WESTON NAKAMURA: Welcome to the Real Vision Daily Briefing. My name is Weston Nakamura from Tokyo, Japan. It is Tuesday, May 3rd, 2022. I'm filling in for Warren Pies and I'd like to welcome Mr. Warren Pies, founder of 3Fourteen Research. How are you, Warren?
WARREN PIES: I'm good. Nice to talk to you.
WESTON NAKAMURA: Yeah, indeed. Tommy Thornton will be back. You are supposed to be in this seat. Instead, I'm going to be grilling you, well, [?] grilling per se. But, yeah, let's just go through some of the overnight data. In Asia, basically, you had Japan and China close.
The Reserve Bank of Australia hikes rates by 25 basis points, which was more than surveyed expectations. It's the first hike by the RBA since 2010. RBA governor Lowe is fairly hawkish, and you saw Aussie dollar rallying nearly 1.5% as yields spike. Europe slightly in the green at the close, Euro Stoxx ended up about 0.5% led by energy.
10Y German yields are now above 1% for the first time since 2015. Then it seems like US equity indices, which opened flat, are closing about 0.5% up on SPX. VIX is getting below 30. 10Y real yields are back in positive territory, and we wait for the May FOMC policy tomorrow, where we're expected to get a 50-basis point rate hike, and potentially a rather hawkish Powell press conference thereafter.
Also on the data front, US job openings rose unexpectedly to a record, 11.5 million. That's the setup going into FOMC tomorrow. Warren, did I miss anything? What are your thoughts heading into FOMC tomorrow?
WARREN PIES: I think that was a good rundown of the daily state of affairs. I'd say that we've been in a bear market this year, this is what we expected and then the rally coming off the March lows into the most recent swoon has been confusing but we spent some time trying to figure that out. Zooming in really close to the last 24 hours, we had the Treasury come out and make an announcement.
I don't think it's a huge, huge deal. But basically, underlying tax receipt data that we've been following and tracking came in strong. The Treasury issuance of new debt is going to be lower than the market expected. I think that the market read that as a potential cap on more of the backend of the curve for rates to not run away from us. Right now, it's important to keep the big picture simple, which is that you have true inflationary concerns that are pushing on Fed policy, pushing on political pressure, which has been pushing on Fed policy.
That's driving interest rates higher, interest rates goes higher, and you see a whole host of assets where valuations have been predicated on low rates for many years and so we have a repricing going on. At the same time, obviously, I think we're all like a frog in boiling water watching the Russia-Ukraine crisis and realizing that we need to keep that in the front of our minds and realize that every day brings us closer to a full embargo of Russian energy and oil.
I'm writing this week's report, and I said in the intro, that coming into the year, there was an [?] risk of stagflation and now, I think it's a coinflip that we get really brutal stagflation. That's the way I see it at this point in time, and happy to go into any of those topics with you.
WESTON NAKAMURA: Sure. I think it was pretty-- just on that point to US nat gas, it touched a new high in terms of its recent rally that we've had year to date. But yeah, let's just take a look back at-- especially the month of April was pretty brutal for equities globally, and then obviously, first quarter of the year was, I believe it was the worst on record in terms of fixed income returns. That's not good.
With that said, I was reading through your report that you put out and first of all, I really liked your steelman approach. Last time you were actually on, hosting the Real Vision Daily Briefing, you said that at 3Fourteen, at your firm, you have the steelman thing, this opposing argument by which, correct me if I'm wrong, but you're using the term within the context of the phrase, a straw man.
Basically, you're trying to proactively construct the strongest argument that goes against your own thesis or your own views in order to expose or bring to light your blind spots or your potential personal risk exposure. Basically, a mission to find what are you missing? By that definition, what did you find in your steelman analysis, and do I have that interpretation correct?
WARREN PIES: Yeah, you said it perfectly. I think it's common for strategists, for humans in general to get wedded to a position and you almost see it if you watch enough of these shows and stuff, you're going to you hear it, permabull, permabear, and inflationist, deflationist, people who believe a certain thing. Once you made this forecast, your ego gets wrapped up in the forecast. When that happens, it gets really difficult to back away from any forecasts, and that's a really tough position to be in.
You need to have flexibility. Flexibility is a huge advantage in this game. I would say even a decent model is better than no model, because a model shields your ego in that way. It's like, I'm not making this call. This is what my indicators are saying. This is what the data is saying.
It's really important to have that distance when you're trying to navigate these markets. That's something we do, we try to be really conscious of that and blind spots that could develop and turn into a bias. We've been pretty bearish. The first bearish report we wrote was in late August of last year, we said 2022 is shaping up to be a tough year.
Then by the time we wrote our outlook, we were pretty bearish on the year. We thought that we would see a Q2, Q3 steep correction in the view at the time. Now, granted, this was before Russia-Ukraine, which is huge, it changes all this analysis somewhat, we thought that the Fed would back off of their tightening cycle and the Fed put was somewhere between 3,800 and4,000.
We did a bunch of analysis and interspersing credit spreads with equities and how equities lead credit spreads, equities lead high yield credit spreads, high yield lead investment grade credit spreads. We did a bunch of analysis there. We looked at yield curve inversions and how long that lasts until the Fed backs off. We had this whole Fed pressure scorecard.
We've been bearish, and then Russia-Ukraine happens. Russia-Ukraine, my background is as an oil analyst for years, that's what I did. We quickly realized how serious this issue was for global commodity markets and already prior to that, we've been recommending having an overweight energy as a hedge to a lot of the things we saw developing anyways, and that just supercharged that trade.
We've been bearish on the markets in general and bullish on a very small pocket of oil and energy for the year. We wanted to make sure we weren't getting-- we had this big rally off the lows in March, and we wanted to make sure that we weren't missing something. We did this what we call a steelman approach which you described well, and we found that this is especially helpful when you're in consensus, which at that point in time, bearishness wasn't the consensus, so I have some self-awareness and realized at that point, AAII survey was at 15% bulls, which is a 30-year low.
When you look at some of the other things we thought that were ostensibly bullish, we model different types of investor portfolios a 3Fourteen and if you're running a vol targeted strategy, which is pretty common, you would have derisked quite aggressively through the middle of March. We're at levels that have historically marked midterm, intermediate term bottoms. We haven't asked--
WESTON NAKAMURA: Sure. Let's just cut in right there. Brian, can you pull up Chart 1. This is from-- as always, I like to steal my charts from my buddy Craig Peterson at the Tier1 Alpha, he studies this very carefully. This is basically just a chart of S&P realized vol and the market day to day declines or advances.
The argument being that as realized vol continues to trend higher, risk parity type strategies, which was over a trillion dollars of AUM, or it was at one point, attach that will derisk because that's how their models are designed to do much to what you were saying before about how you don't invest based on ideology, you just invest based on rules based. That's what's contributing to a lot of this, I guess if you want to call an orderly downtrend or this this bear market or whatever we're in currently on SPX.
I just wanted to pull that that chart up, but it seems like in your report, you were saying that these vol target strategies, yeah, they indeed have been selling off because of realized vol. However, they are at a point in which they're done selling. Is that correct?
WARREN PIES: Yeah. There's a nuance there. Most of the time, we were doing 10% targeted vol, and we were doing a 20- and 40-day blended look back, and most of the time, you see we're at 40% exposure on those. That's just a really another fancy way of looking at realized vol truthfully and trying to put it in portfolio management terms.
We were at 40% of exposure, which is the usual decent place to buy, but that's not where you would really want to get if you're looking for rock bottom positioning, 25%, which is where we were at the COVID lows, for instance, and a few other times, at major lows during the history and we have some studies we showed around those 25% level. There was derisking, but it wasn't enough, ultimately in the report to jump to the end.
It's like we examined all this bullish evidence, we didn't convince ourselves to turn bullish. We remained in the bearish camp. The other things, just really quickly just to walk through the things we did find that were bullish and then I'm going to walk through a new bearish development, I think frames of the stagflation stuff. TINA is a well-known thing, there's not very many places to put your money.
If you run, Brian, if you put the drawdown of a 60/40 portfolio up on the screen, basically, the drawdown of a 60/40 portfolio, traditional 64/40 portfolio has hit the levels that we saw at the end of the tightening cycle in 2018. The Fed's jawboning has already pushed us into this world where stocks and bonds are selling off together, and equities look relatively compared to bonds probably better.
WESTON NAKAMURA: Just to clarify, the risk parity is basically almost like a 60/40 but levered on the 40 side and then you have the MOVE index and rate vol exploding as well. That all ties in together, they're basically the same strategy or cousins of one, that are selling off together.
WARREN PIES: Exactly. Our model, when it rebalanced and we have a hybrid version of risk parity in our asset allocation model, we use a hierarchical risk parity. It's a little bit different, but we still ended up looking at vol in our stuff and coming into May, it went heavier into equities and lightened up its bond position. That's something that you see mechanically happening throughout the markets at a larger scale. This is a real phenomenon.
Couple other things, despite the fact that we saw the index down only like 10%, 13%, whatever it is, under the surface, obviously, there have been a lot of no profitless tech companies and bubble type of stocks that have already been taken out behind the woodshed. There's evidence of the bubble deflating. Macro momentum, we talked about the tax receipt data, how strong that's been, and we saw that flow through in the treasury issuance guidelines yesterday.
Then the other thing, which is not probably popular around here to talk about, but if you look at the implied inflation schedule from the TIPS market, inflation breakeven market, you can see that really, we've seen breakevens rise, 10-year breakevens and five-year breakevens especially have risen a lot since the Russia-Ukraine war. We break it apart here on this bar chart, and we look at where were we on each year's forecast by the bond market of where and how inflation will go.
Then we looked at blue bars, pre-invasion, purple bars, post invasion, the gray bar is the most recent datapoint we had in this report. The key thing here is that the bulk of the move, 85% plus of the move we saw in 10-year and five-year breakevens occurred from inflation happening in the next 12 months. This was like a big pig and a python of inflation coming through the market.
The big question in my mind is going to dictate how quickly you want to get back into the market and with some risk asset exposure, even bond exposure in general, is will this inflation schedule hold? Or will some of that next 12-month inflation creep into 12- to 24-month inflation, what we would call one-year, two-year forward, one-year, five-year forward? Anything outside of that next 12-month inflation, will that creep into those out years? If it does, then we start seeing a structural shift in this inflation outlook versus something that is honestly a little bit more transitory.
WESTON NAKAMURA: On that note, so I have a clip here from-- this is an interview with David Rosenberg from Rosenberg Research Associates, being interviewed by Alex Gurevich, very famous central hedge fund manager, rate vol trader. They basically talked about how the Fed essentially has a pretty high probability of putting the economy into recession. Let's take a look at that clip.
DAVID ROSENBERG: If I didn't have the conviction in my call, and like I said, there is no such thing as a sure thing, but I do have conviction in my call. I am not 35% recession. I am 80% recession odds for this year, 80%. Now, people will say, well, what happened other 20%? Well, the 20% is that there's things that could happen, and if we get some exogenous shock, or something happens to cause inflation to start to come down more quickly, the Fed will not raise rates the extent that's priced in right now. The Fed will not do what it's pledging to do right now.
That could be the soft-landing scenario is that, for whatever reason, inflation comes down, and the Fed recognizes it in time. I have lots of reasons to believe that inflation will come down. I just don't know if the Fed is going to see it in time. They're so prone to making policy mistakes in both directions, but there is a 20% chance that we can emerge from this with a soft landing.
I'm not saying it's 0%, but then you got to ask yourself the question, you're the portfolio manager, well, if I believe and Dave Rosenberg's view of 80%, understanding there is no such thing as zero or 100, is my portfolio and my asset mix positioned for an 80% chance of recession?
WESTON NAKAMURA: That was David Rosenberg being interviewed by Alex Gurevich. Just as a programming note, I also want to mention, I actually have a video coming out as well, in which I get my personal takeaway on some Real Vision content. I used to do this on the Real Vision's Exchange a lot. This is the actual video that I did the first one of those on.
Warren, what Rosenberg is actually saying is that if you just look at history, so essentially that you've had 14 in the post-war era, last few decades, you've had 14 Fed rate hiking cycles, 11 of which ended in recession. The Fed's, I guess, if you want to call it batting average, or whatever, in terms of dragging the economy into a recession during tightened cycles, is about 80%. That's where he's getting his 80% from. The other three out of the 14, those were the soft landings, so 20% chances of a soft landing, 80% chance of recession.
Then he also looks at markets and markets are currently priced at approximately 30% pricing in a recession and so therein lies the mispricing discrepancy. Any thoughts on that? I know that you were-- we just went over your, the holes in the bearish argument and [?] from the bullish argument, but how does that stand up your current actual view, I guess you're still bearish, against David Rosenberg? It sounds like you guys are aligned.
WARREN PIES: Yeah, I don't know about putting an exact percentage on it. We ran some recession probability models and we definitely saw a threefold increase from January through the end of March. But the big thing is we're just seeing cost pressures skyrocket, and it's from the Fed and from the war, and those are the two major-- and there's some supply chain stuff too, but the cost pressures are skyrocketing.
We have mortgage rates shooting up at the same time oil prices are skyrocketing, and food prices are skyrocketing. What we have is really the beginning stages of what I think could be a stagflationary period. You would see growth decelerate and start to roll over. If you look at headline, another chart, I passed along you, Brian, headline versus core CPI, what we're recalling the CPI spread.
Headline CPI includes food and energy, core is stripped out food and energy more or less. If you look at this, this one is the one with commodities, you can see that the spread between headline and core moves with commodities. We've hit this 2% spread on the headline versus core for the only the fifth time, a distinct time in modern history. If you go back into the 1960s, this has only happened five times. It's like 1973, 1980, 2005, 2007, 2022. Those are your cases.
If you look at the next chart, which is market performance for the next two years. You can see these are vol times. The lines can go all over the place, but the history of these periods, there's a lot of volatility, sharp drawdowns. The Fed's having a fight with inflation and consumers, ultimately, your liquidity has been stolen by these cost pressures.
Yeah, I think this is part of what we wound up back in the bear case is because we don't see a quick resolution to the war. We don't see any way for-- even with the China lockdowns, oil is above $100 a barrel of oil. The cost pressures on the US consumer are tightening everything really quickly here.
WESTON NAKAMURA: Yeah. By the way, I really liked that analysis, that spread, the core versus headline spread analysis that you did. I have a question here from YouTube, question for Warren Pies. Do you see demand destruction affecting and hurting the price of XLE or other oil stocks in the next six months or less? Just go off that last point you were making.
WARREN PIES: No, I don't. I don't think we're there yet. We're at $100 a barrel, and that's with China doing intense lockdowns. Now, I think the only way we-- I've said this from the get-go, is that when you look at historic recessions, we think when the dust settles off of the sanctions, self-sanctions, everything that's happ