ASH BENNINGTON: Welcome to the Real Vision Daily Briefing. It's Monday, August 2nd, 2021. I'm Ash Bennington, joined today by Jack Farley and our guest Darius Dale from 42Macro. Here are the stories we're looking at right now. Stocks fractionally lower at the close after advancing this morning on strong earnings then declining after the ISM factory activity gauge weakened, I would say slightly really, for the second month in a row. Jack, what are you looking at today?
JACK FARLEY: I'm looking at exactly that. The ISM Purchasing Managers Index came in at 59.5 below the 61.0 that was expected from economists. Of course, when you're talking PMIs are reading above 50 indicates monthly economic growth, whereas a reading below 50 indicates economic contraction. So, 59.5 does indicate that the economy is still growing. It's just that as you mentioned, Ash, the pace of that recovery is itself slowing down. So, I want to talk to Darius about that. I also know Darius is looking at economic data from South Korea. Ash?
ASH BENNINGTON: Yeah, so a slight decline on the rate of expansion on ISM second derivative. I'm also looking at the infrastructure bill. Senators are putting the finishing touches on an infrastructure bill in the Senate heading soon for a vote. How big will it be? About a billion dollars in the bill in the Senate. $1 trillion on the bill in the Senate and $3.5 trillion in the House. Got a lot to reconcile there. I'm very eager to hear Darius's take on that. Talking of which, Darius Dale, always a pleasure to have you on the Real Vision Daily Briefing.
DARIUS DALE: It's great to be back, Ash. How are you guys?
ASH BENNINGTON: Doing great. Darius, what are you looking at today? What are the things that are popping out to you on your dashboard?
DARIUS DALE: Yeah, so I would say the ISM data was marginally confirming of three things we've been talking about for months at 42Macro. One, growth is going to slow on the back half of the year. Two, inflation is going to slow in the back half of the year. And three, growth and earnings are likely to start to disappoint as we get further into Q3 and obviously into Q4. And so, in terms of that the datapoint that was released this morning, I think it was really one of the few shots across the bow we've seen as it relates to slowing economic growth, most of the shots across the bow we've received in the last few months have been in the direction of accelerating inflation.
This is the first in terms of okay, the growth outlook is a lot more complicated than we also initially assumed as investors and economists. And ultimately, I think the dynamic that's at play here is an economy that is transitioning from past peak from peak demand in the goods and manufacturing sector. We're rolling past that peak, but we're not actually getting to a strong solid hand up for service sector consumption. So, we're creating a little bit of a soft patch in the economy for investors to risk manage.
ASH BENNINGTON: Yeah, extremely well said, Darius. The relationship status to the economy, it's complicated. Jack, dive in.
JACK FARLEY: Well, I want to ask Darius just about the other economic data he's seeing in South Korea, and, Darius, how are your models evolving? Because I read your note today, and you said that you expected that we were to return to a Goldilocks regime, however, deflation remains your most probabilistic outcome. Can you reconcile those two facts for us?
DARIUS DALE: Yeah, absolutely. It goes back to the post Great Financial Crisis era of bad news equals good news, don't fight the Fed, that whole mantra. I think we're likely-- after investors figure out how the Fed is likely to respond, and I think this Friday's jobs report might go a long way to helping investors understand that, hey, we're back in this regime, this old regime for many of us, not risk managers, which is, hey, we're going to cheer on bad news in the economy as long as the inflation dynamics are supportive of that. If you don't mind, I actually put together a series of charts we can walk through.
JACK FARLEY: Yeas, please.
Yeah. So, the first chart is a scatterplot. It just shows that the X axis is the latest manufacturing PMI for all the major economies in the world. And the Y axis shows the delta between the six-month moving average and the 12-month moving average. And I use that as a proxy for the trending growth trend in that indicator, and as you can see in the chart, there's some pretty large major emerging market economies that are actually in south of the X axis, i.e., they're showing trending deceleration and a couple are actually in the left which means they're still in contraction, though, China being one of the most obvious ones there.
But even the ISM New Orders print is actually looking like it wants to go below the X axis over the next couple of months. So clearly, we're very obviously moving past peak demand in the manufacturing sector. The reason I bring that up is when you look at the data that you alluded to, Jack, out of Korea, Korea publishes this business sentiment indices there, their diffusion indices very much like the [?] and survey data. And they very much track and will also lead the ISM data or not the ISM data, market PMI data, global PMI data by one or two months and those datapoints, they came out for the month of August already and they're actually showing incremental deceleration.
So, investors should expect PMI to trend lower from here all the way through the back end of the year into the early part of next year, which the third chart is showing the Korean BSI data relative to ISM data and same dynamic. Rolling over, we're coming off the cycle peak and it's likely to trend lower for a really long period of time. Over a long period of time as it relates to investable duration, three to six months. And the reason I bring that up is the next chart we show, what we call our macro regime summary table.
And so, for those of you guys who are new to our framework and how we think about managing macro risk, we think about the world in regime segmentation terms. The market regime, what markets are doing. And then there's the bottom-up macro regime, what the economy's doing. And when you see this table, the first thing you should notice is the color coding. And we're coming off this very elongated patch of this sea of this patch of green, this green grass that the US and global economies that really feasted on, grazed on for an extended period of time in terms of perpetuating risk asset performance.
Well, if you can look at the chart, you can see in Q3, sometime in mid to late Q3, almost every economy in the world is going to go from that green grass back into murky blue waters. And those murky blue waters are characterized by economies that are trending lower in both growth and inflation terms. So that's an important takeaway, and that's the reason why the VIX is making higher lows. That's the next chart, and how your credit spreads are making higher lows. But to answer your question and laying the plan on this discussion, eventually, investors will figure out that hey, all this bad news, this disappointment economically, it's going to take the wind out of the sails of inflation.
It means the labor market recovery is going to take longer to actually get back to anything close to resembling maximum employment. I'm actually starting to believe that's a different discussion that it might take even longer. And the reality is, is that keeps the Fed in the game as it relates to the pace of asset purchases. So, we have a view that you're going to see a tapering announcement in November, and then the commencement of tapering either in December or January. But even that is at risk in terms of this data.
ASH BENNINGTON: Fantastic, fantastic use of visualization of data on all of those charts, Darius, really a pleasure to look at them, because it does frame the entire global economy in a way that you can actually see it in a single place, which I think is pretty extraordinary. Jack, let's jump over to you. So, bad news is good news. Bad news is coming, but bad news is good news. What are your thoughts? Any questions for Darius?
JACK FARLEY: God, so many, Ash, I think I'll have to start with that last chart. Darius, could you explain for people at home why rising credit yields is very dangerous for the economy and how it can unwind a bull market?
DARIUS DALE: Yes, the Fed's primary transmission mechanism in terms of monetary policy goes to the credit market. What's the cost of credit? What's the marginal supply of credit? Are people demanding credit because the cost and supply are abundant across the board, supply abundant and so on and so forth. So, as you can see from the chart, and both that chart and the VIX chart are basically the same chart. They've been making-- because credit is actually a volatility product, to be quite honest.
But anyway, both of those lines have been making a series of lower highs and lower lows for an extended period of time, in my opinion as a function of that green grass in the prior table. Well, none of the grass is no longer green. And increasingly, it's likely to be broadly blue, i.e., trending deceleration and growth and inflation by the latter part of Q3 and then obviously, throughout Q4. That's the reason the slopes of those lines have inflected. Now, you can make the case as an investor that, hey, since those are lines inflected, and we actually need to go up a lot in the near term, and then obviously price in some real headaches for investors in terms of risk asset performance.
I happen to not believe that even though our model's currently saying that's an elevated probability, I happen to believe that the pace of the job market recovery is something that's going to take a little bit longer than investors expect. We've obviously been on this program for over a month now talking about inflation coming off, we got the first real evidence of that today in terms of the prices paid index, and you're going to see more and more evidence of disinflation as we go throughout the later part of the summer and into Q4.
ASH BENNINGTON: Jack, did you want to follow up?
JACK FARLEY: Yes, thank you, Ash. So just if we put that chart of the high yield back up, the top chart is the option adjusted spread, which is the basis point, so 337. That means it's 3.37% of a spread above what the Treasurys are earning, and then the columns below, the little chart, is the rate of change for 22 days. So, like four and a half trading weeks, and you'll see that from July till now, that has been increasing meaning that spreads have been widening, which is contrary to the pattern over the past year and a half. My question for you, Darius, is, if we were to go one o'clock forward two months, what do you think the high yield credit spreads will be?
DARIUS DALE: They're likely to be higher than they are currently. Who knows? I don't know if that price, sorry, because it's coming out of thin air. But I do believe that the trend has inflected and the credit spreads, i.e., the bare minimum, we're likely to be neutral for an extended period of time from the perspective of our volatility adjusted momentum signal. But the reality is we could easily break bullish and actually trend higher from here. Really, it's not about where the level is or where it's going to be in two months in my opinion, I think what's more, the bigger question for investors to answer is, how fast is the move higher?
If it goes from 337 basis points to 500 basis points over in a matter of three or four weeks or four or five weeks, that's a real, real big issue for investors. You're talking about probably a 10% to 12%, if not 15% decline in the equity market. Now, if it goes to 337 to 400 over by the end of, I don't know, let's say end of October, that's a much different environment. It's a harder environment to manage risk. It likely means the dispersion regime that we've seen in terms of investors favoring defensive sectors and style factors are the types of characteristics that stocks might have that are irrespective of how the business makes money.
And they continue to favor that defensive posturing, which is something we would argue is fundamentally sound as it relates to those bottom-up regime outlooks.
ASH BENNINGTON: Yeah. And just to zoom the camera out a little bit for folks who are not as familiar with the fixed income markets, what we're talking about here on this option-adjusted spread is the rate above US Treasurys that investors are demanding to accept high yield debt. In other words, how much more do you have to be paid? How much more do you have to be compensated to hold high yield debt right now? 337. That's 337 basis points. 3.37% above treasuries of similar duration.
JACK FARLEY: Yeah, and I've heard some people say that a bond, really, a credit bond or a high yield bond, investment grade bond, whatever, really is a Treasury with a short a credit default swap attached where you're shorting the credit default swap risk, and you take on that risk, and you paid a premium just to think of an option. But, Darius, your charts are so great, we got to go back to this. Let's put this chart up which of the table which if anyone is watching this live on an iPhone, I'm sorry about this, but I'll try and make it clear.
The United States is the very, very top and the projections is where the black turns blue. And that's when the green grass turns into the deep, deep waters. I don't know if D stands for deflation, or if it stands for the deep waters. Darius, how could you remain bullish if you think that growth is going to slow down, and deflation is going to take over? Haven't we reached the point of maximum efficacy of central bank policy? If you really think that growth is going to slow down, how could you remain bullish?
DARIUS DALE: Yeah. I'll answer the question by saying, I think a lot of investors thought we reached the point of maximum efficacy in central bank policy in like 2013, but the reality is we didn't. There's always more, there's always more. That's the one thing we've all learned or at least people my age and this is it, there's always more. Don't [?] these guys.
ASH BENNINGTON: I was going to say we keep hearing from the skeptics that that they're about to run out of bullets for the gun. And yet, there are always more shots to fire.
DARIUS DALE: The gun always gets bigger, the bullets get shinier. That's the name of this game. And that's unfortunately, a zombie economy is wired to work, right? We live in a very credit-based economy, US in particular, private non-financial debt is 50% of its [?] balance sheets or non-bank lenders are actually financing half the economy, which means they actually need liquidity to function. They need leverage, they need all these things that aren't necessarily visible to the naked eye. And this is why great investors spend a lot of time focusing on the plumbing of it all.
But in terms of answering your question, Jack, how could you be bullish? Well, it's really just playing the plant rolling the ball forward or lining the docks up as it relates to the policy response. Most of the rules in terms of those D-- yes, D is deflation. When we talk about deflation from a bottom-up macro regime perspective, it means that we have growth and inflation projected to slow in that particular interval. Those Ds aren't nearly as deep as the deep water that we saw in the spring of last year that was a function of the early part of the pandemic and associated lockdowns.
It's not the same color D, so in turn, it's not the same hue of the depth of D. So, the reality is asset markets have conditioned themselves to actually respond positively to modest decelerations in growth and modest decelerations in inflation. And guess why? It's because it means you keep the Fed involved in the game as it relates to the pace and the size of their asset purchases. So, to me, the number one bears catalyst, investors had the risk managers in 2021 was the timing and pace of the Fed taper.
If anything, investors are likely over the next couple weeks really going to come around to our view that hey, look, man, this taper thing is more monster than it is in reality in the near term, which is how you can get another couple of months of Goldilocks-ish price action out of the SPY and out of broader risk assets.
ASH BENNINGTON: Let me just jump in, again. Once again, zoom the camera up explain this hydrographic map as we map the deep blue sea here. What we're really talking about here is seeing these this reflation, and Goldilocks scenario turn a bit a bit darker, a bit more deflationary. What are some of the gauges you're looking at? And how would you explain this, Darius, at the 50,000-foot level to people who are not yet as familiar with thinking about markets in a macro framework? Just give us a sense of how you explain that reflation and Goldilocks and then what it means for us to go into a deflationary scenario.
DARIUS DALE: Yeah, that's a great question. So, in terms of how the model, the system works, if you have growth and inflation as the two primary factors that you're looking at to analyze economies, obviously in rate of change terms, you can wind up in four different states. We call it Goldilocks, that's where growth is accelerating, and inflation is decelerating. Reflation is what we call when both growth and inflation are accelerating simultaneously. We call it inflation when growth is decelerating, and inflation is accelerating.
And then lastly, we call it deflation, when growth and inflation are decelerating simultaneously. And so, in terms of the reaction function for asset markets, when you go from a reflation to a deflation, the number one thing that investors should do is go from being short duration to being long duration. That's a trade we put on nearly if you're not to go to the day, going back to early May. And that's a view because hey, we have this huge--
ASH BENNINGTON: Give us an example of that. I'm sorry, Darius, give us an example of that trade for people who may not be familiar with the duration terminology.
DARIUS DALE: Oh, sorry. Yeah, the simplest way is to be short bonds or long glass in terms of the interplay between bonds and equity market. You want to be when you're short duration, you tend to want to be long cyclicals like the financials, energy materials, industrials, when you're short duration, you want to do that, when you're long duration, you want to be in digital economy, growth type