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The Four Pillars of Macro - And What They Say About This Market | Andy Constan
01:07:47
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- [00:00]
A
I've never seen conditions that could go either way in a digital fashion. More than ever, it's very easy to picture a world in which bond yields go to 4%, you know, three and a half percent and then 6 and equities go to 7, 7,500 and then 5,000. I think AI is very much like that. It could show all the promises that we hope for. But for now we have a large CapEx, we have 500 billion, maybe it's a trillion over the next two years of additional CapEx with no revenue. And so the question becomes how do you generate a trillion dollars of revenue? So you don't need an independent Fed at all. In fact, you never have one except occasionally. And when you have one, when it's that occasion, you really need an independent Fed.
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B
Hi Andy, welcome back to Excess Returns.
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A
Well, thanks for having me guys.
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B
Today we wanted to work through a number of things with you. I think first we'll kind of step into the way that you kind of approach your macro investment philosophy and how you build strategies. We want to talk through your four pillar framework approach which takes into consideration growth, inflation, risk, prema and flows and try to discern what that's maybe telling us about the markets today. And then I think towards the end we want to get through some specific macro related topics. Growth, inflation, the Fed, labor market and all the stuff that I know you're sort of paying attention to day in, day out. So our audience may be familiar with you. But for those that aren't and want to learn more about Andy's ongoing research and how, how he's advising his clients, they can go to your website, damp spring damped spring.com and we'll put a link to that in the show notes so that people can check out what you're doing there. So that's cool. So great. Andy, good to have you back. Let's dive in. You ready to go?
- [02:05]
A
Sure.
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B
Okay, where I want to start with you because I think this is really interesting. You sort of have this in your career. You've spent time at Bridgewater and they deployed more of a systematic approach to macro investing. But then you also were at Braven Howard where I believe it was more of a discretionary sort of, you know, approach and I thought it would be good because you kind of have these two experiences like thinking about the intersection of these two different philosophies, how you actually incorporate that now in what you do. And also like if you could just talk through because I think this is important, maybe the strengths and weaknesses of each as we kind of try to understand this.
- [02:49]
A
Sure. I think that's a great topic. So I think we just have to rewind a little bit to so early on in my career what I sort of was thinking about and is it's always come down to how do you decide to make a trade based on what framework? And how do you test to see if you're any good at it? How do you back test whether your ideas are any good? How do you even judge whether a trade is any good? Like you have to start with some assumption that you made a correct decision. Right. Like there's the outcome of a decision, which is one thing, and then there's the choice. And so if I have a, if I'm a, a gambler who is, you know, trying to find the horse that's going to win the race, I want to know the odds and I want to have an edge in determining whether the odds are a good bet or not. And so just from that framework alone, you know, most of the time you, if you are a profitable horse racing handicapper, you make money, but you don't know whether your decision making process is any good or you've just been lucky. So, you know, one of the big things that I try to focus on for my entire career is trying to distinguish whether my decision making is good or not. And if my decision making is good, conceptually I should make money. But there are periods of time when I may not make money at all. In fact, I may lose money because while my decision was good and while the odds are where in my favor, luck didn't work in my favor. And other times I may be doing great and my decision making process has been horrible. I just got lucky. And so just before we even get into what that is, that's the most important thing you do, which is try to understand how you make decisions. Are they good decisions? And then make sure that you can distinguish between luck and decision making. And so, okay, so now you have that and you say, okay, well, how do you go about doing that? When I started in my career, there was a guy at Morgan Stanley who became quite famous trading the seven spin offs from the telephone company, from AT&T. They had broken up AT&T into a long distance company. And seven exactly the same, but regionally based telephone companies, they all had the same business, they all had the same infrastructure, they all had the same parent, they were all the same. And yet the stock prices would change. And so there was this famous guy at Morgan Stanley who would say, okay, when One stock diverges from the other. I'll buy the one that's written, that's rallied and sell the one that's cheap and I will collect money. And that was, you know, one of the sort of basic stock picking systems that most people become aware of. And it had one data point and that data point was which one's higher had it just depended on mean reversion. Now since then, sort of in the mid-90s, I got very, very involved in, in systematic high frequency trading. It was early 90s. And one of the guys on my team, it had invented a model which he back tested, showed that it worked. And then we implemented that had six or seven sort of fundamental factors that would say how does the world work? So one of them was he wants to buy stocks in general when the S and P is trading at a, the futures are trading at a premium to fair value. That's a pretty sensible idea. And then he had another idea that when this is a world in which people would, you know, sort of buy a stock and then the next thing that would happen or because some analysts said, hey, this stock is cheap. And a portfolio manager at Fidelity would get that call and then buy that stock. And then he would walk down the hallway and tell his buddy who would also buy that stock and the other guy would, and the next guy would buy that stock. And by the end of the hallway, you know, everyone had b bought the stock and the stock had run up. And so the next guy was like, I can't buy it, I'm going to buy them the stock that's just like it. So in the, you know, say if it's an auto company, the first idea was to buy Ford. By the time you got down the hallway, the trade was to buy gm. And so you said, okay, well that's an idea. Can I model that and see that in practice in a high frequency way. And so we had an indicator like that and so we added all these points up to try to get a picture and to say, okay, well is there a trade? And those are all the way you talk about systematic trading. And so now I'm going to just jump to Bridgewater. Bridgewater has so ever since it's always been about adding pixels to the pitch, the picture. The guy at Morgan Stanley blew up in his strategy because he didn't realize that stocks rallying the baby bell that was rallying was eating the lunch of the baby bell that was falling or that the baby bell that was rallying was going to be acquired by the baby bell that was falling. And so there was lots of other things going around other than mean reversion. And people realize you needed more picture, you need more pixelization. So, Bridgewater, you've got this attempt. And so what are we trying to get at? We're trying to get at this picture that when we have a true. And think about analog. Now, if you had a true analog picture of what the world was like at this very moment, and you could compare it to every other picture that looked exactly like that in a truly analog way, not in a digital comparison, but in a truly analog way, and determine that's the same picture, that would help you to know what could come next. And so at Bridgewater, what they're trying to do, and what many others that I've seen do, systematic trading before them and when I was with them, is maximize the number of pixels so you can make sure that your digital picture, because data is not analog. Data is just little pixels. And so when you are trying to create an analog picture with lots of pixels, good to have lots of pixels, but they are pixels. And so he would, Bridgewater, would try to have the most analog picture that they could possibly have. So that they could. And also it was nice that it was a pixelated picture, because that allowed you to look back and compare it to other pictures. So that's the objective. Try to get an analog picture. Now, discretionary traders, they're doing the same thing. They're trying to say, what's the world look like? How does it compare to the prior worlds? Does do things rhyme generally? And then take a decision based on whether the pictures are the same. And great, great discretionary traders could not possibly tell you what pixels are happening in their brain to come up with the picture they see analog. And they say, this is just like that. And they have great memories. They can see the analog through time. They understand when the pictures are exactly the same. They have no time. They couldn't explain the digital, the dots, the pixels. And so there's always room for that, because a pixelated picture is never going to be analog. And there's going to be some great brain that's capable of understanding an analog picture better than any other system. And so that's the struggle. And I think that's what it comes down to, that both the discretionary trader and the systematic trader are trying to accomplish the same goal, which is have a very clear, precise picture of what's happening in the world and then to compare it to past worlds and see what's next. And so it's just two different approaches to the exact same problem. And so I guess that's the way I describe it. Brevin Alan Howard. We saw Paul Tudor Jones talk about what he sees as the current picture on CNBC yesterday. These guys are masters at understanding the analogy. And they have occasional things that they use, data that they use that helps them along with their analog. Paul Tudor Jones loves charts. Loves analog charts. Alan liked very different things as it relates to that. And each just great discretionary trader has their own set of things they look at to try to help them understand the analog. But it's very, very different than a systematic trader. And so, but they're doing the same thing. So what I think is that they're the same. And so now the question is, which approach you coming from? And for me, I'd like to come at the approach. I would like to use both approaches because the pixelated picture, if you have good analog, you can tell none of that picture is not the same as the one that happened that you think is the same. And so you lower the confidence of the systematic trader with a discretionary over overlay. But also discretionary traders have. Are humans and they have emotion. And so you want to root out some of the potential to see a picture like you want to see it, not like it is. So anyway, that's my philosophy on that.
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B
Yeah, no, that's. That's great. Thank you. And I think it kind of plays into the sort of. Next question. Here is like, you've talked about and shared your four pillar framework to macro investing, which is growth, inflation and expectations, risk, prima. And then flows, fund flows, or maybe capital flows.
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A
You can. All right, so.
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B
So I was wondering if could you just sort of explain that framework and then we'll work through each of these sort of items individually to kind of talk about what's happening now and maybe why they're important.
- [14:13]
A
Sure. I mean, I think they've all become flat. One thing that's clear to me, before I joined Bridgewater, everyone I knew, everyone I invested with, everyone I thought about investing, recognized certain characteristics that when economies are strong, that generally is good for earnings, which generally means people favor equities. And when the economy is strong, you want to invest in a. You don't want to be a debtor who's got no upside to the. Sorry, a lender who's got no upside to the economy. You want to be a equity holder who has upside to the economy. And so in growing economies, you don't want bonds and you do want equities. And inflation was also very simple. If you're getting a fixed income and the value of money of your purchasing power is going down, you want something to protect your purchasing power and fixed income is not going to do that. So in inflation you are going to see bonds go down and then you have equities as it relates to inflation. And people understood equities, they were like, well, equities are pretty good because the top line grows with inflation, but can be different if the bottom line, if wages are where the inflation is not where, not at, not consumer prices, meaning they have increasing wage pressure and they can't pass those wages onto in sales, in top line, they're going to have a margin hit. And that's bad for equity. So it depends on how inflation is hitting everything. And also generally when there's inflation, central banks tend to tighten monetary policy, which tends to slow economies, which hurts equities.
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C
And.
- [16:15]
A
Higher bond yields hurt equities because there's a discount factor for forward earnings. So those were two, pretty much everyone agreed that's how the market works. That's how the macro influences various asset classes. And that became, you know, that's like table stakes for decades now is understanding that. And so that's, as I said, table stakes. Everyone has to have a good sense of what the economy is doing, growth and inflation. The next bit is risk premium. And that is, that's an interesting topic, one I spent a lot of time on in my, and I think is still where alpha can be found. If, if alpha can be found at all, I think it can be found in understanding how risk premiums work. And that has a lot to do with how much money is being created that wants to buy assets and how many assets are going to be created to satisfy that demand. And it also has the term risk which says if investors believe that owning assets is going to be very low risk, they're in the, in in the future they're going to want to lever up because they're going to want to get, they have very low risk, they can take more leverage. And so understanding forward looking volatility or risk also has a big impact. And risk premiums work across the board because ignoring growth and inflation and how those things are act differently on, on assets, if risk is coming down and there's more money chasing assets than there are assets, all assets are going to appreciate as one. Now of course all the other things are happening at the same time. So if it's a bad environment for bonds, bonds may not depreciate as much and equities might appreciate more if risk premiums are contracting. But the overall pressure is for assets to rally when there's more money chasing assets and when there's lower risk of holding assets. And so the reason why I think there's been alpha and continues to be alpha in risk premium analysis is because policymakers have become extremely activist as it relates to managing risk premiums. QE, which is now, you know, started in 2008 in the United States, happened in Japan, prior to that was very stimulative for asset prices. Its job was literally to reduce risk premium and bid up assets. And QT does the opposite. And then you get into some really nitty gritty, which I won't deal with. But issuers, the fiscal side all affect that. So it's been a area where that's been basically where I've generated most of my alpha over the last five or so years is being able to track those major policymaker impacts on financial assets. And I guess the last thing is positioning. And that can be trend positioning. Like for instance, every day each of us earn a little money in our bank account from our job and we contribute some of that money to our savings. And our savings are used to buy financial assets or stay in cash or whatever it might be. And so that's a trend pressure that you need to be aware of. Now it fluctuates as our ability to earn money in our jobs fluctuates, but it fluctuates. It also fluctuates based on our willingness to lever up, which comes back to risk premium. But that's a pressure. Another pressure is issuance, like corporations that want your cash, governments that want your cash, and so those tend to depress asset prices. And so I want to check every flow. Now there are flows that are very fast moving, like somebody wants to. This is very popular. Now a central bank wants to buy a lot of gold to get out of its Ukraine risk in terms of its exposure to US assets that get seized. That can have a very immediate and in some cases fairly long lasting price distortion that occurs in a particular asset. So I track those and then, you know, I'm not really much for tracking very, very, very short term flows. But the essential goal of tracking flows is what I want to know is I want to know before a very large order that's going to impact price enters the market. Why do I want to know it? Because I want to buy before they do. And I also want to know when that order is going to get finished, because that's when I want to sell to them. And any one of us who's ever been a market maker, worked on the sell side, knows exactly what I'm talking about. You want to know when Fidelity's coming in to buy a stock and has a million shares to buy and it's going to take a week to buy it. You want to be the one that knows the moment before they enter the order. And you want to be them know the moment they finish because there's just massive money to be made on that. And so that's flow analysis. The problem is no one tells you what they are going to do. And so figuring that out is what that pillar is about.
- [22:34]
C
So we're going to dig into each one of those and apply them to the current market. And I want to start with Brokes. To me, as someone outside of the macroeconomic space, you know, growth doesn't seem great right now. It seems kind of just okay. And you've talked a lot about how some of these policies that are being implemented by the current administration are going to be anti growth. So can you just talk a little bit about what you're seeing with growth right now?
- [22:53]
A
Yeah. So I think what you have to look at and say is growth was really terrible negative in the first quarter. You know, it printed negative 0.4% GDP growth and man, it was hot. I think we ended up 3.8% for the second quarter. And we're running at about that in terms of the estimates for the third quarter with not much more data left to be delivered. So growth is measured. Growth is very strong after being very, very weak. And we can talk about that why. But let's just say what it is, that's what it is. Other measures of economic health are less strong. For instance, employment isn't strong and people expect it to get weaker. We've had some pretty major revisions which take us to how strong growth was, how strong jobs were all the last year, and also most more recently, data has been sort of soft. And so, you know, we're not growing our employment much. And then you look at inflation and you say, gosh, you know, inflation looked like it was going to before tariffs. Inflation was going in absolutely the right direction and looked like it was going to reach target before the election. And then it hasn't. And I think it has to be because of tariffs. But there are other things going on that could be inflationary, easy money, a recovery in the equity markets, all those things. But by and large, inflation is running above target at close to 3% now. And so that's what is. And so my first question is well is that right and why. So I start with policymakers and January of this year I came in very bearish because two things were happening. The Fed had cut rates in September and again right as the election happened and then again in December. And yet long term bond yields had gone up a lot and even two year bond yields had gone up a lot which I considered a meaningful tightening of financial conditions. And every Trump policy that was likely to happen in the short term was anti growth. We were reducing population through immigration restrictions, which is fewer people making stuff means lower growth. We were and by the way more inflation because we have fewer people to meet the demand tariffs which are clearly a tax paid by someone and some of that someone is going to be United States people. And so that's a tax and that's negative growth and is inflationary to the extent that it gets a one time price increase. But isn't is is negative growth. Doge, which you know the, the headline said $2 trillion in a year of, of reduced spending, you know that I, I never thought that would be the number, but my number was 100 to 200 billion of reduced spending and a very strong anti budget deficit, sorry, budget deficit hawk position away from Doge. All those things are pretty bad for growth. So I was really bearish and that worked out extremely well, but was catalyzed by the Tariff Liberation Day. Since then Doge didn't amount to anything. The immigration restrictions have happened in the past and so that impulse to significantly reduce population growth has happened and now it's stabilized, which means it's not a negative impulse, it's still a drag, but it's not a sharp negative impulse. So that's improving. And every other Trump policy has been backed away from, implemented late, backed away from or for that matter stimulus created through the do the one beautiful bill vote. And so that's caused growth to recover. But when I look at growth, I don't get the same picture that this is a robust economy. I get a picture that there is significant rebound buying that has occurred, but also significant capex which is only 20 to 20% of 5% of the economy. Most of the economy is consumption. But the consumption, the capex has been massive and in one direction toward building AI capabilities. So what I would say is that like a lot of people feel we are in a K economy where the, where the 10 top 10%, top 1%, top 50%, you pick it, are doing better than everyone else. I think we're in a Growth K economy where those who are consuming that, where consumption on AI and capital investment on AI is why growth is so strong and the rest of the growth is just not that good. In some cases pretty bad. Which tells me the labor situation, which does not in any way benefit from AI. Let's be clear, AI is about getting rid of employees. So the AI spend and consumption is not good for labor. Now it's also not really so bad for labor yet because no one's really done anything about anything, but it isn't in the right direction. And so I look at that and say, well, okay, so now we have this AI boom that's generating growth. How far can it go? And we don't know. We don't know what the future of AI is. Nobody knows what the, you know, we know LLMs, we know what they're doing. We know some companies that are levering them like Palantir, et cetera. We know what's happening to data center with the need for compute, but we don't know who's going to pay for all this, meaning who's, who's going to actually consume the services and what are they going to be like, you know, we all use Amazon every single day. But. And it seemed back in the, early in the late 90s when that company came around, that most people I knew and most people saw themselves as, yeah, I'm going to use Amazon in the future. It still went up 90% and came back and still fell 90% during a period of overcapacity that then came back. And so I think AI is very much like that. It could show all the promises that we hope for, but for now we have a large CapEx, we have 500 billion, maybe it's a trillion over the next two years of additional CapEx with no revenue. And so the question becomes, how do you generate a trillion dollars of revenue? The first thing I look at is GDP. So a trillion dollars of new revenue is 3.5% of GDP. So you could grow GDP. You could assume all the GDP growth goes to these, to AI spend and we can grow GDP 3.3% more than we otherwise could. So we could have, I don't know, a 6.5% GDP growth that would pay for this new revenue. Or you could have a share change in which the billion, the trillion dollars still goes to AI consumption. But it comes from something. It comes from food, it comes from shelter, it comes from anything that represents the rest of the gdp. Government spending, all these things could fund it. But I don't see the pie growing at 3 1/2% higher than what is expected now. Nor do I see enough room for the share to grow so that these, these investments are going to have any sort of near term payoff. And if they do have a near term payoff and if they do raise those revenues, chances are it's coming from the rest of the economy and that means that K shape is going to get even worse. So that's how I look at the world right now and which is very optimistic about the potential for long term, potential for AI as an impact on the economy and short term. Really wonder how it's all going to get paid for.
- [32:47]
C
I want to go back to terrorists quickly because that's something I struggle with because obviously the market's sort of taking this view and a lot of people are taking this view that maybe tariffs aren't as bad as we thought. I mean rates are a lot lower than we thought they were going to be. And it's a services based economy. We're only talking about imported goods, not total goods that are affected by this. So you could make the argument this isn't that big of a deal or you could make the argument that it's going to be a bigger deal than the market thinks. We just haven't, we haven't felt the lagging effects of it yet. I'm wondering, how do you think about that?
- [33:15]
A
Well, you know, I look at equity earnings expectations which are fairly strong. You know, we've the S and P is up what, 14%, 8% of it has just been earnings growth and the other 6% has been multiple expansion. I don't see any reason why the earnings growth has to roll over. I do think these, these taxes are a, a drag on, on consumption. But at the same time wealth is a lifts consumption, the deficit spending lifts consumption. There's a lot of other things that are offsetting some of the tariff, the negative tariffs. And also to be clear, once the tariffs, let's assume the tariffs do settle and they now are sort of relatively constant. The impulse is gone. So you don't have a negative growth impulse. So the question, and so for that reason you can say 2026 may actually be okay from a change basis. I still think we have a problem with population that has. We are going to need people to grow the economy and I don't think we're going to get them. But there's a pretty optimistic case for ongoing GDP growth. So I guess what I'd say is it's hard to know right now which Way the economy's going, there are a lot of pressures on it. A lot of the very bearish pressures in October, sorry, in January, that I felt are largely gone. Certainly financial conditions with wealth effect is now much stronger than it was back then. Bond yields are lower, stock prices are higher, asset prices in general are higher. The negative immigration and tariff things are going to be in the rearview mirror soon. The OBB actually gets more stimulative in 2026. The deficit grows in 2026 before it starts falling in 2027. So there's a lot of positive pressures. The question of course is what's priced. And so that's a complicated thing. Right now. What I would say is that the economy appears stronger than that. So let's start with rates. The economy appears stronger than it had been, certainly than nine months ago. And yet there's an expectation that interest rates are going to be cut 100 basis points to a 3% trough level. Why are there expectations of that? One is this K shaped economy that people have expectations that growth is going to come in, that inflation is transitory and that we're going to head toward a soft landing. And rates at 3% make sense. That's one way of looking at it. The other way of looking at it is that Trump's going to cut rates no matter what because he wants to stimulate, he wants to win the 2026 midterms. Whatever, whatever your reason, he's just, he's told us he wants rates lower and he's going to have his own Fed chairman to do that. And so not surprisingly, the markets are saying, well, maybe rates are going to be lower, but if they're lower and they don't need to be, that's when you get some imbalances that can be very bullish stocks, very bullish gold, very bullish crypto and very bearish long end bonds. But it's at, at the moment, all that's really happening is gold is up 56% this year. Crypto's up. Is it up anywhere close to 56%? Not even close. Equities are doing well. Bonds on the other hand, aren't really doing that badly. And so this run it hot economy, if you believe the run it hot narrative, you got to hate bonds here, like really hate them at 4, 10 on the 10 year note. But even with Trump cutting rates, and even actually because he's cutting rates, you may want to be very short bonds. Equities are confident that we're going to either soft land or ease more than expected. And Gold man. I have to say that after another day of, you know, all time highs, a 56% move, gold is fairly confident that the central banks are going to be way too easy versus conditions. So there's a lot of cross currents in terms of what's priced. Which makes Macro fun right now because you don't have to. The thing about macro is you don't have to bet on one thing. You don't have to bet on stocks going up or down. You may think they're going down, but you have another trade to do that says, well, if they go up, how am I going to make money? And you can make money in other things if stocks go up. So right now it's a very interesting period of time in terms of when you look across broad ranges of assets to construct a portfolio for the next three to six months.
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C
That's an interesting point. That's something we were just talking with Julie and Brigden about yesterday, which is this idea about it's how important it is to think in probabilities. You know, everybody has their, their view on are we going to get a recession, are we going to inflation, are we going to soft landing? But it's probably better if you're putting together like a macro framework to understand there's probably probabilities on all three of those and thinking about what might work based on how I think those probabilities play out.
- [39:22]
A
Right. I mean, it's just, no, you just don't have a lot of edge betting on one thing. You might as well have a number of bets that as a group are unlikely to all go against you and are more likely to net make money. And that's how all the macro I've ever seen tries to make money.
- [39:46]
C
You mentioned Fed independence and that's something I wanted to ask you about because I kind of have two feelings on this. One is I think all of us want the Fed to be independent and we don't like the attacks on the Fed independence. But then when I think about it from a practical standpoint, I think about like the number of Fed governors that would have to be replaced for like Trump to completely take over the Fed. It seems like it's a pretty big lift for him to actually accomplish it and it was good. And I know you, you had some comments on Steve mirren, like putting 50 basis points in, you know, every meeting going forward, but nobody went along with him at the last meeting. Everybody kind of stayed independent and did their own thing. So how do you think about the, how that might actually play out like in a practical world, if that actually will influence policy.
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A
So I guess the first thing I would say is I wrote a sub stack which is on my substack account on dampspring.com substack whatever. I don't even know what it's labels anyway.
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C
Damspring.substack.com yeah, I don't use it very.
- [40:37]
A
Often, but when I do, I post some interesting stuff and it's free. I put a chart together since 1971 of all policymaker, fiscal and monetary policymaker actions and characterize them on four basic criteria. Crisis response, which by the way, almost all action was crisis response. Overheating, which is pretty rare for them, for overheating policy. Because we'll come back to how this relates to independence in a second political. And really there's very little cases for that and one in which the political organization has changed, like recently where we have a united government. And when you have a united government, very often in the first year of that government, significant changes are made. And I then tracked about how those all played out. And the one thing I think is clear, so, and this, how does this relate to Fed independence? So you don't need an independent Fed at all. In fact, you never have one except occasionally. And when you have one, when you, when it's that occasion, you really need an independent Fed. So, and what I mean to say about that is if there's a crisis, the Fed's going to be perfectly aligned with the fiscal side. They always are, they always have been, they always will be. Perfectly aligned. That's not independence, that's perfectly aligned. Now you can say, well, they are operating independently. No, they're not. They're looking at the same data and behaving the way governments behave very, very infrequently. You have a Volcker who absolutely does not work in the interest of the administration. Even if the administration is aligned with the idea of fighting inflation, they don't want it to be painful. That's when you need independence. And so my question is, do we need it now? Like, who cares? You know, who cares if the Fed is independent if we know they're going to act in a certain way in a crisis, but we don't know if they're going to act in a certain way in a overheating. And so we don't know about that right yet. And I don't think there's a reason for us to say, gosh, the economy's overheating here. We need an independent Fed to hike rates like the Committee, as you described, which ultimately the Fed chair is going to drive the committee to consensus and bring everybody along. And it would be inappropriate for a member, the voting member, to constantly berate and go against the consensus and go against the chair. That just doesn't happen. Like nobody, nobody's a hero on that board, never has been, never will be. The hero is the guy with the name on it. Just, it would just be extremely unusual for them, him not to be able to move his committee to where he wants to be or her committee. So I don't think that's a big deal. But at the same time the committee's moving, the committee's looking at the data and saying, hmm, Wall street consensus is for a slowing economy with a rise in unemployment rate, with inflation that's sticky but is transitory. What should we do? Well, we should cut. Are they going to cut as much as Trump says? Doubtful, but they're going in the same direction as the administration wants. So while I think it is critical that there is an independent Fed when we have a massive spike in inflation, not a well, we're 50 to 100 basis points from target, but a 3, 4, 5, 6% premium to target inflation rate, that's when we need the independent Fed. And I don't know if we're going to have one or not. You know, I don't know who he's going to, who he's going to put in the chair. Frankly, if it's Waller, I'm okay. If it's hasn't, I mean, that seems to me to be problematic about whether he'll be willing to go against Trump's wishes. If we have a massive inflationary spike, which we may not have, but if we were to. So that would be a concern. Many of the other candidates. I don't know what it matters, Moran, like, I know Steve well and do I think he's going to let inflation run at 4, 4 and a half, 5%? I doubt it. Will he let him run at 2 and a half, 3% to help Trump along? Sure, of course he will. So I think it's really a bit more. It's like, it's fascinating, right? Everyone wants to talk about this, but in the end of the day, if we have a crisis and employment crisis, the Fed is going to act in perfect alignment to the administration. And so who cares? And a massive inflationary spike without the conditions of 1970s, to which, by the way, you look back at my chart, in 1971, we went off the gold standard, we broke Bretton Woods Shockingly, we had inflation for eight years. Now I don't know if we're going to in a circumstance where we have 8, you know, 5, 6, 7, 8, 9, 10% inflation without some other geopolitical crisis, another pandemic or some sort of, you know, war, highly kinetic war. So I'm just sort of pretty relaxed about the Fed independence narrative. You know, do I think that means that inflation, that we're going to run it hot? Yeah, but only if it doesn't cause enough inflation that Trump loses an election because of not being able to fight inflation.
- [47:16]
C
Just one more I want to ask you about, and you mentioned the labor market before. This is something I've been thinking about a lot because it seems like we've got an interesting dynamic. Like there's not a lot of hiring going on in the labor market. There's not a lot of firing going on either. And then college age kids like have really high levels of unemployment. And I'm thinking about like, is this AI? I just can't, I can't put it all together and think about like what's going on based on all those variables.
- [47:38]
A
Yeah, I mean, my youngest is 23, my oldest is 31. You know, thankfully they're all gainfully employed, all their significant others are gainfully employed. But as I understand that job market is very, very weak and the data would support it being very weak. And I don't know whether that's uncertainty around AI or uncertainty more broadly about staffing, but that cohort is suffering without a doubt and I'm not sure what changes that. The good news is population isn't growing, so those jobs should come around. But I don't have, I wish I had more insight but to say, is this AI or is this just uncertainty around AI and the overall economy? And I think it's too early to tell, but that cohort is definitely hurting.
- [48:34]
C
So your third pillar is risk premia. And this is probably, I would think for your average person is probably one of the more difficult ones to understand. And you explained it before, but maybe you could talk about how you take that and apply it to what we're seeing right now.
- [48:45]
A
Yeah, so I, I just want to know whether I want to own assets or own cash. That's the simplest question. Is cash a better deal than assets or assets a better deal than cash? The great thing about assets and why a basic framework idea for me is we can talk about market timing, but that's really, really hard to do and you're competing against the best and it's Zero sum. And then we could talk about just owning assets and holding them for life in a balanced way. And that one is the way to go. Like everyone on this thing should stop trying to beat markets, just invest broadly and go about trying to earn and save as much as they can in their profession. Not, not try to beat markets. And that's what I do. Most of my, my net worth is always in a broad portfolio that I call a broad long only beta portfolio. And the reason is absent market timing, people pay you for your cash. Pe if you, if you're, the global world is trying to compete to borrow your money, governments are offering you yield, stocks are offering you yield plus appreciation. They're all trying to get your money from your cash to allow them to have your cash so they can use that cash today either to consume or to invest in the real economy and factories, whatever it is, and they pay and they have to compete for it. And so at a minimum they pay you a risk premium in excess of cash. So if you own assets, you should beat cash. That's it, full stop. And so it's, if you're thinking about not owning assets, you're willing to give up collecting that every day you get a little bit of juice for being invested in assets in a broad sense. Every day it's working in your favor and every day you're in cash, it's working against you. I mean, you may get interest on your cash, but you're missing out on that interest plus excess return for owning stocks and bonds, et cetera. So I want to, I want to really be certain that if I'm not going to own assets, or for that matter be short assets, that they're going to underperform cash and underperform it for a period of time. And so that's risk premium. That's saying risk premium is always working in your favor, but sometimes it's not as good a deal as others. In other words, sometimes assets are cheap relative to cash and sometimes assets are rich relative to cash. And so from an my pillars are about trying to beat the market, which I said to begin with really hard and you probably shouldn't even try. But if you're going to try, you really want to know if assets are rich or cheap and valuation is a terrible way to trade, particularly short term, because assets can stay rich for months, years even. But you want to know, is there something in the near term that's going to cause assets to appreciate relative to cash, meaning their risk premium is going to contract or depreciate Relative to cash, which means that the assets are going, risk premiums are going to expand. And so all my work is about, well, what type of things could happen so that risk premiums contract or expand, meaning assets are either rich or cheap to cash move relative to their. It's not that they're rich or cheap at a level, but they're expected to change in that way. And so a great example is if somebody announced tomorrow that there was going to be QE and it was a surprise to everybody else in the world, you'd want to own assets, you wouldn't want to own cash, that simple. If you knew it was coming tomorrow, you'd want to own assets. So now you have to say, well, okay, QE is a potential game changer for owning assets. So qt, the initiation of QT was a game changer for owning assets. My most impactful damp spring report ever was called drumbeats of QT and it was on December 15th of 2021, right before the worst bond and equity sell off we'd seen in decades, certainly in bonds, the worst. And that's because we went from a period of QE to QT fairly rapidly. And so it really matters. Now, there are lots of other factors, as I've said, the expectation of future volatility. So for instance, if volatility, implied volatility is very high, you might think, well, that's something to be cautious about because it's saying that there's going to be turmoil, or another way of saying it is, how high could it go if it's only going to go, if it only has one direction to go? You want to own assets when volatility is very, very high. You don't want to own assets when volatility is very, very low, because there's only one place it can go and that'll cause a risk premium expansion. So modeling forward volatility not only of assets but also of portfolios, which gets involved in correlations of assets. And then also you want to know, like if you told me banks were fully levered, they've extended all the credit they could possibly extend and they can't extend anymore. I don't want to own assets because the money printing that a bank does is the same as qe. If a bank is out of capacity to lend, assets are going to do badly. Now that said, if they have tons of capacity to lend and no one wants to borrow, that can be a great time to own assets, because as soon as people start levering up, asset prices jump. So bank credit is an important aspect to. And then at the, and then the last bit is well, how are investors are they levered up relative to their cash? And so when you look at each of those factors you can predict whether assets are a good deal at a level basis. That helps you a little bit. And then what is the likely change in the value of assets? And I find that useful. That's been the greatest source of my alpha in the last five years. Trying that second bit which says things are changing that are going to significantly impact the relative value of cash versus assets.
- [56:05]
C
And how about the final one, flows? You talked earlier about trying to get ahead of things that you think might flows that might be coming in the future. Do you see anything interesting there?
- [56:12]
A
Right now most people focus on very, very short term flows. I guess the biggest thing that I'm thinking about right now by far is how is this capex financed? So how is Capex finance? One would then ask and say well so far the way the AI capex has been financed is that hyperscalers have some, somebody in the real economy has bought some software and AI app and you know, has created enough some revenue to the hyperscalers. The hyperscalers have essentially spent every penny of that cash flow to buy chips and to help build and to spend to build out data centers. The chip makers have said geez, I can't, I mean I'm getting so much cash in here, I got to reinvest that cash into things. So that money flows back into the real economy. But ultimately it's sourced from three places. Earnings or cash flow, existing cash on the balance sheet of these companies or issuance. What is the situation for the hyperscalers? Well, they still buy back, they still net retire shares so they're buying back stock which is consuming cash that they could otherwise use to fund data center buildout. So will they continue to share repurchases aggressively? That's a super important question to me because share repurchases could be worth, I don't know, a multiple point a year in terms of multiple expansions. I've seen some work, my friends at ELM wealth recently put something out where it's sort of like basically a multiple point a year over the last five to 10 years of expansion due to share repurchases. If it stopped, would that mean the multiple would stop going up or would it actually revert? So that's a super important bit. But at the same time they, the cash balances on all of these hyperscalers are coming down. So they're not so they are constrained, they're running out of cash, they're still buying all their stock back and they're not issuing, but they, and, and the cash flow may or may not come in terms of earnings. So I think that dynamic is probably the most interesting bit right now, which is for US equities, whether this ongoing share repurchase train will keep running or will financing of capex require issuance? They're not going to issue stock. They don't need to issue stock. They're buying back their stock. They're not going to suddenly turn to issue stock. But they might issue corporate debt. And so that might push spreads a little wider. That might consume some of the demand for treasury bonds, it may even consume some of the demand for equities. And so I'm looking at how they finance this thing because so far it's been financed with existing cash and operating cash flow, and both of those look tapped out to me. And yet the capex budget is still half a trillion dollars.
- [59:53]
B
So I'm curious, is there, and this may be somewhat of an unanswerable question, but do you have, if you were to like have a scale of 1 to 10 on the economy using this framework, with 10 being the most favorable outlook and 1 or 0 being the least favorable, like, can you apply, like where are you right now when you look at the US Economy, not necessarily the mark stock market, like in returns, but the economy itself through this framework, you know, are you more positive or are you more negative, would you say?
- [60:30]
A
Okay, so I have the things that I'm focused on is so I don't know really right now, but I will tell you the things I'm focused on, which is there's a huge wild card regarding tariffs. And I don't know how it's going to play out, but I think we find out before Thanksgiving when the Supreme Court makes its decision. And that will create a digital, in my view, in terms of how the economy will behave. So I'm looking for that. Oddly enough, I have just in terms of that piece, I've operated under the assumption that tariffs were bad for growth, which means bad for stocks and good for bonds because they're tax, they slow GDP markets, and certainly the President of the United States thinks the opposite. Let's start with the president. He thinks tariffs are a great thing. He thinks they're good for stocks and they keep bond yields low. And by the way, he's right, that's what the market's done. So we have all these tariffs we're collecting and because the budget deficit may be coming down and because maybe all this anti growth is being felt by the rest of the world and not by us. This tax is being paid by someone else. That tariffs are good for stocks and bad for and, and not so bad for bonds and that's what, that's what's priced. I don't think it's true. I think tariffs are bad for stocks and good for bonds. But market doesn't think that and certainly the President doesn't think that. So then he said the Supreme Court. Well firstly he hasn't attacked the Supreme Court yet. He needs that to work out. But he has attacked the appeals court to say that they made a terrible decision, the earlier court made a terrible decision and that we're going to have a 1929 style stock market crash and depression if tariffs are eliminated. Now again, I think it's good for the economy if we get rid of tariffs. But he thinks the opposite and he's the President of the United States and he's going to set a tone based on that. And maybe it's just threatening the courts, but I don't know what's going to happen. So I'm going to just watch and see. But to me it's a big wild card. Here's what I would say. If tariffs stick around, I'm much more confident that the economy is going to weaken significantly. If tariffs go, whether that's good for stocks or not, I have no idea. It should be bad, but I don't know. But I do know that if the tariffs stick around, it's going to be a major tax and it's going to affect spending, it's going to affect consumption. It may not affect AI, but it's certainly going to affect the majority of the economy in a negative way. And if tariffs stick, if tariffs don't stick around and by the way, it'll allow the Fed to cut rates if tariffs disappear, the budget deficit's effed. If tariffs go away. At a very simple level, how do we pay these things back? Like to whom, who gets the money and how's it raised? Because we all owe the money back if tariffs get a made illegal. So that's an interesting play. So I think there's a fascinating outcome coming. I think it happens by November. The oral arguments start on November 5th. They're probably going to have a, probably going to have a decision before Thanksgiving and certainly by the end of the year. So I have no. The one thing I do know is I have no idea how that's going to play out like I can't predict the Supreme Court's at all. So I'm not going to even try. But I certainly am going to position based on the outcomes. But then I guess the other thing is, okay, so let's assume that's not a big deal. Then the question is how easy does the central bank get and how sticky does inflation get and how does that tension play out? I guess that's the other dynamic I care a mouse about. It appears to me that the markets do not think that they're going to cut aggressively. They just don't. You know, we're priced four cuts and then four, four cuts over the next two years and then we're done. That is nothing like what Trump says we need. And it's certainly nothing like any sort of real weak economy circumstance. It's just sort of a normalization cuts. And I just don't think we're in a world in which a normalization outcome stands a chance. It could get overheated, it could get ugly. But the normalization case seems very everything to me right now. Seems very digital and yet implied volatility is not very high. So that's sort of an interesting dynamic as well. Realized volatility is extremely low, implied volatility is pretty low. And yet I've never felt that. I've never seen conditions that could go either way in a digital fashion more than ever. And so it makes me think that you want to own tails and you want to be short the middle. You want to be short volatility in the middle. So I just feel like there's a tail outcome coming and I don't know what the stimulus will be. And it could, frankly, what I've said could be both ways. It's very easy to picture a world in which bond yields go to 4%, three and a half percent, and then six and equities go to 7,500 and then 5,000. There's very like I could easily picture those things happening. And so I just have never seen things to be quite so spread out in terms of potential outcomes and predicting them. There's so many wild cards right now that are outside of my expertise, like the Supreme Court, completely outside of my expertise.
- [66:58]
B
Well, what I think we'll do, Andy, is we'll get through the fourth quarter here and as we get some clarity on these things, hopefully you come back and join us again and we'll work through all this stuff and see where we're at. So really appreciate all your time and your knowledge and you walking us through all this. Thank you very much.
- [67:18]
A
I appreciate it. Thanks for having me on.
- [67:20]
B
Thank you for tuning in to this episode. If you found this discussion interesting and valuable, please subscribe on your favorite audio platform or on YouTube. You can also follow all the podcasts in the Excess returns network@xcessreturnspod.com if you have any feedback or questions, you can contact us@xsreturnspodmail.com no information on the this.
- [67:40]
C
Podcast should be construed as investment advice. Securities discussed in the podcast may be.
- [67:45]
A
Holdings of the firms of the hosts or their clients.