SI424: Can Your Portfolio Survive the AI Hangover? ft. Alan Dunne

0:01 I mean, from trend following, there was a time, I'm sure where we said, you know, Q4 is traditionally a good time for trend. I. Remember that. That was definitely a stat that people used to talk about. And so, you know, we still have two months to go, so we'll see, you know,. Just like the one selling May and go away.

0:15 I mean we had, we had our fourth quarter bullish saying. Welcome to top traders unplugged in markets, success doesn't come from predicting what happens next. It comes from being prepared for what you can't pred. In each episode, we go deep with some of the world's most thoughtful minds in investing, economics and beyond to understand how they think, how they prepare and how they decide and the experiences that shaped how they see the world.

0:45 No noise, no shortcuts, just real conversations to help you think better and invest with confidence. Welcome or welcome back to this week's edition of the Systematic Investor series with Alan Dunn and I, Nils Kastulasen, where each week we take the pulse of the global markets through the lens, a rules based investor.

1:05 Alan, it is wonderful to be back with you. How are you doing? What's dublin like on October 29, 2026? I'm good, yeah. Nice sunny day here. It's nice autumnal weather, Halloween coming up. So everything is good. Yeah. Have. You bought all your trick or treat stuff? Oh, yeah, yeah. Stocked up and ready for all of that.

1:27 So yeah, it's a beautiful, fun weekend for sure. Yes. Yeah, no, absolutely. Now we've got a very good lineup today. Thanks very much to you. Things you found, things you've written. So that's going to be amazing. We even have a question that came in, so that's super. We appreciate that. Before we do that, we always want to know what has been on the radar.

1:51 So what's been on your radar? Well, there's a lot. We could have chosen so many, many candidates but one that stuck out for me recently, it was a story I've been read about the credit sector of the markets and the hedge fund industry. And it's interesting when you go to a lot of the hedge fund conferences, obviously CTAs and macro tends to be a small component relative to long short equity and then there always seems to be a large number of credit managers and it's not a space that I know very well, but I know the last few years when you talk to people about credit, the one name that kept coming up time and time again was this hedge fund Are capital which had posted very strong returns For a period

2:37 of time. The PM is a former Credit Suisse trader and without knowing much about the strategy that was certainly the name that was on everybody's lips, had raised a lot of assets really quickly. I think 7.5 billion in a very short period of time. And fast forward to this year and towards the end of October now and the same fund is now down something like 22 or 25% on the year, which is quite substantial by any measures, particularly in the credit markets.

3:08 So again, just an interesting observation on the challenge of manager selection. If you had said what's the likelihood of this manager being down 25% to those investors at the start of the year, I'm sure it would have been regarded as a very low probability. But again, just shows you how people tend to extrapolate relatively short track records and assume they'll continue.

3:32 But maybe even more interestingly the story on this is how now it's starting to be seen as almost a systemic issue in the kind of the high yield junk sector of the credit markets in the sense that this manager had been quite an aggressive buyer of maybe the lower rated, lower quality names. And with that bid stepping away, there are more systemic concerns.

3:56 So again, another interesting angle which I hadn't been aware of and a number of other credit managers have been struggling there as well. So yeah, interesting story and one certainly to keep an eye on to see how that evolves in terms of credit markets going forward. Yeah, no, I know, absolutely. And I did notice in the, I think it was like an FT article that you shared with me that they had raised a lot of money.

4:22 I think even recently they raised something like one and a half billion. And sometimes I kind of, I'm wondering how some of these firms can attract so much capital in such a short space of time compared to how long it takes in our world. I mean unless you're a replicator of course. But, but you know, it is, it is kind of interesting.

4:44 Then the other thing that reminds me of that is, you know, when I speak with Andrew actually he, he, he mentioned from time to time that in. People sometimes forget that this private label, it doesn't. It, it wasn't used to be called private Lab Private. It used to be called like junk bonds or something different.

5:05 Right. Where you kind of knew what you were getting into into. But, but as soon as you put the private label on, it's kind of oh yeah, no risk, let's just do it. All right, well on my radar this is something that's literally came in on my Radar in the last half an hour. I don't know when it came out today, but apparently the ECB president, Christine Lagarde, has announced she's going to leave her post in February of next year, which is ahead of time.

5:34 And of course it comes at an interesting time, I think, for Europe, for European fixed income markets and of course referring to the turmoil in France where by the way, for those who don't know, she used to be finance minister under Nicolas Sarkosy. And I mean, some people may say that perhaps some of the problems they're facing now is because of lack of reform back when she was in charge.

6:02 But the timing is interesting and I saw just already some commentary on this. I'd love to hear your thoughts on it. But of course, timing is interesting in the sense that we haven't quite won or the ECB hasn't quite won the fight with inflation. So that's still out there. And the other thing is that by leaving early you still have Macron and the German cancer merged in power.

6:33 And therefore it allows them an opportunity to, between themselves, kind of say, decide on, okay, who should lead the ECB going forward, as they probably have the most sway in those matters. I have no idea. But I mean, wouldn't be surprised if that's part of the thought process here. Any, any thoughts on, on this news?

6:55 Well, I mean, it's not totally unexpected. I mean, there has been talked about in market, so I wasn't shocked to see it. So I certainly had read that this was a possibility and I think Lagarde herself said she always thought she was going to do five years, I think, instead of eight. So. But you're right, I mean, definitely comes at an interesting time.

7:13 Obviously we've got European bond markets under pressure and French bond markets in particular. And obviously a lot of people are looking to the ECB wondering at what point would the ECB intervene in European sovereign debt markets? Obviously they have that facility to do that, but they tend to be reluctant to do so and particularly with a country like France which is going through the deficit procedure because their deficits are so large.

7:43 So, I mean, it adds some, I suppose, you know, delicacies to negotiation process like will commitments be given or et cetera, around supporting the bond markets from whoever goes in. Obviously, as you say, there's always a lot of horse trading around this. I mean, some of the people who I thought might have been candidates like Isabel Schnabel, she's a very common board member, she's leaving as well to go to the imf.

8:14 And Philip Lane, the chief economist, his term is due to expire, so I think it'll be some kind of political compromise, as you say, but definitely coming at a time when European bonds are under pressure. And obviously with the French presidential election coming up and the candidates there having extreme views on Europe and various proposals around getting the ECB to write off bonds, et cetera, from some of the candidates, it's definitely going to be a.

8:46 A politically fraught environment, for sure. Yeah. And I think that's the other thing, actually. That kind of. Some of the comments I saw was that by leaving early, it actually does allow her to get involved in the French election. Okay. Because apparently as long as you're president of the ecb, you can't really say anything, but you know, you can once you're done.

9:08 So. Yes. Anyways. Interesting. The other thing that was not surprising as this may be, but the other thing that is, of course, that hit the news wire this week is the IPO of Anthropic. Again, it's just way too long to get interesting to me to read up on, except I did see a headline from a commentator saying public investors would supply capital with little influence over the company's direction.

9:40 And so apparently the founders keep 50.1% of the voting power. So. So, yeah, but 100 billion. I think that is what they're looking for. And at a valuation of one and a half to two trillion dollars for Anthropic. So. Interesting times. And of course, the other thing that hit my radar is because I have been traveling a lot, I have been flying a lot.

10:08 So what better thing to do than put on a pod? And I have been exceptionally intrigued by your two conversations with two Japan specialists and optimists, I should say, Jesper Cole and Andrew McDermott. They were excellent. Fascinating insight to, of course, biased. But, you know, with Jesper, who's lived there, I think, since 1987 or something like, I mean, these are real experts in what's going on.

10:41 And I was kind of. You know, sometimes when you listen to a podcast, it's almost like, oh, I wish he would ask this or I wish he would ask that. And there's one question, because especially maybe the one I remember most vividly was the one that came out this week was with Andrew, where he's obviously incredibly bullish and pro Japan, and I think many, many good arguments for that.

11:05 But I wish that we could get his thoughts on what happened with this Carlos Ghosn or whatever his name was, where the Japanese put him in jail. And he escaped in some kind of music box or whatever. It was Love to hear his thoughts on that side of Japan, but you did a great job. That. Sounds like you're saying I didn't do my full research ahead of that one.

11:33 But no, I'd actually forgotten about that whole episode. But I was looking at another podcast saying, I saw that listening and I saw that reference. But yeah, maybe. Maybe if we get another Japan expert on that will be one to add in. Yes,. No, it was fascinating. I really hope people will go and listen to these because, I mean, it really does sound like a very, very interesting development.

11:53 And. And again, the parallels to maybe what we need to go through in Europe and in the US Is not. Not irrelevant, I think, from a. From an investment case and actually from a societal point of view. No, I think that was what I took away. I mean, both of them, very bullish on Japan. Bullish from an investment perspective, but just bullish on the Japanese model and how society, how the economy is organized, what the focus has been in terms of focusing on their core competencies in manufacturing and being highly competent in certain areas and how that is yielding dividends, which is interesting amid the massive investment in AI.

12:36 And AI technology in Japan is participating in that to an extent, but in a different way in terms of kind of providing the. More of the nuts and bolts, I would say, but. But also, as you say, the kind of the. The more recent changes in society coming from, you know, partially from the new prime minister, but more generally kind of maybe a demographic shift.

12:58 You know, like Jess was talking about, you know, younger CEOs coming in with a different mindset that, you know, the jobs for life mentality maybe has been changed and all of that. So, yeah, well worth the listen. And it certainly made me think to, you know, of a need to look more closely at Japan. You know, definitely.

13:16 You should have like your own little month of Japan every year where you invite people in to talk about this, because sometimes it's actually quite nice to follow up on. On these things so they're not completely forgotten. And I did like the fact that you pushed back from time to time a little bit on.

13:32 On sort of the importance of all the challenges that they had with their governance in the past, where it's kind of skipping over that a little bit. And then you brought them right back to that, saying, oh, well, there was some problems back then, but anyways, I thoroughly enjoyed it, so well done. And by the way, the last thing that, again, not that I have in fact checked it, but I'm sure it's right when Andrew mentioned that in terms of foreign investments, Buffett is fully 100% invested only in Japan.

14:03 I mean, that's. It's pretty amazing. Yeah. I'm not sure. I'd have to check exactly what. No, no. I mean,. Again. But, you know, I'm sure he's. Yeah, yeah. Or a big proportion of it anyway. Yeah. All right, well, let's move to something a little bit closer to Shaw, which is trend following. My trend barometer finished yesterday at 36, so that's a little bit weak.

14:24 And you know, we only have like a day and a half left of trading in October. And so I think that number is fairly in line with what's going on in terms of the performance for the month as a whole. I will say though, that the last few days have been encouraging in our space. So just to, just to make a note of that.

14:49 And of course, we can run through some of the numbers in a second. We can talk about some of the market moves and all of that stuff. But we have two months left of this year or we have a midterm election next week. So this is far from over. Even though it looks pretty good for trend followers so far, this is far from over, I would say.

15:13 Any thought from where you sit and the things you follow? Yeah, I mean, in terms of the managers we allocate to and monitor, obviously it's been a simple story of October. We've had a correction in bonds, so that's been the major headwind and at the same time gains more on the commodity side, energy in particular.

15:36 So that's kind of been, obviously, if we went back a month to September, obviously fixed income was a real standout. We've seen a correction there, a bit of a give back. So nothing unusual there. Definitely very. I mean, it's an interesting year. When you take a step back. There's been some, the usual, I mean, wide dispersion, but maybe even more than normal, I'd say with some very strong performers and some couple that have lagged for, I would guess, idiosyncratic reasons.

16:06 I guess you always get that to an extent. But some years it feels like everybody's up. But here definitely there's one or two that have lagged this year and at the same time, a couple of positive outliers. So that's certainly interesting. The midterms as well. Yeah, I mean, I think it's interesting. I'm sure I'd have to check now, but my sense is that often you see these analyses at this time of what is split presidency or White House is Republican and then the House and the Senate are the opposite from recollection.

16:42 I think that's a positive scenario for equity markets historically. But it feels like coming into this one people are a bit more pessimistic on that scenario with the possibility of maybe if the Democrats come in there's going to be a more disruptive, an even more disruptive time for the next two years with maybe pursuing Trump again and also greater pushback on the whole AI area and the data center build out.

17:09 So they're seen as kind of risks to a Democrat surge. So I'm not sure but certainly based on history, I think that's my understanding is that that kind of split, you know, government is, is generally seen as a positive for, for equity markets. And I mean from trend following there was a time I'm sure where we said, you know, Q4 is traditionally a good time for trend.

17:33 I. Remember that that. Was definitely a stat that people used to talk about. And so, you know, we still have two months to go, so we'll see. You know,. Just like the one selling May and go away. I mean we had our fourth quarter bullish. What you saying? Two things that comes up when you mention that one is that just an interesting observation by the way.

17:54 Not that we know what equity market is going to go, where they're going to go, but I would say in the last two, three months CTAs have definitely reduced their long equity exposure as far as I can tell. But the other thing you mentioned, you mentioned the word dispersion among managers and so on and so forth and actually I saw and I forget the website that was doing the comparison but and I know this is actually an argument that is used a little bit against us saying oh, how do you pick a manager and so on and so forth.

18:23 But actually there's a huge dispersion as well in the CTA ETF land as well. So not just in, in the real CTAs but also how do you pick the, the right ETF if that's what you're going to do. So yeah, that's always going to be the case when people do different things, including inside a different wrapper.

18:46 Anyways, as I mentioned, these numbers are. Well I didn't mention that, but these numbers are as of Tuesday night and I will say yesterday was a good day overall for the industry. So the numbers will be better as of last night. Although who knows what happens today and tomorrow. Anyway, beta 50 index is down just 1.16% for October, still up 13.53 for the year.

19:09 SoC gen CTA index down one and a quarter and up 14.21 for the year. SoC gen trend is down only 93 basis points and up 14.73 for the year. And the maybe the only surprise still is the Soc Gen Short Term Traders index. It's down 1.09% for the month of 5.15% so far this year in the traditional world. MSCI world as of last night is up 74 basis points, up 12.6% for the year.

19:41 If we take out the US and Canada. So we have the MSCI ETH, we're down 1.18 for the month and up just 9% for the year. So huge difference when you take out North America World government bonds. Up 80 basis points, 79 to be precise, but down 2% so far this year. And the S&P 500 doing well, up one and a quarter for the month and up 14.17 so far this year.

20:16 As usual, Alan, we need to start with your global macro view. So I am in a world that moves as fast as it does. What's your current view? Well, I just wanted to pick up on a couple of themes in the macro segment, really. One of the things we've been talking about obviously has been the Fed and communications and, you know, Kevin Warsh's new approach, et cetera.

20:43 And we had the latest installment of that last night. We had the latest press conference which was, you know, the outcome was largely expected, the Fed were unchanged, there were two dissenters and you know, as usual, not a huge amount given in terms of forward guidance, et cetera. But there were a few things that I think were interesting in the press conference.

21:05 One was, you know, the Fed now are going to have fewer meetings going forward. So that's one thing from 8 to 7 and then to 6 that are policy focused and a couple of them will be more. Strategy meetings. Strategy meetings, yes. So I mean, that's going to be interesting. Obviously they didn't really say what they were going to talk about or what would the output be in terms of those strategy meetings, but arguably a good thing.

21:32 But I guess what it does point to, as well as the point that the reason that they paused this month was because they felt the upcoming period was data rich, is that maybe we should expect less frequent actions from the Fed. But if that's the case, then presumably the actions will be of greater magnitude.

21:54 So that would point to potentially more volatility around meetings than maybe we've seen in the past. But a couple of other things. One was denoted that the tighter financial conditions and that was seen to be a good thing, which is interesting because where we've seen tighter financial conditions has been in credit markets and some of the higher yielding bonds or the bonds of neoclouds, et cetera.

22:21 So interesting. Presumably then the implication is if we saw more of that, that wouldn't be unwelcome. And the final thing that I wanted to talk about that was just interesting, he was kind of questioned as to why they didn't move at this meeting and why wait. And he kind of took a step back and wanted to reflect.

22:41 And he said, well, if you take a step back and look at what we've done is we've brought in what he called new monetary medicine. So what does that mean? It was five things. One, they've reaffirmed their target that the 2% is the inflation target. They said they've taken responsibility, they own the target.

23:00 They laid out a framework in Jackson Hole where was kind of fairly generic framework. They interrogate reality and they act. So I mean, it struck me like that's one way of presenting what they've done since May. Another way would be to say, you know, Kevin Warsh is coming in in May and they've made one minor adjustment of 25 basis points.

23:22 So it's just if somebody is presenting something that's not especially unusual as something with a label now called new Monetary Medicine and outlining five components to reeks of somebody trying to make it, what they're doing is sounding more substantial, more significant maybe than they actually are.

23:43 So I don't know if that's been unfair, but it's certainly, you know, if you want to make something sound significant, you know, have five components to it, list them off, put a label on it is always a good thing. But in reality, you know, I'm not sure, I'm not convinced about that. What I've been saying about, I suppose Kevin Warsh and this whole area of communications is he's kind of taken this approach of if they can kind of come in and talk tough and say it's 2%, 2.0, we own price stability, it's our responsibility that somehow they get some credibility.

24:17 But I think that only gets you so far and over time action is required if you really want to build credibility. So I feel like it's been one step forward, one step back with the war chairmanship. Since he's come in, he's had some good Days, which has convinced the markets yesterday wasn't, wasn't a very negative day, but it would certainly still leave some questions to my mind.

24:41 So that's still something, I think still hanging over the Fed as to why there's such labels, frameworks, when in reality the adjustments to date have been very modest. It sounds like a typical politician in a sense, selling something maybe for more what it's worth. And who knows? I mean, he has been predicted by something that he might run for presidency, you know, in the future.

25:10 But speaking of action, do you know when these task force are going to come back with actual feedback or recommendations? It's due to be the end of the year and he said some would probably be by the end of the year, but the sense was that maybe one or two would not be. But I think they're also having like a meeting.

25:31 It could be Nick in November in California, I believe, with the productivity Task force. So that's a. I think that one might have been referenced at the last meeting. But definitely we're supposed to hear some more tangible output by the end of the year. Yeah. Yeah, okay. All right. Well, I mean, in the end, obviously People removed the 25 basis points hike for September, but there's still 75 basis points I think, priced in for next year.

26:00 So, yeah, a little bit less than before the meeting, but you know, rates are still headed higher. It's, it would seem. Let's move on to something that I found kind of a little bit difficult to grapple with in my preparations. So I'm gonna definitely let you steer this one. And that was the Perkini Report, which, which when I started reading it, I thought this style of writing reminded me of Cliff Essnes.

26:35 I think he wrote a piece where he was looking back from 2035 or something like that, back at what would you have done with your portfolio? Whatever it was. Anyways, I'll hand it over to you because no doubt it's interesting. You sound like you need to be convinced, but it's from Dario Perkins, who's been a guest on Global Macro series a couple of times, who I enjoy reading and hearing from, Dario.

27:00 And obviously it's called, I think it's obviously written a little bit tongue in cheek in the sense that it's a play on the Citrini Report, which was obviously heavily influential in markets in February. And when this came out, I noticed it drew a fairly good amount of attention on social media. So I thought it was interesting from that perspective and worth a shout out.

27:23 And basically, as you Say it's written in the style of the Citrini report and as you say, not dissimilar to that cliff essence piece where it's kind of written in the future looking back and in this case it's looking back at the unwind of the AI boom and bubble and bust essentially and how that might, you know, how it might play out.

27:42 So it's kind of written from, you know, essentially I think 2030 or you know, post the boom bust and recovery. And you know, I think what it does well is it kind of sets out some of the mechanisms at play in terms of the self reinforcing AI boom. How revenues have been boosted by the capex but at the same time the expenditure has not been depreciated.

28:09 So that kind of boosts the overall aggregate earnings for the market. You've got these circular financing flows within the industry as well, which are a key factor. And it distinguishes between how the technology could be highly significant from an economic and societal perspective versus how it might prove to be not a great investment.

28:31 And one thing as well, I think from an investment conclusion, he doesn't say sell everything now. I think it is a sensible conclusion of well, how do you position for this? You have to have a portfolio that has some exposure to equities but at the same time have strategies, have assets in there that can deal with an eventual downturn and an unwind of this type of scenario, which I think is a good idea.

29:00 I mean from my perspective I thought he could have been even more stronger on some of those reflexive elements within the boom in the sense that we have this kind of soros reflexive process at play where you get strong capex which boosts earnings, which raises stock prices, which lowers the the cost of capital for some, up to a point creates a wealth effect which causes more equity purchases and reinforces the whole cycle and creates positive economic growth.

29:35 So it is a classic kind of reflexive process. The other thing is where does it all end? And in Dario's scenario it ends at some point, I think in 2027 when the hyperscalers decide to abruptly cut back on their capex spending. Which is one plausible scenario. But what you often find with boom bust scenarios is that the boom itself sows the seeds of its own destruction.

30:01 And that could be the scenario here. We started to see that a little bit more recently with the neoclouds and some of those stocks whereby this competition for capital is pushing up bond yields and those higher rates are making some of those business models less tenable. So we're already seeing some of the stress and some of this idea of, of how the higher yields could be a kind of a curtailing factor for the boom.

30:28 And then the other factor, I thought it was somewhat blase, maybe not, but certainly sanguine was on the longer term economic impact. His view was yeah, it's a boom followed by a bust. But actually the economic impact wasn't so great because from a GDP perspective strong capex is important for the US but a lot of it is seeping out to places like Taiwan and Korea.

30:52 But you know, my sense is, you know, that there is that strong multiplier element from this data center construction. A lot of, you know, anecdotally you hear of a lot of industries even here in Ireland who have benefited from that, you know, whether they're engineering firms or project management firms.

31:09 A lot of this, you know, certainly the construction sector has repurposed at least it would seem towards into the data center sector. So I'm not sure that his idea that, that an unwind would be orderly and particularly on the wealth effect, which he again seemed to think wouldn't be that significant.

31:29 But actually if you look at a Buffett indicator that's at an all time high, it's the ratio of the stock market capitalization to GDP. So every 10% fall in the stock market would have a very meaningful impact on consumption to my mind. And the other part that's missed then is that he draws parallels with the past.

31:51 Maybe it's a bit like 2000, somewhat like 1990 and that's true. But one thing that we've got now that we didn't have in those periods is very high debt levels. And if you do get an economic downturn now on the back of an unwind of this capex boom, that's going to push up debt levels even more. Every time we've seen a recession in the US debt levels always jump higher.

32:16 So that would be my major concern that in the post. I mean we're speaking of busts as a certainty. It's obviously not a certainty. But if this kind of scenario played out and we had this unwind that we could see a more severe downturn that could significantly push up debt levels again. And then you're into the whole area of fiscal dominance, potentially financial repression, which has come up a little bit so far.

32:44 But I think it would be even much more in that scenario. So I think it's definitely an interesting thought provoking paper. Everybody has a view on this boom. Is it a bust boom, bust cycle, how will it end? Will it ever end? Et cetera. It certainly presented a plausible kind of scenario, but I thought it could have been even more extreme in some ways.

33:07 Sure. No, no, absolutely. And in some ways, to me at least, it kind of brings back some parallels to your conversations about Japan and how Japan was doing in the late 80s. And then suddenly things changed and the, the fallout of that just took forever to go. To go through so. Exactly. To completely dismiss.

33:31 That is interesting. Of course, these names for reports will inspire me, I'm sure, to write the Trendini report in the near future and see if we can get the same uptake. Obviously, the way, if you want to go viral with your research, that's what. It has to be, something with Dini in there. Maybe, you know, the year is 2030 and you're reflecting on a fantastic decade for trend following.

33:56 Yes, absolutely, absolutely. You know, speaking of that, maybe you should just be reflecting on 1,000 episodes done, which we will come up to in on the 13th of January next year. We will would, I think, publish episode number 1000. So maybe that's when I publish my Trendini report. You never know. But that's not the only thing we're going to talk about because in a sense, it's kind of a nice lead in.

34:24 Because in an odd way, what the report is also I think the impression I sat with was, okay, so how do you prepare for all of this without becoming a forecaster? Right. How do we deal with that? So very kindly you produced another piece which is of course written by yourself. I don't know if it's public yet, but it's a new blog post about bond equities and the challenge of diversification.

34:53 Very much look forward to getting into that one. And I think we have a question that relates to maybe this or it's the next one, I think maybe more so the next topic we want to talk about, but let's nice and slowly, so everybody can follow along, talk about this because it's very important, even though, you know, there's been a lot of talk about these things.

35:16 But this relationship and changes to that relationship produces a lot of, you know, considerations for investors, let's put it that. Way, definitely. Well, obviously what we're talking about is the, the relationship between bonds and equities and the bond equity correlation. And yeah, I've just published it on my LinkedIn all weather investor blog, but I'll probably post the same one on beyond the Cycle on substack.

35:47 The point I wanted to make here is that everybody's talking about the change in the bond equity correlation. It was negative for many decades. You know, the 2000s, 2000s, maybe the 90s as well. It's now shifted to positive since this decade. If you go back in time, actually it was more typical to be a positive correlation.

36:11 But that aside. But I mean to some people that means, okay, the correlation has shifted from positive to negative. That means throw bonds out of your portfolio. And other people say, no, look at bond yields are higher now, keep them in better times for the 6040 head. So the point was these are kind of first level thinking as what Howard Marks would call them.

36:37 Looking at the historic correlation has so many issues with it that you kind of have to delve a little bit deeper than that. So that's the first thing. And then okay, what do you have to think about? What are the issues when you're building a portfolio? And the piece is really about all of that. But even looking at the period since 2020, you see how markets have really gone through many kind of sub regimes, maybe in that period as well.

37:04 In aggregate, you would say it's a period of positive correlation between bonds and equities. And if you were to categorize it in aggregate, it would be that inflation has been higher than in the last decade. It's been stickier. We've had more adverse supply shocks, Ukraine Covid, the war in Iran, et cetera, higher energy prices.

37:24 And all of that has contributed to that negative or sorry, that shift to positive in the bond equity correlation which has meant that bonds have had more a tough decade basically. But within NASS you've had different periods. It started off in more for a typical kind of COVID It was initially kind of a growth concern, equities, then bonds up.

37:52 Then we went into the recovery from that immediately and then we had the stagflation of 2022. But then following that we had what was called at the time the immaculate disinflation. Inflation came down without much economic costs. We've had concerns about tariffs, we've had concerns about debt. And now we've had a scenario, stronger economic growth.

38:18 So actually if you look at the rolling correlation, it's shifted quite a lot during that period. And we've had scenarios within that. We've had periods where equities have gone down, bonds have done quite well at the start of the decade. We've had periods where equities have done. Bonds have gone down as well due to stagflation concerns.

38:38 But we've also had periods where we've had kind of hints at scenarios that could become bigger, but ultimately didn't. So I'm talking about like in March 2020 and again post Liberation Day when you had kind of concerns about an unwind of the basis trade and equity selling off and bonds selling off at the same time.

39:00 Both episodes ended up being curtailed, but you could see how they could become bigger issues. We've also seen at times when debt concerns have crept into the market. We saw in 2023, we've seen it to an extent in the last while obviously people debate more growth driving up higher yields or is it debt sustainability?

39:18 But it's certainly there as a theme, but it hasn't developed into a full blown crisis in most markets. We did see that to an extent obviously in 2022 in the UK with the Liz Truss moment. So again, what it points to is that if you say the Average correlation is 0.3 since the start of the decade, that's true, but that masks a lot of variability and a lot of scenarios that played out to differing degrees.

39:43 So I think from an asset allocation perspective, the question isn't what's the past correlation been, it's how are bonds and equities going to behave going forward. In the 2010s, when equities were down about 2% in the month or more, bonds tended to be up about 2%. So that was perfect. But in this decade, because of the influence of 2022, you haven't seen that.

40:09 But then at the same time yields are higher now. So you've got to consider that bond yields are higher her and also you have to understand that correlation tells you about the co movement of assets. It doesn't tell you about where they end up after a long period of time. So actually bonds and equities were negatively correlated in the 2010s, but both bonds and equities posted positive returns over that period.

40:33 Obviously equity is much greater because they're more volatile, but it was a reasonably positive period for bonds. Whereas this decade bonds and equities are positively correlated, but equities have done very well, well and bonds are actually negative returns despite that positive correlation. So it's another wrinkle in the kind of the challenge of interpreting correlations that averages paper over a lot of stuff.

40:58 There's a lot of dynamism there. And also you get lead lag relationships as well. You can have this period where equities are going up and bond yields are going up like we've seen this year. So that's, you would naturally say well, will that be a negative for equities? But often it's yields rise for a certain period and then they bite and then you get a reaction.

41:22 In the equity market, we saw this in 1987 was the extreme example of this. Bond yields went from 7% to 10%. The equity market went up 35% between January and August. And then it was like equity markets. Equity investors said, wow, if you get 10% risk free in Treasuries, why don't we just get into that and exit at equities en masse?

41:43 But the point there was that in the sell off, bonds and equities were negatively correlated. Equities sold off, bonds went up, but you still had a huge hit to a 6040 portfolio. So negative correlation by itself isn't enough to prepare a portfolio. So I suppose I'm given a whole menu of different scenarios and different things people have to consider.

42:06 What I would say is that, that there's been this sense that okay, maybe investors should exit duration and go into short duration. And that makes sense in the current environment, but everything comes with a trade off. If we were to go into the scenario, the Perkini scenario, as you might call it, of a big equity sell off that ultimately was very disinflationary, duration would probably do very well then.

42:32 And if you've moved into short duration, you're not going to get that, that kicker from the duration side. But equally then, if we go beyond that and into the fiscal dominance scenario that I'm talking about, that might cap the fall or limit the fall in bond yields and that would justify having allocations to assets like gold or also to adaptive strategies like trend following.

42:56 So my point is, yeah, it's complicated I guess is one thing to say. You have to build and think about the allocations for multiple scenarios. And the other point is obviously people have been talking about 60, 40 and the 40 side for so long, it's almost a given that the 60 will continue to deliver. But that's obviously not a given.

43:20 So in terms of being the primary driver of a portfolio, should it be purely reliant on equity risk? That's a whole other debate as well. So yeah, the key points of the blog were very much around building more robustness, not relying on one or two assets, but being more diversified and also thinking about multiple economic scenarios.

43:43 Yeah, well, let me try and, let me try and come up with some thoughts on this. So one is you mentioned Liz Truss and the list trust moment. Did you see yesterday on the Financial Times there's an Article out. I think that she just published published her book which the ft, I think, I'm not sure they fully agree with how she account for some of the events, but.

44:05 I see she's a bookhead. Yeah, I didn't read a review or haven't read it yet. No, no, there's a review out by Toby Nangle yesterday. So anyways, people can read that themselves. Of course the other thing I was thinking of is that you mentioned the 60 40, you mentioned the 40s and historically at least if we sort of tie it a little bit back to our world or I should say maybe more my world because you invest in many things but in my world, I mean obviously trend was positioned as this crisis alpha but the crisis was always equities.

44:46 And so that's where we've done most of the studies and we have all the slides, the good looking slides to show for that that. I would say though that what this year maybe in particular have done in my view is that it's opened the debate a little bit whether that quote unquote crisis alpha couldn't be quite useful towards the 40.

45:10 And especially if you have say a trend following CTA strategy that is not too volatile, where you could almost talk like about a replacement in terms of risk levels but where you get some, you know, benefits from not being tied to only making money if interest rates go down. And at the same time, of course, you know, people still might look at it as something for the 60, but I just think it opens the dialogue a little bit as to what it's been used for.

45:44 So I've certainly seen, seen people doing that especially towards obviously some, some low volume trend strategies. But what I wanted to ask you is that maybe you just take it some something pretty simple and that is what are the kind of the worst economic scenarios that would really, really challenge a 6040 portfolio?

46:12 If we look out maybe a little bit longer than the Pikini report, but sort of the next 10 years or so, what are the things people should really worry about? Well, I think obviously I mentioned the types of scenarios that impact bonds and equities adversely. At the same time are typically adverse supply shocks.

46:35 And we've seen that obviously in 2022 with rising rates after higher inflation. And we've seen it to an extent in March of this year we saw it with higher energy prices. So obviously a big, an extreme run up in oil prices is one thing, obviously a debt crisis is another one in the sense that that's what you typically see in more emerging economies.

47:01 In emerging economies loses investor confidence. The term premia risk premia rises on the bond side but the higher bond yields then become a negative for the economy more broadly. And that influences the equity market and then a weaker market in general. And a more pessimistic growth outlook influences both sides as well.

47:22 So as I say that's more emerging market debt dynamics. But we have seen that to an extent in developed markets recently. So I think that's another one. Currency crisis could be another one depending on how they play out if they were particularly disord. So yeah, I think one of my points in the blog was if you think about the 2010s, the big risk was always seemed to be around economic growth.

47:48 Would growth be sustainable or not. And because of that we had ongoing qe, we had low rates. So that was the big risk that was constantly there in baccarat. Why? Because we were living in the post financial crisis era of the global economy was healing, it was deleveraging, it was hard to get people to invest.

48:08 Consumption was weak. Now we're in a totally different scenario. The risks are much more diverse with markets priced in tariff risk. One week it's debt sustainability, it's the risk of an AI sell off. But equally we could have an AI driven blow up or blow up. Sorry, what's melt up? Yeah, true. Yeah. You know, so I mean there's much greater variety of risks that that that investors have to account for.

48:36 I think in portfolio construction. I think the last one you mentioned there, I actually think that's a really interesting one. Right. Because we always think about risk is to the downside. But you're absolutely right. I mean the risk for investors is also missing out on something, you know, huge. Which of course speaks to you know, things that we do in the non predictive world where we just follow the price.

49:01 I mean where you can stay long bonds much longer than people thought back in the 2000s because the interest rates were so low and so on and so forth. I think that's a very important point that we don't necessarily always have to worry about the downside. We also need to make sure we have enough exposure if things continue until it all stops.

49:27 You mentioned this thing. I don't know if we need to talk about that again. But you mentioned an example where even if there is a negative correlation, bonds might disappoint. Yeah, that's true. Yeah. I mean I think that that is definitely worth making sure. But when everything is said and done, I mean how.

49:49 How are investors tradition to deal with that without being too predictive to go back to the Pikini report. Yep, good question. Obviously we have solutions that offer potential ideas for investors, but I mean, broadly means having an element of growth exposure in your portfolio but not being excessively exposed to equities and growth assets because of the obvious risks with that.

50:21 I mean, I think, I think the debate on 60, 40 has become too polarized. It's either all or nothing on bonds. I've made the point before. You can still have a core allocation to bonds that's probably less than 40, obviously. But then if you allocate to something like trend or macro, you're still getting fixed income exposure in a managed way.

50:42 So you have to think about that as well, that you've effectively got a passive core bond exposure exposure complemented with a tactically managed bond exposure. But I think having exposure to commodities makes sense. Precious metals, I think there's a case for it. I think cyclically, obviously there's headwinds to metals in the last few months that may continue, but with financial repression, fiscal dominance concerns, I think they remain a part of the diversifying sleeve in portfolios.

51:17 So my framework on this is, you know, in the paper that we published last year, it's, it's about balancing growth with diversification, with, with adaptiveness as well, which is where the, the trend type exposures or macro type exposures come in. So I think it's, and that probably leads into our next topic, but it's having greater balance for, for, you know, greater resilience.

51:41 There was one number, by the way, I thought, I don't know if you picked up on that. I just thought it was kind of interesting. You have a table in your, in your report or in your blog post where you list different start and end dates and you show how much equities did and what bonds did. And you show the daily correlation.

51:58 The one that really stood out was December 21st to September 22nd, equities down 20.5%, bonds down 60.2, and then daily correlation was negative 0.01. So no correlation. But they still managed to fall. Both of them. Exactly. By the way, that's the other thing. It comes from this, you know, this period of, you know, perfect correlation and convexity in a sense.

52:31 But I do get the sense a little bit that investors have become very demanding in terms of the convexity that even strategies like ours should provide even on, in the short term. Meaning it's almost like, oh, if equities are down one day, you, we need something in the portfolio that can offset that straight away way, which is a very, very short time horizon to try and do that and then also make money in the long term.

53:00 So I don't know if that's a little bit of a legacy that we, we were spoiled, so to speak. And you know, today it's, it's very hard to come by anything like that. We're going to jump to, I think the final topic today which is very related, of course, and that is, is portfolio resilience. We often use this word about being resilient, but we never really talk about what does it mean.

53:29 So I think we're going to do that a little bit today. I wonder, you did get a question from Torsten, who wrote into a blog post. Not a blog post, a LinkedIn post. You, you built. Is that a good time to bring it up now? Okay. All right. So he writes, building portfolio resilience is necessary to reduce maximum drawdowns and to lessening the duration of recovery.

53:52 That's I think, a quote from you. What kind could be diversifiers in macro environments, eg, rising inflation, slowing growth, which could hit a classic 6040 portfolio on both sides. Discussing the pros and cons of the different potential risk diversifiers would be very insightful. Eg, currencies, managed futures, CAT bonds, hedge fund strategies, private markets, etc.

54:18 So yeah, why don't you just jump into this part and try and explain maybe what you think of in terms of resilience for a portfolio. Yeah, I mean, as you said, this is a term that we throw around a lot in the industry and everybody seems to want a more resilient portfolio. And you'll hear people saying, well, if you add this, your portfolio will be more resilient, which is generally deemed to be a good thing.

54:45 But there's not much, there's no kind of hard definition of this. I haven't seen anybody showing how to measure how resilient your portfolio is. So I thought this would be useful and particularly because if you look at, particularly in the kind of financial advice world, it tends to be do you want more return?

55:14 And if you do, you take more risk. So it's very much two dimensional risk return axes. But nobody says do you want more resilience? That doesn't seem to come into the equation. But in the institutional world we do talk about resilience to a much greater extent. So I mean, from my perspective, a few things, I think you have to differentiate between having a resilient overall portfolio and then the components that you might use to Generate that.

55:47 So obviously where if you have equity exposure, and to the listener's question, if you add in private equity, then obviously that's not giving you diversification. It's probably not going to improve resilience. It might a little bit in the sense of fewer mark to markets, et cetera, volatility laundering, as Cliff Asness calls it.

56:13 So maybe there might be the impression of resilience, but in reality you're adding more equity risk. So I mean, what do we mean by resilience? I think the word resilient means kind of an ability to recover and an ability to bounce back relatively quickly, an ability to withstand shocks. So from my perspective, you got to think about how to construct a portfolio to deliver that.

56:42 There's a question about can you assess that kind of ex ante. You can probably assess it ex post. If you look at a particular portfolio through a long enough period and then you can say, well, how has a particular portfolio done through the major drawdowns, 2000, 2002, 2008, Covid, 2022, et cetera. And look at annualized return versus drawdown.

57:04 Those types of measures would give you a sense on how resilient the portfolio has been historically. But then the question is also what are the components that contribute to portfolio resilience? I think from my perspective that was probably, probably four things. And we're trying to develop a tool around this to help educate investors.

57:27 And they are having a moderate reliance on growth, but not excessive reliance on growth. That's one thing. Being more diversified is a second thing. And obviously being diversified again is another topic that is hard to pin down. A lot of people say, well Look, I've got 10 different asset classes in my portfolio, but a lot of them could be growth related.

57:50 So what you really need to do is calculate the number of independent bets you have in your portfolio. And obviously the more independent unique sources of return you have, the more statistically diversified the portfolio is, not counting the number of assets you have. So moderate growth alliance diversification.

58:12 I think inflation protection is another thing. You could have a portfolio that is, is defensive, but maybe not doesn't have a great ability to withstand inflation. So then that's not resilient from an inflation perspective. And then obviously being kind of able to withstand major shocks in markets, whether that is by having protection or long volume or protective type strategies or adaptive strategies like CGA's that can respond to different environments.

58:45 So I think they're all the components, components to my mind that go into a more resilient portfolio. I Mean, to my mind, you could score the portfolio on each of those measures and get an aggregate resilience score. That's the way I'm thinking about this. I mean, I'd be curious to hear how other people view that.

59:07 And then obviously you can kind of assess the resilience of a portfolio ahead of time then as well as then look at how a particular kind of asset allocation can, would have performed historically to sense check that against the actual data. So because I think where people, obviously where people kind of struggle is in terms of looking at a portfolio in aggregate and viewing individual components and obviously to produce a resilient portfolio, you may want to have some allocations to strategies that are maybe not optimal or certainly not necessarily the things that have done well in the recent past and maybe less allocations to some of those things as well.

59:53 So there is a question there as to do investors really want resilient portfolios or do they want growth centric portfolios? But I think for those that do, they're the metrics that I'm thinking of in terms of the components of what goes into portfolio resilience. Does resilience have to cost money? Because you know what I'm getting at?

1:00:17 Meaning often people talk about, oh, I'm going to have an ongoing hedge and probably going to cost them some money to do that, but resilience is a little bit different. So in your experience, and okay, maybe we don't have a lot of live data to go by, but, but I mean, is it possible to actually create portfolios that are more resilient but actually also better performing?

1:00:47 Well, I think that that would be the point of it over the longer term because what you get is with kind of more concentrated, higher volatile portfolios, you get, you get a bigger volatility drag. You know, the idea being that, you know, if your portfolio is then 50%, then it has to recover, but by 100% to get back to where you are.

1:01:08 So a more resilient portfolio can mitigate those tails and compound them at a higher rate over time. And that's the rationale for having convexity in the portfolio. In some instance, you could pay for that in terms of protection. Having strategies with a long volatility profile like cta, that type of thing through adaptive and convex, that you don't necessarily pay for that, but there are periods where those strategies will underperform relative to equity beta.

1:01:37 So you're kind of paying for it in terms of opportunity cost. But I think you can get the point is that over long enough periods of time. Certainly more resilient portfolios or more balanced diversified portfolios can deliver a more smoother ride and probably even a higher return for the same level of risk by mitigating those major equity drawdowns.

1:02:03 The point is, the major equity drawdowns come along so infrequently. Like I'm talking about the 50% drawdowns that came, you know, 2000, 2002, 2008, we had a significant drawdown in Covid. But a 50% drawdown that lasts two, three, five years, that's a different proposition. That's the kind of thing that really impacts long term compounding, they come so infrequently that people forget about the need to have this resilience, genuine resilience in the portfolio to be able to extract those longer term returns.

1:02:40 Yeah. And of course, it's always a challenge for investors with any kind of diversification, which usually means you're lagging when equities are just roaring ahead. And seeing a pure equity portfolio do better than your own portfolio is a challenge. It's an emotional challenge for investors. This was great, Alan.

1:03:02 Really appreciate that. Now we had a piece also that came across our desk, which is from cfm. I think we should keep that because it's written by one Philip, Philip Seger, that you and I spoke to a few years ago on the podcast. But we're having another Philippe, not spelled exactly the same, but another Philippe on the show very shortly where we're going to to be recording with him next week.

1:03:28 So let's talk to him about it. That I think would make a lot of sense. Cool. All right. I think we've done a pretty good job today, so appreciate that. Thanks for all the, the prep work. And of course, if you want to show your appreciation, appreciation for Alan, go read his blog and also go and leave a rating and review on your favorite podcast platform so that more people can listen to these conversations.

1:03:53 We really do appreciate. And if you have a question for a future episode, infobtradersunplug.com that is the email that I will be monitoring. And you might have a question for next week's guest because it will be Jim Kazan and he has some strong views at the moment about the world, the future. So if you want to challenge those views, here's your chance.

1:04:17 But be gentle, be nice in your chat challenge. Anyways, that's it for this week from Alan and me. Thanks ever so much for listening. We look forward to being back with you next week. And in the meantime, as always, take care of yourself and take care of each other. Thanks for listening to Top Traders Unplugged.

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