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A sick joke


Hello everyone

Welcome to beat the market

Over the next 10 minutes, we will talk about our investment strategy for the week ahead.

Both bond yields and stocks moved higher last week. (Chart 1)

The Bloomberg US core bond index was down 1.3% on the week while the MSCI World equity index was up 1.4% (Chart 2)

The Unbound Balanced Portfolio that was max underweight stocks finished down 19bp on the week. (Chart 3)

Natural gas was the outsized gainer last week, going up 14% while the Japanese yen was the biggest loser on a volatility adjusted basis. (Chart 4)

The underperformance of defensive trades was the big theme for the week.

It was a particularly tough week for our thematic absolute return portfolio that was weighed down by a fall in gold, utilities, and TIPS, as well as a big rally in US stocks. (Chart 5)

Our thematic Absolute Return portfolio underperformed cash by 41bps on the week. Ooch. (Chart 6)

The fact that both bond yields and stocks were higher last week meant the market traded in our growth optimism regime. (Chart 7).

The outperformance of tech stocks, small cap stocks, EM equities, and commodities was all consistent with an improvement in growth expectations (Chart 8)

So what happened last week that inspired this brightening of perception of growth outlook?

Well, the market decided to stop worrying about the debt ceiling. (Chart 9)

As you can see here, the spread between 1-month treasury yield and the 1-month overnight swap rate, which is a good market proxy of the risk of default by the US government over the next month, fell by 50% from Monday to Thursday. (Chart 9)

It ticked up higher on Friday but it still finished the week at just 30bps (Chart 9)

Another market proxy of default risk is the 1 year US credit default swap. As you can see on this chart, it fell so much last week that it is at the lowest level in a month (Chart 10).

The bottom line is that default risk premium dropped even though the latest data show that the US government is running out of cash so fast that it would be lucky to get through next week. (Chart 11)

So what caused the market to decide that default risk has fallen?

Well, positive soundbites out of Washington early in the week led the market to conclude that the differences between the two sides were narrowing. (Chart 12).

As a result, financial conditions eased further last week (Chart 13) which in turn drove up real yields (Chart 14)

Higher real yields pushed down gold price (Chart 15) and pushed up the USD (Chart 16).

Now that we know what happened last week, we can opine on whether it made any sense.

You probably already guessed what I am going to say, but I don’t trust anything coming out of Biden’s mouth

As I said last week, Biden has a strong incentive to sound reasonable so that he can blame the failure on the Republicans.

I also told you last week that Kevin McCarthy won’t fall for it.

And he didn’t. As you probably know by now, the Republican negotiators walked out from the meeting with the Democrats on Friday.

What this means is that things are going to look very dicey next week (Chart 17)

Before we discuss investment strategy, let’s take stock of where the negotiation is right now.

The Republicans have 3 main demands:

They want to see work requirements added and tightened for able-bodied adults with no dependents who are currently receiving entitlements and benefits under the Temporary Assistance for Needy Families, the Supplemental Nutrition Assistance Program, and Medicaid (Chart 18)

Some progressives are making a lot of noise about this demand, but we should see it as a low lying fruit in the negotiation.

Even Biden signaled last week that he is willing to contemplate making some concessions here. (Chart 19)

Opinion polls show that the Republican proposal is popular with most Americans.

The Republicans’ second major demand is crawling back the unspent funds for COVID-19 relief. (Chart 20)

Congress mandated $4.6 trillion for COVID relief but so far only $4.2 trillion has been spent. (Chart 20)

The Republicans want to take back the $400 billion that has been budgeted but not yet been spent. (Chart 20)

However, if we were to exclude the $316 billion of remaining funds that the government is legally obligated to pay out, there is only 30 billion left (Chart 20).

So even though Biden has said that rescinding the COVID relief is on the table, this means nothing. (Chart 21)

$30 billion is just pocket change in this negotiation.

If the market has understood this, it would not have reacted so much to the soundbite.

I told you last week and I will say it again. This white house is very good at spin.

I am not very impressed by the market’s ability to decipher the spin.

Let’s be honest, most people who work on Wall Street voted for Biden.

I can understand why Wall Street wants to give him the benefit of doubt.

The way I see it is that this creates investment opportunities for everyone else.

This brings us to the third main, and the most pivotal, demand of the Republicans.

The Republicans want to freeze discretionary spending at the 2022 level. (Chart 22)

This would imply an 8% spending cut in the next fiscal year that starts on the 1st of October. (Chart 22)

The Republicans want to exclude military spending and veteran health from the spending cuts. (Chart 22)

What this implies is a 23% cut in everything else. (Chart 22)

The Republicans want to maintain the spending cap for 6 years. (Chart 22)

Over 10 years, the savings would amount of $5 trillion, relative to the current forecast. (Chart 22)

By the way, this doesn’t mean that US debt will fall by $5 trillion. All it means is that it will go up a bit more slowly.

To see just how far we are from an agreement between Biden and the Republicans, we just need to look at the White House counter-proposal that has been leaked to the press over this weekend


Whereas the starting point for the Republican plan is the 2022 budget, the starting point for the Biden team is the 2023 budget. (Chart 23)

What the White House is offering is freezing the 2023 budget in real terms, meaning inflation adjusted, for 2 years. (Chart 23)

By the way, freezing in real terms means still an increase in nominal terms. (Chart 23)

The Democrats’ plan will save $1 trillion relative to current forecast.

The bottom line is that with not much more than a week left before the drop-dead date, we are looking at a massive gap between the two plans

This stock market rally last week feels like a sick joke

Nevertheless, I am not predicting default

But I do think the probability is going up that Biden will invoke the 14th amendment, at the urging of Bernie Sander and Elizabeth Warren (Chart 24)

It will be a sad day for America if he does invoke the 14th amendment

In the short term, it will be less violent than a default but in the long-term it will destroy the little sanity that is left in Washington

By the way, do not expect Kevin McCarthy to pull a rabbit out of his hat.

It is not a coincidence that Trump decided to weigh in yesterday by urging the Republicans not to cave (Chart 25)

Nobody plays the game of chicken better than Trump.

Other than the 14th amendment, another way out is a big drop in the stock market that forces the two sides to reach a compromise

I reckon a 10% decline in S&P 500 might do the trick. That will bring us to 3700. (Chart 26)

Despite the massive US stock market rally last week, the breadth of the market continues to deteriorate (Chart 27).

And VIX is trading not far from 12-month low (Chart 28)

Interest rate vol is a little higher but not much more (Chart 29)

What does the market know that I don’t?

Or what do I know that the market doesn’t?

This brings me to the other war, the Ukraine war. (Chart 30)

I think pressure is intensifying for him to launch his offensive (Chart 30)

The Russians declared yesterday that they finally have full control of Bahmut. (Chart 31)

I don’t understand why it took 9 months. But the fact it did means Russians have no obvious reason to lie about it.

Yet, Zelensky continues to insist that Bakhmut is not “occupied” and the western press is going along with his account for now (Chart 32)

If Bakhmut is taken but Zelensky does not want to admit it, it can only be because he is under growing pressure from the west to show that he has what it takes to defeat the Russians

Especially, he has been promised even the F16s. (Chart 33)

I have to believe that Zelensky has to move soon, especially given the Russian missiles have been targeting his logistical hubs, supply lines and weapon depots (Chart 34)

I predicted some time ago that the Ukrainian offensive will start in May. I still feel this way.

For this reason, I think oil vol is too low (Chart 35), especially given the US crude oil inventory build leading up to the driving season has been slower than usual (Chart 36)

The G7 announced more sanctions against Russia over the weekend. It is very clear that the west has not yet reached the inflection point regarding the war. This means the situation has yet to get worse.

One war is enough for the stock market to be in trouble, let alone two wars.

I will remain max underweight stocks next week on the view that the fiscal brinksmanship will finally unfold in earnest, when both sides will take off their gloves. (Chart 37)

I will remain neutral on bonds given risk-off will dominate the bond market if I am right about the debt ceiling fight. (Chart 37)

For our absolute return portfolio, gold and TIPS will be winners if the debt ceiling fight goes down to the wire. (Chart 38)

Also, we will keep riding the AI bubble for now as the market might continue to see AI as a safe haven from the debt ceiling volatility. (Chart 39)

Now let's find out what John has for us.

Thanks David.

This week we saw something of a puke in defensive positions, with gold, rates, utilities and consumer staples all selling off sharply. I think that this validates my conclusion last week that we didn't need to add another negative beta position to our portfolio.

It may also mean that we have an opportunity to tweak our weightings to take advantage of the cheapening of these defensive assets. However if we look at our risk exposures, we can see that our defensive positions in TIP, GLD and XLU are all still above average weight in the portfolio. Therefore I think it is better to focus

on a tail hedge this week.

Last week I thought it was premature to add a tail hedge, because we don't expect significant volatility until close to the debt ceiling deadline.

Well I think we're close enough now for it to make sense. We can add a tail hedge without changing our beta by swapping out SPXU for UVXY. To see this, if we look at the distribution of returns of these assets, we can see that UXVY is much more positively skewed than SPXU. That is what we want for a short term tail hedge.

Now for my 2 cents on the Debt ceiling negotiations, I have a picture here with two news articles - one from 2011 and one recent one. They both have rhetoric about cutting funding to schools and hospitals.

This is called the 'Kidney machine gambit', and it is how government bureaucrats have tried to avoid funding cuts to their departments basically forever. In other words I think most of what we hear from the two sides is just meaningless posturing and I wouldn't read anything into it just yet.

As always I'll have full details of our new positions in more buyers or sellers on Monday. Also this week, I'll be looking at AI, to see where

regulation might help or hurt the industry.

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In a passive world, markets are hindsight discounters. Quite frustrating

Replying to

Good point. Even active is behaving like passive when returns are difficult to achieve


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