#959 - Green Shoots or Rising Risk? with Darius Dale

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0:35Green shoots or rising risk? Welcome to Real Vision Daily Briefing. It's Wednesday, January 24th, 2024. I'm Ash Bennington, joined today by Darius Dale, founder of 42 Macro. Darius, welcome back. Ash, it's a pleasure to be back, man. Thanks for having me. It's always a pleasure to be with the Real Vision gang. It's always great to have you on the show. Darius, it's been a minute since you and I have done one of these together. Bring me up to speed. Big picture, where are we right now? All the key variables that you track over at 42 Macro. Big picture, what's happening right now? Well, let's just hop right into the charts, my friend.

1:09So Brian, can you throw up a slide number one, our macro weather model? This is the tool, one of the primary tools we use to determine how long what asset markets are, what asset markets are going to price in, in terms of how long that's going to last, and what it's likely to transition to based on the, you know, sort of the critical variables in the economy that we're all trying to observe and predict. So we'll start with the left side of the table in the real economy cycles. Growth trending higher. It's expected to inflect and trend lower over the next 12 months. Headline CPI is trending lower.

1:36It's expected to trend lower over the next 12 months, according to consensus estimates. The unemployment rate is trending higher. That's expected to trend higher over the next 12 months, although it may not. The implied sales growth rate is trending lower. The implied earnings growth rate is trending higher. The sovereign fiscal balance, the nominal GDP ratio is trending higher. And the dollar real effective exchange rate is trending higher. Transitioning to the right side of the chart, where we show the financial economy cycles within our principal components of macro, we have our 42 macro net liquidity model as well as our global liquidity proxy trending higher.

2:06So those are obviously positive. Despite that, credit growth, both domestically and globally, is trending lower. Interest rates are trending sideways. The two-year nominal yield spread continues to price in. Rate cuts, and that's trending lower. Aggregated dollar positioning is neutral. Aggregated treasuries positioning is extreme bearish. aggregated commodities positioning is at extreme bearish levels, and aggregated equities positioning continues to be neutral. So when we backtest each of these factors on an independent basis and relay those back tests back into each of those asset classes in the middle of the page on an independent basis, we're coming up with a neutral three-month outlook for the stock market, a bullish three-month outlook for the bond market, a neutral three-month outlook for the U.S.

2:46dollar, a neutral three-month outlook for commodities, and a neutral three-month outlook for Bitcoin. And so what does that mean? Neutral just means you should expect baseline type returns and baseline type volatility in that particular asset class over the next three months. Whereas the bullish signals suggest you should expect higher above median returns in that asset class below median volatility. So it's still a decent time to be taking risks, albeit less bullish than it was a month ago when I was last on the program. Well, there you have it. Risk asset markets neither outperforming nor underperforming, performing roughly at trend based on your analysis.

3:16Darius, one of the cool things about what you guys do at 42 is that you break down all of these variables. So you can give it, I guess you call it a weather forecast, right? The weather report. You can look at all of these different variables. You can look at them over time. You evaluate them the same way week to week, month to month. So you can get consistency across them. Obviously, a lot of data that you gave us at the top of the show. That's the big picture. Let me ask you this. What of all of those variables or a couple of them do you see being the most salient, important, grabbed your attention either for good or ill based on that report you just gave us.

3:49Where's your focus on those? Absolutely. So my focus is always on what's changing at the margins. And if you look at the current signals, the thing that's changed the most at the margin or most recently is the sovereign fiscal balance to nominal GDP ratio. We went from a negative trend in that particular statistic to a positive trend in that particular statistic. And so what that ultimately means is the fiscal impulse went from being positive to now it's starting to be slightly negative at the margins. It doesn't mean the budget deficit is going to, you know, budget surplus, but obviously we're getting less budget deficits on a trading basis.

4:19And ultimately, that is taking some of the resiliency out of the economy vis-a-vis the income support we've seen in the household sector. And it's taking some of the resiliency out of the economy at the margins vis-a-vis some of the capital investment support we've seen in terms of the private sector. So in terms of the corporate sector. So things are, like I said, getting less bullish at the margins, but again, still not in terms of still not seeing anything out there that should be a big cause for concern. Tarius, for folks who don't have your macro background, break that down, explain it, talk a little bit about what the transmission mechanism you see there is and what's happening underlying.

4:52In other words, how is that becoming less bullish at the margins? Yeah, absolutely. So one of the things, so you obviously can't see these charts, but how the system works is it backtests excess returns and relates that express return back onto those three-month composite outlooks. And so ultimately what happened in the most recent weeks when that signal inflected to positive is that we went from a positive excess return signal for things like the stock market and things, for the stock market, for instance, to a negative excess return signal from that particular variable. This is a dynamic stochastic system that allows us to sort of move forward in time without having to make independent projections for all these different principal components of macro.

5:31It just allows us to actually just accept it as is and now cast what that ultimately means for asset markets. And it's done a great job of helping our clients stay on the right side of market risk. So what's happening in that variable with regard to deficits specifically? Yeah, so the budget deficit on a trending basis is now trending higher. So we used the sovereign fiscal balance as a percent of nominal GDP had been trending lower throughout 2023. I'll just throw a couple statistics at you. You know, in June of last year, the budget deficit was$835 billion higher than it was in June of 2022.

6:04Now, that incremental delta has downshifted in recent quarters. In December, it was around$320 billion higher on a nominal basis. So, again, the fiscal impulse is shrinking now. It's still positive, but it's shrinking, and it ultimately means the economy is getting slightly less resilient from the perspective of income support for households and from the perspective of support for capital investment for the corporate sector. So this is a comparison of two flow variables, Darius. You're looking at the rate at which the U.S. federal government is overspending, hence deficit, relative to the amount of growth in GDP that the U.S.

6:39economy is producing. 100 percent, 100 percent. And one other flow variable, not to diverge from this topic, but I think it's a very important discussion we need to also have here, is this bounce we've seen in productivity. So if you go back to late October, early November, when we pivoted bullish, was kind of projecting and expecting this sort of soft landing trade to really take hold. Back at that time frame, we got a data point, one of the more important data points that I've seen in recent quarters, which is we finally broke back to positive growth in productivity. And the reason that's important is because historically, in order to have a soft landing in the economy, you need two of these three things to happen.

7:17You need sustained trend or above trend productivity growth. You need the Fed to cut interest rates and pivot and try to support a soft landing outcome with monetary policy. And you need trend or above trend sort of government expenditures and investment in the economy. We have a trend and above trend government expenditures and investment in the economy. We have an outlook for Fed rate cuts, which are already being priced in the markets, by the way. So we have already gotten the rate cuts, if you think about it, from a financial condition standpoint. And we finally got the third shoe to drop, which is a trend of trend growth in productivity.

7:49So the probability of a soft landing has risen dramatically in recent months. And obviously, asset markets have priced that in. But when we think about what the go-forward outlook is from the perspective of the economy, we're not really seeing too many negative things on the horizon, at least not yet, that suggests this current Goldilocks top-down market regime needs to transition to something more bearish. Let me ask you this. You talk about what's happened in terms of financial conditions with the forward pricing of the implied or expected rate cuts. So let me ask you this. You say we've already gotten those rate cuts in terms of their impact on financial conditions.

8:23What if we get fewer rate cuts than we already got? In other words, what if the market has priced this more dovishly, more aggressively than the Fed actually follows through on? Yeah, no, 100%. I think that's the biggest market risk. And ultimately, I think that's something we're going to have to deal with as investors as we progress throughout 2024. It doesn't necessarily mean you need to put the trade on now. But at some point, our market signals will tell us, hey, it's time to put gains in this Goldilocks trade that we call for and ultimately start to pivot to something that's more bearish.

8:51If you think about it from a distributional standpoint, the modal outcome of the distribution of probable economic outcomes is very clearly a soft landing, at least according to our research. We pump out 125 slides of macroeconomic content every month in our macro scouting report. But the second most probable outcome is a no-landing scenario, a scenario where growth does not slow fast enough or to a low enough level that allows inflation to drag down back towards 2 % or thereabouts. And ultimately, we do see elements or emergent signs of sticky inflation in some of the inflation data. It's not permeating throughout the inflation data in a way that will be very obvious to the average market participant yet.

9:30But if you roll the clock forward three, four, five months into the summer, particularly once we get past the kind of accelerated deceleration that many analysts, including ourselves, are expecting in shelter disinflation, once we get into Q3, perhaps even Q4, it's going to become clear in our opinion that there are elements of sticky inflation that are becoming more obvious to consensus. And that will be the catalyst for asset markets having to price out some of those rate cuts. But in our opinion, you don't have to rush to put that trade on because, again, we're not getting market signals that are confirming of that just quite yet.

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11:15All right, I got to ask you this tangential question. as someone who's had to make macroeconomic slides for a living. When you say 120 slides per month, is the model pumping out some of those numbers for you, I hope, doing the heavy lifting? No, no, no. This is fundamental research on the economy, connecting the dots on the economy, which I think is my core competency, alongside, obviously, building a kind of metric problem. When do you sleep if you have to do 120 slides of original research every month in addition to fine-tuning the models? Look, what's that saying? If you do what you love for a living, You never work a day in your life.

11:48And I'm definitely living that, living my dream here at 42 Macro. We're doing a lot of great work for our clients, helping them maximize upside capture in bull markets and ultimately minimize downside capture in bear markets. And, you know, we invest very differently in 42 Macro. It's a lot more systematic. It's a lot more momentum-based than the average investor who's out there consistently trying to pick tops and bottoms. And at the end of the day, they're, you know, be my guest, do that. We can support you with our research. But ultimately, we found a better mousetrap that's been delivering superior results for our clients.

12:15Yeah. Yeah, and once you have the framework built, I guess from there, it's just doing the work, right? Once you've got the model, you can at least be consistent across quarter to quarter, month to month, week to week. Absolutely, my friend. Absolutely. Let me ask you this. Growth. It seems like the watchword from your recent analysis is currently resiliency. How long does that resiliency last? Yeah, so, you know, I love the word resiliency because that kind of doves down to what I think our next topic should be, which is where the resiliency or the upside surprises and growth may come from in 2024.

12:45So go back to summer of 2022 when I was on this program with you and Maggie, kind of espousing and helping investors understand our resilient U.S. economy theme that we authored back then. And ultimately, and obviously, that was the key variable, the key theme that allowed investors to either make money in 2023 or either significantly underperform, if not lose money from getting squeezed to the high heavens throughout 2023. So that was our theme. It ultimately materialized in asset markets. When we look at where we are today here in January 2024, we have another theme that we've authored and we ultimately believe may create some upside surprise in asset markets throughout 2024 as well.

13:22Obviously not in a linear straight line, but we do believe there is upside risk to asset markets based on economic variables. And it has nothing to do with the U.S. economy. It has everything to do with the global economy. You know, we're seeing green shoots globally. If you throw up slide two, Brian, we got the preliminary January PMI data out of the major economies this morning. You're seeing bottoming and green shoots in places like the Eurozone. You're seeing bottoming and green shoots in places like the UK. Japan is starting to reaccelerate. Even at the bottom there, you got the global PMI starting to bottom and take higher.

13:55Now, we're not calling for a significant acceleration in economic growth, but if you look at our models in terms of our projections, where we go on slide three and slide four, Brian, you can just kind of rifle through those. You know, the major economies in the world all have a, you know, kind of 60 to 65 percent chance of seeing a acceleration in growth over the next six to 12 months, which obviously means they have, you know, kind of a 30 ish percent chance of seeing a deceleration in growth. So, you know, we're seeing emergent signs of green shoots in the economy that can contribute to upside surprises in global growth that ultimately may, you know, support asset markets vis-a-vis a lower dollar, more global liquidity, and ultimately just better earnings, outlooks, expectations, revisions, all that kind of good stuff.

14:35And there's the grid model that you can see right there on the screen that you guys are famous for doing over at 42 Macro. Let me just get in one more question because I know we've got a ton of questions coming from our audience. And I want to ask you this because it's some important themes in what you're writing about, which is inflation. And I want to ask you not just for your inflation outlook and for your characterization of where we are today, but for you to define three key phrases, immaculate disinflation, sticky inflation, and last mile, the last one of which I think is going to be an important concept as we try and get from where we are now, 3.2 some odd percent down to the target.

15:06Yeah, absolutely. So immaculate disinflation is this aggressive disinflation that we've obviously observed across many of the inflation statistics, the most important being core PCE, super core PCE. Core PCE is tracking around 2 % three-month and six-month annualized. We're tracking around 2.5 % or 2.6 % if you look at three-month annualized, six-month annualized for super core PCE. So that immaculate disinflation just means it shouldn't be happening based on where we are in the broader business cycle, based on where we are in the labor market cycle. You typically, inflation is the most lagging cycle within the economy.

15:42It typically breaks down multiple quarters after a recession begins. So the fact that we've seen so much disinflation almost back to target with respect to core PCE suggests that it's essentially mono from the heavens. And this is one of the many reasons why asset markets outperformed most investor expectations last year. When we talk about sticky inflation, as I mentioned, there are emergent signs of sticky inflation. If you look at things like the three-month annualized rate of change of supercore CPI, median CPI, trim mean CPI, those numbers are all in the 3.5 to 4 % range still. And more importantly, not continuing to decelerate, in our opinion.

16:20So that's suggesting to me that what we know about inflation, at least historically, that it tends to break down well after a recession begins. you know, we're starting to see some stasis and some stickiness in inflation that suggests some of these broader, more well-observed measures of inflation may not continue that immaculate process. And then lastly, in terms of that last mile, that's what we mean by the last mile is that, hey, you know, we've gotten a lot of good news on inflation. But at some point, if we're, you know, if history proves correct and the models prove correct, we're probably going to no land on inflation relative to where the Fed's sort of targets are relative to where consensus has inflation projection.

16:58But again, in my opinion, it's a negative risk factor for markets. We just don't necessarily believe you need to put that trade on today like most folks would otherwise have you do. Terrence, let me ask you one follow-up. And this is a real big picture question. Maybe it shows that I'm obviously not following this as closely as you are. But my question for you is this. Do you ever wonder, worry about, wonder about or worry about the predictive power of the models for inflation when what we've seen here is so completely unprecedented, so completely off the charts. It's like CPI, PCE, PPI, whatever chart you look like.

17:30It's like the Angry Birds chart. It's literally like this parabola. It goes up and then it crashes down. I mean, it's something that we've never seen before. We've never seen a model that has this kind of gyration in it in terms of the data set getting just pushed around. Is there some risk of hysteresis, some risk of the predictive power of historical models not playing along because the data set that we've seen historically is just so completely off the charts. Ash, you absolutely nailed it. And this is why our entire investment process has pivoted for better towards an observation and momentum-based process, whereby we're trying to take advantage of momentum in key economic variables and ultimately take advantage of momentum in asset markets with our positions in portfolio construction.

18:11We used to, when I started the firm and for most of my 15-year career on Global Wall Street, would base my entire portfolio construction and asset allocation recommendations on my predictions. Where do I think inflation is going to be? Where do I think growth is going to be? What do I think the Fed or policy is going to do at some time horizon and therefore let me put on trades today? In our opinion, that process there, this positioning for predictions, in my opinion, that's the number one reason most investors have significantly underperformed asset markets over the last two and three years. And it goes back to what you just said, Ash.

18:45Most models, if you think about how investors and economists forecast growth, forecast inflation, they fall into one or two camps. They're a DSG model or they're an autoregressive model. Both of those models broke substantially in the COVID area. Obviously, we had the shutdown and lockdown of the economy that created a lot of volatility in the base rates in the time series. But we also had significant fiscal and monetary stimulus that created a lot of additional volatility in the base rates for some of these models. So this is why so many economists were wrong-footed. So many investors were wrong-footed on thinking about growth or thinking about calling for a recession last year.

19:21This is why so many economists and investors missed the surge in inflation going back to 2021 and 2022. It's because they're using broken models and broken tools. And ultimately, their entire investment process is anchored to those broken models and broken tools. That's why we've pivoted at 42 Macro to things like the weather model, which are more observational tools. Things like our global macro risk matrix, which now casts a top-down market regime. It's more observational rather than predictive. And it's done us a great job in terms of helping us stay on the right side of market risk. Yeah, and of course, you look at some high-frequency variables that give you the ability to do things in real time.

19:54100%, my friend. Yeah, really interesting stuff. Yeah, totally. All right, Darius, as you know, you're a superstar here at Real Vision. So we literally have almost a full page of questions coming in in the first 15 minutes of this show alone. So before we do that, let me just ask you, any other charts you want to get to before we jump in and start taking the year? We can just rifle through them. Brian, if you could rifle through slides five, six, seven, and eight, where we show growth expectations for the United States, for the Eurozone, for China and Japan. And what I circled on those charts, each of those charts, is the growth estimates over the next one, two, perhaps three quarters.

20:27And you see for each of these major economies, we're talking about like zero to one percent growth per quarter over the next, you know, kind of over the next two to three quarters. And so in our opinion, we think the hurdle for upside surprises to global growth, including the U.S., is actually quite high. Or actually, the hurdle is low. The probability of seeing upside surprises and growth in 1H 2024 is actually quite high. So in our opinion, I think that, again, represents an upside risk to asset markets. Because, again, you still have investors who are using those broken models and positioning for the output of those broken models.

21:03They're still in the hard landing camp. And then some of them are still in the no landing camp. and they may be forced to chase us off landing camp higher, particularly if we get to the next two weeks of data points. We got a lot of data points coming over the next two weeks, not the least of which is that productivity discussion we had, non-unit labor costs, the employment cost index, obviously the jobs report's coming as well, GDPs tomorrow, PCEs on Friday. So if we can get through the next couple of weeks of critical economic updates and not, oh, I forgot the quarterly refunding announcement next week as well.

21:30But we get through all that and we're still in Goldilocks. People in the no landing camp, people in the hard landing camp will be forced to capitulate in a way that they probably never had done in their careers. And in terms of the no-landing camp, they'll be forced to capitulate because of central bank activity restricting monetary policy and therefore tightening financial conditions, a rebound effect. Bad news. Good news is bad news. No, not quite that. More in the sense that they're just not receiving any confirmation from the observed data in the economy that suggests their positions are going to be right.

22:00Obviously, asset markets are moving away from those positions. positions. So if it stays Goldilocks, in other words, you don't see too much over here. If we can get to mid-February, if we can get through the first or second week of February, and we're still in Goldilocks, there's a very clear runway for Goldilocks to persist well into the spring. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.