MACRO INVESTING EXPLAINED
Prior to that, he held investment management roles at Main Street Capital and T.Rowe Price. He is also a CFA charterholder and a member of the CFA Society of Washington, DC.
- Introduction (00:00)
- What do most investors struggle (2:05)
- Growth and inflation framework (3:50)
- The importance of the business cycle (5:17)
- The four economic regimes (6:15)
- Growth cycle and its implications (7:05)
- The relationship between markets and the economy (11:29)
- Equity sector performance over different economic regimes (14:54)
- Equity style factors (17:05)
- Investment risk spectrum (18:11)
- The importance of monetary policy (19:16)
- Confirmation from asset markets (21:52)
- Lessons from Stan Druckenmiller (24:18)
- The growth cycle drives trends (25:26)
- Why analyse positioning and sentiment? (26:58)
- Typical day in tracking markets for Mike (27:46)
- Thoughts on crypto (30:48)
- Where is the market in the four regimes? (33:59)
You have access to the same data that we have. Hedge funds have access to that same data. So if there's no informational edge, where does the edge, why the edges and how do you analyse it? There's a lot of misunderstanding when it comes to macro. Probably more than any other discipline within finance.
Everything else is either a noise or b an input into our growth and inflation outlook. Almost every analysis we do at Invictus whether it's looking at the employment situation or the credit cycle or we're doing some type of market analysis, it's always with the end goal of trying to get a better grasp on the growth and inflation outlook.
Anytime you are presented with new information, anytime anyone, any analyst of the business cycle is presented with new information and you don't know what to do with it, a pretty good first step is to think about how it might change your outlook for growth and inflation.
In other words, we care less about growth or inflation being higher or low. We care more about it getting better or worse. And this is sort of logical, right? It doesn't really matter to the markets if growth is high in absolute terms. If growth is about to crash, stocks will do poorly. Likewise, if growth is very low in absolute terms but it's in the process of bottoming then stocks are very likely to do well.
And it gets even better than that because forecasting growth in inflation will take a step back. Not forecasting, but growth and inflation are not random. They're not unpredictable. They are cyclical, right? And they move in trends. So if you want proof of that, we will go to the next slide here we're looking at the growth in inflation cycles going back to the 1950s and you can see that they look like a sign curve.
If you remember from Trigonometry they trend and then peak, trend and then trough trend and then peak over and over and over again. Growth in inflation is both cyclical and together. That's real growth on the top, not nominal growth. We need to clarify together the real growth cycle and the inflation cycle from what we at Invictus call the business cycle.
So the first two regimes, early recovery and inflation broadly risk on and the bottom two, stagflation and deflation broadly risk-off risk on. You could think of them as being good for risk assets and bad for risk assets. It's just sort of the parlance. We'll discuss more about these regimes but first, let's explore the growth cycle in the US and what the implications are.
But this is only a very slight simplification. It's not really that complicated. Purchasing managers are asked in a survey whether our business conditions are getting better or worse. If they say better then this line goes up. If they say worse, then the line goes down. That's it. It's pretty much that simple. The PMI is indexed to 50. So above 50 means positive manufacturing growth and below 50 means negative manufacturing growth. Although keep in mind we're still more interested in the rate of change here than the absolute level. So the PMI is just another way to measure growth.
Think lumber for homes, copper and steel for cars, oil for power, and industrial activities. That boost in demand, in turn, pushes up prices. The prices, anything is just a function of supply and demand, and the PMI represents demand, so all else is equal. Faster growth should mean higher prices for commodities. So, in short, just from looking at the Ism manufacturing PMI, you can get really valuable information about the US. The growth cycle, the global growth cycle, the commodity cycle, and all of this are just from looking at one diffusion index. That's a pretty good bang for your buck there.
And they look very similar. Why is that? Well, the price of commodities is certainly an input into inflation, so that's part of it. But commodity prices are also the most liquid and economically sensitive constituent of inflation, right? When there's an economic shock, what typically will react first the cost of your rent or the market prices of freely traded commodities? Well, obviously it's the latter. The markets frontrunner reported economic data for about three months. Markets are forward-looking. They are what a classic investor would call a discounting mechanism and that's extremely important to understand. The markets take economic information and they price it in advance.
So you should see largely the opposite large caps, outperformed defences, outperform low leverage, high liquidity. And also another high-level comment. If you see a back test that doesn't make any sense economically or intuitively, it's probably not a great backtest. Common sense is a very important skill when interpreting a back test.
And there are a variety of explanations for this which we can maybe touch on later. But on a high level, the reason is that developed markets are rife with naturally deflationary forces. So over the last 40 years or so, when inflation has kicked up, it's been largely benign and at least relative to pre-1980. So deflationary forces have been deflationary. Shocks have really been the larger risk to the markets since around 1980 versus inflationary ones.
So first, what do we mean by monetary conditions and victims? We define it as the impact that the Federal Reserve has on liquidity through the financial markets. Let me see the water real quick. We call it inorganic liquidity because it's a result of an exogenous force, not free market behaviour. In terms of stocks, all you really need to know is at the bottom of the page there at the bottom left. A tighter policy means higher discount rates for discounted cash flows and lower asset valuations. Think of the price-to-earnings ratio. In the case of stocks, easier policy means the opposite lower discount rates and higher asset valuations. And this is all equal, right? Obviously, there's never just one-factor affecting stocks.
The best way in arguing to measure monetary conditions is through real-time market indicators like the dollar relative to other currencies' mortgage rates, mortgage spreads above and beyond the risk-free rate, the relative performance of growth, equities, real rates, yield, and curvature. You can also look at some reported data, like the Fed funds rate or the Fed's balance sheet.
We want validation from the asset markets before we start underwriting new investments with real capital. Why is that? Well, it's because human beings, including us at Invictus, might forecast the business cycle incorrectly, but the asset markets as a whole will never forecast the business cycle incorrectly. Never. Moreover, as we mentioned earlier, the asset markets will actually front-run the economic data every time, with virtually no exceptions. So you'll give yourself a huge edge in terms of forecasting and more importantly, portfolio management by studying the bond market, the stock market, the commodity market, the forex market, and learning what they have to tell you about growth and inflation. So here's some quick evidence of what we're talking about.
And the reason is that they're all trading on the same underlying macro dynamics, more or less, namely growth. All three of these indicators largely trade on the rate of change in economic growth. So if we were to do sort of a thought experiment here, if we believe, based on our fundamental outlook, that growth is going to accelerate, we would like to see all three of these indicators going up, confirming faster growth. Over the last year or so. We've actually seen a historic divergence in these charts.
You can see usually they move together. Right now they're kind of moving in opposite directions. It sort of looks like a Neapolitan ice cream carton, but we can talk about that later if you want maybe a conversation for another time. If you want more evidence that studying the market will refine your forecasting and more importantly, help you make that better investment decision. And look no further than Stan Druckenmiller, probably the most successful hedge fund manager of all time
He has his own expectations for growth and inflation, but he respects what the market is telling him. He respects things like the copper-gold ratio, small cap, large cap ratio, and performance of cyclical stocks versus defensive ones. He wants validation from the markets before investing. If you've ever listened to Stan talk on YouTube or whatever, you know how seriously he takes market internals. Alright, one last mental model before we wrap it up. First, we need to answer a question. The question that we haven't addressed explicitly, and that's on the topic of time horizon. So what’s the time horizon is the market? Are the markets an accurate reflection of underlying economic activity? To use around number at Invictus, we say about a month, although obviously that's not a rule, it's just sort of a principle.
And the good news is that analyzing sentiment and positioning data is fairly straightforward in principle, although it's more challenging in practice. The reason it's straightforward in principle is that it tends to be mean. Reverting positioning tends to oscillate from bullish to bearish. In a perfect world, we want to be adding exposure when everyone is bearish and reducing when everyone is bullish. And obviously, the reason we would want to do that is better returns when positioning is really stretched in one direction. Even small counter consensus surprises can cause big moves in price. We have it in the quote there. But think of it like a rubber band. The further it stretches, the more violently it will snap back on a catalyst and victims. We use a number of sources to evaluate positioning and sentiment including investor surveys, flow funds, data from the Fed, which is longer-term data, and the weekly commitment of Traders Report from the CFTC. And we also look at a lot of options data. So that's the overview of the Invictus process
The kind of bluster and all the headlines that are coming out every single day. How much is it following tracking? Single items of major news flow like a central bank speaker saying X or a company stock coming out with an earnings report y or to then looking at data and just looking at the growth and various different or looking at the other types of information that you said with market internals. What's a typical day in your life look like from your analyst perspective? That's a great question. And it's funny; a lot of investors really like Warren Buffett, right? And Warren Buffett famously says he spends all of his day reading. He says he subscribes to eight different newspapers. And so within the industry, there's this thing that everyone wants to read newspapers and be on top of the news. So here's the perception that there's some edge from that.
However, we don't think his edge actually comes from reading the newspaper.
And so that's part of the value-added Invictus is we're looking at the world the way an investor looks at the world, not the way a journalist looks at the world. And maybe that seems like a fine distinction, but as an investor, where you get your information is really important because in subtle ways it can affect how you think in terms of what you actually spend your time looking at. Almost all of our information is taken from basically column government reports, the BA, and the various Federal Reserve surveys in the markets. So that's where we get information that we use for making investment decisions.
There are two constituent parts of financial conditions. There are economic conditions and there are monetary conditions. Right? They're the two inputs into liquidity. So liquidity gets better when economic conditions improve, which should make sense, right? And then the second constituent to liquidity is the inorganic liquidity that we talked about earlier. That's basically the Fed, right? So Bitcoin does better in risk on regimes where economic conditions are improving, people are feeling good, they're buying a car, they're investing in Altcoins, they're getting stimulus checks, whatever.
And crypto is also an asset with zero cash flows, which sort of de facto makes it a very long-duration asset. So it's very sensitive to the discount rate. So when the Fed is raising rates, that's really bad for crypto and when it's easing monetary policy, reducing rates, particularly real rates, crypto tends to do very well. So right now, our outlook on crypto, bitcoin, Ethereum, the altcoin complex is bearish. And the reason is the Fed is explicitly saying it wants to take the wind out of risk assets.
And there's only one institution in the world that has the credibility to say something like that, and it's the Fed. So if they're promising us they're going to do it, we believe them. And we have some precedent for this. Right? If you look at a chart of real rates and a chart of the price of bitcoin, they look fairly inverse. And if you look at the last hiking cycle, the last policy cycle which ended in 2018, you can see that as real rates went up, bitcoin crashed, saying it wants to do the exact same thing. It wants to take rates above neutral.
Let’s refer to the framework we use in our last monthly market outlook. There are three parts to our thesis right now. One, we expect growth to continue declining. It's already declining. We expect that to continue. The asset markets are clearly pricing that in. Two, we expect inflation to decline in the coming months.
Obviously that has not happened yet. We think the April print is very likely the first decline in year-over-year rate of change terms. I'll add the asset markets aren't totally pricing that in yet. Right. Inflationary exposures are still doing quite well. So we don't really have validation from the asset markets on that part of the thesis. So we're not short inflationary exposures yet because we don't short up trends. We don't short strong momentum.
Our back tells us it's a horrible idea, so we don't do it. And I've certainly lost money betting against those things in the past. And then the third thing is tightening financial conditions, which is, like we just said, the Fed saying it's going to tighten, it's happening. Yield curves are inverting, and rates are moving up or have been moving up across the curve. We saw the Dixie Dollar indexes moving higher, mortgage rates are spiking. Clearly, financial conditions are tightening.
Eventually, that's going to break something. That's sort of the history of central bank policy-making in the Western world. And when that happens, that will happen through crushing demand. So that'll push growth down further and it will also reduce inflation. So that's around the corner at some point in terms of when it actually happens. We're watching closely, and we would guess it's going to happen in the next couple of months. But really, part of being a good investor is keeping an eye on things and changing your mind when information changes.
And right now, the market is still saying stagflation, faster inflation, slower growth, and tightening policy. We expect that to transition into deflation, but we leave it to the market to tell us exactly when that is cool. All right.