Weekly Highlights: The Fed, Small Cap Prospects, The Yen, And a Critical Macro Thesis

Fed's Getting Worried

From Powell’s comments to congress today – it appears as though the Fed is beginning to fret recession risk right here:

Recession Looms??




Small Caps! Eventually

Totally agree – and we’ll definitely be scaling into small caps during the next recession:

The Yen!!

As I look across all asset classes each week the one thing that continues to jump off the page at me is the yen.

Per the below, it presently sits at historic lows vs the dollar.

30-year monthly chart (note the bullish technical setup):


Simply put, the yen is historically undervalued.

Based on PPP (consumer):


Based on The Big Mac Index:

And it's shorted, big time, across the board (i.e., huge, ultimate, short squeeze in the offing)!

Non-commercial futures traders net positioning:


Asset Managers:


Leveraged Funds:


Given the massive amount of outstanding carry trades (with the yen as the funding currency), given my expectation that over the next several months the yield spread between JGBs and USTs will narrow, and given the huge probability that the yen will likely be the best performing currency during the next recession (which, per the next chart, BCA agrees with), while I suspect we’re still early, it makes nothing but sense to continue to scale into our FXY position.

Now, while a rising yen will be a tailwind in dollar terms for Japanese equities, it’ll be a notable headwind for Japanese multinationals… On net, I suspect it’ll be bearish for Japanese equities.


Macro Thesis

This from Cem Karsan, a recent guest on Grant Williams’ podcast, precisely echoes our go-forward macro thesis, with one caveat: he thinks the market is “probably going up quite a bit before it comes down.” 

While, as I’ve explained – despite the notably bearish technicals and sentiment right here – my short-term view of yields and the dollar present a not-small immediate tailwind for stocks, the notion that we can go “quite a bit higher” from here is a tough one to support… Of course “quite a bit” is in the eye of the beholder: If we’re talking 10 to 15% at the extreme, yes, I can see that potential… Beyond that, at this point, I simply can’t… Thing is, regardless, the downside potential, before all’s said and done for the present cycle, stands to take back a few, if not several, years of equity market gains:

Cem Karsan:

“We knew in ‘98 that markets were already getting way too expensive and that there was a tech bubble brewing and things kept going for two years and eventually crashed. We knew, people were talking in ‘05, ‘06 about the housing bubble, it just went till ‘08.

So it’s coming. People understand that markets don’t go in a straight line. Things go, like we were talking about, up and then eventually come back into line.

So that’ll come. That doesn’t mean it’s coming tomorrow. And, again, I think we’re probably going up quite a bit before we come down. That said, it's coming and the cause of it is very different this time. And that’s important.

It’s a very different thing than ‘07, ‘08. It’s a very different thing than ‘99, 2000. How? Because of this inflationary piece. The Fed has been able, for 30, 40 years, to come to the rescue without any hindrance, without any cost really to what they’ve done.

The cost has been inequality. And it’s been much slower. But because we’ve reached this political point where populism, where the zeitgeist and the political forces, these millennials on down essentially saying, “I’ve gone through 40 years, I’m still living in mom’s basement. Wealth creation, household formations at 40% of where baby boomers were at this time. I can’t afford a house.”

Because we’re at this point politically, the Fed can’t just come and push more money to the rich and bail out banks and do everything that it’s done in the way it’s done it before. The response will have to be more fiscal. And this is what we saw in 2020. This is the first time we’ve seen a fiscal response for 40 years, a real fiscal response that’s in line with a great society or the new deal, these bigger pushes. So the next response will have to be politically fiscal. And the problem with that is that’s massively inflationary and what’s already now an increasingly structurally inflationary period.

So you have structural inflation going one way. We’re trying to control it with cyclical measures. We are going to have a slowdown eventually on the back of that, the wealth effect will help hold things going. But when the market does turn down and the economy’s turning down at the same time and unemployment starts to increase and we start to have cyclical issues, the boom bust cycle that we’ve seen again and again happens, it will eventually come.

When that comes, the response will be very different and it’ll be forced to be different. And the reaction of that, the inflationary impulse that will come from that, we’ll talk about a second line higher in inflation. And the problem is that is what will be really, really tough for markets. And the realization of that and the loss of faith in the Fed’s ability to bail out the markets like they have in the past, will eventually cause a much bigger issue.”

Grant Williams:

Going back to that ‘68 to ‘80 period, as you described it, they had no choice to do what they did with interest rates back then. What does the no choice scenario look like this time? What is it that gives them no choice this time around? Is it inflation? Is it a weakening economy? What is it? Do you think.

Cem Karsan:

It’s structural inflation – we have been able to keep inflation at bay because of monetary policy’s ability to be dominant. The way things have worked the last forty years, the Fed has two mandates, price stability and maximum employment.

The Federal Reserve has been able to just print money and do QE all day long ‘cause they’ve created a structural deflationary environment by doing that. They spurred globalization. We brought China online, we sent money to corporations every day. I call it, we’ve been sending money to planet Palo Alto. I think I mentioned this to you guys last time.

We’ve been printing money and sending money to planet Palo Alto. That’s not inflationary. That money doesn’t hit our shores and the trickle down of that effect is not meaningful. What we’ve done is we’ve created a supply, we’ve been sending money to supply. Monetary policy is supply side economics.

We have been pushing money to supply and then getting Ubers and Teslas and Amazons being shipped to us from planet Palo Alto. That’s not inflationary, that’s deflationary.

And we’ve been in a massively deflationary environment, which has has allowed us for 40 years to keep – cyclically – stimulating against that. Because if you keep sending money, yeah, it’ll trickle down at that time enough to cyclically stimulate some, but ultimately the bigger effect is the structural deflation that it causes. And now we’re doing the opposite.

Now we’re sending money to our shores, which is demand side economics, which has a velocity of one. Every dollar in causes that much demand. And meanwhile we’re not sending money to supply. So venture capitals had 75% down rounds the last couple of years. We’re not spurring globalization, we’re spurring deglobalization. We’re putting up tariffs and putting up borders.

And the reason we’ve had to do that is reflexively, because of all the monetary policy we did, there was one cost to that. It wasn’t the Federal Reserve’s mandate. They had a mandate of, they had one tool, monetary policy, and it was to deal with price stability and maximum employment. This was a perfect machine for them. We’ll just keep doing monetary policy and creating deflationary environment, which we then stimulate against.

But there was a cost and that was inequality. All the money went to the top. We didn’t get inflation because all the money went to the top 0.1% and 0.1% doesn’t spend the money, they invest it.

Bill Fleckenstein:

Well, we ended up with financial inflation instead of goods inflation.

Cem Karsan:

That’s correct. Asset inflation, which is like investment inflation. Exactly. But what does that do? That creates more inequality because all the owners of the assets are at the top.

And it takes time. It’s not just a matter of the inequality itself. And I think there’s an important takeaway that most people don’t realize. Inequality is not just stratification between rich and poor, it’s generational because the asset owners are older. And when you leave college, that generation is labor. And so for 40 years, labor in the US and developed world has been underperforming. That younger generation has been stuck at home. They have 40% of the wealth creation, household formation.

And guess what? Those are now the voters, the baby boomers are dying and the millennials are growing up. They’re 35, 45 years old and they’re trying to create families and they’re behind schedule and they don’t have the ends to meet their needs. Hard to get out of the house.

And so guess what? Bernie Sanders and Donald Trump come along. And people globally, same thing. Everybody is trying to cater to this populist rhetoric. Whether you’re African-American in Chicago or poor white in West Virginia, your social issues may be different, but you’re both populist at this point. It’s all about rusted out cities in middle America here in the US, and similar things in Europe.

And that rhetoric puts up borders, boundaries. We’re now unwinding. China, and labor unions are having a new push. We can go on and on and all that. Guess what? China doesn’t like that. Other countries don’t like that. When we’re going from globalization for 40 years to de-globalization, guess what? We go from a cooperative peacetime to a time of global conflict. Guess what? OPEC and entities with their own embedded power try and flex their muscles now, because it’s not just about cooperation and building a bigger pie, it’s about my people and your people and who’s going to get the money.

So we’re in a very different regime and it’s an effect from the last regime. And this is why cycles happen.

Cycles happen because of these generational effects. Inequality is not just stratification and it’s not just an accordion. It is a cycle. It’s a sine cosine graph of generations going through their own respective period.

So we’re at the beginning of a generational period of trying to get our people in the developed world back to where they want to be. And we don’t have a choice but to listen to them because they’re the voters. They’re the ones driving policy.

Look, time matters. At the end of the day, we’re amidst a major big cyclical, we are talking about decade, multi-decade, forces here. And trying to trade day-to-day directly or week-to-week or month-to-month or even year-over-year based on those is hard. Trading decade-over-decade is easier.

And so seeing these and realizing them is critical to the bigger picture. But the path between here and there is much more in the weeds. It has to do with market structure. And that’s like full circle to what we’ve been talking about.

So you have to keep these realities in mind, keep track of them. Are they continuing down the path we’ve expected and seen? Has anything changed that might affect these bigger structural forces and extend them or decrease them?

But in the context of that, you have to continue to look at the other forces and try and map out path and connect those two.