Last week, I issued a challenge to test your macrotrading mettle. I asked you to indicate whether you would go long, short, or neutral over a broad range of assets in three different scenarios: 

Scenario One: The United States goes into a recession. This drags Europe into recession and slows Asia down significantly. Inflationary pressures abate. This is the “US as locomotive” scenario. 

Scenario Two: The United States economy goes into her recession, inflationary pressures abate in the US, but the recession does not spread to the rest of the world. European growth is reasonably strong with mid to high inflation while Asia continues strong growth with inflationary pressures. This is the so-called “decoupling” scenario.

Scenario Three: Both the US and European economies are characterized by recession and inflation – stagflation. Asia slows down while experiencing inflation as well. This is the “stagflation” scenario. 

I want to emphasis just how useful such an exercise can be in the current climate of uncertainty when “buy and hold” in U.S. stocks is a dead 20th century artifact. 

The matrix below offers my view as to where the best direction of the trade lies. Note that I do not allow for any secular trends in the trade, only short run cyclical movements in the asset classes. 

I had many good responses to the challenge. Much of the disagreement many respondents have with the chart below is the result not of bad macro thinking but rather of bringing secular trends into the calculus. For example, energy is a clear short in the U.S. as Locomotive Scenario based on falling energy demand. However, a secularist might argue that the market is supply-constrained and will continue to move up in a secular trend. I don’t discount that rationale. However, it is not part of the assumptions underlying the challenge.

Below the chart are my explanations for the boxes. Clearly, the hardest part of the matrix is the currency pairs, as I shall explain below:

The Commodities

I view gold as primarily an inflation hedge. While energy and industrial metals have some inflation hedge component, that component is assumed to be dominated by the cyclical nature of energy and metals demand.

Under these assumptions, in Scenario I, gold is a short as inflation moderates and energy and metals are shorts as cyclical demand moderates.

In Scenario II, robust global demand and inflation make gold, energy, and metals all longs.

In Scenario III, inflation makes gold a long while recession makes energy and metals shorts.

The Bond Market

The critical relationship here is the inverse relation between bond prices and interest rates while nominal interest rates rise with inflation.

While the Fed and ECB set short term interest rates, the market sets long bond rates based on expectations of inflation. Falling inflationary expectations in the presence of recession lead bond investors to go long the long bond to lock in higher yields. As inflation falls, interest rates fall and bond prices rise, rewarding bond investors.

In Scenario I with recession and low inflation, going long the long bond is clearly the winner while in Scenario III, inflation makes the long bond a good short.

Scenario II is the most difficult. Recession and low inflation in the U.S. suggest going long. However, as interest rates rise in Europe and Asia, bond investors may move out of U.S. bonds, causing bond prices to fall. 

The Currency Markets

Scenario II is the most clear cut. With the U.S. falling into recession and cutting interest rates and both Europe and Asia growing, interest rate differentials between the U.S. and Europe and the U.S. and Asia will put strong downward pressure on the dollar. Thus, both the Dollar/Yuan and Dollar/Euro pairs are shorts. As for the Euro/Yuan pair, this has to be an N. We just don’t have enough information about relative interest rates and relative growth rates. Nor do we know how committed the Chinese will stay to the Dollar/Yuan peg.

As for Scenario I, this one is very sticky. The Dollar/Euro is clearly an N as both the U.S. and Europe are in recession and rate-cutting modes. However, it is unclear which entity will cut more aggressively. 

One can offer at least a weak argument to short both the Dollar/Yuan and Euro/Yuan pairs on the assumption that both the Fed and ECB will be more aggressive at cutting interest rates than China. This could easily be an N as well, however.

Scenario III seems to be a total spin of the macro wheel. You could argue longs on the Dollar/Yuan and Dollar/Euro pairs on the U.S. as safe haven argument but shorts on the “Asia grows faster” argument. 

The Equity Markets

I assume that equity prices reflect profit expectations and that current growth projections are built into stock prices at the beginning of the period BEFORE the scenarios unfold.

In Scenario I, both U.S. and European equities are clear shorts as are U.S. growth stocks. More subtly, Asia is a short as well because a slowdown is sufficient to trigger a cyclical bear movement.

Scenario II features shorts for both U.S. S&P and growth stocks on declining profits while Europe and Asia are clear longs.

Scenario III features four of a kind – shorts across the board.

U.S. Residential Real Estate

Scenario I is a clear short as consumers retrench in a recession. However, this is a good sector to try and find a bottom as the Fed cuts short term rates, the recession plays out, and eventually a new expansion led by housing takes hold.

Scenario II leans to the short side for the same reasons as Scenario I. However, robust growth outside the U.S. coupled with a fall in the dollar as the Fed cuts rates may bring in foreign buyers into the U.S. real estate market to prop up demand. I favor N here.

Scenario III is a housing market nightmare and a clear short. Recession depressing demand plus inflation driving up mortgage rates is the killer. 

CONCLUDING COMMENTS

Readers may quibble with at least some of this logic. However, keep in mind that most of the disagreement I detected in the submissions to the challenge came from those arguing countervailing secular trend arguments not embodied in the assumptions of the scenarios. I encourage such richness of thought. 

AND THE WINNERS ARE:

The three top winners of the challenge were those who not only filled in the matrix (mostly) correct but who also gave sound macro arguments for the direction of their trades. These winners plus “best in show” are:

Jouni Harjula (Best in Show!), Ron Husker,Richard Kolon, Magnús Sigurðsson 

Congrats! 

HONORABLE MENTIONS 

Keep up the good work: 

Kurt Oldenbrook, Omer Gicvan, Frugal1stMillionat33, Richard Yates, David Merrill, Rob Sturgill, Albert Ohandjanians, Fred Dupont, David Harooni, Sinisa from Croatia

“Any trader or investor who ignores the power of macroeconomics over the world’s
financial markets will, sooner or later, lose more than they should—and if they are
trading on margin, perhaps more than they have.”
 -- If It's Raining in Brazil, Buy Starbucks

The Market Edge Market Summary from www.marketedge.com 

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Peter Navarro
Irvine, California USA
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DISCLAIMER: This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever. Trading and investing involves high levels of risk. The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The authors may or may not have positions in the financial instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future performance.