"Day-to-day fluctuations in the profits of existing investments, which are obviously of an ephemeral and non-significant character, tend to have an altogether excessive, and even an absurd, influence on the market."
- Keynes
Alright, here’s the game:
Guess a number from zero to 100, with the goal of making your guess as close as possible to two-thirds of the average guess of all those participating in the contest.
Got your number? (if you’re familiar with Keynes’s Beauty Contest please don’t spoil it for the person next to you)
Ok, let’s see if your “right”.
The exercise is an attempt to convey the idea of the Nash Equilibrium (Nash = the A Beautiful Mind guy) and effectively categorizes you based on your proclivity for derivative thinking.
- Level 0 = random guess = many people harbor an aversion to “math problems” so will just guess a random number between 0-100.
- Level 1 = guess of 33 based on assumption that most people will just randomly select a number b/w 0-100 (level 0 logic) which will simply average to 50 (33 = 2/3rds of 50).
- Level 2 = guess of 22 (2/3rds of 50) based on assumption that most people will probably be level one thinkers.
- Level 3 = guess of 15 (2/3rds of 33) based on assumption that most people will guess 33 (layered assumption that most people will be smart enough to figure out the game but won’t be “that smart”)
- Level 4+ = there is no way to escape from the recursive logic embedded in the thinking above which means the only fully rational guess (Nash equilibrium) is a guess of 0.
h/t Richard Thaler (Keynes's Beauty Contest)
Macro alpha is generally realized by forecasting and frontrunning derivative or higher-order effects.
I’ve used this macro case-study before but I’ll redux it here because it serves as a potent example.
Consider the Argentina Currency Crisis:
In an attempt to quell recurrent hyperinflations, Argentina adopted a formal currency board in 1991 – which means they held a dollar (& gold) against every peso in circulation and stood willing to exchange the two one for one. The goal of a currency board, in effect, is to import another country’s monetary policy – in this case Argentina wanted to displace the lost credibility of its own central bank by importing the legitimacy of the U.S. central bank and its monetary policy with the goal of re-anchoring inflation expectation.
The regime was stable and successful for a decade before collapsing spectacularly in late 2001.
Why?
Brazil (not Argentina). The flow of impact can be sufficiently captured in the following way:
Brazil Currency ↓ → Argentine Currency (relative to the Real) ↑ → Exports to Brazil (largest trading partner) ↓ → Argentine Growth ↓ → Argentine Unemployment ↑/Budget Deficits ↑ → investor angst over Argentine growth/deficit ↑ → Argentine interest rates↑/ability to tap credit markets ↓/ability to service debt↓ → currency board abandoned/Peso devalued → Argentine Peso ↓
In other words, Brazilian fiscal and monetary policy and the government budget constraint ultimately manifest in the massive devaluation of Argentina’s currency.
Being a level 3+ thinker is cool, but it comes with a caveat …. It may not be profitable.
Markets are comprised of people and if the majority of market participants are level 0-2 thinkers, applying level 0-2 logic to the decisions that collectively determine prices, you may be better off being somewhere in the 2-3 range.
Empirically this is probably why many academic studs or ivory tower all-stars find it difficult to effectively operate amidst the uncertainty and pseudo-rationality that characterize markets.
Practically, you can profit from TRENDing 1st order exposure if you can get there early, but there are a lot less people on the 2nd/3rd order effect playground and more PnL up for grabs if you can connect the higher dimensional dots.
Back to the Global Macro Grind …..
So, frontrunning higher-order effects is always and everywhere the macro M.O.
Except when it’s not.
Currently, everybody knows that everybody knows that we’re set to traverse an epic reflationary palooza.
And the first-order gravity associated with the following labor/income/consumption dynamics will continue to define Quad 2’s reality domestically. The trinity below remain the fulcrum factors of consequence.
- Payrolls: Almost every high-frequency indicator (Fed Surveys, Homebase data, Indeed Job Postings, NFIB, etc) continues to point toward large-scale hiring in the services sector. Positioning for a March NFP disappointment may catch some headlines but it’s not a high probability scenario. It won’t be high probability the month(s) after either.
- Excess Savings: Through the latest February data, aggregate excess savings totals more than $1.9T (see Chart of the Day below). And with employment continuing to improve and stimmy checks hitting in March that number is set to breach $2T. I know at this point we’re desensitized to numbers with 12 zero’s after them, but take a moment to internalize that.
- And Don’t Forget: Households will continue receiving monthly checks from CTC (child tax credit) beginning around July. And, of course, will get the details on the next $3T in proposed infrastructure spending over the next couple days.
The reflationary story here is as straightforward as it ever was: vaccinations and macro renormalization will catalyze a multi-month stretch of large-scale hiring. That improvement in organic consumption capacity will be amplified by a drawdown in the Savings Rate and the deployment of excess savings and further juiced by ongoing fed-fiscal support.
As hard as it is to believe for anyone macro immersed on a daily basis, all of this hasn’t even happened yet. And don’t be fooled, no one really knows how it plays out beyond the initial reflationary impulse.
But, during Trending regimes or conditions sets associated with once-a-century externalities, first-order thinking can suffice. Just let the Quad 2 exposure horsemen ride (short bonds/gold, long inflation leverage/pricing power, long rate (and cycle) sensitivity, etc). That remains unchanged this morning.
Macro evolutions are, of course, path dependent and prevailing conditions carry forward implications that are reasonably definable. I’ll game out the duration sensitivity and probable derivative implications associated with current conditions in the next Early Look.
Lastly, and as it relates to next-gen asset beauty contests, ‘kind of late’ is better than never with respect to global phase transitions and macro epiphanies.
As a crypto-phile and agnostic connoisseur of all things objectively amusing … I invite you to indulge in the following (h/t @DocumentingBTC) as you attempt to bootstrap you Tuesday mojo.
Immediate-term @Hedgeye Risk Range with TREND signal in brackets:
UST 10yr Yield 1.59-1.78% (bullish)
UST 2yr Yield 0.13-0.17% (bullish)
SPX 3 (bullish)
RUT 2099-2351 (bullish)
NASDAQ 12,811-13,534 (bullish)
Tech (XLK) 127.92-134.01 (bullish)
Energy (XLE) 47.14-52.30 (bullish)
Financials (XLF) 33.26-35.08 (bullish)
Utilities (XLU) 60.68-64.31 (bearish)
Shanghai Comp 3 (bearish)
Nikkei 288 (bullish)
DAX 148 (bullish)
VIX 18.04-23.12 (bearish)
USD 91.26-93.31 (bearish)
Oil (WTI) 57.23-65.58 (bullish)
Nat Gas 2.46-2.72 (bearish)
Gold 1 (bearish)
Copper 3.97-4.19 (bullish)
Silver 24.13-25.96 (bearish)
Best of luck out there today,
Christian B. Drake
Macro Analyst
