“Lather, Rinse, Repeat”
The big picture
I’ve spent a decent amount of time coming up the coding curve over the last 6 to 9 months.
Like it or not, the coalescence of programming, linear algebra and applied math and statistics in the service of innovative data analytics has already pulled-forward the future state of quantitative fundamental and macro investment research.
This should be self-evident to the point of being tautological but if the aspiration is towards analytical artisanship, you have to know how the tools work.
Without a foundational understanding, how can you know what’s even possible, let alone blueprint and engineer an elegant solution to a pioneering question.
To be sure, experience and technical investment acumen will always hold value, but it’s at the nexus of big data and experience (the capacity to ask the right question and curate & contextualize the data effectively) where investment research alpha will increasingly concentrate.
I feel comfortable with that assertion because we’re already doing it.
It’s still (very) early days.
A critical part of any programming team is the QA (Quality Assurance) squad who is effectively charged with creative destruction – identifying bugs, terminal flaws and otherwise ferreting out what could go wrong and blow up the program.
In macro investment space you are generally your own QA commando, stress testing your baseline expectation against creative scenarios capable of blowing up your forecast.
And with professional interventionist’s (central banks), rogue actors (Erdogan, Tony Stark (Elon) et al), reflexive price amplifiers (machines/systematic trading) and nonlinear network effects (complex market & macro systems) all conspiring against your Sharpe Ratio, your Risk Management Factory (i.e. the macro QA team) should perpetually be pushing up against productive capacity.
Anyway, yesterday we hosted our 4Q18 Macro Themes call. It was, again, another higher-high in attendance. As active participants in our attempt to evolve the process of Risk Managing and Trendcasting macro and markets, we thank you for your continued engagement and trust.
Here’s the sacred trinity for 4Q:
- #Quad4: After a likely nine consecutive quarters of accelerating economic growth domestically, investor consensus is positioned for the so called “fiscal impulse” to perpetuate further upside. Unfortunately for new-wave U.S. equity and credit bulls, our proprietary GIP Model is suggesting the now-record acceleration in U.S. growth (and inflation) that we prospectively and accurately identified two years ago is coming to an abrupt end. In the presentation we shall detail the catalysts for the aforementioned inflections and the associated investment implications – not the least of which is an anticipated upside capitulation in the U.S. Dollar.
- #CyclicalPeaks: Two of the most underappreciated risks heading into Q4 of 2018 among investor consensus are the cyclical peaks in corporate profit growth and corporate profit margins – both of which have important sector and style factor implications. We’ll detail why investors would do well to adopt a defensive posture with respect to their respective portfolios as the associated rotation out of the domestic Momentum, High Beta, and Growth style factors could be quite violent given current positioning.
- #LongHousing: #Quad4 represents a macro environment typically characterized by falling rates, a more dovish policy lean and outperformance in defensive yield and select interest rate sensitive equities, including Housing. Unprecedented late-cycle fiscal stimulus has cultivated an interesting, somewhat anomalous macro condition set as it elevates the prospects for further acceleration in wage inflation and the potential for households to see improved consumption capacity at the same that both headline growth and inflation are slowing and yields are making lower highs. It’s within this broader setup and against a backdrop of significant 2018 underperformance that we’ll explore a contrarian long position in Housing.
I’m not going to give away the full institutional research thunder (if you’re an institutional investor and would like access to the replay, please email email@example.com) but I will treat you to a few succulent morsels from that larger macro analytical meal.
On our Macro calls the Q&A generally serves as the QA forum with much of the focus on how we could be wrong or what emergent global macro conditions could blow up our forecast.
We had multiple similar inqueries around the topics below and it’s probably safe to extrapolate that others harbor similar questions.
In the interest of proactively addressing probable areas of broad interest while offering some research insight, below are a selection of questions from yesterday’s Q&A and the associated answers/context around our thinking:
Q: Does the model anticipate/incorporate any action from the Fed in December? For example, if the Fed pauses in December, does that change anything, or is the model generally agnostic to Fed decisions?
A: The model is not agnostic to Fed decisions in the sense that we believe the model front-runs reactive Fed policy. In this instance we think a multi-month reporting of quad 4 data, both globally & locally, shifts policy maker rhetoric at the margin. Remember also, we’ve been raising rates for almost 3 years - from 1.4% to 3.1% - most of the alpha capture has already been realized and we are closer to the end of the tightening cycle than the beginning. Indeed, rates & derivatives markets are attempting to discount whether Fed easing is a 2019 or early 2020 event. It is called the GIP model (Growth, Inflation, Policy) and it is dynamic and integrated à the “G” and “I” feedback to influence the “P” which in turn feeds back on both “G” & “I” and assets prices in a kind of homeostatic, self-regulating, co-dependent system.
Q: Lower rates will flow through reported housing activity on a lag which means it may not be evident until early 1Q19. Are you waiting for some tangible fundamental evidence of improvement or would lower rates and a positive quantitative signal be enough for some initial exposure?
A: It’s an important question and it’s an important question of timing. With rates rising, housing has underperformed significantly and is/has been equivalent to catching a falling knife which is why he haven’t gotten long yet. Remember, quad 4 starts in Q4 and we won’t begin getting reported Q4 data until we’re into the quarter. I’d be waiting for a wash out in some of these growth slowing/Quad 4 exposures we like as the last of the more hawkish Q3 Quad 2 data rolls in. My signal says its still too early to pull the trigger on long Housing but we think the opportunity opens up as we move intraquarter in 4Q.
Q: How are you balancing the prospects of accelerating wage growth (& some potential consumption upside) with the expectation for slowing headline growth? …. Do you keep on some selective consumer exposure at the company level?
A: The short answer is yes. Broadly, remember, we are looking to get long of two big consumer exposures in Consumer Staples & Housing. In the former, we get leverage to late-cycle wage inflation flowing through to consumption but with some defensive yield as a sector/style factor and the latter, remember, housing lagged the broader recovery by almost 3 years so while the broader macro cycle is late-cycle, the housing cycle itself is only mid-cycle which is a pretty anomalous setup, historically. It’s also why, despite high-grading our preferred exposures and reducing high-beta, growth exposures, we haven’t gone explicitly negative on consumer discretionary – the top sectors to be short/UW in Quad 4 are Tech, Industrials & Energy. Moreover, looking across the domestic fundamental data and our expectations for the major expenditure types, the consumption related metrics (retail Sales, Real PCE, etc) do slow but not in an oversignificant way. Modest deceleration across the domestic consumption economy is belied by sharper deceleration across the everything else (i.e. Capex, Investment, Net Exports) … which are really responsible for driving the deceleration in headline growth.
Q: If your call of going into Q4 is non consensus and there is so much systematic trading, is there a risk that the market has a violent type sell off or flash crash given disappointing rate of change data and with the market already getting more and more narrow at the very top end of the range?
A: Yes, potentially. We haven’t been one of these perma-doomsday blog shops serially calling for the end of the world. We have been, by process (or by luck), long growth and beta for all of this record 9 consecutive quarters of GDP growth accelerating. But with two consecutive quarters of quad 4 as the outlook, this is the most dangerous period in our model going back to 2015. Imagine we didn’t make the call to short China Brazil and EM when we did (when the consensus narrative was still to be long “globally synchronized recovery”) at the beginning of the year. Our call to short those markets coincided with those economies being set to transition to Quads 3 and Quad 4 (growth slowing environments). Some of those markets ended up being down 20-30% in a matter of weeks – economic gravity and market price risk sets in slowly, then reflexively and all at once. That same risk is starting to manifest in the momentum as a style factor exposure in U.S. equities, for example. We don’t claim to know when, precisely, the market epiphany will occur but we do know what the causal factors are that will drive that investor epiphany and current market structure, systematic strats and the machines will only serve to amplify the move once it gets in motion.
Q: Where could you be wrong?
A: The whole thing. The whole process could be wrong! ….. where we could be discretely wrong is if the data accelerates in the 4th quarter. Our model, forecast and preferred allocations don’t anchor on some specific point-in-time point estimate for growth, it anchors on the probable slope of the line. If the data accelerates in 4Q, that’s where we could be wrong. It’s very simple.
Measure. Map. (keep) Moving.
Prepare. Perform. Prevail.
Our immediate-term Global Macro Risk Ranges (with intermediate-term TREND views in brackets) are now:
UST 10yr Yield 2.93-3.12% (neutral)
RUT 1682-1708 (neutral)
NASDAQ 7890-8068 (bullish)
Nikkei 22685-24367 (bullish)
DAX 12058-12528 (bearish)
USD 93.25-95.11 (bullish)
Oil (WTI) 68.75-73.20 (bullish)
Gold 1179-1206 (bearish)
Copper 2.60-2.90 (bearish)
Have a great weekend,
Christian B. Drake
U.S. Macro Analyst