Bullish or bearish

A part of me “wants” to get bullish. Who wouldn’t? It means (usually!) good things, solid macro, markets that go up, spreads that go down, all the good stuff.

My base case is a “soft landing”, inflation goes down, unemployment doesn’t shoot up, and rates can drop from 5% currently to something less confronting (e.g. 3%).

So, why not get more bullish?

Well, imagine, just for a moment, that we have a recession because rates went up too fast.

So we would be looking back, in a kind of “post mortem” on what went wrong, and trying to see “what were we thinking at the time, how did we not notice that this might be problematic”.

And the graphs would look like this.

You would look at the above and note that each time r > r*, the real rate got above the natural rate, we had a recession (the grey bars).

That seems straightforward; it has happened each time over the past four recessions, spanning 30 years.

It is perhaps a little visually easier to eyeball with nominal rates rather than real rates, even though real rates are the ones that matter.

When the teal Fed funds line has zoomed past the natural rate estimates we have had a material downturn in the economy.

Do we really, really imagine that conditions warrant a Fed funds rate of > 5% for any length of time?

“Yes”, you might say, because we have inflation. Well, there’s lots of good data on that front, not the least of which is the one below, which shows we are past the peak of inflation. If there is any lagged effect to policy (it takes a while to affect economic decision makers), then that headline inflation measure should keep going down.

Also, if getting to some “restrictive level” and holding rates there works, then headline inflation should keep going down.

“But core inflation is persistent”, you might say.

Well, not for long, if history is any guide.

For that to be true, you’ve really got to believe that the economy is now rate insensitive, for reasons that are hard to be all that confident of (e.g. US households have “locked in” 30yr mortgage rates).

It seems far more likely that the Fed overcooks things because it is too reactive rather than measured.

So, what is the point of this note. I myself am not all that sure.

We “want” to be bullish because that would mean (circular reasoning, perhaps) that things are good. But history tells us to be careful. The track record of success for the Fed on a “soft landing” is a perfect 0.

That has to matter for one’s asset allocation.

And whilst we say “valuations are good, risk premia are supportive of an allocation in line with one’s SAA”, they aren’t so good that you would just load up and close your eyes.

So, we’ve got a fair amount of fixed income (some government, intermediate duration, 7ish years) and some credit (with duration risk as well as spread risk) and some floating (so no duration risk) and some cash and some alternatives (stuff that won’t behave like either bonds or equities or property).

If we “muddle through”, we’ll wish we had more stocks in the portfolio. If they go badly, we’ll wish we had more defensives.

A good compromise leaves everyone feeling a little unsatisfied.

But in either scenario, we stand a better chance of meeting CPI + X type objectives, than if we went all in on just one.