs before the big drop, which means that many or even most (!) market participants are currently under water as they all bought at the top. Whoever hasn’t been stopped out from this group may be glad to use any rallies as exit opportunities which could weigh on the space for some time

Oil

I remain constructive on crude. However, any longs face downside risk from Iranian oil coming back onto the world market, e.g. if the regime collapses due to intervention or on its own, so I continue to see this as a market to be bought on dips

Bonds

I expected Bonds to be a long on weakening labor market data in my last post. This has not really happened until yesterday, and there are also some crosscurrents e.g. potentially higher energy prices or tariff-related price hikes for goods at the start of the year. My bias remains for long end yields to go lower but this is a lower conviction view

US Dollar

I believe there are too many US Dollar bears right now for the Greenback to move lower for now. Once that positioning has cleared and new policies are introduced we could go back to the debasement path

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

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DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, the author does not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

I also provide an outlook into early ‘26, which given the many variables influencing the path of the economy I feel is as far as I could go without resorting to generalisation or speculation

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Current Dominant Drivers for Markets

Enterprise AI

• I’ve introduced the theme of successful AI enterprise adoption here a few months ago when it was mostly either still ignored or heavily doubted. Safe to say that this has now found broad acceptance in the market. Investment banks are putting forward “AI beneficiary” baskets and the recent outperformance of old economy stocks over Tech was credited to “AI earnings efficiencies”

• Developments in this area continue at a high pace, e.g. with Anthropic’s introduction of an browser agent that is only a few steps away from doing proper agentic work, and Google’s NotebookLM and NanoBanana making inroads into corporate presentation work (sorry Powerpoint!)

• It is safe to say that the AI use case frontier is now moving from coding to the knowledge worker

The enterprise AI theme has arrived into the mainstream which may limit near-term upside, but given its enormous broadness will likely be relevant for years

AI Capex

• Equally, the issues around OpenAI’s ability to fund its capex commitments were picked up early on here, with some stocks within the “OpenAI complex” down 50% since (e.g. ORCL, CRWV)

• These issues likely remain unresolved until either OpenAI gains significant share in Enterprise AI where the money to pay for the capex is likely made, or the cost of compute comes down a lot. However, with such large stock declines they seem in the price for now, or at least not an asymmetric bet anymore

• As discussed, Google remains in a favorable position as consumers increasingly type AI queries into the browser search bar bypassing apps while releases like Gemini 3.0 flash continue to convince

Worries about OpenAI not being able to fund its capex commitments have reached consensus and are -for now- in the price. We should await new developments to judge the further evolution of this theme

Global Fiscal

• The most notable development on the global fiscal side is the Bank of Japan’s third interest rate hike in 24 months at its recent December meeting. The benchmark rate is now at 0.75%, however this is still far below inflation which is currently running at ~3%

• Markets remain unconvinced of any serious intention as the Japan 10-year bond continues to drop while Asian investors heavily bid precious metals as a safe haven

It seems highly likely to me that Japan provides for some very volatile market episodes in ‘26 as its domestic combination of high inflation and overly accommodative monetary policy appears increasingly unsustainable

NEW THEME:

US Growth Worries

• Over the past months, several signs emerged that US economic growth is slowing, including a steadily worsening labor market, the lowest wage growth since Covid and flatlined retail sales since the Fall

• Further, the Fed’s interest rate cuts actually remove a significant private sector subsidy, a dynamic completely overlooked by consensus in a high debt/GDP economy. Simplified, paying a 5% interest on 130% US government debt/gdp equals to $1500bn interest payments to the private sector, at 3% this drops by $600bn1

• Some offsetting dynamics are on the horizon. The big beautiful bill (OBBB) in particular releases $150bn in tax refunds mostly to low income groups from late January

• Either way, early in the year a “growth window of weakness” exists, and we’ve seen early fingerprints in markets of it over the past few weeks

Markets have started to episodically trade a US growth slowdown over the past weeks. This theme seem is in its infancy and may broaden in Q1 until or unless the OBBB funds offset it

What Does that Mean for Politics and the Economy?

The US economy is very closely tied to its equity markets. These have now surpassed housing as dominant household net worth component, so any weakness in stocks quickly translates into lower consumption and higher financing costs

Thus the urgency to halt and reverse any stock market decline would be high. The US administration in many statements has indeed already flagged it would do whatever it takes for it. Potential measures include:

• Sending cheques to low income groups

• Cancelling some tariffs, or only reinstall some of those potentially cancelled by the coming Supreme Court decision

• Jawboning the yield curve down by increasing political interference at the Fed

• Stimulating the housing market, e.g. uncapping the Fannie/Freddie balance sheet so these can hold more MBS and thus compress the spread to the 10-Year

• Historically unprecedented policies to soften AI’s impact on the labor market, such as nationalising a share of public corporate equity and redistributing that broadly. This is highly unlikely in the near term, but should not be ruled out for beyond ‘26

Expect some combination of these in response to a market decline, should it materialise. The challenge will be to implement them without stoking inflation or destroying the US Dollar (which would in turn also be inflationary)

• Keep in mind: Rising asset prices at the expense of inflation are the most unpopular policy outcome and highly likely would lead to a disastrous Republican midterm result. The K-shaped economy continues to dominate the vibe of the time, as illustrated by the seating plan for the new United 787 plane, where less than a quarter of the plane is assigned to economy (!)

The US administration has shown to keep a close ear on these currents, and it would not be totally surprising if some redistributive tax proposals are picked up, as Mitt Romney has just floated them

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What Does that Mean for Markets?

The following section is for professional investors only. It reflects my own strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please always note, I may be entirely wrong and/or may have changed my mind even by the time you read this. This is not investment advice, please do your own due diligence

Let’s tie the themes together for their investment implications

Equities

Projections covering the entire year ‘26 are habitual and the staple of sell-side strategist. However, I cannot with seriousness provide a forecast that far. Why?

• As modern economies have become more complex and technological advances much more rapid, the fan of outcomes even looking out even 6-9 months has widened enormously. How will AI progress in ‘26? What policy decisions will be made in response to market events? If anything seems certain to me, it would be that volatility in 2026 likely goes up, possibly a lot

• Staying with year-end equity forecasts, in my view, if forced, the best choice for any strategist is to predict a 10% increase in the S&P 500. Stocks go up in 75% of years and roughly by that amount, so over time you’ll be right 3 out of 4 years

• One could then extend this concept of generalisation to make safe calls on other asset classes such as “don’t own US Dollar cash as it devalues with 7% p.a. on average” or “own productive assets as its stewards are incentivised to advance them over time”

• The second best choice would be to take the strategist consensus and pick a target in opposition to that. This as the consensus reflects aggregate positioning which means it is in the price already and thus likely wrong (see more further below)

So moving to the outlook for early ‘26 which is as far as I feel I can see, where do I stand:

• Since my last post, stocks rallied from very oversold conditions to then dip again just as everyone positioned for a Santa rally too early. I waited for that dip to go long into the swing low this past Thursday anticipating that Santa would now actually come this time (see here)

• I still hold some of that long exposure, however, as per the new theme introduced above, my outlook into early ‘26 is shaped by the new US growth slowdown theme, so I intend to soon position for what I think could be a correction in Q1 of the New Year

Aside of the growth narrative introduced above, here are some additional reasons:

• Margin debt as a % of M2 is near all-time highs. Historically this has predated larger sell offs

• Hedge fund net exposure is ranging near multi-year highs (though has come off a bit last week as markets sold). Many exposure measures are very stretched:

• Most sell side strategists have ambitious S&P 500 price targets, a sharp contrast to e.g. 2023 or 2024

• The technical picture in US indices is that of a topping process, with an extended consolidation over the past months and significant block volume suggesting large institutions are reducing equity exposure

• Market leaders are currently the Dow Jones and Russell 2000, which historically very often have lead the last innings of a bull market. I think a healthy risk-on tape should be lead by Tech

Accepting that the future is uncertain and I could always be wrong, here is what I would look for to change my mind:

• Breakaway momentum from recent all time highs. This would negate the currently negative technical picture in most US equity indexes

• A visible change in positioning that suggests enough market participants have turned bearish for the price to go up (e.g. high equity put volume)

• Policy announcements that change the fiscal trajectory (e.g. the Supreme Court cancels most tariffs and they are not replaced by alternative means)

• A new AI breakthrough

Should we sell in Q1, I also intend to go long into that, anticipating the policy response outlined in today’s political section

Moving on to other asset classes:

Bonds

• As discussed here, I have been reticent to go long US bonds as CTAs showed max long positioning and US growth data remained inclusive. With positioning improved, their price retraced and the Sahm rule potentially being triggered with the January US employment data, I am now taking a more constructive view and looking to trade these from the long side. Trade is the right word here, as bonds are never for investing, unlike equities. There is no permanent wealth creation in them, and few assets are as reflexive to their own price changes (lower rates = more growth = higher rates etc.), so always keep that in mind

Crypto

• Bitcoin has not been able to shake off its recent lethargy, and the technical picture tells me it isn’t about to either. What weighs on crypto in my view is threefold: (1) reduced liquidity as a consequence of the above introduced growth slowdown theme, (2) still no practical use cases outside Bitcoin and (3) its championing by entities too closely linked with the US government which removes its “rebellious” or at least neutral aspect (e.g. China would not add it to its reserves therefore, unlikely Gold). I do not see sentiment as poor enough yet for a structural low, but could be wrong

Oil

• Speculative short positions in Crude and Brent are currently at multi-year highs. I recently wrote that I am waiting for a washout in crude to get constructive on the long side, as the near-term fundamental picture seemed challenging (Ukraine peace (?), oil at sea inventory) but the medium-term supportive. I feel this may have occurred in the past few weeks and I am now trading this from the long side. Over time I would expect higher prices, or at the very least some aggressive short squeezes

FX

• As a safe haven from US Dollar debasement and since US front end rates are likely to be cut further thus closing the interest rate differential, I am warming up to the Swiss Franc and waiting for a technically opportune moment to go long (not yet)

2025 has been a good year and the Dominant Driver Theory portfolio since 17/10/24 now stands at +132%. However, nothing ever moves in a straight line, and one of my coming posts will discuss the psychology of drawdowns, how to deal with them and how they can be the best source for growth if used in the right way

I wish all of my readers very happy holidays and merry Christmas to those who celebrate it. See you all in 2026!

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DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, the author does not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

As a brief reminder for those who missed it, the Next Economy posts are now the regular output of my Dominant Driver Theory work that I apply for my macro investments, articulated in three segments: (I) the current drivers, (II) implications for politics & the economy and (III) implications for markets

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Current Dominant Drivers for Markets

Google AI Dominance

On Tuesday, Google issued its latest AI model Gemini 3.0. It is fair to say that it blew well past already elevated expectations

• Below table shows its performance across a variety of benchmarks. The most important is probably “ScreenSpot-Pro” which tracks how well a model can read what’s on your screen - highly relevant for the AI agentic work that corporates look for and far ahead of Claude or GPT 5.1

• Its release will have immediate impact on many applications where AI already plays an important role, just to take diagnostic accuracy for radiologists as an example:

Gemini 3.0 is currently in a league of its own, which highlights some tremendous competitive advantages that Google holds in the AI race

• Google developed the model on its own semiconductors which are ~70% cheaper than comparable Nvidia models. Thus, unlike other AI labs it does not pay the “Nvidia tax”, i.e. Nvidia’s very high gross margins which are everyone else’s main cost => Google has a substantial cost advantage

• Further, it owns the world’s largest and most valuable private data resources via Chrome, Gmail, Search and even Waymo. It can combine Gemini 3.0 with all these products, creating a user experience that others lack the ingredients for => Google has a substantial strategic advantage

• It has preserved a positive corporate culture that let the sharpest AI minds such as Demis Hassabis thrive and find purpose. This in sharp contrast to e.g. to Meta’s mercenary approach and in some instances toxic social media products or the high leadership turnover at OpenAI => Google has a substantial cultural advantage

Google has pulled away in the AI race. High markets share gains likely follow, and pressure on the competition has been turned up several notches

This has some implications for the themes already introduced last week:

Enterprise AI

• As discussed last week, enterprise AI cost savings are coming through faster and more sizable than expected. Clifford Chance axing 10% of its backoffice staff due to AI is another of many recent examples

Gemini 3.0 likely accelerates this dynamic further, the same applies for the Low Income Consumer Weakness theme (cf. “A Political Storm is Coming”) as faster AI savings mean more layoffs

AI Capex

• Recall, the market is concerned whether OpenAI will be able to finance its enormous $1.4tr capex commitments. Gemini’s impact here can be seen two-ways:

  • Positive: Step-change in capabilities proves that AI models continue to scale. Others incl. OpenAI will follow suite soon, in particular once Nvidia’s Blackwell is more widely available, so the worries will be overblown

  • Negative: Google pulls away from OpenAI and market share losses amplify the existing OpenAI monetisation concerns. Blackwell models take more time and/or won’t yield the same degree of improvement

The market is telling me for now it is the latter (see more in investment section). OpenAI is under pressure to produce a powerful response to Google soon, just as it already struggles to fight off Anthropic in Enterprise AI. Given the substantial cost savings (see above) this is the one area where - in my view - there is a chance to fund the gargantuan capex

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What Does that Mean for Politics and the Economy?

Two very important dynamics come to mind:

• First: Gemini 3.0 has proven that AI capabilities continue to scale, whether via Google or others. This likely increases pressure on the labor market and the persistent weakness in lower income and Gen Z/Millenial consumer groups. The urgency for political change discussed last week only grows

• Second: There is a not entirely unlikely case that Google’s moats are so significant that it becomes the “everything company”, as AI dominance could lead to dominance in everything else, from holiday bookings to daily transport. Vined Khosla mentioned a future where AI gains are redistributed to the broad population via a partial nationalisation of listed companies - maybe Google ends up in public hands over the coming decade

If you think this is wildly unlikely, then I want to point you to this quote by President Trump during his meeting with new NYC mayor Mamdami:

In my view it is very clear that the political winds are going to turn much more populist and interventionist. As layoffs continue to grow over the coming months, that change is likely right in front of us

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What Does that Mean for Markets?

The following section is for professional investors only. It reflects my own strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please always note, I may be entirely wrong and/or may have changed my mind even by the time you read this. This is not investment advice, please do your own due diligence

Let’s tie the themes together for their investment implications

Equities

As you might recall, last week I had US equities as “underperform” on the twin issues of rising layoffs and OpenAI. This was followed by a choppy week with several aggressive sells

As as result, they are now very oversold on a wide range of metrics. I therefore am now much more mindful of two-way risk for them, and currently see two scenarios from here for US equities, and frankly global risk:

• Scenario 1 - Bull Case: Real-time data (e.g Citi/BofA card) and retailer commentary (e.g. Walmart) suggest US consumer spending remains on track, Gemini proves AI keeps scaling and any OpenAI wobbles can be absorbed, the administration and the Fed will support the market (e.g. Williams on Friday), the market is overhedged to the downside and seasonality strong → fundamental logic supports this view

• Scenario 2- Bear Case: Layoffs continue to grow and it is only a matter of time until they show in consumption. The admin can’t support that much as e.g. stimulus checks will make affordability worse. Tariffs cause a fiscal drag so liquidity increasingly worsens. The Fed is too late. The AI monetisation question grows in urgency and private credit will see more distress → technicals support this view (e.g. the large head & shoulders structure in the Nasdaq, 21/50 ema cross etc.)

Technicals and the fact that layoffs usually pick up steam once they get going make me think the odds somewhat favor scenario 2. However we are very oversold and there are always lots of bear arguments in the hole

• Therefore, this past week, I’ve worked with this information very tactically, first going long risk on Tuesday when it looked like a low was made, then on Thursday I shorted the strong rebound at the open which was short cover and fomo driven. On Friday morning after the overnight puke I went long risk again as it appeared that all dip buyers had given up and despondency was spreading, and closed that once I saw the “AI Balance Sheet Theme” fail to participate in the rally (I’ve shared these views on X in real-time in this thread, these trades are, as most of mine, equity index trades, S&P 500, NQ etc.)

• Overall, the Dominant Driver Theory approach continues to work - below is, as before, from 17th Oct 2024

Let’s briefly expand on the “AI Balance Sheet” theme: This refers to the companies that are meant to fund the build out of the huge data center capex over the coming years such as ORCL META MSFT OWL CRWV NBIS etc. If these stocks do poorly, AI monetisation appears more doubtful (and vice versa). Given the importance of data centers to both US stock market as well as US GDP growth, this group is the critical lynchpin

• The poor price action on Friday in this theme was concerning to me, as these companies are (I) very oversold and should catch a bid and (II) as in a healthy bullish tape high beta tech should lead and not lag the market

• While there can always be a first, it would be an anomaly for a bull market to evolve with high beta tech lagging. Rallies as on Friday lead by value and defensives are historically due to degrossing and repositioning

Thus, the market is telling me that the AI monetisation question remains unsatisfactorily answered, and barring any news I’d think more downside is likely from this leading group, which puts the overall market at risk with it

• Given the highly volatile and oversold conditions, we may see a very emotional tape with rips and dips in either direction. Unless AI monetisation is resolved my sense is it will ultimately break lower

Obviously I could be wrong with that read. I’ve been wrong plenty before, and a good streak always increases the odds of it, so keep that in mind

Moving on to other asset classes:

Bonds

• My inclination continues to be that US bonds move lower in price as layoffs rise, but I have not traded this view (yet), as the max long CTA position keeps me away. Should the more optimistic scenario above materialise they could also see more downside from here. I patiently wait for a setup

Crypto

• Together with other risk assets this has perhaps made a local low on Friday. On the medium time frame however I’d think Crypto likely follows US liquidity flows which I still see as curtailed by tariff revenues. There is also the 4-year cycle theory that many crypto OGs follow that stipulates that Bitcoin made a high for some time in October. Aside from playing short term bounces I see easier asset classes for now

FX

• The BOJ intervened today to keep USDJPY from reaching 160. Historically, the market has often tested these levels multiple times. I’d think this situation is not over yet. It could lead to an interesting, assymetric setups in the weeks to come

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, the author does not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

I. The themes and narratives currently guiding markets as I see them - i.e. the dominant drivers

II. What they imply for politics and the economy - i.e. the high level context for everyday life

III. What they imply for investors - i.e. what I think will perform well or not

You can then always choose to skip to the section that interests you most. I hope you enjoy the read!

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Current Dominant Drivers for Markets

Enterprise AI

• Enterprise adoption is moving fast, with many corporates reporting meaningful improvements from AI initiatives

• The general vibe here is that cost savings are coming through faster and are more significant than expected. Examples range across industries and include JP Morgan, Rolls-Royce, ABB, RXO and many others

• As a result, hiring plans are dramatically cut and layoffs are on the rise. The two largest private US employers, Walmart and Amazon, have recently both spelled out growth plans for the coming years that keep headcount steady (WMT) or even decrease it (AMZN). Verizon (100k employees) just announced it would cut its workforce by 15% for efficiency gains

The market theme of rapid enterprise AI adoption is reflected in broad corporate margin expansion and rising layoffs

AI Capex

• The flipside of rapid AI adoption is the boom in AI infrastructure, i.e. datacenters where capex plans have grown to multiple trillion USD through 2030. This helped propel the S&P 500 to record highs this year, both via its -now very large- semiconductor component as well as higher earnings for the entire related industrial value chain

• However, the increasingly obvious question is how will all this be financed? In particular, the market has started to challenge OpenAI, as reports surface that the ChatGPT owners’ expenses are running way ahead of plan, making it unlikely that its $1.4tr capex commitments could be fulfilled. Lack of financing would mean forecasts for the entire semiconductor space are way too high

• OpenAI has done little to cast these worries aside. In fact, a desperate-looking pivot to include erotica as revenue source, a zesty answer by Sam Altman in a recent interview on the financing question and CFO Sarah Friars talking about the US government as guarantor of its spending moved the topic firmly into the center of attention

Potential risks to OpenAI’s ability to finance its capex committments are a major market theme affecting semiconductors and the datacenter value chain

US Low/Mid Consumer weakness

• The immediate flipside of successful enterprise AI adoption is higher unemployment for easily replaceable entry level jobs, which are primarily young and lower income demographics. As a result, the unemployment rate for graduates has gone up sharply

• At the same time, the asset price boom and very stimulative monetary and fiscal policies of the past years have massively pushed up the cost for basic services such as health insurance, childcare and increasingly utility bills which are driven up by AI datacenter energy demand

• As a result, low- and now increasingly also mid-income consumers are hurting as they are squeezed from both the expense and job security side

The low/mid consumer weakness theme is visible in the poor recent performance of casual dining and some travel stocks

Global Fiscal Support

• While the fiscal picture in the US is currently slightly contractionary, several economic blocks around the world are actively stepping up fiscal spending, including Japan, China and Germany/EU

• Recall, every deficit dollar spent is a dollar of corporate profit

Fiscal support ex-US has driven recent outperformance of regional markets such as Japan, Europe and China

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What Does that Mean for Politics and the Economy?

Let’s tie these themes together on a societal level first:

• AI enterprise adoption means higher corporate margins & layoffs

• AI capex means strong demand across the industrial value chain, but also higher utility bills

• Higher unemployment for entry levels jobs and continued cost-of-living increases for basic services put pressure on low- and increasingly mid income groups

• Strong global fiscal support has primarily two effects: (1) input price pressure via global goods such as commodities & (2) higher demand for US exporters

It doesn’t take a rocket scientist to realise that this combo only really works for you if you are long assets. And it does not work for you at all if you are young or low/mid income

• We have been on this “K-shape” economic train for a while. It started with QE after the GFC, and under Bidenomics it picked up a lot of speed

However, a tipping points seems now reached, and a lot of Americans seem to have exhausted their patience

• Over the past years, I’ve managed to fine-tuned my X feed into a good barometer of current vibes and moods. This helped me spot many trends early on, e.g. such as the retail mania around quantum stocks. Since the NYC election, this feed is now full of posts from very disgruntled and mostly young Republican voters, who seem to have enough of their current situation. Below just one example of an avalanche of similar ones (similar here, here, here or here), each with millions of views

In fact, this mass outburst of discontent seems way overdue if you consider the following:

• The price of health insurance has reached comical levels, having grown at a 6% clip p.a. over the past 6 years. It now costs $26k to insure a family of four, while claimants often still receive the defer, deny, defend treatment first. Compare this to a median US household income of $83k (!!)

• The median first home buyer age has risen to >40 from ~28 in 1985. Closely related, family formation has imploded

• The S&P 500 has gone up 650% since 2000. Over the same time period food stamp recipients have more than doubled to now 41m. In other words, over one tenth of the US population struggles to feed themselves, including many people in the work force (the unemployment rate is 4.3%)

• Add to this, OpenAI asking for government support while its technology eliminates jobs, costly foreign intervention, perceived corporate favoritism around H1-B visas or large asset managers emerging as mass home buyers are several other, smaller topics inflaming public mood

This post is titled “A Political Storm is Coming”. This storm is the Gen-Z and lower/mid income dissatisfaction that is now blowing into the open

• This very large and energetic demographic was crushed by Bidenomics, then held hope out for improvement under Trump and is now at risk of a drastic swing to the far left as it looks for its state to finally improve. This makes AOC 2028 a real possibility

• If that sounds wildly unlikely to you, consider the following: Mamdami won NYC on 4x mobilisation in Gen Z. He even has reasonable appeal amongst Republicans under 40 (!). Unsurprising, if you check the unemployment rate amongst the young again in the chart above

The clamor for change is getting very loud and many people finally want to see their daily lives improved. The difficulty, however, is how to achieve this. The standard trick of stimulating the economy via more printed money will make this affordability crisis only worse as prices likely go up more in response

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What Does that Mean for Markets?

The following section is for professional investors only. It reflects my own strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please always note, I may be entirely wrong and/or may have changed my mind even by the time you read this. This is not investment advice, please do your own due diligence

Let’s tie the themes together for their investment implications

Equities

• I currently see US equities as underperform due to both the low/mid income weakness which I expect to spread, as well as the unanswered questions around OpenAI capex trade, which affects a lot of market cap and is currently attacked from all sides (cf. MSFT CEO Satya Nadella comments here). I expect it will either need either a major shakeout or a positive catalyst to reset. Once that reset occurs, I will likely turn more constructive as the AI potential remains huge

• Having said that, do not get too bearish near term. This trade has been in swing for a bit and will likely have several starts and stops. I would not chase it down here, in fact I have last night closed corresponding directional short exposure as some support levels were hit. There are also some important bullish policy developments in the pipeline, incl. $2k stimulus cheques for <$100k households and the Fed reverting to expanding its balance sheet. Irrespectively, the outlook for US stocks today is complicated, and political currents are now at work that could turn against it

• I see Rest-of-the World equities as outperform, this includes Europe (yes indeed…) and China, where AI is making huge progress. One can put all this together into the EEM/SPY spread trade, which also has a favorable long-term chart

• For sectors, I like the power theme which is a key bottleneck for datacenters, incl. gas and also solar and batteries which are increasingly less dependent on subsidies. I am currently bearish on alternative asset providers. I expect credit issues to grow, with more sloppy loans likely coming to the surface

Bonds

• I see bonds in a 2-way pull between some inflationary dynamics (e.g. higher power prices) and rising layoffs. Usually, I would overweigh the latter and be long, but the CTA max long position in US 10y/30y keeps me away from it for now

FX

• The US Dollar has strengthened for a while now as yield differentials moved in its favor. This period may come to an end, as a forceful political response is likely needed to stem the lower income bleed, and it will likely involve more printed money

Commodities

• I had shared in my last post the BBG Commodity Index as example for the Dominant Driver methodology. This has now broken out and I see global fiscal and AI as continuously supportive for this major theme

• Gold after a strong rebound in the past days I see as near-term choppy, but the secular themes of central bank buying, money printing etc. remain

• Crude looks surprisingly robust technically, while the near-term fundamental narrative is difficult, with a huge supply overhang. However, looking further out, the current weakness could translate into tighter supply down the line - the medium term bull case is well articulated here

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

Subscribe now

DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, the author does not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

Before going into further details, a brief reminder: I am not selling anything. My posts have always been and will always remain: free. There is no vehicle to invest in or subscription to be paid. I have learned a lot from others who have freely shared, and enjoy doing the same now

So let’s get to it - from Oct 17th ‘24 to Oct 13 ‘25, the strategy returned +101%. Some further details:

• This is a classic macro trading strategy primarily focussing on hyperliquid futures such as equity index (e.g. ES, NQ), rates (SOFR, 30Y), FX and commodities/precious metals. Single stock contribution is <5% (so no quantum or other yolo stocks), no crypto, and as you can see from the chart, a negative correlation to equities (!)

• It is my only funded account and the majority of my net worth, which means that it carries the full psychological weight of being wrong

• With c. 5 trades a day and a hit rate of ~50% I am indeed wrong a lot. However, winning trades produce gains on average ~3x larger than losers

• This compares to the average macro fund being up ~8% this year

Becoming a profitable trader in global macro was the hardest thing I’ve ever done out of a reasonably wide range of things I’ve done over time. It took several years and many very humbling episodes to get there

• The first paragraph of today’s post explains why - in my view - this investment approach is both so hard, but also so rewarding

The key insight for me was that (1) global markets are connected and moved by a shared dominant driver and (2), that it is often possible to identify this driver in time to benefit from it. Hence the strategy name Dominant Driver Theory (DDT)

The below will introduce the details of DDT. I tried to keep it very light reading, you can skip to each of the subsequent sections directly

• WHY IS MACRO BOTH SO HARD AND SO REWARDING?

• THE SIX PARTS OF DDT

  • NARRATIVES & THEMES

  • PRICE

  • CROSS-ASSET SIGNALS

  • POSITIONING

  • RISK MANAGEMENT

  • RADICAL JOURNALING

• ADDITIONAL OBSERVATIONS

• CONCLUSION & OUTLOOK

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WHY IS MACRO BOTH SO HARD AND SO REWARDING?

Two reasons: (1) complexity and (2) psychology

• First, on complexity

  • Macro is highly complex because pretty much everyone participating in capital markets is a macro investor. This ranges from the corporate that defers bond issuance because they think rates are too high, to the Tech hedge fund that takes up its net because they feel bullish, or the retail investor who yolos into altcoins as their only hope to catch up on society - in other words, the competition is endless

  • This means that whatever you perceive as obvious is likely in the price. Convinced interest rates will be higher forever as inflation is sticky? Likely in the price. Strong belief that markets are a bubble but we are in the early innings? Likely in the price. Seems obvious that Europe will forever underperform the US? Likely in the price. Etc. This pushes successful investing both into the counterintuitive which goes against the default wiring of our brains (“be fearful when others are greedy”) and into the second/third derivative (“have to take a variant view to the market”)

  • Throw in the fact that price action influences future outcomes in a reflexive way, and you get a set of constantly changing and interdependent variables. The best that one can do here is to accept to be wrong often, but look for asymmetry - make more when you are right than lose when wrong

• This brings me to the second part, psychology

  • While fundamental stock analysis can often lead to high conviction conclusions (“I am 95% certain that Microsoft is a great company”), Macro hit rates are much lower, and at the same time the turnover of ideas much higher

  • This creates a fast and emotional setup, for which evolution has given us the reptile brain where fight or flight sits. Since everyone’s brain works the same way, we all feel greedy or fearful at the same time and this is what makes prices go up or down. Thus, your emotional reaction will be your biggest enemy in doing this well

  • Rewiring your brain away from fight or flight is incredibly hard. It mostly works via experiencing the pain of getting it wrong and vowing to never do “that” again. As this is highly unpleasant, you really need to love it to go through these episodes over and over again, until it finally gets better

Complexity and psychology in combination create a “high barrier to entry” to the strategy, where a small handful of experienced market participants print extraordinarily high returns (the investors with the highest long-term track records are mostly macro investors) while a long tail churns out inconsistent results. This is reflected in the allocators’ dilemma around macro funds, where the few desirable ones with outlier returns have long converted into family offices

Now, what makes it so rewarding? The reason is simple: Global capital markets are intimately interwoven with both the real economy and politics. Dealing with these topics every day gives you a better glimpse of how the machine works - a treat for anyone with intellectual curiosity

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THE SIX COMPONENTS OF DDT

1. NARRATIVES & THEMES

• The basic foundation for DDT is a thorough understanding of the many narratives and themes that can drive markets. The way to acquire this is simple- read, read, read

• A brief list of current narratives and themes that is far from exhaustive:

  • Expansionary fiscal policies across all major economic blocks (US, Japan, Europe and China)

  • First signs of AI having a positive impact on corporate productivity and thus margins, and a negative impact on hiring

  • Competitive devaluation, with the major economic blocks showing little regard for a decline in the purchasing power of their currency

  • Central Banks actively acquiring Gold to diversify their FX holdings

  • Private Credit issues related to a US low end consumer slowdown

• Now, the important part is that there will always be many, usually conflicting, narratives available at the same time. More so, with hindsight many will turn out to be wrong! So which one is it then?

  • Without any further process, we typically default to bias. Everyone’s bias is different, we just love to hear what we want to hear, so we stick to that

  • In macro, this is the sure most way to get run over. Stick to a narrative that is wrong, while price continues to move in the other direction

Which brings me to the next component

2. PRICE

• For a good while, I was in the narrative-only camp. I spent most of my time analysing the often un-analysable (“Where will interest rates be in one year?”) and then stuck to a narrative that I liked

• The first major breakthrough away from that was when I started to integrate price in a structured way. We often perceive “technical analysis” as child’s play of drawing lines on a chart, but this could not be more wrong. It helps unveil an incredibly rich information surface shaped by millions of informed market participants. Today, I start every day by going thru the same set of ~100 charts to shape an initial, intuitive view of what is going on

• Reading price action is its own science (I think it is fair to describe it as science rather than art). The patterns in which asset prices move have remained the same for centuries (just compare a chart of the Dutch tulip bubble with some altcoin charts from 2021), as they are largely a reflection of the human psyche. While the details here are endless, I can point to the two seminal books on the topic by Schabacker (1932) and Edwards & Magee (1948) that still stand the test of time

• Investing solely based charts works for some. In my experience the their potency really comes from the combination with narrative

Simplified example: The narrative of fiscal stimulus across the major economic blocks should translate into higher commodity demand. Can we see evidence of that in price? Yes- the BBG Commodity index looks to break out higher after having formed a multi-year base

3. CROSS-ASSET SIGNALS

• It is not just price action within a certain asset that has a lot to reveal. Another way to crosscheck the likely accuracy of your views is to look at the behavior of related assets

• This as the market’s dominant driver is usually visible across asset classes. Some cross check examples:

  • If you are long bonds because you think a recession is coming, but oil and cyclical stocks are rallying, that view is probably wrong

  • If you are short US equities because of liquidity issues ahead, but Japanese and European stocks are ripping, that view is probably wrong

  • If you believe Powell was hawkish so you short SOFR, but Gold is up 3%, that view is probably wrong

Simplified example: Are cross-asset signals confirming or rejecting the commodity price breakout thesis? Commodities (often, not always) need a weak USD to work. The greenback appreciated recently, it appeared to break out of a consolidation pattern but has now stalled. While not outright supportive, at the very least this does not appear to be a headwind

4. POSITIONING

• This component addresses the fact that a marginal buyer/seller is typically needed to advance price momentum further. Extreme crowdedness is what we need to watch out for, as it negates that dynamic, instead indicating turning points. Various inputs can be applied here:

  • Prime broking data which today can be found everywhere online (X etc.)

  • CFTC data that shows futures positioning between speculative and commercial investors

  • Surveys and anecdotal conversations with other investors (“if all my friends are bearish maybe that’s bullish?”)

  • CBOE Put-Call data

Simplified example: Looking at the CTA positioning for major commodities, there is no extreme crowdedness in either direction

5. RISK MANAGEMENT

• Even with all the above, any macro view will still be wrong a lot. This is also in large part because not only do you want to get the narratives, technicals and cross-asset signals right, but also the timing

• Thus risk management takes paramount importance. The following are my guiding principles:

  • Only ever bet a small part of the overall portfolio (0.25%-2% on one individual trade)

  • Never double down (this can annihilate a book when it goes wrong)

  • Never move a stop (this is you tricking yourself into not taking the loss)

  • Never average up (this is often greed rather than a good plan)

  • Slow down when things are not working (protects you from compounding a bad state of mind)

• And most importantly, never deviate from the process. I have learned over time that no matter how tempting and obvious any situation looks, if I deviate from my process nothing good awaits

Simplified example: Establish a long position in the Bloomberg Commodity ETF with a stop 4% away from the breakout line. Given the neutral DXY signal with a small portfolio risk of 25bps = 6% NAV size

The DDT process elements are based on extensive iteration of frankly doing things badly first, then noting that, thinking on it and trying to improve. Iterate, iterate, iterate. This brings me to the perhaps most important, and most personal part of DDT:

6. RADICAL JOURNALING

• Macro investing resembles playing timed chess while someone is punching you in the face. Only in this case it is not a person, but your emotions. They will shout “greed”, “fear” very loudly and aim to trigger your fight or flight response when you are meant to think clearly

• This is what makes process so important. The easiest way to “think” in that situation is by having the plan ready at hand. As everyone’s emotions, biases, information etc. are different, each process is highly personal

• For me, the way to get there was the concept I call “radical journaling”. Radical because it involves observing and noting down every possible aspect of the decision-making process, from the emotions I experience at the time, to the time of day and of course the fundamental context around it

• I do this every day, grouped into (1) general observations, (2) breakouts to go in depth on a particular topic or theme and (3) daily learnings of which indeed every day there are many, small and big. Finally, (4) all time learnings, which are mostly actions of utmost importance, to either never or always be repeated :) E.g. “Don’t short the rebound after a hole” “Always take profit after a X% move etc”

• Over time, this process has not only created a database with many thousand lines that I can eventually use as context for an LLM. It also helped me tremendously in identifying patterns and biases that I was not aware of before, or worse, did not want to acknowledge. As an example, I noticed that I often came into the day thinking “what can I short today” (=bearish bias) which made me miss good longs, that my decision making quality was significantly worse after very short night’s sleep (often thanks to the kids ;)), or that one major bad decision often lead to others as the emotional equilibrium was thrown off

I would think this approach to the be good for any type of frequent decision making, or in fact for life generally. For macro it appears particularly useful as the feedback loops are very short, so a new insight can often be applied a few days or weeks later. Even in the chart at the very top this progress is visible

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ADDITIONAL OBSERVATIONS

This is the synopsis of DDT, and hope you found some inspiration reading it. A few additional thoughts on pushbacks I frequently hear:

1. The market has changed and has gotten dumber

   1. I agree, as the share of active investors has declined significantly, to be replaced by passive and retail. But why not just take advantage of it rather than complain about it?

2. How can anyone compete with the information access of large investment firms?

   1. Historically, information was indeed limited and hard to access. Today, I’d say the quality of output you can find outside the traditional buyside-sell side network is actually much higher. There are countless substacks, X feeds or discords full with stellar investors that you may have never heard of just because they did not go to Wharton. In fact, this has tremendously levelled the playing field

3. AI will soon replace active management

   1. Sure, maybe, but I see no indication of that happening any time soon. However, in the interim I believe that anyone incorporating AI tools into their process will see huge advantages, and as the cost of coding collapses anyone can do that

   2. If I take my personal approach as an example, I know that I am still only scratching the surface of what is possible, with the primary constraint my attention capacity. I have and am actively working on incorporating more AI tools into the workflow to unblock that bottleneck

All this together leads me to believe that public markets investing is currently undergoing a quiet revolution. While I come from “inside the system”, I don’t think there was ever a time like today where superperformers can emerge outside of it, and it seems likely to me that we will hear of many such success stories over the coming years

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CONCLUSION & OUTLOOK

• Getting good at macro investing requires plenty of time, introspection and internal honesty. You always have to be on top of your game and need to absolutely love it

• However, it can be very rewarding once you reach a satisfactory level. You learn a lot about yourself (principally by being humbled a lot), you start to understand the economy much better and you acquire the life skill of intelligent asset allocation - in the end, everything is a macro trade

From here on, I will again resume to write notes with observations on markets and the economy, though these will be significantly shorter than in the past. They will remain free, and I look forward to the continued dialogue with many of you

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DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, the author does not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

Case in point, at the April lows, the market’s narrative was that Trump’s tariffs would push the world economy into a stiff downturn or even recession. A few months on, the contrast could not be bigger. Tariffs are now seen as irrelevant, and a booming economy lies ahead

Today’s post argues that this will soon again change. Focus will shift back to tariffs, and their likely very significant impact on the US economy in the coming quarters. It also discusses the positive dynamics that could offset that blow and draws a synthesis. In the markets section, I share how I think to trade it

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First, let’s quickly summarise the context:

• The current US administration has mandated tariffs on the vast majority of its ~$3.3tr annual imports. Via a series of framework agreements or unilaterally imposed, the US now charges a blended rate of ~18-19%1 on the $2.7tr worth non-exempt goods entering the country

• This equates to an annual run-rate of c. $500bn new income for the US Treasury, or ~1.66% GDP

What else do we need to know about the tariffs?

• Tariff collection within this new regime started in April, but really ramped up over the following months

• Tariffs are paid by the importing company in the US, who wires the required amount to the Customs Office which is part of the Treasury. In other words, tariffs are a tax paid for by US corporates

• The typical commercial inventory cycle is ~90 days. Thus, even though tariffs have been collected for a bit more than a quarter, companies so far haven’t had to pass any tariff costs to consumers

As their old inventory runs down, this changes. Corporates now have to decide how to deal with this new $500bn burden. Generally, they have three options:

1. Push the cost onto their suppliers by asking for discounts. So far, there is no evidence that this has successfully happened. We can track aggregate import prices (e.g. here) which are flat year-on-year, and various surveys confirm only minimal suppliers concessions

2. Absorb the cost into their margin. This would represent a ~12% decline on the aggregate $4.4tr US corporate profits. This slide by GM is a good example of what many more US companies would face soon in that case

   

3. Push the cost onto consumers. Corporates that have pricing power, or think they have pricing power, will jack up prices

The last point is what we're about to see over the coming month. Walmart and Amazon are moving forward with some very significant price increases for back-to-school season, with other retailers to follow

• For consumers, this is a very unwelcome surprise. This kind of inflation is a “negative supply shock”, and in contrast to Covid not caused by everyone having more money available

• In fact, wage growth has been slowing for some time. If the prices for some expenses go up a lot while consumers don’t have more money, they will buy less of the same item, or have to cut back elsewhere

In summary, there is no good way out. Either the companies take the margin hit or consumers get fleeced. The tariff wall, at 1.66% GDP equivalent, is about to hit the US economy from August onwards, at full speed

• Further, empirical studies show that tariffs are typically associated with another ~0.45 cents of “dead-weight losses” for every tariff Dollar raised as the supply chain becomes more inefficient, so another ~0.8% drag on top

• In comparison, real GDP for 1H 2025 likely was ~1.0%

In isolation, the tariff wall impact would be a pretty sure bet that the US enters a stiff recession from Q3 onwards. Growth has been slowing all year, and tariffs would be the classic supply shock trigger that pushes the economy over its skies

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However, there are also some very important dynamics that could offset this impact:

1. The Big Beautiful Tax Bill

• Key here is enhanced capex deductibility, backdated from Jan 1st ‘25, which this year alone provides ~$100-150bn of additional free cash flow to US corporates that invest heavily, such as telcos, utilities or the AI data center complex

• AT&T in their earnings call this week quantified this effect at $2-3bn for the year, to be reinvested into new projects (rather than share buybacks) over the coming years

• In addition, there are individual tax breaks, such as for seniors, or on tips. However, these won’t be available before Spring ‘26

2. Reshoring

• The various trade deal negotiations included a flurry of investment announcements, e.g $550bn within the US-Japan trade deal

• Several corporate announcements were also notable, such as the $50bn capex Astra Zeneca committed to last week for the coming 5 years

3. AI Capex

• Hyperscaler investments into AI data centers continue to grow, from Meta’s Prometheus or Hyperion projects to Google’s capex upgrade from $75 to $85bn for ‘25 on yesterday’s earnings call

• As a side effect of this demand, power prices are likely to go up considerably in the coming years

4. Credit Growth

• Banks have been lending more this year vs last year, to the tune of ~$20bn per month. This is newly created money that can circulate through the economy and stimulate growth. The positive multiplier on this in comparison to the negative multiplier on tariffs is debated and frankly unknown

5. Wealth Effect

• The majority of US consumption is done by the top 10% consumer which is asset rich. There is an argument that this cohort may be price insensitive on most everyday items. However, US consumption has been slowing all year so I don’t find it convincing

Summary: Various positive dynamics within the US economy are currently taking place. It is difficult to quantify them, but they are likely to provide some offset to the tariff shock. Unfortunately we can only speculate on the degree. Either way, a timing mismatch is likely; In particular, the various capex initiatives unfold over several years, while the tariff impact will be imminent

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Conclusion:

• The US economy faces a very significant growth hit starting this summer, as the tariff wall and its corresponding dead-weight losses hit consumers and corporates to the degree of ~2% GDP

• On the other hand, various supportive dynamics are in place, in particular multi-year industrial investment programs

• It is unclear whether these are enough to cushion the growth hit. At the very least there appears to be a timing mismatch, leaving the US economy vulnerable in Q3/Q4 this year

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Current Market Views

The following section is for professional investors only. It reflects my own strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

So, how to trade the information above? I mentioned in the introduction that markets have become more short-term, signs of the tariff wall in hard data or corporate earnings are still spurious and being early is also wrong, so timing is everything. As such, this is how I think about equities at the current stage:

• You may have noticed the word “capex” several times in the growth supportive section above, and this is what I believe the current narrative in equities is - the reflationary trend across the US (driven by OBBB incentives and AI) and Europe/China/Japan (driven by fiscal stimulus)

• This favors further rotation into the very underowned US small caps (Russell 2000) as well as the closely correlated real economy segments (S&P Equalweight/Dow Jones) and their globals twins (DAX/Nikkei), with a special role for China following the recent recession of the Nvidia chip boycott

• I am currently long the beneficiaries of this current trend, such as commodity equities, IPPs and Chinese equities. I emphasise currently as we are in the later stages of this equity rally so this view may change at any time (see below)

As I mention already in a post in June, I believe the last leg of this rally is driven by breadth expansion, i.e. the lagging real economy stocks catch up to Tech. This typically forces hedge funds to cover their shorts (they typically are long growth/Tech and short old economy) and thus extending length, while systematic funds (CTAs/Vol Control) go back all in

• It is very hard to predict when that has played out. It could be now, it could be next week with the FOMC or QRA, or it could be mid-August. I think we are very close, possibly we are there today. Either way, when this has played out the market’s focus will shift to the tariff issue above, and then (in my view) is it time to move on to the “tariff wall” narrative and look for equity downside

• Accordingly, I have bought out-of-the-money September Puts on the S&P 500 today, and I put on an S&P 500 short with a tight stop above yesterday’s high, while I will reduce my long exposure in the coming days/week(s)

Further, below an update on my views shared last time on Gold, the US Dollar and Bonds. Please see my X feed for near-time updates

Gold:

• Short term: During the reflation narrative outlined above, Gold faces competition for capital from higher front-end yields. I’d expect it to chop around or drift, but for dips to get bought

• Medium term: The current US administration has made it clear that they want to “run it hot”. Thus, I’d expect a very forceful response to a tariff crisis, i.e. many more printed Dollars. I see the medium-term outlook for Gold as unchanged and positive

Bonds:

• Short term: The current reflationary vibes are bearish bonds in the short run, but the growth-negative tariff wall is looming large. Chop or some more updrift in yield I think

• Medium term: Should the tariff wall not be offset by the various growth drivers I outlined above, then growth and thus yields can drop substantially, perhaps to 3% on the 30-year. I am looking to go long again the 30-year bond on any blow-out move in yield in the coming weeks

US Dollar:

• Short term: Higher front end yields as per above can support the US Dollar in the coming days/weeks, but the overhang from anti-greenback policies is considerable. I expect chop around

• Medium term: Bar a substantial policy shift the trend is likely further down. While this is be a crowded view, politics > positioning in my view. More so, the US Dollar is in a very vulnerable position *if* market turmoil unfolds in Q3

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This post first reviews the particular events, followed by how I see their market impact and how I’ve traded it. It closes with a perspective on whether these actions are the right steps and what their longer-term consequences may be

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What particularly happened?

• First, in a press briefing this past Friday President Trump once again stated his dissatisfaction with Fed Chair Powell’s decision to wait with interest rate cuts. This has been well telegraphed. But this time, he also said that he told his administration “not to do any debt beyond nine months or so”, until a new Fed chair is installed

• Second, yesterday in a Bloomberg TV interview Treasury Secretary Bessent reiterated the same idea. In particular, he said “why would we issue debt at current long-term rates” (Minute 5 video below)

In other words, Trump and Bessent are telling us that going forward, the US intends to change its issuance mix towards short-dated debt such as T-Bills (<1 year maturity), and away from long-term debt such as the 10-year or 30-year bonds, potentially significantly so

It sounds like some arcane financial plumbing detail, so why does it matter so much? We need to go through a few steps to understand this:

• To start, we need to know that interest rates on long-term debt are decided by the market, and on short-term debt are decided by the Fed1

• Next, if the administration installs a Fed chair who follows its interest rate demands, and it mostly issues short term debt, it can effectively decide the interest it pays on its debt

  • NB: Interest payments are currently the second largest item in the Federal Budget after entitlement spend, a lower Fed Funds rate would save the government a lot of money

• Further, if the issuance of long-term debt is greatly curtailed, long-term yields likely drop below their “natural” level, i.e. what the market would decide is fair in light of growth and inflation expectations. This would be very stimulative for the economy, as long-term yields are highly relevant e.g. for corporate debt issuance (~7 year maturity) or housing (10 year maturity)

By installing a “friendly” Fed Chair and moving the financing mix towards short-dated maturity, the administration achieves two goals: (1) Reduce the budget deficit and (2) stimulate the economy via lower long-term interest rates. Great, so what’s the issue?

• This policy mix is called Fiscal Dominance, as it subordinates a previously independent Central Bank to the needs of the Treasury. It is most well know from Emerging Markets where the government has given up on budget discipline and just prints the money it needs to finance the deficit, ignoring price stability risks

• So indeed, these policies are successful in stimulating growth, but in the past have typically come at the expense of structurally higher inflation, currency debasement and ultimately political crisis

In the next sections I will first review what I see as immediate market implications, followed by whether this pivot was potentially the right decision, irrespective of historic precedent

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What does all this mean for markets? In the below, I walk through the consequences by asset class as I see them, and the trades I put on in accordance after watching the Bessent interview:

• Long-term Bonds: In past precedents, the immediate consequence from significantly lower bond issuance was - unsurprisingly - lower long-term yields. This is true for Japan in the 2000s/2010s, as much as it was true for the US in Q4 ‘23, when Janet Yellen took the first step towards Fiscal Dominance and increased the issuance share of T-Bills to ~50% from previously ~25%. Further, the 30-year real yield is still near a multi-decade high, while the US economy has visibly decelerated in both real and nominal growth in the past month. I am very long 30-year bonds

• US Dollar: Fiscal dominance puts a lot of pressure on the financial system as the government inundates the economy with liquidity via cash-like T-Bills. With long-term yields neutered, there is only one escape valve left - the currency. I am very short the US Dollar (DXY)

• Gold: A rapidly declining US Dollar will soon represent a major headache for other currency areas, especially if they are heavily export-driven, such as Europe or Japan. Their growth will slow down due to FX headwinds, so they’ll be forced to also cut rates and be dovish. This phenomenon is called competitive devaluation, and needs another escape valve. I am very long Gold

• Equities: Here it gets a bit more complicated. US stocks in particular face a two-way dynamic:

  • Positive: In isolation, FX debasement is very supportive for real assets, as the amount of US Dollars (or cash-like T-Bills) in circulation grows much faster than the real assets around. This would speak for a run-away bull market in nominal terms

  • Negative: Historically, however, an imploding currency has lead to capital flight by foreigners who incur significant losses via the FX move. Foreigners indeed hold trillions of US equities and may be incentivised to sell. However, whenever they are done selling, the positive dynamics take over

  • To acknowledge this bifurcated risk, I am focussing on single names such as ARM which I mentioned in my last post, and has since been the best performer in the Nasdaq 100, and trade or hedge these opportunistically. I generally note that the strong July seasonality for stocks is well telegraphed and perhaps pre-traded, so maybe we sell first on the negative dynamics, and then get a panic bid later on the positive dynamics once some recent late longs have been washed out

As a general observation, in my view, capital markets have changed materially due to what is effectively the death of active management, which has been replaced with passive flows, retail, multi-manager platforms and “machine money” that mostly trades headlines

• As I mentioned, I’ve been running my account in a style that fills the void these strategies leave, which could perhaps be described as “thematic macro”, properly documented since 15 Oct. ‘24. So far so good:

• Either way, I am just scratching the surface on its potential and believe the material change in market structure opens the path to a new public markets investment paradigm, especially with AI, where advanced reasoning models such as O3 pro or Gemini can replace entire analyst teams at a very low cost. I will write more about this and the results in detail in the Fall, or when the Calendar year is over

As always for this section, please keep in mind the disclaimer. This in particular as macroeconomics is deeply reflexive, and today’s policy decisions impact tomorrow’s market behavior, which means the market always moves on and thus views can change any time:

Please note that any trades mentioned reflect my own strictly personal capacity and are shared with other likeminded investors for the exchange of views and informational purposes only. I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

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Now, the big question: Is this policy pivot the right decision? What are the political and economic consequences?

• The gut reaction of most is one of head-shaking and disbelief, as it turns out after 2 months of trying via DOGE and “Main Street over Wall Street”, this administration has given up on that, and is instead going all-in with “Bidenomics on Steroids”, i.e. government-funded growth at the expense of inflation risks and higher inequality

However, it is not that simple. Some very important dynamics apply:

• First, in contrast to Biden’s 2022-24, the US economy is now very clearly slowing. Especially the labor market has weakened a lot (see continuing claims below), and in the past, whenever employment cracks appeared, eventually a major downturn followed. In my view, it makes much sense to try and front run that, especially as inflation now appears subdued. I think Trump is right and the Fed should cut rates now

• Second, of course, in a perfect world it would be ideal to reign in the humungous US budget deficit and bring it back to a balanced level. However, the path to that is incredibly narrow (aside from the fact that no political constituency wants to accept any cuts). The fiscal impulse has been the primary driver of US growth over the past years. Cutting it back would very quickly introduce a downturn, which would cause the deficit to expand again on higher social security payments and lower tax revenues. Not to mention the political consequences of a recession in an already deeply divided nation. In some ways, playing offense may be the only realistic way out

• Finally, the historic precedent is not all bad. FDR and the post-war period was shaped by delevering via yield curve control - and it worked

In my humble view, the biggest risk of these policies is another significant increase in inequality. Newly printed US-Dollars typically end up with large asset owners, (“Cantillion effect”) as lower income groups need to spend all they have and don’t own anything that benefits from the increasing ratio of Dollars to Real Assets. If the US does not manage this not-so-small “side effect” well, the already deep divisions in the country, between Coast and Flyover, Millennials and Boomers, Left and Right, Men and Women are very likely to grow, and eventually spill over into political instability. There is still time to avoid that outcome!

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With this I return to write again at the intersection of technology and macroeconomics where today I explore the hot topic whether AI will lead to mass job losses in the years to come. As always, at the end you can find my own market views as I invest, putting my money where my mouth is

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Anthropic CEO Dario Amodei recently warned that AI could push U.S. unemployment to 20 % within a few years by automating many office jobs. With the US labor market already soft, his prediction hit a nerve - it would have very drastic social and economic consequences

Now, how realistic is that outcome? In my view, the best way to answer this is twofold:

• First, let’s look at how employment fared during periods of comparable technological step change. Over the past 150 years, there were four episodes of breakthrough innovation

• Second, we review the impact of already available AI applications on current jobs and workflows

Let’s dive in, starting with the historic comparison:

• Technological innovation becomes visible in economic data when it significantly lifts total factor productivity. In other words, when the economy produces more goods and services than before with a similar amount of capital and labor

This is typically enabled by a transformational technology such as:

• Electrification (1890-1930s) which greatly increased the energy available to the economy

• Refrigeration & Farm Modernisation (1915-50s) which increased food production and availability

• Highways and Appliances (1950-70s) which connected urban centers and brought industrialised goods into homes

• PC and Internet (1990-2000s) which improved communication

Over time, the AI era should be comparable to these periods. AI allows us to perform many tasks faster and more efficiently, eventually to a degree that should show up in total factor productivity. So let’s walk briefly through these historic comparisons to see what happened to employment each time and why:

Electrification (1890s-1930s)

• What jobs were reduced or eliminated by the new technology?

  • Steam-engine tenders, coal-stoker crews, gas-lamp lighters

• What was the long-run labor market outcome?

  • By the late 1920s, US total non-farm payrolls were significantly higher than in 1890 despite output per worker doubling (!)

Refrigeration & Farm Modernisation (1910s-1950s)

• What jobs were reduced or eliminated by the new technology?

  • Farm employment reduced by c. 66%

• What was the long-run labor market outcome?

  • The 1930s saw very high unemployment and a shortage of job opportunities in agricultural sectors (e.g. as described in John Steinbeck’s Grapes of Wrath). However, the cause is mostly ascribed to severe fiscal and monetary policy mistakes that ultimately triggered the 1929 stock market crash and Great Depression. Full employment returns by the 1940s

Interstate Highway & Appliances (1950s-1970s)

• What jobs were reduced or eliminated by the new technology?

  • Some rail & freight jobs. Highway construction once it ended

• What was the long-run labor market outcome?

  • Falling transport time and cost triggered a boom in big-box retail that overcompensated job losses in traditional logistics

PC & Internet (1990s-2000s)

• What jobs were reduced or eliminated by the new technology?

  • Travel agents, print ad-sales, mail

• What was the long-run labor market outcome?

  • Payrolls grew 24 million from 1990 to 2007. New industries (e.g. online travel, ecommerce) and strong economic growth overcompensated job losses in outdated industries. Sluggish 2010s followed due to aftermath of the subprime mortgage bubble, back to full employment by late 2018

Summary: History tells us that step-changes in technological innovation were overwhelmingly positive for overall employment. Typically, the economic gains translated into growth in existing in new areas, which far outweighed the employment losses in outdated industries

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Moving on to the evidence already available today, we can split this into three groups:

• First, applications that entirely replace, or dramatically reduce employment in certain sectors. This is the analogue to the steam engine tenders replaced by the electric locomotive

• Second, for many professions AI will function as support that allows users to focus on core tasks, while delegating menial and time consuming ones

• Third, the broad everyday adoption which is analogous to electricity for the home, or a typical office worker using the internet

Turning to each:

• It is highly probable that AI will eliminate or decimate entire professions, in particular via autonomous driving (e.g. Tesla/Waymo/[Baidu]), advertising/movies (e.g. Google Veo 3) or software development (e.g. Cursor/Lovable). This will likely be employment negative, however the degree should be contained. The sectors mentioned amount to ~3.1% of total US employment, compare that to 31% working in agriculture in 1910

• AI working as significant support is already the case today in many sectors, from investment banking (e.g. Rogo) to call centers. Just expanding on the latter:

  • Early evidence from Agentic call center apps such as Crescendo shows a better consumer experience due to faster and more helpful responses. Staff turnover declines as the call center job becomes more pleasant (typical 33% turnover within a year) and employees can be upskilled. Employment is steady, but margins grow and that extra profit can be spent elsewhere in the economy. This describes a classic positive productivity cycle. Sector specific AI agents match productivity patterns of previous technological breakthroughs and will likely be employment positive as economic gains outweigh job losses

• Finally, ChatGPT has achieved broad consumer adoption, not only with a parabolic user curve, but also with the time that users spend on the app. I like the analogy to electricity in the home, which made everything a bit easier at the time. So does ChatGPT, which shortens the time to resolve queries and provides knowledge faster and with more ease. This will likely be employment positive as the countless small efficiency gains across the economy add up to more aggregate time spent more productively

Summary: Early evidence from current AI applications suggests we follow the historic precedent. Employment in some industries will likely be severely impaired, but mostly AI looks to increase productivity across the board, which creates more economic growth

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Conclusion:

• History and early examples suggest that AI is unlikely to lead to a wave of mass unemployment. It is much more likely that, over time, the effects are employment-positive as growth overcompensates jobs made redundant by AI

• However, these effects will take time to play out and equally can be overruled by monetary, fiscal or other business cycle dynamics. The Great Depression (1929/30) and the Great Financial Crisis (2008/09) occurred during periods of technological step change, as did many other periods of more moderate economic slowdowns

• The current weakness in the US labor market is very likely owed to these larger cyclical dynamics, in particular the overhang of Covid-stimulus which first created a sugar-rush and is currently in a long, drawn-out process of counterbalancing, as the chart below well shows

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Current Market Views

The following section is for professional investors only. It reflects my own strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

While 2025 appears to be the most challenging year in over a decade for global macro strategies and CTAs, I am so far very content with my trading over the past six months, which would put me comfortably into the top percentile of that group. I plan to share more details on that at a later stage, in particular the long list of learnings over time which can be summarised as “If you touch the hot stove often enough you eventually learn to put a kettle on it, instead of burning your hand again”

• Either way, I’ve shared some of these views already more actively on X, where I’ve called for the market correction in February just before the sell began, predicted Trump’s tariff walk backs near the April lows (here), the recent high in bond yields to the day (here) or as per last week the outperformance of US Small Caps, which I continue to see as the dominating narrative for the very near future

In particular, one always has to recognise that there is an economic truth, and what the market wants to do. All we really care about is the latter. Since if we are right on the economic truth and wrong on the market, it just means losses. Further, most often the economic truth is ambivalent, and our judgement of it far from perfect. What do I mean by that?

• At this very moment, the totality of the economic data shows an US economy that is slowing, somewhere between very gradual and perhaps a bit more concerning, depending on whether your bias is glass half-full or -empty. This is the current economic truth, and as I already allude to, there is ambivalence to it

• Institutional investors in particular are positioned for the glass half-empty outcome, which can be seen in the below two charts which show big overweight in defensives vs growth/cyclicals, and very little exposure to Small Caps which are very sensitive to economic growth assumptions. More so, short interest in the later is very high

I’ve seen this movie many times before, and my sense is this gets solved in a very painful short squeeze that forces hedge funds out of cyclical shorts and into an overall more net long position. This will likely be accompanied by a “goldilocks” or “growth is fine” narrative, which justifies the price action (but may or may not match the economic truth)

• Once that squeeze reaches its apex, equities likely correct. This correction could be shallow if hard data holds in, or it could be more significant if hard data weakens. I refrain from predicting which one it will be and prefer to attempt judgement at the time

Accordingly, I am currently long US Small Caps. These are my further positions and views by asset class:

• Emerging Markets - China, India, Taiwan and South Korea (the biggest constituents of the MSCI EM) share many positive dynamics incl. growth, tech exposure, low valuation and ROW flows that are diverted from the US and looking for a new home. I am long MXEF, and see this as hopefully longer-term position

• AI - Today’s AI story is well understood, from the data center value chain to Nvidia’s earnings growth. It surely continues to be a great theme, just with some near term positioning headwinds to fight off. However, tomorrow’s AI story may soon be explored next as inference moves onto devices. I still see this story as underowned and am long ARM

• Europe - My sense is that investor exposure to the Germany theme is currently sufficient, and it is now a “show me” story, where stimulus needs to be demonstrated in numbers. Some digestion may be in the cards. European Banks still look attractive as the ECB cuts and the yield curve steepens. I am long SX7E

• Bonds - These appear as two-way risk to me, with the US deficit and global issuance as negative, and slowing economic data as positive (for bond prices). I think they are ok *for now*, but am watching this very closely. Another breakdown in long-term yields is the biggest market risk aside of a deterioration in hard data

• US Dollar - The structural trends for a weaker Greenback are very strong, from deficit spend to policies driving ROW investors away from US allocation. However, this view is very consensus, with most major Wall Street Banks seeing the Dollar as a Sell. A shakeout of Dollar shorts seems possible first, but it should eventually resumes its way lower

• Gold - In the near term some “tariff escalation premium” may still be removed as Trump and China continue talks. The structural drivers however appear firmly in place as economies across the globe dial up deficit spending, with the US in the lead. Same applies to Bitcoin

A very good investors once told me to think about the market as a sequence of episodes, each with their own narrative. In that vein, I’d think of the current episode as “goldilocks”/“growth is fine”, perhaps to be followed by “growth worries” or “yield tantrum” next. I hope to update you on the next iteration at the time

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

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My very first post in March 2021 was about inflation and inequality, forecasting the inflation wave that followed. I wrote it not only as an investor, but also because I deeply care about the topic. So it is hard to watch this continued drift into an ever-more bifurcated society, and very recent policy being another big step in that direction

Today’s post briefly lays out why the outlines of a very specific second inflationary wave are now clearly visible. This wave will go straight to the heart of the American Dream, the one of owning a single family home - and if it goes unchecked, it will have serious social consequences as increasingly reckless monetary and fiscal policy transforms the US into an Emerging Markets economy, where asset ownership moves ever further away from the middle class, with political radicalisation to follow

It is important to keep in mind that economic history does not repeat, but rhymes. As such, unsurprisingly, the combination of money printing, a high deficit and a dovish central bank is highly likely to be inflationary. But while in the 1970s oil was the bottleneck, this time it is likely single family housing

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Let’s dive straight in. Since December ‘23, Fed Chair Jerome Powell held a decidedly dovish stance in every FOMC press conference. This also included the most recent one, despite a very visible rebound in inflation, even as measured by the understating PCE-gauge

This stance is likely driven by a desire to get ahead of any potential economic weakness, with inflation risks either deliberately ignored, or underestimated

• Indeed, there are some cracks in leading employment data, as I had forecast in “Labor Day” in February. Further, wage growth is clearly decelerating as per the chart below

• The implicit assumption is that wage growth and inflation are interlinked, and it would require a supply shock to push inflation up again. This supply shock seems nowhere to be seen, at least not in the traditional places (oil, labor etc.)

Now, later in 2024 or 2025 we may indeed get the economic slowdown that Jerome Powell seems to be worried about (I wrote about this risk early in the year). This may just be the inevitable evolution of the ~7-year business cycle

While the Fed cutting rates may not make a huge difference to its evolution, however, the persistent dovish attitude immediately translates into another area - asset prices, from houses to stocks to gold or crypto, much more so than in the past. Why?

• The answer lies in the two charts below, which -simplified- show the amount of “interest bearing cash” in the US economy today

• Money market fund holdings, household and corporate deposits (~$2.2tr) amount to a staggering 13 Trillion US Dollars of cash today, compared with ~$4.5tr in 2018. (NB: this ignores T-Bills in circulation which are cash-like)

• The Fed dictates the investment intention for this huge pile of cash. If it guides to cuts, everyone wants to rotate out of it into other assets as they see their interest income dwindle. If the Fed holds rates steady, this bid is kept in check

Why does this matter for housing? After all, in the wake of the GFC the link between asset prices and inflation broke. The wealth gap caused by the QE-asset pump created political discontent, but not inflation

• In fact, everyone seems so certain of this breakdown that Jerome Powell himself in 2020 famously dismissed any relevance of higher asset prices for his policy choices. A “doctrine” he clearly still seems to adhere to

But Covid and its stimulus splurge changed the makeup of US economy. The private sector went from overlevered to termed-out and awash with cash. Thus, the link between asset prices and inflation is back. Not via stocks, but via housing

Before we explore that further, let’s recall a few statistics about the US housing market:

• There are 147m households in the US, of which 31% rent and 69% own

• C. 71% of those households are single-family homes, and 29% are multi-family homes

• Only 3% of single family homes are owned by institutional investors, vs ~15% for multi-family homes

The American dream is about owning your own home for your family

Let’s look how the cost of this dream has evolved recently, specifically via home prices, real-world rents and rents as tracked in the CPI (OER-Methodology)

Starting with the obvious first - home prices

• Home prices have been on a tear since the Fed pivot in December ‘23 and are now up 7.7% ytd (!)

• This means home affordability continues to track out of control. How can anyone afford to buy a home then? These are subsidised via asset price gains, often in the parents’ portfolio who then help finance the purchase

Summary: US house prices are on fire, despite 7-8% mortgage rates. They are highly likely to squeeze significantly further if rates are cut

However, home prices are not part of the CPI (they were in the 70s via mortgage cost, but the methodology was changed). So in order to maintain a dovish policy we can pretend this doesn’t matter and look at real world rents instead

• A lot has been made of various indexes showing how new apartments rents are flatlining or below zero, and how that rhymes with decelerating wage growth

• But new apartment rents are only a very minor share of the minor part of the US housing stock. First, the major share of multi family rents for obvious reasons is renewal apartment rents. These are tracking at a pretty solid 5% p.a….

  

• … but more importantly, recall the statistics above - America is about houses. And new single family rents are on the way up again, despite decelerating wages

• As the chart above shows, February new single family rents have turned up and are tracking with 3.8% p.a. This average is dragged down by low income homes and the sunbelt, with many metro-areas running way above. (Meanwhile, renewals single-family rents, again the vast majority of single family rents also track at 5-6+%)

Importantly, more near-time information is available via the earnings calls of two publicly listed single family REITs, Invitation Homes and AMH Homes

• Invitation recounts improving new rent trends in April and May, targeting again an all-in rental growth of 6-7%

• AMH spelled out the same, and wasn’t shy to explain to its investors why it believes single family rents will go up further, as shown below. The left side of the slide lays out the historically well tested relationship between house prices and rents. If house prices go up, rents eventually follow as both markets are interlinked

Summary: Single family and multifamily renewals are tracking at 5%+ p.a.. New single family rents have turned and are approaching 5% p.a. again, with more upside likely given the trajectory of house prices. Only new multi family rents are flat (perhaps <10% of all rents, yet all the press focus is on them…)

It is fair to say that real world rents, which are dominated by renewal and single family, are tracking at an aggregate ~5%, with upside bias. This is way above the Fed’s inflation target and way too high for comfort. Again, for dovish policy purposes we can ignore the real-world data and only look at rent inflation as measure in the CPI index (OER)

• Many government inflation measures (such as the PCE index) understate real-world inflation, but interestingly enough the OER-method isn’t too far from the truth. In fact, it follows the Core Logic Index for new single family homes quite closely, as work by great strategist Warren Pies or inflation-expert Michael Ashton has shown (I also recommend @rev_cap’s work who has been an excellent source). Further, as I shared in my last post, the Core Logic index references in BLS inflation papers

• However, the OER method has a significant “black box” element. While I assign a high likelihood to these higher rental costs showing up in the CPI statistics over the coming 3-6 months, any individual print can still be skewed by sample rotations or other quirks

Summary: While individual prints are impossible to forecast, it is highly probable that official CPI data will soon reflect higher rent inflation. This is significant as rents account for ~40% of CPI

Ok, so home prices and rents are going up at an uncomfortable pace, aside of the minor market of new apartment leases. But what is behind all that?

• I mentioned in the beginning that every inflationary period will have its own bottlenecks. In the 1970s it was oil, now it is housing

• The single family home market is experiencing a major supply shortage. This is owed to a decade of underbuild following the GFC now met by delevered households and a Millennial cohort that has reached early-family age

The single family home market is to inflation today what oil was to inflation in the 1970s

Conclusion:

Let’s go back to the Fed’s dovish policies, and why I think they are entirely inadequate in light of this analysis

• Should the Fed cut rates, then the $13tr+ cash will want to find a new home and aggressively bid up assets, including single-family homes

• This will first hit house prices and, with a lag, rents as many are priced out of home ownership, which will likely see a significant rise of institutional participation

• It is highly unlikely that wage growth will match cost inflation. With parts of the population being able to revert to asset gains in order to finance themselves, the squeeze will fall onto lower income groups, increasing the societal wedge between haves and have-nots

In other words, a dovish Fed is pouring gasoline on a supply-constrained market already on fire. This is a market of tremendous social importance at the heart of the American promise of upward mobility, where everyone can make it

The Fed’s policies are shaped by progressive views that put the avoidance of any economic weakness above all, yet in a bizarre combination do not care about pumping the prices of assets held by only a very minor share of the population. The end result is likely that eventually both the economy weakens and the wealth gap goes stratospheric, just like in the many Emerging Market precedents

For the remainder of the year, capital markets are likely in for some uncomfortable inflation surprises that will force the Fed to walk back on its policies. Eventually though, at the first hint of real economic weakness I think it will fold and stimulate, with the above laid out scenario as consequence

In this context, productivity gains achieved by AI are likely our best bet on an exit from the highway to Buenos Aires

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So far, the lion share of AI value has fallen to semiconductor companies, similar to the early innings of previous tech breakthroughs such as internet (e.g. Cisco in ‘98-’00) or mobile/cloud (e.g. Qualcomm ‘10-’12, see chart below). Infrastructure and applications came later, from phones to online shops or SaaS businesses, each often enormously profitable

The expectation is for AI to follow a similar path - semis now, then some infrastructure, and powerful, margin-rich apps later. However, its peculiarities suggest that the outcome could be very different this time. In fact, most of the value likely ends up in consumer wallets, or, wherever pricing power allows, industrial profits

Let’s walk through the reasoning, step-by-step for each layer:

• Semiconductors - The compute demand of AI is surreal, and at current model efficiency practically infinite. However, semis are hardware that has historically always been very cyclical. Clients overorder, to then get much more efficient with what they have. At the same time, their shareholders eventually want them to reign in spending, so equipment orders tail off. We may see the very early outlines of that in Microsoft’s or Meta’s lacklustre share price performance since their earnings, as investors perhaps worry about free cash flow in the face of escalating capex - whether now or a few years down the line, semis seem likely to follow past patterns of leaving most value generated to later parts of the value chain

• Foundation Models - here we see the first particularity and deviation from historic comparison. While there is only a handful of leading foundation model (GPT, Gemini, Mistral, Llama, Claude, Grok), they compete on both performance and cost, and as mentioned the cost declines so far are formidable. A comparison with mobile phone operators in the 1990s comes to mind. Again, only a handful emerged, but competition was fierce via rapidly decreasing prices, to the benefit of those buying the service - FANG-like monopoly or oligopoly profits currently seem unlikely for this layer

• Applications - Given the rapid advances in generative text, it is plausible that AI drives the cost of coding eventually to near-zero, with the recent release of the “first AI software engineer” Devin an exemplary step in that direction. This means the barrier to create new applications will likely be incredibly low, with endless custom solutions possible. Take another example - this week, Amazon introduced Q Apps, which lets users build apps on top of their own internal data with natural language (i.e. no coding necessary) - collapsing coding cost and the corresponding ease of creating new apps should drastically shrink the AI app-layer profit pool

If foundation models and applications don’t take the lion share of the AI-generated profits, who is it then? Exactly - the end user, i.e. corporates and consumers

• In competitive industries, ordinary consumers benefit from lower prices and/or better service quality as efficiency gains are passed on

• In industries with pricing power, efficiency gains increase margins and with it, the respective industrial profits

Now, let’s break this down further, by company size:

• Large and medium sized enterprises are typically already very efficient. They have gone through endless cost cutting programs. If you ever visited, say, a BMW factory, the first thing that stands out is the position of every screw and every tiniest little detail has been optimised to the T. AI-driven efficiency gains will happen here, but these are not companies full of low hanging fruits

SMEs on the other hand are a whole other story…

• SMEs are the back bone of our Western economies, they generate ~50% of GDP and are responsible for up to 70% of employment

• More so, they are typically very local, owner/founder led and have been around for a few decades. They are well established in their ways, but not exactly role models of corporate efficiency

In fact, with much less pressure to continuously rationalise, and less affinity to latest technology trends, their tech stack is often hopelessly outdated. Especially essential legacy services are often still run with pen and paper

Think of all the plumbers, pool cleaners, HVAC installers, building inspectors or care workers coming to your home to provide a service that is highly dependent on locality and people

McKinsey estimates that these workers spend ~40% of their day on bad routes and paperwork (!). An unbelievable amount of waste, but also gigantic low hanging fruits

AI provides cheap, easy to implement solutions to harvest these low hanging fruits. Some examples:

• Scheduling/Dispatch - Many of the services I mentioned have to coordinate multiple stops on daily routes, with differing worker demand for each. Planning these in an optimal way is a math problem destined for AI

• On-site Problem Solving - Plumbers and installers often work with a wide range of different heating, aircon or ventilation units that each involve their own set of problems. LLM RAG chatbots, with respective unit manuals uploaded, can be queried on-site via voice instruction, to receive immediate feedback for possible solutions - Check out the screenshot from an on-site HVAC problem solver my team and I have been working on:

• Invoicing - Many bills are still written by hand or printed, especially in Europe. Companies like Pennylane offer smart solutions that every SME should have

• Marketing - Reminders for maintenance or other regular appointments are an easy way to generate additional revenue, and straightforward to automate

• Document Pre-population - From requests for proposal (RFPs) to required documentation, there is a long range of tasks that can be worked off much more efficiently with generative text AI (see more below)

• Customer Chatbots - Probably the most well broadcast AI application, chatbots can drastically cut the time and cost of customer queries. Klarna published some phenomenal cost savings recently. While the AI relevance in these was called into question given the previous low-tech version in place, this again reminds of many SMEs who don’t have chatbots at all. I have made very good experience with decagon.ai that seamlessly integrates into other apps (stripe, salesforce etc.)

While these improvements seem material low hanging fruits, very few companies so far have centered their business model on proactively picking them. Worth highlighting are:

• Cera - Outpatient care aggregator in the UK and Germany that increases the margins of its acquisition targets ~3x via implementing its own tech stack. Examples include cutting recruitment cost by 80% via digitising the process, and using GPT-4 to convert conversations recorded on care assessors’ phones into a care plan, cutting its preparation time from 12 to a couple of hours (see document pre-population above). Cera last raised $320m in late-stage funding in ‘22

• Odevo - Private-equity owned Swedish property manager aggregator with its own tech stack that automatises the many menial tasks involved in the business

• Pipedreams - US-based HVAC rollup that upgrades the tech stack of its acquisition targets and boasts of 100% local sales growth within 24 months. The company just raised a $25m Series A

Importantly, many of the essential services SMEs share in common that they rely on skilled labor, which is increasingly scarce, especially in Europe. AI tools can significantly improve service quality for their customers, but cost efficiencies go straight into margin as these businesses maintain pricing power. Typically they see more demand than they can fulfil

• Margin gains added up across the vectors above can be significant. This brings me back to the post title, which is a word play on the Software-as-a-Service companies that dominated the 2010s. Will we see an attention shift from SaaS to essential legacy services with software-like margins as they implement tech? The ease of AI tools puts this proposition within reach

However, one big problem remains. SMEs are notoriously hard to sell into, and very few vertical market software vendors have cracked this segment

• It is easy to see why - SMEs are often local, owner-run businesses established many decades ago. Once these companies are humming along, and as many founders now reach retirement (over 300k in Europe alone over the coming years!), there is often little appetite to go the extra mile necessary to elevate the business further

The solution is simple - it is the path that Cera and Pipedreams have chosen. The easiest way to get an SME to upgrade its tech stack is to buy it. VC investor Elad Gil also sketched this out recently and termed the strategy “AI Buyouts”. This approach unites several other highly advantageous features:

• SMEs are the final frontier of investing in a world where institutional strategies have penetrated almost every possible niche, and public markets have become a knife fight between quants over basis points

• Due to size constraints, Private equity firms typically avoid the market below $3-5m EBIT, which ironically now sees an avalanche of sellers due to demographic change. The few that participate via platforms or buy-and-build see astronomically high returns such as Shore Capital’s >50% IRRs. Lots of sellers, few buyers = high returns

• With the substantial supply/demand mismatch and little institutional participation, it comes as no surprise that the average search fund investor (one of the rare strategies participating in SMEs) yields a return of 32% p.a., despite c. 40% of search funders failing to find a target (!). Again, a staggering result in a world where the search for yield has arbitraged almost everything away

In other words, the SME supply-demand asymmetry provides ample return even before any tech stack upgrades are implemented. Just imagine the additional upside

Now, there is plenty of prejudice out on SMEs, from a perception of low-quality to founder dependency or excessive economic sensitivity

• Having reviewed hundreds of them myself over the past months, I can confirm that these views are unwarranted. Sure, many SMEs are not exciting. But given the abundance of supply, these is still a huge number of high quality businesses full of opportunity, available at multiples that large business buyers can only dream of

In my view, upgrading the SME tech stack via acquisitions is a generational opportunity whose time has come. Capturing it will involve an unusual mix of skills that includes investing, operations and AI

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Current market views

The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

As I frequently stated in the past, liquidity is the most important, and likely least understood variable in the current period of high financialization and excessive government deficits. Measured by proxy of US bank reserves, we can see these declined recently as I had forecast in my 11 March post. With it, global equity markets rolled over, and this past Wednesday’s QRA details suggest no near-term change to this story

• Very few investment houses focus on these relationships that now dominate global capital markets. I notice Ruffer spelled out some similar dynamics, even forecasting a 1987-type equity meltdown, however this seems unlikely to me. Why? Liquidity is essentially set by the government, thus the Treasury and Fed could easily fight such an outlier risk should it really transpire

Either way, in light of this, I had already maintained a very cautious stance for Q2, and as per this recent tweet converted my remaining asset holdings (precious metals and Tesla) into cash, which I once again see as - temporary - king

Here is what I think for the rest of the year:

• Liquidity likely weighs on markets for the remainder of the quarter, but likely turns positive from July onwards once T-Bill issuance picks up again, latest probably with the 1st August QRA

• Inflation data probably won’t provide much near term relief due to shelter inflation, which I see as having troughed. The math is too boring to spell it out extensively, but essentially single family new rents are picking up again as per Core Logic’s SFR index which forms part of the BLS OER calculation, while renewal rents have flatlined for some time at 5%. New apartments rents are still in decline, but a smaller part of the calculation. Also note the 1-yr lag between Case Shiller and OER

• Deficit spending will continue. Simplified, deficit spending is bullish as long as it is financed by T-Bills, and bearish if it is financed by long-term bonds. For that reason I think eventually, most of the deficit will be financed by T-bills, like in the 1970s, as historically no one wanted to own the long end of a spendthrift sovereign. T-Bills are cash-like, thus fuelling both inflation and asset prices

I plan to go long when one of the following occurs:

• A major CPI miss that brings back rate cuts. This would motivate the $9tr parked in MMF to want to get out of them, providing a bid to all assets (keep in mind it is about the intention, there is never “cash on the sidelines” that disappears, cash just changes hands)

• The next QRA refunding announcement increases bills substantially (1st August)

• The Fed ends QT, for example due to market stress. This would reduce the Treasury’s funding needs, especially if they cut bond issuance for it

• A major equity washout occurs with very bearish sentiment. With speculators the most long the S&P 500 in over two years, I still see dip buying as prevalent and do not think we are near this, but it could happen over the coming months

Whenever one of the above happens, I want to go long high beta (e.g. semis) and long the monetary debasement plays (e.g. gold, bitcoin), as I do not see another long-term outcome bar further money printing. I do not think anyone is serious about reducing the deficit, in fact Europe is now trying to emulate the US with Draghi in view as European Council president and his endorsement of deficit spend. An AI-driven productivity wonder that offsets these dynamics is possible, but likely takes several years to transpire

Finally, for anyone tempted to buy US bonds (=coupons) to hold them for the long run, I encourage to read the passage below from this week’s TBAC statement, the private market advisors to the Treasury on issuance composition. Who would want to stand in the way of this ever expanding supply avalanche?

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Curiously, at the same time, financial markets over the past weeks have been increasingly shaped by a “monetary debasement bid”, where real assets are aggressively bid in a presumably valuation indifferent way

• As an example, the price of gold (a low volatility asset) appreciated ~5% in April alone, even as interest rates rose across the curve. In other words, investors preferred to own gold, which pays nothing, over cash US Dollars, even though the reward on the latter improved. A highly unusual dynamic last seen at scale during the 1970s. This only makes sense if one expects the purchasing power of said US dollars to decline significantly

So which one is right? The many forecasters who see inflation as about to be retired to recent financial history given likely near-term softness. Or financial markets with their monetary debasement bid?

Now, I have no way of predicting this week’s CPI and PPI prints which, like most government data, contain a large element of randomness (though I do note that March inflation swaps have trended up recently, likely due to higher gasoline prices). But I would agree that the market has reasons to be concerned about resurging inflation risks. Here is why:

• Large part of the sharp inflation decline of the past 6 months was owed to the goods economy, with services still sticky at an uncomfortably high level. Destocking and a depressed China did much of the work here. In fact, with long leads, goods pricing is likely to continue to be weak for a few more months

Yes, this is today, but the market is forward looking. And what does it see? It sees global manufacturing now expanding for the first time since 2022, e.g. as measured by the ISM Manufacturing survey

• While surveys always come with all sorts of drawbacks, given the ISM matches with other important variables such as the swing in US-retailer inventories as well as expanding electricity consumption in China, I take it as a good proxy for the global goods economy

Unsurprisingly, commodities have started to move, too. But there is more to it. While the improving goods economy cycle gives investors reason to buy them, the real motivation comes from elsewhere

What is that? Simple - Jerome Powell gave a very dovish press conference a few weeks ago that point-blank dismissed any inflation risks. While he may be lucky and right, as I wrote at the time, in my view it wasn’t good Central Bank policy. The risk of resurgence definitely exists, dismissing it is not credible and in fact increases exactly said risk

Why? Because credibility is the highest good for a Central Bank. If it is weak, investors worry about the value of their money, and seek protection. It is no surprise that the “monetary debasement bid” started the moment Powell ended the press conference

• Many market participants had a different view on inflation risks, whether right or wrong. But by ignoring the risks entirely, Powell gave them the reason to pull the trigger on protecting against them

So what did they buy this time around? Gold and commodities. This is how inflation in face of a dovish Central Bank can become a self-fulfilling prophecy. Rising commodity prices feed directly into higher inflation expectations, which investors protect against by buying exactly said assets - a circular reference of higher prices

• We see this statement in financial markets data. Here is a chart of the 5-year US inflation expectations. It has steadily increased since the Fed’s pivot in November ‘23. Put this on top of your screen and follow it closely

Now, there are also many signs that the US economy is slowing (e.g. weak retail trends, slowing wage growth as per Indeed), but this post-Covid cycle remains unusual. In other words, the goods economy (1/6th of GDP) can recover while services (5/6th of GDP) slow down. Which means that inflation can - at the very least temporarily - pick up into weaker economic growth, just as inflation slowed in H2 ‘23 into torrid economic growth

• My view is that commodities will remain bid until either this nascent global industrial recovery falters, or the Fed leans hawkish again. As long as they are bid, the market will likely continue its monetary debasement narrative, no matter what near-term CPI prints say, as the market likely looks through them

• This bid also extends to house prices, and eventually rents. Redfin data shows house prices are up 6.6% y-o-y, the most since September ‘22. It seems unlikely to me that this doesn’t eventually translate into rents

What does that mean in the near term? Let’s say the CPI print comes in on the low side and short-term yields decline in expectation of the now more likely Fed cuts. In response to this easier money, commodities would be bid more, leading in turn to higher long-term yield and a steeper yield curve

Summary:

• Near-term inflation may continue to slow, with possibly weak CPI/PPI prints ahead

• However, financial markets are already looking past that. With the industrial complex in expansion for the first time since 2022, commodities have caught a bid, substantially aided by worries around monetary debasement

• Absent a less-likely u-turn in global manufacturing, these self-fulfilling inflationary pressures likely continue until the Fed acknowledges them

The interesting part comes when/if the market realises that amidst fiscal dominance the Fed can in fact not do much, even if it wanted to, as higher rates likely add more private sector income than they slow the economy, with only the Treasury able to make a true difference. But this realisation, which would sharply accelerate the bid into real assets, is perhaps still some time away

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What does this mean for markets?

The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

In my last post, I highlighted gold, gold miners, the commodity index, Tesla and the Swiss Franc:

• While gold, the commodity index and especially gold miners caught a strong bid, the Swiss Franc has leaked lower (I am stopped out) and Tesla has chopped sideways as excitement over FSD 12.3 is kept in check by very poor near term sales. I don’t know which one will win near-term

• Staying with the theme of slower EV sales, in addition to an improving industrial cycle as well as investor preference for monetary debasement hedges, I see Platinum and Palladium as attractive (see Le Shrub’s great write up on the topic here). A likely higher near-term hybrid penetration means more automotive demand for these metals relative to recent expectations, while demand for other industrial use cases improves and Platinum as the world’s rarest precious metal benefits from the gold-like monetary hedge. It has massively lagged vs gold, as per the platinum-gold ratio chart below from Shrub’s post. Rather than buying the metal itself, I’ve bought a small position in PGM producer Sibanye Stillwater. It is down 80% from highs, highly levered and provides an asymetric risk-return profile to higher PGM prices. (Please always do your own due diligence and use stops!)

On a more general note, inflation caused by money printing (e.g. within a high deficit) is usually good for equities as the value of real assets rises vs paper money

• This is different if there is a Central Bank fighting it, or if inflation is due to supply shocks (oil embargo etc). Money printing of course invites supply shocks caused by bad geopolitical actors. So as long as the Fed stays dovish and there is no big escalation in the Middle East, from the inflation side there is not much worries for stocks

• However, there is also liquidity. As mentioned in recent posts, I see the latter as headwind over Q2, as a net-negative bill issuance drains liquidity for the private sector, thus I am keeping exposure light until that changes

• For that, I have a keen eye on the 1st May QRA, which could still show low bill issuance as I suspect that the tax intake comes in better than expected. However, from the summer I’d assume a return of the liquidity firehose and another big ramp in asset prices

• Should bonds rally on weak CPI/PPI data, I would fade that move, especially as long as the commodity complex remains bid

Finally, as the market is a never ending sequence of narratives, a new one surely isn’t too far away. Perhaps next ahead is again the story of an economic slowdown due to higher long-end yields and higher input prices, and then higher bill issuance as well as Fed cuts to help growth pick up again (to be clear, not imminent, but perhaps next…)

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DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity and do not reflect the views of White Square Capital LLP and/or Sophia Group LLP. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security, including an interest in any private fund or account or any other private fund or account advised by White Square Capital LLP, Sophia Group LLP or any of its affiliates. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, we do not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

In the below I explain why I think Private Credit is not a bubble, why I find CLOs particularly interesting and what the pushback to this conclusion would be

As always, the post closes with my current outlook on markets, where I explain why I shifted some of my equity exposure into the Swiss Franc, as a compromise to account for both the possibility of further US Dollar debasement as well as the liquidity air pocket that may still affect markets in Q2

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Until recently, I had perceived Private Credit mostly from the sidelines, via articles in the financial press that highlighted its rapid growth. This changed when I started working on a new project, where a financing aspect is involved and I realised that the role traditionally filled by banks was now filled by private lending funds

Always interested in the makeup of financial markets as well the driver behind its returns, this piqued my curiosity, so I decided to dig further and see what’s behind. So let’s dive in

To start, we need to define what Private Credit actually means:

• While the field is wide and there is no official definition, I would frame it as follows - Private Credit includes all sources of debt outside of banks, public markets or government, typically provided by private investment funds who use their investors’ money to allocate loans to whoever demands them

If we look at the growth of this asset management strategy over the past two decades, we see a parabolic curve, with total AUM more than doubled in the past few years

More so, the typical Private Credit fund advertises returns between ~10-15% p.a. This is notable due to several features that make credit a different animal in particular in comparison to equities

• To start, this is significantly higher than the return on global equities, which appreciated c. 8% p.a. over the past 50 years. However, credit ranks higher in a company’s capital structure. In case of default, lenders are first in line to receive funds, and subordinated equity may be wiped out. So very broad credit strategies should typically see a return below equities

• For the same reason, credit typically also performs very differently in times of crisis. While all assets may sell off during an adverse market event, credit will “pull back to par” unless a default is at hand, while equities can continue to trade below pre-crisis levels for years

• Compared to its “sister strategy” private equity, for many private credit strategies there is also no capital that needs to be held back by investors for capital calls, where the investors’ realised return can end up being significantly below the funds’ advertised return

So for a broad credit-based asset class to see higher returns than equities over a considerable amount of time is highly unusual, to say the least

So where is the supply-demand mismatch coming from that appears to drive Private Credit returns?

• Before we get to an answer, let’s recall the following: Asset class returns have a lot to do with demand and supply. To take an example, equity hedge funds in the late 1990s had 25% IRRs running simple long/short strategies. Today, these same strategies have ~2-4% alpha, as much more capital, both steered by humans and computers chases these returns

With that in mind, I believe the answer is two-fold:

• The first and biggest reason has to do with banks and regulation. The Great Financial Crisis in ‘07/’08 as well as the Euro Crisis in ‘10/’11 cost global taxpayers trillions to cover losses at financial institutions that messed up their risk taking and blew up. The governmental answer was “never again”, achieved through regulation. Capital requirements were dialled up and banks were generally discouraged to take risk (Basel III etc.). Their retreat left a huge void

• The second reason has to do with access to public markets. We see that high yield debt traded on public exchanges typically returns ~3-4% less than its Private Credit counterparts for the same credit risk. However, this market is only accessible to large issuers who can fulfil the burdensome requirements involved in a public debt listing, from ratings agencies to roadshows or exchange fees. At the same time, the potential buyer pool is anyone with a brokerage account, from retail to pension funds

With this in mind, looking at the chart below, the return spread between private and publicly traded loans for the same risk starts to make sense

• Private loans see high issuer supply as banks don’t want to cater to them, and seemingly still not enough demand from Private Credit funds

• Publicly traded loans see restricted issuer supply due to the high threshold to access public markets, while demand is practically unlimited

Summary: Looking at the context outlined above, my common sense answer is straight forward. The explanation for the excess returns of Private Credit can be found in a vast supply-demand mismatch that hasn’t been filled despite the strategy’s rapid AUM growth

• In my view, the surest tell-tale sign for maturation or even overheating could likely be found in Private Credit returns compressing further, and possibly aligning with public market returns

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Diving deeper, we can divide Private Credit broadly into the following four disciplines:

• Direct lending. This involves a corporation taking a loan from a private credit fund at individually negotiated terms and accounts for the vast majority of AUM

• Asset-backed financing. Examples include a lender providing upfront cash in exchange for the future cash flows of an asset such as utility bills, consumer car down payments etc.

• Distressed debt. This strategy mainly involves buying existing loans that are at risk of default

• Collateralised Loan Obligations (CLOs). Here, various loans of the same risk profile are bundled together and then sold to investors

Direct lending, asset-backed financing and distressed debt all appear self-explanatory to me. If one wanted to invest in these asset classes, either directly or via a manager, one has to do the homework of assessing the risk taking, loan quality etc. It is similar to investing in an equity mutual fund, there are good and bad ones and manager quality will matter a lot

Instead, I want to expand on CLOs which I find particularly interesting for their incentive structures

• As mentioned, in CLOs several loans of a similar risk profile are bundled together into one asset

• In addition, as visible on the chart, they include an equity tranche by the CLO’s manager that serves as first loss buffer as well as incentive for the manager to get the risk right

• Further, a lot of the underlying loans are typically related to private equity owned companies, which will fight to keep their equity alive, come with a below average probability of nefarious activities such as accounting fraud or similar, and are generally well run

While the CLO terminology evokes bad memories of the related CDOs which blew up during GFC as they were stuffed with subprime mortgages, they performed very well during said period, with barely any defaults despite enormous economic distress.

Summary: Due to their incentive structure and performance in previous performance during downturns, CLOs stand out as particular area of interest within Private Credit strategies

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To conclude, nothing is ever perfect or easy in investing, and there are a variety of pushbacks to Private Credit that I want to walk through in the below:

• Very high recent strategy inflows: I would look at the spread of similar credit quality between public and private loans as possible signs of oversupply and do not see it as an issue yet

• Poor underlying credit quality: It is absolutely possible that some managers chose assets poorly and their portfolios are at higher risk. Thus, nothing replaces the legwork of careful due diligence, this also includes the investor in private credit funds

• Looming maturity wall: In the coming years, a lot of debt that has been termed out at low rates during Covid will need to be rolled. With many private credit funds sitting on significant dry powder, this seems more opportunity than issue to me

• Private marks are unrealistic: This is certainly an area of concern. With no public benchmark, managers can set the marks on loans wherever fits them best rather than what is actually the case. The irony is that many investors prefer that anyways, as they also won’t have to show losses then. I would point out the pull-to-par as relevant dynamic here as write offs only materialise in defaul, and again the need for individual due diligence

• Hyperinflation: If inflation escalates to very high levels, any credit investment gets run over as inflation outpaces even high interest rates. I find this outcome possible, but unlikely, and need to point out that most private debt is floating, which would benefit from higher yields within realistic reason

Summary: Private Credit strategies are not without risk, and anywhere with fast growth someone will have gotten undisciplined. Private marks are another area to be mindful of. More broadly, even with this strategy benefiting from the supply-demand gap outlined above, there is never any substitute for close due diligence

Conclusion:

• Due to the supply-demand gap left by retreating banks and the inability of public debt markets to fill this void, Private Credit strategies have over the past decade consistently achieved equity-like returns with credit-like risk

• The persistent yield spread of private credit over public loans of similar quality suggest that despite the substantial capital inflows this inefficiency has not yet been arbitraged away

• Within Private Credit, CLOs stand out as seemingly attractive strategy given their incentive structures and low historic default rates

• Like any investment strategy, there are also many risks that need to be taken into account. Rapid growth makes good manager selection and close due diligence critical, while private marks may at times be misleading

My special thanks go to Gerhard Grüter, a Private Credit specialist with decades of experience whose multi-family office Tropea Asset Management focusses exclusively on the strategy. He generously offered his time and insight to get me up-to-speed on this topic for today’s post. He has published extensively on the topic here

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What does this mean for markets?

The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

While I’ve been long equities this year in China, Germany and Oil majors, and had gone long US equities at the lows in late October ‘23 when the QRA surprise came out, I had clearly sold the latter too early, and then avoided them this year due to their relentless ascent

• With Powell’s super dovish press conference on, I changed my view on them and went long. Since then, I couldn’t shake the feeling that many had exactly the same thought at the same time, which was also supported by the reactions to last week’s post, of which there were many and mostly confirmatory. As such, I have to accept that I, like many others, was possibly “stopped in” and simply capitulated to a seemingly never ending rally, while Q2 risks are in fact still the same, in particular the liquidity drain I had highlighted in “On Liquidity” (see slowing decline in Reverse Repo facility below, likely to eventually grow again in Q2)

At the same time, I cannot deny that last week Powell clearly told us that he doesn’t care about inflation risks and sees his emphasis squarely on the labor market, all in the context of a persistent 7% government deficit. There are few scenarios that scream to own assets more than the combination of a dovish central bank, lingering inflation and a spendthrift government

• Still, with an unknown future, we also have to accept that there is a scenario where Powell is simply right, whatever the probability is. Perhaps the downside risks to the economy are underestimated or perhaps inflation is indeed seasonal, or at the very least takes much longer to resurface, and rates should be cut quickly

How do I square all these probabilities with my “original sin” of having sold US equities way to early after the turn in October, and the risk of having gotten “stopped in” again at the highs? This is the compromise I’ve come up with - while keeping some, I’ve decided to trim my long exposure in US equities and instead roll it into a Swiss Franc long position, for the following reasons:

• The Swiss Franc reflects one of the world’s most responsible and prudent government and monetary finances, yet it has lost 8% in value vs the US Dollar year-to-date. With the SNB’s rate cut last week, perhaps that move is now done, the currency can return to its more gold-like historic profile, and if the US Dollar keeps getting debased against most other assets, this should also include the Swiss Franc from here

• At the same time, should we indeed see a moment of equity weakness, due to the Q2 liquidity air pocket or whatever other reasons, the Swiss Franc may be bid due its traditional flight-to-safety characteristics

In other words, the Swiss Franc could work in either scenario, risk-on and market weakness

• Should market weakness materialise, I can simply roll the Swiss Franc exposure into long equities e.g. towards the end of the weak Q2 liquidity window. If markets rally, my remaining risk exposure plus the Swiss France should help

I’ve maintained the exposure in gold/gold miners, Tesla and some US equities. For Tesla, I see the frequently cited headwinds to EVs at this time, but in my view this is really about autonomous driving, with a call option on humanoids further out. I do think the progress in FSD 12.3 is very impressive, and future upgrades should increasingly bring the bull case around autonomous driving closer. As always, I could be wrong, please always do your own DD and use stop-losses

• Related to this, one of my coming posts will be a two-part series on AI, first checking in on the current development state and future outlook, followed by an introduction to the already existing possibilities in corporate use

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

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DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity and do not reflect the views of White Square Capital LLP and/or Sophia Group LLP. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security, including an interest in any private fund or account or any other private fund or account advised by White Square Capital LLP, Sophia Group LLP or any of its affiliates. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, we do not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

To start, let’s briefly frame the context coming into said meeting:

1. US economic growth has decelerated from last year’s torrid pace, but continues to track at a very healthy ~2% real and ~6% nominal growth. Recent housing data is supportive, suggesting growth unlikely to fall off a cliff soon

2. Inflation has been on a downtrend for the second half of ‘23, but rebounded early this year. There are some arguments for this to be a seasonal effect…

3. …but also some signs that are more lasting rebound could be on the cards, as goods inflation seems to have troughed, while gasoline and commodity prices are up

4. Finally, while headline data suggests a strong US labor market, with 275k new jobs generated in February, there are cracks under the surface in secondary employment data, such as the NFIB Small Business Hiring Plans

The FOMC meeting communication consists of two parts. A press release at 2pm EST which includes the committees’ economic projections, and the press conference with Chair Jerome Powell at 230pm. Let’s review each:

• The press release represented a realistic reflection of the context laid out above, something I had predicted in detail coming into it here. FOMC members continued to forecast three cuts for ‘24, but more than before saw the possibility of only 2 cuts. Economic growth expectations as well as inflation for ‘24 were moved up, just as the Fed Funds rate forecast for ‘25, ‘26 and long term (“terminal rate”)

This could be described as a moderately hawkish outcome, acknowledging higher structural growth as well as the inflation uptick earlier this year. But the team’s press release is just a piece of paper, the real juice, as we all know, is always what the boss tells us - i.e. Jerome Powell

And his press conference was decidedly dovish. In particular the following:

• He played down the early ‘24 inflation bump as seasonal

• He dismissed the increase in the terminal rate as irrelevant

• He introduced the taper of QT from June onwards, previously expected a ‘25 affair

• He described financial conditions as restrictive

Why is the above so important? It is simple, Central Bank policy is all about credibility. If a Central Bank is not taken seriously by markets, then these will change their behavior, affect economic outcomes in their wake. Why is the Fed’s credibility at risk after yesterday? Let’s walk thru the above:

• The early ‘24 inflation bump: Of course it is possible that the higher prices earlier this year are due to some seasonal effect. But it is not certain. It could well not be the case. As a Central Banker, inflation is your risk to manage. That includes acknowledging possible adverse outcomes and talking against them, not taking the more favorable outcome for certain

• Higher terminal rate: US real and nominal GDP growth has been running on a very high pace. Yet, the terminal rate is still similar to the depressed pre-Covid years. Again, it does not sound good to ignore something that has obviously changed (e.g. due to high government spend, delevered households etc.)

• End of QT: With markets at all-time highs and inflation at risk of picking up, why the need to end this early?

• Restrictive Financial Conditions: Crypto meme coins are flying, and the dogwifhat coin project raise funds to advertise on the Las Vegas Sphere - does this sound like restrictive financial conditions to you?

In summary, Jerome Powell had all the possibility in the world to simply repeat the slightly hawkish stance of the FOMC press release. He actively chose not to. Why?

• Before I come to the answer, an important thought to clarify: In today’s hyper-efficient financial markets, monetary policy is not set via the Fed’s actual rate decisions, but through their communication. If Powell talks dovish, bond markets the very same minute price in more cuts, and financial conditions ease without an actual rate cut ever occurring - this is why these press conferences are so important

He chose not to because the Fed is much more worried about economic growth and in particular the risk of higher unemployment, than it is worried about inflation. In his press conference, Powell mentioned the weakened secondary labor market indicators I mentioned above

From his point of view he is taking a gamble, with the goal to avoid an increase in unemployment at all cost

• If he is lucky, the inflationary bump turns out to be seasonal and he stimulates the economy without a price to pay

• If he is less lucky, then the dovish stance invites inflation down the line, as easier financial conditions feed through to more economic activity

Here is what’s important. Financial markets do not like Central Bankers playing “at risk”. They will assume some decent probability that inflation returns, and bid up real assets to protect themselves from this outcome

• Ironically, this makes higher inflation more likely, as it drives up the prices of goods and services (e.g. people leave the labor force due to asset price gains like in ‘21, commodity and house prices go up etc)

This is why Central Bank credibility is so important, and why - in my view - it was unnecessarily put at risk yesterday. Yesterday, the Fed implicitly admitted that it shifted its inflation target to the 3-4% range from the historic 2%

This outcome is bullish for real assets and bearish for inequality (good luck with finding an affordable house to all Millennials whose parents won’t help them with it). In the short term it is also bullish for the economy, but in the long term higher inflation corrodes economic activity and historically very often has caused high unemployment

Conclusion: Jerome Powell chose to be very dovish while the risk of an inflation rebound still cannot be ruled out. Financial markets likely adapt by bidding up real assets

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The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

So what have I personally done with this information after the press conference? I sold the S&P put and took the US Dollar cash I had, which I feel is at risk of debasing, and swapped it for real assets. In particular:

• Long Gold & Gold Miners: The former is self explanatory, the latter is at a multi-decade low relative to the gold price and could see a rapid up-move in price should gold continue its ascend. I also bought out-of-the-money calls in them

• Long FTSE 100: The UK large cap index has broken out of its base, and could follow the DAX, Nikkei and other non-US benchmarks

• Long Nasdaq 100 and Dow Jones: A higher inflation/financial repression regime is great for companies with high pricing power, low debt/net cash and high market shares. US large caps are the best companies in the world and should benefit accordingly. I also bought some short dated OTM S&P 500 calls

• Short 30-year Treasuries: This is a hedge to the above, as the key risk I see is that no one wants to buy US long duration bonds anymore with a 7% deficit and a dovish Fed. However, the QT taper and bank reform changes supply/demand dynamics in a favorable way (probably deliberately so). Still, why own long-term US Treasuries?

• Long Tesla: FSD 12 has been received well, humanoids will increasingly be an important story, the stock is high beta and has underperformed a lot. I also bought long-dated OTM calls here

Relative losers from this policy stance are further likely US Small Caps (Russell 2000), anything yield sensitive and also the US Dollar. However I’d expect other Central Banks to follow suit, so I see real assets as best hedge to the steady debasement of the Greenback

On a final note, I personally did not expect this very dovish turn at this juncture. Perhaps it is my German roots with some disciplined Bundesbank memory still in mind. But as Keynes used to say - When the facts change, I change my mind

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

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DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity and do not reflect the views of White Square Capital LLP and/or Sophia Group LLP. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security, including an interest in any private fund or account or any other private fund or account advised by White Square Capital LLP, Sophia Group LLP or any of its affiliates. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, we do not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

Let’s jump right in this time - starting with the all-important US inflation data released this week

Both the Consumer as well as the Producer Price Inflation print came in significantly hotter than expected. I had pointed the likelihood of this already in late January here and again more recently here

• Rather than going into the details, I would just like to apply Occam’s razor and show the below simple chart by the WSJ’s Nick Timiraos:

• Whichever way you turn it, the three- and six-month annualized change is clearly moving up. Taking this simple “visual” as cue, it looks like US inflation made a low last Fall

This makes sense when we keep in mind that the global goods economy went through one of the roughest downturns in recent history, as overordering during Covid-19 was followed by a year of destocking across the global value chain. Inventories were cleared at discounted prices and weighed on inflation

• This process has come to an end, and goods inflation has likely found a local trough. That doesn’t mean it will escalate again to worrisome levels, but the balancing effect to still very sticky services inflation will likely be gone

Moving on to the Fed, just last week Jerome Powell declared on Capitol Hill that he is “not far” from cutting interest rates. In next week’s FOMC, he will likely be reminded of that comment by the press, in light of the latest strong inflation data. What will he say?

• In my view, it is likely that he walks back on those comments. He cannot maintain them without looking like the Central Bank Chair of Venezuela, it is not serious. So he will most likely make cuts data dependent, wanting to see more proof of disinflation, caveating that a better March CPI is likely not enough, which means the odds are that the market starts to price in less than 3 cuts for this year

The inflation rebound may complicate matters for the Fed as I increasingly see signs of slowing growth, in particular in the labor market and to some degree now in consumption

• While official headline data remains strong (February NFP = 275k jobs added), many secondary indicators point to a much less benign picture, such as the staffing component of the NFIB Small Business survey

• Now, surveys are always lower quality data than hard measures, so one in isolation can always be misleading. However, the same weakness is also shown in a plethora of other data, which the Kansas Fed summaries into one aggregate Labor Market Index

When we look at consumption trends, the tepid picture year-to-date is thus perhaps unsurprising. February retail sales came in below expectations, and near-term data continues in the same vein. Compare below ‘23 vs ‘24 so far

Moving on to asset markets, as laid out in the more detailed post earlier this week, I expect liquidity to be a headwind for the coming quarter

• This is due to higher than expected tax payments, negative T-bill issuance (bills are like cash, and ~$225bn more will be repaid in Q2 than issued) as well as the Reserve Repo facility likely getting filled again

• At the same time, as usual, active fund managers have gone all-in at the highs, with the NAAIM fund manager survey showing the most extended exposure in over two years. Similar can be seen in prime broker hedge fund net exposure data

Summary:

• Inflation is rebounding. It remains to be seen whether it is just a bump in the disinflationary road. But so far, the trend is again up

• The Fed is unlikely to ignore said data and likely to lean against it, at the very least relative to very dovish market expectations

• The labor market shows too many cracks for comfort. Should these trends persist, expect consumption and overall real growth to decelerate in the near term. Important: Please also keep in my that the goods economy can rebound from destocking while the overall economy slows

• Liquidity is likely a headwind for asset markets during Q2. However, once the quarter passes, high bill issuance will return and once again likely prove a strong tailwind

• Active manager exposure is at a 2-year+ high

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Putting it all together, this is the roadmap I see for the remainder of the year:

• In the near term, all of the above combine a narrative that might see the “S-word” re-emerge for the first time since the 1970s. The combination of low growth or even stagnation and inflation, i.e. “stagflation”

• This will possibly be used to explain a pullback in asset markets over the course of Q2 that may see its actual origin in temporarily unfavorable liquidity conditions (narrative to follow price?)

• As data over the coming quarter perhaps disappoints while all these dynamics reflexively feed on each other, at some point towards the summer the narrative peaks, perhaps on an ugly employment print, while inflation has cooled off again due to said slower growth

• This opens the door for both the Treasury and the Fed to pivot back to a fully dovish mode, with the then closely looming election a strong additional motivation. Out of a midyear trough, a very bullish second half for asset markets possibly follows, as the Fed cuts while the Treasury once again pumps T-Bills into circulation. This would also indicate a likely inflation resurgence in ‘25, as fighting unemployment is prioritised over fighting inflation

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What does this mean for markets?

The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

Aside of a small long in Natural Gas futures, which came back to multi-year lows and faces very favorable seasonality ahead, there are no changes to both the short- and long-term book vs my earlier post this week “On Liquidity”. I still have the S&P 500 May puts in the short term book and my intention is to patiently wait for a moment that gets everyone beared up in Q2/summer (possibly on the “Stagflation” narrative) to then go max long for the second half of the year. Obviously things may turn out entirely differently, but that’s my plan

A brief word on AI, as I see many analogies to the 1999/2000 new economy bubble going around. As discussed in the last post, yes, if you buy semiconductor stocks here, you are likely exit liquidity for those that bought much lower and are now trimming. Just look at the retail inflows into the semiconductor ETF over the past days:

Having said that, I do not think that AI is a bubble. In another project I am working on, my team and I can see the tangible benefits first-hand (I will write more about that in the future), and I think it is fair to say that over the coming years the technology will permeate a large share of corporate processes, with substantial productivity gains as mundane processes become much more efficient, from answering costumer queries to prepopulating cumbersome RFPs or matching staffing or transport queries with their ideal counterparts. It is the real deal in my view, and will contribute to global GDP growth over the coming decade in a non-trivial way, not to speak of the more medium-term potential of humanoid robots (see e.g. here)

This major positive will likely be sorely needed in the coming years, as the current trajectory of the US is very concerning. The profligate fiscal spend over the medium term likely translates into both fiscal and asset price inflation, which screws the 40% of Americans not involved in the game. Reducing the deficit via budget cuts seems unlikely given its social implications. Reducing the deficit via taxes on asset-owners is out of the question, as this would cut off the hand that feeds both parties via donations. Accordingly, the choice falls to the invisible tax of inflation, which is disproportionally paid by the poor. If Technology doesn’t bail out the country, then a massive increase in inequality over the coming decade seems likely, with a very bifurcated society much more the hallmark of Emerging Markets such as Brazil

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

Subscribe now

DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity and do not reflect the views of White Square Capital LLP and/or Sophia Group LLP. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security, including an interest in any private fund or account or any other private fund or account advised by White Square Capital LLP, Sophia Group LLP or any of its affiliates. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, we do not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

Today’s post reviews what I could observe as liquidity metric with the closest relationship to markets - bank reserves, as well as its outlook for the coming quarter and beyond, including the possible implications for equities

As always, the post closes with my current outlook on markets

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A long list exists of metrics measuring the amount of US Dollars within the various circuits of economic and financial markets activity. Most of them, such as the well known M2 Money Supply, with little explanatory utility

Since the pandemic however, one liquidity metric stands out with close correlation especially to US stock market activity - bank reserves

• I plotted the Billion $ level of bank reserves held at the Fed by US banks against the country’s total stock market capitalisation below, the relationship appears obvious and too immediate for coincidence

Let’s recap quickly how bank balance sheets work:

• On the liabilities side, a bank mostly borrows money from consumers and corporates (via deposits), and from capital markets (e.g. via bonds). On the asset side, it then lends out these funds to whoever wants credit, or invests them in securities

• On the asset side, each bank will also keep some of the money in a cash account at the Fed - these funds are called reserves. They are set to ensure there is always sufficient liquidity in the banking system, e.g. to provide funds to bank customers wishing to withdraw cash

• Should the level of reserves fall to a worrisome level, then the bank would be forced to turn other items on its asset side into cash, e.g. by selling or not renewing one of the loans it made

• Conversely, with reserves at a high level, the bank could easily give out new loans, should demand for them exist

The US is currently in an “ample reserves” regime, which simply means that banks - on aggregate - have significantly more reserves than necessary. However, as previously discussed, loan growth is anaemic due to high rates, so the stock-market/reserves correlation is unlikely due to that

Yet, coming back to the above chart, the close correlation between US bank reserves and risk-taking since 2020 seems obvious. Why?

• Since 2020, the amount of consumer deposits on banks’ liabilities side has increased dramatically due to Covid-19 stimulus. This has turned the US economy into an income-driven economy, rather than one constrained by leverage

• Thus, fluctuations in income are much more important for the economy and markets than credit expansion or contraction. Just as an example, the amount of new mortgages has collapsed since Covid as mortgages rates shot up to ~7%. Still, housing is booming due to cash payers as well as builders subsidising buyers

The evolution of income across the economy is well reflected in the level of deposits on banks’ asset sides. As deposits go up or down, reserves follow

• Consequently, if reserves decline, bank risk appetite declines. Even with ample reserves on aggregate, some regional banks in particular are much closer to tight reserves levels and shed assets each time these go down

Summary: The level of US bank reserves is highly correlated to equity markets for good reason. In an income-based economy, reserve fluctuations mirror deposit activity, with a direct influence on risk appetite

• As an example, in 2022, deposits declined due to large tax payments and a government budget surplus in Q3 ‘22. The stock market fell

• In 2023, deposits rose due to government deficit spend, which pumped billions into bank reserves especially in Q4, coinciding with an equity bull market

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The next important question is then, where do reserves go from here? My expectation is that they decline in Q2 ‘24, to then rise again for the remainder of the year. Here is why:

• The rapid increase in reserves over the past five months has been closely correlated to the Treasury’s decision to predominately finance itself with bills over the same period. This high supply of bills pushed their yield above that paid of the Reserve Repo facility and drained it:

• The money parked in the Reverse Repo facility first moved into the Treasury coffers, then from there onto private sector bank deposits as the government spent it

This effect will likely reverse in Q2, as bill issuance actually turns negative. In other words, $245bn more bills will be retired than issued

Further, just as in 2022, tax payments which are mostly due in April, will likely be considerably higher than expectations, which again moves deposits from the private sector to the government. There are three reasons for it:

• First, due to the roaring stock market over the past year, capital gains tax payments will likely be above expectations

• Second, the IRS has been staffed up to collect previously unpaid and overdue taxes more aggressively

• Third, nominal economic growth over the past quarters has come in significantly higher than expected, with previous budget deficit assumptions based on ~3.5% nominal growth (vs recent run rate of 6-7%)

Take all of the above together, and a decline in bank reserves over the coming quarter appears likely

What about the remainder of the year though? I would expect these dynamics to improve again from Q3 onwards, for the following reasons:

• The negative bill issuance will likely only be temporary, to return to high net issuance again once tax payments have passed

• With the election looming in November, the government is incentivised to maintain market-friendly policies

• Some growth strains have again appeared in the economy, in particular within the labor market. This may be amplified by the likely deposit drain ahead and thus see more liquidity subsequently (e.g. via higher deficit spend etc.)

Summary: Negative bill issuance, lower deficit spend and higher tax payments likely see bank reserves decline in Q2. This likely reverses in the following quarters, with a positive “liquidity” outlook as measured by bank reserves for the remainder of the year

On possible growth strains for the US economy, one cannot ignore recent employment data which under the hood now shows a clear deterioration in many metrics

• While the US labor market was “red hot” for the best part of the past three years, it has now moved to resemble the mid 2010s - a state of balance, however with little margin to the downside

Some chart relay the message best:

• The unemployment rate is drifting up and now the highest in 2.5 years…

• …while part-time jobs are holding the baton…

• … the household survey shows job declines…

• …the quits rate is dropping sharply….

• …while surveys imply more weakness ahead

I had pointed out the possibility of a peak in the market’s growth optimism in the tweet below, with Treasury yields down 30bps since

• The Fidelity fund dumping all Treasury bonds was just a proxy for the predominant market view, which leaves plenty of scope for adjustment

Summary: The US labor market is slowly deteriorating. It is a very slow moving tanker, with cycle spans of several years. As such, a rapid worsening is unlikely. A rapid improvement seems equally improbable, even as the cyclical economy shows signs of life as previously discussed. But cyclicals are only ~12% of the economy, with services today the far dominant part

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Conclusion:

• While most liquidity measures show little explanatory utility, since the pandemic, an undeniably close correlation exists between US equity markets and bank reserves

• Bank reserves are likely to decline during Q2, as negative bill issuance, lower deficit spend and higher tax payments create a drag on private sector deposits. For 2H however, this particular “liquidity” outlook is constructive

• This Q2 deposit drag may coincide with, or in fact amplify strains on economic growth, with recent labor market data continuing a trend towards soft employment conditions

• This ties into my view that capital markets likely experience an overall weak Q2, followed by a bullish second half of the year as “liquidity” returns, and is potentially even emphasised in response to growth worries

Like most correlations, one can also expect the one between the US stock market and bank reserves to eventually disappear as the economic make-up changes. For now, in my view, it continues to be relevant and I would encourage anyone with interest to explore and track it closely

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What does this mean for markets?

The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

While there are many ways to investment, the two most dominant strategies in public markets can be summarised as trend following and contrarian

• Trend following bets on a continuation of recent price patterns, and especially in equities applies most of the time. The biggest risks are to jump onto the bandwagon late and then lose as the trend turns, or to exit too early in the belief that the trend is over

• Contrarian bets on a reversal of price as most of the crowd has piled in. It frequently applies to bonds and FX which are more range bound, and less frequently to equities which are higher one year from today c. 70% of the time, however where turns can cause very significant swings. The biggest risk is to see turns when in fact trends continue. Regular readers will know that much of my work has focussed on catching these turning points

• If well executed, both in combination become very powerful. Equally, there are many lessons to be drawn from either. For trend following, the most important one is perhaps not to be the exit liquidity for the smart money that sells. I see some vibes of that right now in semiconductors, where in conversation with sector specialists I see trimming in some favored names in light of valuations that already anticipate a fair share of AI development. Concurrently, the drastic volatility expansion in the sector is a sign that the easy money has been made in the near term. Semis have lead the market on the way up, and dragged the momentum factor with them, with some US high quality stocks now sitting on extreme valuations (e.g. CostCo or WingStop on 50x PE). In other words- don’t be exit liquidity!

With this in mind, below my current stance across short-term and long-term allocations:

Short-term book (Active Trading, Long & Short, Changes Frequently):

The Tech Insurer I mentioned in my last post (see link to write-up again by Value Investigator) has more than doubled since. Even if I can see the case for further gains as it has just reached breakeven with its net cash holdings, I’ve sold it as I’d expect profit taking ahead. I’ve also exited the remainder of this book with only the S&P 500 puts left, concurrent with my outlook for the next 1-2 months, though Natural Gas continues to look technically interesting. With regards to Google, I notice that 3rd party data continues to confirm stable Search, even as the Perplexity.ai userbase keeps rising. Perhaps they are more complementary than thought Please keep in mind that this is a high turnover book and it may already be different by the time you read this - always do your own DD

In summary:

• S&P 500 puts May expiry

Long-term book (Asset Allocation for Medium & Long Term):

No changes here, I hope to add to Equities in the Spring, following the logic of today’s post. As mentioned, my next write up will be on Private Credit

• 86% T-Bills

• 14% Equities (5% DAX, 5% XLE, 4% China Equities)

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

Subscribe now

DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity and do not reflect the views of White Square Capital LLP and/or Sophia Group LLP. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security, including an interest in any private fund or account or any other private fund or account advised by White Square Capital LLP, Sophia Group LLP or any of its affiliates. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, we do not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

This has perhaps unleashed a self-fulfilling circuit, as the forward guidance to cuts in the future was enough to translate into looser financial conditions today, inviting back inflationary pressures down the line. A first shot across the bow in that direction was the unexpectedly high January inflation print. Now, all eyes are on the coming February data to judge whether we’ve been served a seasonal fluke, or whether a “pivot from the pivot” may be necessary

While government releases such as the US CPI are some of the important events for public markets, they also contain a fair degree of randomness given their often opaque and arcane survey methods. So any predictions are to be taken with much caution. Nevertheless, two current inflation trends are worth highlighting that suggest upside risk to the February CPI estimate

As always, this post closes with my current outlook on markets

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Let’s dive in and unpack the two inflation trends worth highlighting

First, on Services

As alluded to above, many commentators as well as some Fed governors wrote off the hot January CPI number as seasonal aberration in a broad disinflationary trend. Now, according to a 2019 paper by the Fed itself, there is indeed seasonality to be found at the start of the year

However, crucially, these findings attest the historically observed seasonality mostly to goods prices, which moves in a much more fickle way than services prices, which typically face much less volatile demand

• Looking at the details of the January CPI print, aside of Shelter which is discussed below, it turns out that the hot reading was mostly driven by services, which can be summarised in a “supercore” measure. Below chart by SuperMacro illustrates this well

This speaks to seasonality playing a lesser role than commonly presumed for the January CPI surprise. Further, it would be reasonable for services prices to continue their upward drift for a while longer, as their ebbs and flows are typically lethargic

• We will get some indication to the durability of this trend before the February CPI is released. The ISM Services survey issued on February 5th tracks service pricing, it showed a meaningful jump for January before

Summary: Services as measured in supercore inflation contributed substantially to the hot January CPI number. Given the lethargic nature of services pricing, it is reasonable to expect some of this to continue in the coming months

Second, on Shelter

The January CPI contained another big surprise in the measure of housing costs. The housing part of the inflation basket is split into rents as they have actually been paid, and “owner equivalent rents”. The latter is (simplified) a survey asking homeowners for how much they’d rent their own home1

• Usually both move in tandem, however, this time the owner-equivalent rents shot up, while actually paid rents stayed down. The chart below shows this historically unusual divergence

• Let’s take a step back and think about whether that makes sense. It is true that the totality of actual rents has been trending down, with little sign of pickup. This is because the vast majority of rents is from apartment buildings (“multi-family”), and there is an oversupply of those that started during Covid and still weighs as units are completed

• Here is the crucial part: Most Americans don’t live in apartment buildings, but they live in single-family homes. And most single-family home occupants own their home

Now, since the Fed has loosened financial conditions so drastically with its October ‘23 pivot, single family house prices shot up

• Why? Because single family is a structurally undersupplied market facing a growing demographic - you typically buy a home when you start a family, and in the current years many Millennials are reaching that age

• The decline in the 30-year yield which drives mortgages from 5% (Oct 31st) to 4% (Dec 31st) was enough to push prices higher in this very tight market

In other words, single-family house prices have gone up, with it the cost of living in a single-family home has gone up, so it would only be logical for that to be reflected accordingly in CPI data

Here is the interesting part- the Bureau of Labor Statistics who is responsible for the CPI data indeed recently implemented changes to the “owner-equivalent rent” survey to adjust better for the fact that the cost of living in a single-family home is much more important than apartment-building rents (see in Jan ‘23 here and again last month here)

• Rick Palacios from John Burns Real Estate Research comments accordingly on the January CPI surprise:

• Further, we can see the very different dynamics for single-family and multi-family rents in the chart below. It appears that the CPI methodology has simply been brought in line with reality

Summary: Most Americans live in single-family homes and own them. Accordingly, the CPI index should and now increasingly does reflect the cost of living in single-family homes, which are on a different trajectory than the oversupplied apartment market. While the shelter component of the CPI is highly opaque and complex, it appears reasonable to expect more upside pressure from it as long as the single-family housing market remains tight

Conclusion:

• While US CPI releases like most government data come with a fair degree of randomness, clear upside risks exist to the coming February inflation data

• These likely originate from services, where higher price resets may persist for some time, and shelter, where the methodology has been brought more in line with the reality of single-family homes dominating housing cost

• A “hot” February inflation print would likely force the Fed to “pivot from its pivot” and give up its dovish stance, as the risks of inflation acceleration then likely far outweigh any current risks to the labor market or economic growth

This in particular in light of a US economy that continues to grow at a brisk pace into Q1 ‘24, with the latest GDP nowcast estimates around 3.3% real GDP, or ~6-7% nominal growth (!)

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What does this mean for markets?

The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

This is my current stance across short-term and long-term allocations:

Short-term book (Active Trading, Long & Short, Changes Frequently):

I have expressed the view of an accelerating global economy, lead by the US, with the addition of an Oil long as well as two containership longs (Maersk and ZIM), which have given up most of the upside move due to Red Sea disruptions, while these continue to exist. I have also added some Tech Insurer exposure (see this great write-up by Value Investigator), though have to caution that this has run a lot already since. The Google/Semis pair trade went down like a lead-balloon after Gemini’s prowess was overshadowed with woke-filtered responses, so I’ve exited that quickly. I continue to like Natural Gas a lot, which shares many technical commonalities with China in late January. Finally, I’ve re-added the small cap short as well as the Large Banks/Regional Banks pair trade as I would expect interest rates to continue to drift higher. I still see equity market weakness into Q2, so I still keep the S&P 500 puts. Please keep in mind that this is a high turnover book and it may already be different by the time you read this - always do your own DD

In summary:

• Long Maersk/Zim

• Long Tech Insurer

• Long Natural Gas

• Long Crude Oil & Long Transocean

• Short US Small Caps

• Long US Large Banks vs Short US Regional Banks

• S&P 500 puts May expiry

PS: I haven’t all given up on Google yet, whose Gemini 1.5 Pro runs at ~10% of the cost of OpenAI’s GPT-4 turbo and has shown great results outside the troublesome woke-related responses which are not very relevant in corporate AI use such as Klarna’s customer service chatbot. So I will continue to follow the situation closely

Long-term book (Asset Allocation for Medium & Long Term):

This book has been started on the 1st February and since performed in line with the S&P 500 at much lower volatility, as the equity components outperformed that index and some good profits could be taken on the AI 2nd-leg basket. However, the main goal of this book is to avoid meaningful drawdowns, which is why the vast majority remains in T-Bills for now as I see little value in bonds or US equities currently. This hopefully changes over the coming quarter, at least for equities. I am patiently waiting. Finally, I have started to do the work on some private credit strategies and on a preliminary look see some market inefficiencies of interest (=excess returns due to capital demand/supply mismatch). A write up on this strategy is in the pipeline for the month ahead

• 86% T-Bills

• 14% Equities (5% DAX, 5% XLE, 4% China Equities)

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

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DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity and do not reflect the views of White Square Capital LLP and/or Sophia Group LLP. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security, including an interest in any private fund or account or any other private fund or account advised by White Square Capital LLP, Sophia Group LLP or any of its affiliates. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, we do not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

Moving on to markets and the economy, in recent posts I suggested three views that at the time were unpopular and out-of-consensus, but now increasingly seem to be embraced by markets

First, in “Is the Honey Moon Over?” I put forward that inflation would likely return soon, as the tremendous easing of financial conditions by the Fed accelerates the US economy into the Spring, with a particular risk that January inflation would be “hot”

• This has been confirmed, both the January CPI and PPI print were much hotter than expected, and are bound to push the Fed’s favorite inflation metric Core PCE back to uncomfortable highs, as shown in Nomura’s chart below, with “Supercore” in particular concerning

Second, in “Hawks and Supply” I opined that the substantial step up in US Treasury coupon issuance within the Treasury’s January 31st Quarterly Refunding Announcement would weigh on long-term rates, and I had sold the Treasury bond component of my long-term book in accordance. While most commentators described the QRA as “Non-Event”, the 30-year yield moved up 25bps since, pretty much in a straight line

Finally, in “Labor Day” following the release of the latest Non-Farm Payroll data I expressed the view that equity markets would likely top either in the last week of January or the first week of February. While tops are incredibly hard to predict as the tipping point of Fear-of-Missing-Out is not a rational process, it looks like the S&P 500 peaked on February 12th (i.e. I was a week early). I could obviously still be early or simply wrong with this view, but the market appears to be in distribution since

Either way, the stock market rally since the October lows has been tremendous, as generous US fiscal policy coupled with a dovish Fed provided fuel that seemed inexplicable by traditional economics. This has put the spotlight on a controversial economic theory that observers including former ECB-President Mario Draghi increasingly turn to for explanations - Modern Monetary Theory (“MMT”). On the fringes of economic science for the best part of the past two decades, its various axioms appear to better explain - at least to some degree - the mechanisms at work in “fiscal dominance” i.e. a state of the economy defined by exceptionally high government spending

Today’s post aims reviews some core tenets of MMT through a common sense lens, to hopefully discern what has merit from what may stand on a shakier foundation. As always, the post closes with my outlook on current markets

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MMT - What my common sense agrees with

1. Interest rate hikes increase inflation

• MMT view: If the Fed raises interest rates, it creates inflation rather than fighting it

• Common sense view:

  • The calculation is rather simple: If US government debt/GDP hovers at ~130%, an interest rate increase from 1% to 5% represents interest payments worth ~5%/GDP from the government to the private sector. This is a huge subsidy to private accounts, currently to the tune of $1 Trillion annualised (!)

  • Now, the bills and coupons, and indirectly cash bank and money market fund accounts that receive these interest payments are not evenly distributed. Large corporates and affluent citizens typically have a lot of cash and little debt, small businesses and lower-income groups have little cash and more debt

Summary: This tenet has merit. However, it may be somewhat oversimplifying as some economic actors are still certain to suffer from higher rates, while the interest rate recipients may end up saving most of their additional income rather than spending it. So rather than being straight-forward inflationary, rate hikes may divide the economy more deeply into winners and losers

2. US Treasury bills and coupons are financial wealth

• MMT view: US Treasury bills and coupons are cash like and/or create private sector financial wealth

• Common sense view:

  • A simple thought experiment. I have $100k cash in my bank account at, say 2% interest. Next, I use the $100k to buy the equivalent amount of T-Bills to get 5% interest. I perceive my account just as cash-like as before, as T-Bills have no risk of principle loss. But someone else now has my $100k cash, either the government, which will spend it into the economy, or another economic actor. So yes, in my view it is fair to regard T-Bills as cash-like, and the more of them are issued, the more liquidity for the economy and financial markets increases (in the example, I now have $100k T-Bills and someone else has my $100k cash, so the amount of cash-like means in the economy has grown)

  • This thought experiment changes if I use the $100k cash to buy 30-year Treasury coupons. Anyone who has ever traded these knows that they swing wildly in value even on small interest rate changes, due to their long duration. If I owned $100k of 30-year, I would not perceive them as cash. In fact, if inflation was high and I did not trust the government to end it, I’d look to get rid of it as quickly as possible. In my view, yes, long-term Treasury paper is financial wealth, but in inflationary times an undesirable one to own

Summary: Again, this tenet has merit. It is fair to perceive T-Bills as cash, and the more of them are issued, the more liquidity for the economy and markets. Long-duration paper on the other hand is not cash-like, it may be incremental financial wealth, but of a potentially toxic nature

3. In fiscal dominance, the Treasury is more important than the Fed

• MMT view: Focus on what the Treasury does, the Fed is either misunderstood (higher rates=more inflation) or powerless

• Common sense view:

  • Below chart is a great illustration why I think this view has merit. Bank loan growth is driven by the level of interest rates and has stalled recently. Yet the economy has grown at a brisk pace, as the federal deficit far eclipsed the slowdown in credit

  • Derived from this is a view that I have much sympathy with, that fiscal and bank flows in combination to some degree correlate with asset prices. In other words, forecasting the deficit and bank flows provides some indication as to the path ahead e.g. for the S&P 500, as these flows need to find a home

Summary: Fully agreed, in fiscal dominance the Treasury is the “new Fed”. For the current quarter, Janet Yellen has decided to issue a lot of coupons, while bill issuance will actually be negative. This will likely weigh on markets. But the levers are there to reverse this in the future. They will be used, eventually likely aggressively (= prioritise bills > coupons to stimulate markets, e.g. closer to the election)

MMT - What my common sense disagrees with

4. Interest rates should be at 0%

• MMT view: Interest rates should be set at zero. Instead, the economy should be kept from overheating by other means, e.g. taxes

• Common sense view:

  • This may (or may not) work in theory, practically I do not see merit in this assumption. If the Fed set rates to zero tomorrow, a speculative frenzy would ensue as everyone and their mother would take out loans to buy assets. Animal spirits work instantaneously, any efforts to reign them in take a long time (e.g. raising taxes)

Summary: This makes little sense to me. While I agree that further rate hikes at high government debt/GDP may be stimulative to parts of the economy, the more obvious tool to prevent overheating would likely be Quantitative Tightening, which the Fed has shied away from in a meaningful way so far

5. Taxes should be used to prevent the economy from overheating

• MMT view: Use government spending to stimulate the economy, and taxes to slow it

• Common sense view:

  • This may work well on paper, but in reality the US political system has evolved to a state where tax increases are impossible. If congressmen raise taxes on the poor, they lose their election. If they raise taxes on the rich, they lose their donations and with it their ability to hold the seat. This leaves “stealth taxes” as the only viable path - and guess what is the most obvious “stealth tax” of all? Inflation

  • It is needless to say that inflation disproportionally affects poor people, which may also explain why so many Americans are currently unhappy with the state of affairs, yet no one seems to be able to properly explain why

Summary: Raising taxes works in theory, but especially in the US has very low probability of working in practise

6. Fiscal Dominance means Equities will “Crash Up”

• MMT view: The financial wealth created by additional bills and coupons will lead to households indiscriminately piling into assets, sharply driving up their price (“crash up”)

• Common sense view:

  • I perceive the economy and markets as similar to closed biological systems ever-oscillating around a balanced state, with no free lunches around. As such, if the government pumps trillions of bills and coupons into the economy, I find it unlikely that the only side effect would be higher asset prices. Much more likely in my view would be that inflation goes up, and with it long-term interest rates. That drives up the discount rate for all assets, which would level out the positive financial wealth effect from the larger supply of bills and coupons

  • I would also note that the recent run up in US equities was largely driven by the Fed indicating to cut interest rates, while the economy remained strong and inflation low for an intermediary period (i.e. the discount rate declined). Further, looking at some Emerging Markets examples (eg Brazil post 2016), one notices rapid stock market gains as both the deficit and inflation decline, whereas the Brazilian market was very weak in the period before of both high inflation and deficits

  • However, one way to “hotwire” the balancing effect of higher long-term rate is to suppress 10-30 years yields via yield-curve-control or other means. This would indeed create the “crash-up” mechanic, but at the cost of even higher inflation, as the slowing effect higher long-term rates have on the economy would be neutered

  • More generally, any crash-up in asset prices not rooted in fundamental reasons such as fading inflation or higher productivity is extremely negative for society (see Argentina or Turkey) and a pretty undesirable outcome overall. It could still happen of course, the political temptation will certainly be there

Summary: A “crash up” in asset prices likely requires governmental control of long-term rates. It is a possibility, but for now the US Treasury and Fed have not taken that step, and there is no sign that they are close to doing so

Conclusion:

• MMT is a controversial economic theory, however it has contributed important view points that have merit. These included unexpected stimulative effects of rate hikes in fiscally dominant regimes, the relevance of bills and coupons as financial wealth or even cash, as well as the focus on the Treasury as dominant actor, with the Fed in a secondary role

• The common sense test appears to show weaknesses in the demand for 0% interest rates and taxation as means to slow overheating, which seem in conflict with practicality and animal spirits. Finally, the recent “crash up” of US equities seemed to be driven by the expectation of lower rates and inflation amidst a still booming economy, rather than an oversupply of government debt. More broadly, an inflationary “crash-up” of asset prices seems more plausible if/once the government surpresses long-term yields, which is not the case (yet!)

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What does this mean for markets?

The following section is for professional investors only. It reflects my own views in a strictly personal capacity and is shared with other likeminded investors for the exchange of views and informational purposes only. Please see the disclaimer at the bottom for more details and always note, I may be entirely wrong and/or may change my mind at any time. This is not investment advice, please do your own due diligence

This is my current stance across short-term and long-term allocations:

Short-term book (Active Trading, Long & Short, Changes Frequently):

I notice three dynamics with regards to current markets:

1. Teenagers are trading semiconductor stocks, just like in the ‘20/’21 SPAC frenzy or in fact the New Economy bubble (see WSJ article here “These Teenagers Know More About Investing Than You Do”)

2. As per prime broking data, hedge funds in the past week bought the most semiconductor exposure in over a year

3. Hedge fund exposure in Nvidia is described as a “10 out of 10” into earnings, with everyone certain of a dramatic beat (what if the outlook misses?)

With semiconductors having lead the rally year-to-date, this tells me that the boat is now more than full and plenty of room to disappoint panicked late-comers. At the same time, I notice the overwhelmingly positive feedback on Google’s OpenAI competitor Gemini, with the company perhaps prematurely written off as AI-loser. This lead me to set up the Long Google/Short Semis pair yesterday at the open. In addition, I still have the S&P puts looking for market weakness in the weeks ahead, as well as newly established GBP/USD short as the BOE seems ready to cut while the Fed drifts in the other direction. I’ve closed the small cap and regional bank relative trades as my sense is market weakness may originate from the very crowded momentum trade heavy on quality and tech, but still find them attractive and look to set them up again another time. I have also added a Natural Gas long, which shares the same bottom forming characteristics China showed earlier this year (I am still long China in the long term book)

In summary:

• Long Google/Short Semis

• S&P 500 puts

• Short GBP/USD

• Long Natural Gas (small- very volatile!)

Long-term book (Asset Allocation for Medium & Long Term):

I find US equities and bonds across the board expensive, so have sold the S&P 500 and AI 2nd Leg basket yesterday. While I continue to like European, Oil and Chinese equities, I am waiting for better opportunities to deploy capital into US equities (and bonds). These may arise in late Spring/early summer as presidential election years typically see a strong second half (for obvious reasons)

• 86% T-Bills

• 14% Equities (5% DAX, 5% XLE, 4% China Equities)

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

Subscribe now

DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity and do not reflect the views of White Square Capital LLP and/or Sophia Group LLP. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security, including an interest in any private fund or account or any other private fund or account advised by White Square Capital LLP, Sophia Group LLP or any of its affiliates. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, we do not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

Subsequent data further supports this view, which lead me to split today’s brief update into two parts: What the market sees right in front of it, and what it may focus on soon as a consequence

Let’s start with “Front of Mind”, what imminently lies ahead:

• The near-term inflation trend remains soft, and after a possible January bump due to annual contract resets Truflation’s live readings suggest further disinflation into February…

• …further, yesterday’s initial jobless claims data has put any imminent labor market worries further to rest the most recent slight increase was reversed…

• …at the same time, growth remains strong. The US economy exited 4Q ‘23 at a stellar 3.3% real GDP growth rate, which is set to continue for 1Q ‘24…

• …while many lead indicators suggest growth acceleration into the coming months, such as the ISM Manufacturing New Orders component…

• …and finally, wage growth appears to ease back into historical line

Summary: Very strong economic growth with odds of acceleration, accompanied by disinflation and moderating wage growth - one is hard pressed to come up with a more benign context

Moving on to “Back of Mind”, what could await past the near-term

• The key question is, as the economy re-accelerates out of a high-growth context, will inflationary pressures resurface? Several forward-looking measures suggest the risk is real, such as the ISM Services Prices Paid…

• …or the pick-up in Gasoline prices year-to-date. It is absolutely still small in the bigger picture, but the direction of travel notable and consistent with a pick-up in growth

• 1-year forward inflation expectations can be seen as the aggregate of these various other inflation leads. They have made a new high, as this subset of capital markets now expects inflation to hover at close to 3% for the coming year, much higher than just a few months ago

Summary: Looking past the near-term narrative, the outlines of an inflation rebound are increasingly visible

Where does that leave us?

Rather than a detailed walk through various assets, today I want to single out what I perceive as the obvious mismatch in light of the above:

• Historically, the 10-year yield has tracked nominal GDP closely, as this great chart by @supermacro illustrates well

• The reason is simple- if rates (and with it the rest of the curve) are set considerably below nominal growth, then a credit boom would ensue that quickly leads to instability and overheating (= borrow as much as you can at 4% yield to invest in 6% growth)

• The 2010s were the exemption, as the Fed surpressed long-end yields via QE to stimulate sluggish growth suffering from the legacy of the ‘08/’09 credit meltdown

Keeping it simple, right now, the 10-year yield is at 4.1%, while US Nominal GDP runs at 6%, with upside risk in the near-term. Does that make sense?

• To me, it doesn’t. It tells me that any rallies in the long-end of the US bond curve (eg due to inflation revisions today or a lower than expected January CPI) should be sold, until we see data that suggests growth is slowing down

• As I said in my last post, higher yields are not a headwind per-se for many equities if they march higher due to growth. But they will likely continue to be a serious headwind for vulnerable areas such as CRE or Regional Banks

Thank you for reading my work, it makes my day. It is free, so if you find it useful, please share it!

Subscribe now

DISCLAIMER:

The information contained in the material on this website article is for professional investors only and for educational purposes only. It reflects only the views of its author (Florian Kronawitter) in a strictly personal capacity and do not reflect the views of White Square Capital LLP and/or Sophia Group LLP. This website article is only for information purposes, and it is not intended to be, nor should it be construed or used as, investment, tax or legal advice, any recommendation or opinion regarding the appropriateness or suitability of any investment or strategy, or an offer to sell, or a solicitation of an offer to buy, an interest in any security, including an interest in any private fund or account or any other private fund or account advised by White Square Capital LLP, Sophia Group LLP or any of its affiliates. Nothing on this website article should be taken as a recommendation or endorsement of a particular investment, adviser or other service or product or to any material submitted by third parties or linked to from this website. Nor should anything on this website article be taken as an invitation or inducement to engage in investment activities. In addition, we do not offer any advice regarding the nature, potential value or suitability of any particular investment, security or investment strategy and the information provided is not tailored to any individual requirements.
The content of this website article does not constitute investment advice and you should not rely on any material on this website article to make (or refrain from making) any decision or take (or refrain from taking) any action.
The investments and services mentioned on this article website may not be suitable for you. If advice is required you should contact your own Independent Financial Adviser.
The information in this article website is intended to inform and educate readers and the wider community. No representation is made that any of the views and opinions expressed by the author will be achieved, in whole or in part. This information is as of the date indicated, is not complete and is subject to change. Certain information has been provided by and/or is based on third party sources and, although believed to be reliable, has not been independently verified. The author is not responsible for errors or omissions from these sources. No representation is made with respect to the accuracy, completeness or timeliness of information and the author assumes no obligation to update or otherwise revise such information. At the time of writing, the author, or a family member of the author, may hold a significant long or short financial interest in any of securities, issuers and/or sectors discussed. This should not be taken as a recommendation by the author to invest (or refrain from investing) in any securities, issuers and/or sectors, and the author may trade in and out of this position without notice.

While Friday’s strong Non-Farm Payroll release still contained some hairy details, it appears to have decided this tug-of-war in favor of growth for now. Even if some may debate this conclusion, more importantly, market consensus will likely read it that way for some time

The implications span across asset classes, with US rates and the US Dollar at the center. A possibly cracking labor market was the biggest obstacle to a continuation of the torrid rate of US nominal GDP growth. Remove it, and the market's assumption of a substantial growth slowdown as well as the corresponding 150bps cuts priced for ‘24 as recently as this past Wednesday seem very offsides. The resulting 3.8% Fed Funds rate would be nonsensical in light of current NGDP growth of 6%, no matter the level of inflation

A higher growth context is certainly positive for many equities, in particular those with a dominant market position, scale and secular tailwinds. It also likely represents a phenomenal challenge to the weakest links of the market, such as Commercial Real Estate, Regional Banks or Unprofitable Tech, which have recovered substantially since the October lows, yet maturity walls are now closer than during last year’s yield tantrum

As always, today’s post concludes with my current outlook on markets, where I explain why I see long US Industrials, short REITs as possibly favorable expression of said dynamics

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Let’s look at the details of Friday’s crucial labor market release. As always, the data had something for everyone

• If we apply Occam’s razor and look for the simplest explanation, it tells us that the labor market is strong - the headline figure printed 300k new jobs, wage growth accelerated to 0.6% month-on-month, and the medium-term trend appears to have turned up

• Under the hood, details were more nuanced, one could construct a more negative case out of them. In particular average hours worked plunged…

• ..which was likely weather related, but it probably inflated reported wage growth (which is calculated by earnings/hours worked). Further, full time employment as measured in the household survey declined, indicating an ever growing share of the gig economy, which may also explain the deterioration in some of the US Treasury data (e.g. paid out Benefits)

I am inclined to give the glass-half-full explanation the benefit of the doubt, to focus on the strong headline number, for the following reasons:

• First, a recent important detail of the Conference Board survey showed consumers saw a significant improvement in their perception of the state of the labor market (I highlighted this as employment “greenshoots” in my last post)

• Second, the high wage growth number may not be entirely due to weather, as it had been forecast by the December NFIB small business survey, which indicated higher compensation ahead

Assuming the labor market is in decent shape, little appears to stand in the way of economic reacceleration. In fact, we see more evidence of it in the data:

• The ISM Manufacturing survey came in strong for January and remains on track to cross into expansionary territory soon (= above 50)

• South Korean semiconductor exports historically lead global industrial production and are looking good (some of this is obviously AI related, but that’s also productive activity)

• Finally, freight data has picked up considerably, historically a strong lead indicator for further industrial growth, and there are now signs of life in loan demand

Conclusion:

• Friday’s NFP data likely has put labor market worries to bed. Whether warranted or not, the market will likely see it that way until proven otherwise

• This provides the all-clear for the market narrative to pivot from slowdown worries to growth acceleration, with profound implications across asset classes

Looking further ahead, this implies two possible outcomes for the US economy:

• Bull case: Growth re-accelerates, but inflation does not, e.g. because immigration keeps a lid on wage growth, or oil never rallies due to enough supply. This is the halcyon case one can dream of - I don’t rule it out at all

• Bear case: Growth re-accelerates and inflation follows. This seems the more likely case given historical precedent, but it is far from certain