Podcast Transcript: Andy Constan on Lessons From Bridgewater, Equity Valuations and Top Trades

This is an edited transcript of our podcast episode with Andy Constan, published 18 March 2022. He has spent the past 33 years investing and trading global markets. He’s worked at leading hedge funds Bridgewater Associates and Brevan Howard as Chief Strategist and is the founder of Damped Spring Advisors. In the podcast we discuss, the problem with bonds, how to outperform the market, what is next for the Fed, and much more. While we have tried to make the transcript as accurate as possible, if you do notice any errors, let me know by email.

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Introduction

Bilal Hafeez (00:00:01):

Welcome to Macro Hive Conversations With Bilal Hafeez. Macro Hive helps educate investors and provide investment insights of all markets from crypto to equities, to bonds. For our latest views, visit macrohive.com. Markets can be fickle and appear to have shrugged off any risks from the Russia-Ukraine conflict. We’ll see how long that indifference lasts, and in the meantime, all eyes have been on the Fed, which just recently hiked interest rates. The first of what are likely to be many interest rate increases.

Dominique Dwor-Frecaut writes a piece on what this means for the US economy. And also we updated our US recession indicator, which uses the yield curve, and it continues to show a high probability of a recession in the next 12 months. For equity investors, we look at whether European banks are attractive to invest. The picture looks very interesting. On crypto, we look at whether the Feds hike could actually be bullish for Bitcoin. Then on the educational side, we have an explainer on how the European Union is defining what energy sources are green or not, which then has an implication for green investments.

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Now, onto this episode’s guest, Andy Constan. Andy has spent past 33 years investing in trading global markets. He’s worked at top hedge funds, including Bridgewater Associates, and Brevan Howard, and Andy started his career at Salomon Brothers. Now, onto our conversation. So, welcome, Andy. It’s great to have you on the podcast. I’ve been looking forward to this for a while now.

Andy Constan (00:03:21):

Wow, thanks, Bilal. Pleasure to be here.

Bilal Hafeez (00:03:23):

Great. And as usual, before we jump into the meat of our discussion, I always like to ask my guests something about their origin story. So what did you study? Was it inevitable you would end up in finance and how did you end up where you are today?

Andy Constan (00:03:35):

Well, I studied biomechanical engineering at University of Pennsylvania and no, I had no intention of coming to Wall Street and spending my time in finance. I wanted to be a doctor, but my grandfather was a neurosurgeon and his brothers were doctors. And one of them pulled me aside during college and said, “You don’t want to be a doctor,” because he had a lot of things with malpractice insurance and the changing dynamics back then about how healthcare was going to work. I still think about that decision and what it could have meant to helping people, but I’m happy doing what I’ve done and that happened because of the fraternity I was in and the close friends I developed there, a couple of which had a birth story that was destined to Wall Street.

It was also the time, ’86 was when spreadsheets really had become invented a couple of years prior. And so, quantitative analysis of corporate finance deals was all of a sudden a thing. Whereas, it had been entirely relationship and less by the numbers. Now everyone had a discounted cash flow analysis or a LBO model or whatever, and they needed young people to crunch those numbers. And so, they started hiring aggressively and I wanted to live in New York by that time and join Salomon Brothers.

Bilal Hafeez (00:04:52):

Okay. That’s where you started. You started as a junior as a grad and which department was it?

Andy Constan (00:04:56):

It was in the corporate finance department. I was in their analytical section, which was the ones who were called in for more complicated analysis. There was two departments like that, mergers and acquisitions, which focused on that very narrow section. And then all the other potential needs of a company were done by my area. And then there was the whole relationship team that actually managed the relationship with the client. And so, we would be called in for pluses and minuses of a particular style of issuance, convertible bonds versus equity versus debt, things of that nature. And also try to model more complex problems. That was where I joined and I really started, excelled there. Thankfully, it was fun. Worked crazy hours like they say. I think I was at the firm for the entire month of February in 1987 and many all nighters and that whole thing. And so, that was fun, but I also had the blessing of being invited to be Salomon’s representative on the Brady Commission after the stock market crashed, and that really generated the thirst I’ve kept since then about solving what happened in markets and what could happen.

What Andy learned from Bridgewater and Brevan Howard

Bilal Hafeez (00:06:07):

Okay. Yep. Understood. And so you spent a number of years on the sell side, but then eventually you moved to the buy side. So how did that transition happen?

Andy Constan (00:06:14):

So, throughout my career, Salomon was a market maker in lots of different things. I was on the convertible bond trading desk. And during that period of time, there was a big question of where proprietary trading should happen. Salomon had its, arb group, which focused on fixed income, but everywhere in the firm from the high yield desk to the convertible desk, to the derivatives desk, even the equity desk would have a fair amount of their P&L would be associated not with market making, but with proprietary trading. And so, I’ve been proprietary trading ever since. And the natural place to do that eventually is in a hedge fund.

A number of my colleagues started Long-Term Capital, and I knew those guys extremely well and thought about asking them to hire me during the mid-90s, but my career was taking off at that point in time. It was always a goal to do what I do proprietarily at Salomon in the hedge fund industry. And then it was just a matter of timing from then. And that happened in 2003. A bunch of my friends in the fixed income area decided that they wanted to start a hedge fund, and the equity area at Salomon at that point was dealing with the post-tech bubble, and more importantly, the Spitzer led questioning of how equity research is handled and paid for, and for whom is it really for? Is it for investors or is it for sourcing corporate finance relationships? And that created a bad dynamic for equities, which on the back of the tech bubble was already dealing with more automated trading, lower commissions, lower volumes, and higher costs because the investment banks were no longer allowed to pay any portion or control any portion of the research budget.

And so, there was a lot of firing going on. I was running global equity derivatives at the time and my business was actually flourishing doing extremely well because of a variety of mergers and the talented people we brought together in the late ’90s, and also good environment for derivatives. And I looked at my next job, which would be my boss’ job, which was running global equities, and realised that was the job I’d never want. And so, that really said at the same as my friends were starting a hedge fund, I didn’t want my next job at Salomon. And so, I chose to join them.

Bilal Hafeez (00:08:46):

Yeah. And then how did you find the difference between prop trading at a sell side institution versus trading or being a portfolio manager at hedge fund? Were there differences or was it the same?

Andy Constan (00:08:58):

So, I would describe it differently. Because we were… The prop trading was part of the daily function of market making because it wasn’t separate from the customer business at Salomon except in certain, a very specific area. You were constantly active making markets as well as holding inventory and managing your inventory and constantly busy. Actually, because you were collecting the bid offer spread, it paid for you to be busy. When I joined the buy side. And I think this is true of many, many, any traders I’ve seen through the years when they go from the sell side to the buy side, particularly those who go from sales to trading, which is a common occurrence as well. Because they have the relationship typically with the hedge fund that they join is that when you sit in a hedge fund seat, you are bombarded with information from people who want you to trade and sell side people like to trade and be active, but in this case, they’re now paying the bid offer spread.

And so, the biggest challenge, which I overcame in a very concrete way is to try not to answer the phone and to not trade. The information is useful that these people send you, but it is in itself toxic to trade. And so, I took active steps to avoid trading, essentially. Things like going on a long run at 11:00 AM and then having a lunch and then getting back on the desk and having 1,000 messages or 100 messages and responding to none of them because it simply isn’t a good use of my time, and counting on certain people who I ended up trading with fairly actively when I did trade to be self filter for what’s useful to me so that I got to know the sell side well, but made some close relationship ships with salespeople who knew what I wanted and didn’t waste my time. So, I think that’s the biggest thing.

The second biggest thing is personally. So, as a proprietary trader at Salomon and as a hedge fund CIO and founding partner at two different funds, RV trading strategies, which is what I was doing are both at Salomon and at my hedge funds have far more macro and beta-like risks than I think most people realise when they start out in the RV space. And so, when macro is doing a certain thing like tightening and markets are being de-levered, it hits RV relationships very, very hard. And so, in 2008, we had just launched a new fund. My original partnership broke and we closed our original fund. And a few of us started a new fund. We started at bad timing, so it never really got off the ground with funding. We had a seed investor, but by the time we started, there was literally nobody allocating money because The Financial Crisis had started. But what I saw is all of these relationships that I would’ve thought would’ve been great relationships to do RV acted like beta, and had huge drawdowns.

Things like there’s the classic trade was Citadel famously was long a whole bunch of cash corporate bonds and had bought protection at below the cost of the coupons that they were receiving from the bonds. So, essentially had a bonafide arbitrage, and they’d simply hold the thing and collect it. But during The Financial Crisis, no one could hold cash bonds. No one would let you do recall on cash corporate bonds, and those cash corporate bonds started falling and the CDS didn’t because those didn’t have any collateral problems. And so, corporate bonds traded at one point… You could pick up 400 basis points on a perfectly credit risk covered transaction. Now, part of that was the counterpart risk, but the spread had gotten astoundingly large during that period of time. And it just tells you that when margin calls are happening, RV is not immune. And so, that really made me think that the next set of learnings I wanted to do was understand macro and that’s the reason I joined Bridgewater.

Bilal Hafeez (00:13:13):

And so, you went on to join Bridgewater and then Brevan later as well. They’re obviously two very prestigious hedge funds. I mean, what were the main things you learned from those organisations? And they all have very distinctive cultures as well.

Andy Constan (00:13:24):

Sure. And I learned amazing things from both. It was really a great set of places to really perfect my understanding of macro. Let’s start by saying, I’ve always been on a journey from the late ’80s till today in comparing systematic trading strategies with discretionary trading strategies. And my vision has been that there is no discretionary trader who if really pushed and shoved could… And it’s very hard and it’s not easy to do, but is anything more than a systematic trader. They follow rules. They identify things in the world. They compare them to how things happened in the past and make connections to a particular worldview at the moment and what is likely to happen.

And so, Ray Dalio used to say that his vision was to have computers do that function. And essentially what he wanted the computers to do is identify today, the snapshot of what’s going on in the world in pricing and economic conditions, recognising that he was doing it with data, which provided a pixelated version of the picture, a Georges Seurat impressionistic picture and his job was to fill in as many dots as possible so that he could see what’s going on. And then use computers to compare those dots with prior dots and what subsequently happened after when those dots aligned. And so, he could compare today with past pictures through history and then look at those past pictures and see what outcomes are. And that’s what a systematic trader does. It’s constantly looking to refine the dots and get a clearer picture.

When I think about a discretionary trader, a discretionary trader is analogue, sees the world as it is in its full vibrancy, colour, depth, and focus. And so, doesn’t have any problem with missing dots that he just hadn’t gone around to putting in the systematic guy’s pixelated picture. He sees it all. What he has trouble doing is that it’s very difficult to compare an analogue picture to a prior analogue picture because there’s no way a computer can help you with that. So he has to use his brain to compare those things. And that’s something that’s complicated, but the great discretionary traders of which Alan is one of is able to do that.

And so, really everyone’s just trying to figure out what the picture is, whether it’s an analogue picture with its vibrancy or a pixelated picture with as much of the image as you can get and compare it to history and history doesn’t necessarily repeat, but in some way, get some grounding for the future because alpha is predicting the future. And so, that’s what I got. I’ve been thinking about that my entire career and watching Bridgewater build the pixelated way to trade markets in a purely systematic way and Alan in a purely discretionary way having his own great success was probably the biggest learnings I had in working at those firms.

Bilal Hafeez (00:16:38):

And so, now in terms of your process, you implied earlier that there is a way to systematise discretionary views or you were saying that you have to run both in parallel and combine them somehow?

Andy Constan (00:16:49):

I think there’s a theoretical way. I don’t think anyone’s done it. And I certainly haven’t. I think what you have to do is respect what you can get from each and that I’m not… Whereas, Bridgewater is religious about it and Brevan is religious about it, I’m not. I’m agnostic about what tool I use and use them both.

Setting up all-weather portfolios

Bilal Hafeez (00:17:05):

Yeah. And you mentioned alpha earlier, which brings on the question of beta where we hear about 60/40 portfolio, where we hear about all-weather portfolios. Some version of kind of being long in the market in some combination of assets. And then, so should that form the core of your investment and then you have alpha on top of that or do you look at things differently?

Andy Constan (00:17:28):

I definitely believe that owning assets in a diversified way with balancing whatever risks you can get balanced. Whether diversify away country risk, diversify away security selection risk, diversify away importantly, and this is the all-weather concept, diversify away exposures that you don’t have a view on through time like growth or inflation in particular, which are the principle drivers is the best way to make money over the long term. And there’s some challenges to that view at the moment with one of the key security types not providing what it used to provide in terms of exposures and that’s bond markets globally. Bonds have always been a good anti-growth asset and you need anti-growth assets because the 60/40 portfolio itself, but certainly equities on its own are pro-growth. And so, it’s always been useful to own an anti-growth asset like bonds, and they’re just, unfortunately, bond prices won’t rally as much as they did in past environments when there is an anti-growth shift. A recession in Europe is just not going to rally the bund enough to protect the DAX. Same in Japan. The US is a little better off.

Bilal Hafeez (00:18:50):

Yeah. I mean, on that then, I mean, what do you then do when you don’t have that anti-growth asset? Does that mean you have to leverage that bond in some form to derivatise it to try to get some greater exposure or do you just have to put your money in cash or something?

Andy Constan (00:19:07):

Yeah, I mean, that’s the challenge. When you have a portfolio that has a lower risk adjusted return, which is the portfolio you’re describing. There are lots of ways to tweak your exposures using derivatives that I think for a portfolio that’s designed to be long term and passive, that’s probably not the right thing to do. You’re paying transaction costs, a variety of them, but let’s just stick with the idea that you have a portfolio that’s not as balanced as it used to be. And what that means is it’s not as… It doesn’t have the same expected return for the amount of risk. The expected return can be the same, and it should be, but the amount of risk is changed. And so, there’s a very simple logic to that, take less risk.

Unfortunately, we’re in a world in which less risk means more cash and in such a world when you have inflation that cash wastes away. So, we are in a very tricky time where both interest rates are very, very low and inflation is very, very high. And so, I don’t have a simple answer to what you do, but without a doubt, the first principle is to reduce risk. And so, I think what’s interesting about that, and I’ll just take a tangential point to that is Japanese investors simply don’t have a portfolio that is adequately anti-growth, meaning balanced. They have plenty of pro-growth assets, but they have no anti-growth assets. And similarly, the European continent has no balanced portfolio. And so, that puts a strong wind on the US dollar because Europeans want to take risk because they want the return, but they need balance. And so, you go to the place that has balance, and that remains with 30 year bonds nearing two and a half percent, that remains the US dollar asset market.

And so, I believe a lot of the strength in the US dollar versus the Euro and versus the Yen have been those sort of investor flows both domestic US persons selling their non-US exposure and Europeans and Japanese buying US exposure. And both of those flows are more power than trade flows and faster moving. And that’s caused some strength in the US dollar. And I think while the massacre in Chinese internet stocks is ongoing, China represents a country that has plenty of ammunition and is more balanced from a monetary area and fiscal policy, and has assets that are priced quite attractively for a balanced portfolio. Unfortunately, you have to deal with the political risk, but that’s an interesting market right now. And I think part of the CNY strength has been both trade and investment flows trying to squeeze into that market. We continue to buy from them and that’s the trade flows and that’s strengthening Renminbi, but we also are, the world is looking for a balance in their investments and that’s available there with some significant risk premium associated with politics.

Bilal Hafeez (00:22:28):

And in terms of China there. Obviously, you have the equity side which has some challenges, regulator risk, political risk, and so on, but also the bonds which have yields that are higher than the US’s both in nominal and real terms. So, there’s been a lot of talk recently about how China stocks are very attractive. Do you think that’s a value trap, and really the better investment is really bonds in China?

Andy Constan (00:22:48):

I’m agnostic on bonds versus stocks. As it relates to alpha, that’s the whole completely different discussion, but as it relates to beta I’m agnostic, I want balance. And so, if I were to add assets to an all-weather portfolio, that’s one place you can do it. Again, diversify so that you have less country risk, but that’s one location that has a balanced portfolio of growth and anti-growth and pro and anti-inflation assets. So, that seems interesting to me and a currency that is heading in the direction. Ray thinks it’s sooner than later actually heading in the direction of at least competing with the US dollar as a reserve currency. And those are very attractive things absent to what I think is fascinating and interesting news on the last few months of Chinese internet stocks and all the political and regulatory houses.

Bilal Hafeez (00:23:44):

You mentioned how US bonds are relatively more attractive because obviously the normal yields are higher. Does it matter that inflation’s much higher in the US than it is in Europe and Japan? I mean, does that affect your idea of the balance portfolio or do you look at things in nominal terms?

Andy Constan (00:24:00):

Yes, of course that matters. It’s sensitivity to rising inflation is probably… Based on inflation expectations is probably fairly well priced. I mean, you’ve got 10 year inflation expectations that are approaching 3%. Most of that’s driven by the front, but still. And so, those bonds would respond well to falling or rising inflation expectations. Obviously, TIPS is a important part of a balanced portfolio as well. And so, those respond to inflation going up for instance.

Bilal Hafeez (00:24:32):

Then on the alpha side you mentioned earlier the systematic approach. So the core of systematic tends to be some kind of carry strategy of depending which asset class you are in then there’s momentum and value. These are the core blocks. I mean, do you think that their efficacy still worked in a low yield world or has something changed?

Andy Constan (00:24:54):

So there are a lot of alpha streams and those alpha streams that you just mentioned are very well picked over in the CTA world and amongst many systematic macro. I think of it more at a longer term horizon. And so, of course, having a momentum indicator is useful for it’s sort of table stakes, but I think it takes more than that to make alpha and markets. And so, you need to have an understanding of the linkages between various data, whether it’s GDP or CPI or any of the more idiosyncratic data and the asset class that you’re comparing.

Bridgewater, this is why I fit well with that culture wasn’t big on data mining. Taking streams of data and comparing them to streams of asset prices and finding the ones that best get cobbled together using whatever technique from basic regressions to artificial intelligence approaches, whatever it was, some tool to find the best fit of those things. I think it’s just what you’re comfortable with I’m comfortable with. I like to see causes and then use data to identify if those causes are valid. And so, I spend almost all of my time in thinking about markets trying to establish frameworks, understand the linkages and the data, and the systematic approach comes from that not from big data libraries that I just compare.

And so, that’s my approach. I think it’s useful. And what I’m saying is that there are many different causal drivers for market prices. There’s flow and positioning. There’s changes in economic data relative to consensus. There’s a number… You can rattle off many, many ones. And then there are very unusual market specific ones that I’ve been talking on my Twitter feed about mortgage convexity lately, over driving rates down to 170 on tens a week ago, and potentially driving them through to 215 today, and that the equilibrium price is being affected by hedging activity. And so that’s the signal. So you cobble all those things together and you have many signals and that gives you a bet, an indicator.

The impact of mortgage convexity hedging on bonds

Bilal Hafeez (00:27:16):

And you mentioned mortgage convexity just for the benefit of our listeners who aren’t familiar with that concept, can you just describe what mortgage convexity is and how it relates to regular bonds?

Andy Constan (00:27:25):

Sure. Roughly, I mean, it’s up to people to judge their own opinions and mortgage convexity has shifted through the years as Fannie and Freddy were the dominant force to mortgage servicers becoming the dominant force. And now the Fed owning a good portion of the mortgages and not hedging their convexity, but let’s start from a base principle. A mortgage is something that in the US, which is, I think only Netherlands has this type of security. It’s unique to the US, essentially. You can pay off your mortgage at any time, and there are 30 year fixed mortgages. So, they are a very, very high duration asset, long term bond that you can call away from the owner, the investor at any time, for any reason. People call them away in a non-economic sense when they sell their house and buy it and move to another state. But in an economic sense, they call away their mortgage when they refi. And so, when does one refi? When interest rates are lower.

So, what happens to a mortgage in the US, a 30-year fixed rate mortgage is when interest rates fall, the investor who purchased the mortgage from the bank that the homeowner engaged to set the mortgage all of a sudden has his 30 year bond turned into cash at very low interest rates, and that’s a very bad thing for the duration of your portfolio. All of a sudden your portfolio goes from, and it doesn’t happen like this, but from 20 years to zero years very quickly. And so, at the macro level, when interest rates fall, mortgages get refinanced. And prior to that, everybody had as much duration, long term interest rate exposure as they desired. And then all of a sudden they didn’t.

So, what that means is that the world now wants to buy more bonds. When interest rates rise and refis become less likely, the duration extends on these mortgages. And so, the world of mortgage holders now have a portfolio that is longer duration, more interest rate exposure than they wanted. And so, their natural job is to sell. So, that’s what negative convexity is, and that’s how it affects the macro market in that when interest rates fall, the world wants to buy more bonds. That’s at high prices. And when interest rates rise, the world wants to sell more bonds, which are actually at low prices right now. And so, that’s called negative gamma, negative convexity of interest rates. And it tends to exacerbate, those flows tend to exacerbate rallies in bonds and sell off in bonds.

Now, you’re talking about a 15 to $20 trillion market and a 25 basis point change can change the duration such that to neutralise you may need to see a trillion of buying. Now, the question then becomes, who does buy? The Fed doesn’t. The Fed just says, “Okay. So, my duration’s changed. I’m not going to do anything about it.” Many mortgage funds who are clipping both credit out of the mortgage, and the fact that they’re paid a higher interest rate because they’re short with this call option say, “We won’t re-hedge. We don’t do anything about it.” Markets, who knows? But there are economic interests that are both levered and have tight P&L restrictions both because of the leverage, and because that’s their business that they dynamically hedge that exposure. And so, it’s up to the reader, the viewer to figure out how much those flows are, but they can be sizable. And so, that’s something that I pay attention to.

Bilal Hafeez (00:31:08):

So in recent weeks, your sense is that you think this is influencing some of the market move. So, you wouldn’t necessarily extract too much of the macro interpretation to some of these recent swings in bond yields?

Andy Constan (00:31:19):

No, I think both are true. You have to respect the macro. Inflation expectations have certainly risen and for good reasons. The thing that’s surprised me, I guess, is the extent of the rally once we hit around 185 on the 10 year. Going down to 167 I think was the low on tens, had to be. And then it reversed, and retracing almost within two days all the way back to 185 had to be some sort of short squeeze is one word you’d use, margin calls another word you’d use, but it could simply be the activity of these hedgers. I don’t know what the answer is, but something happened such that macro conditions didn’t change. They didn’t change from 185 to 167 and back out to 215 in what has amounted to nine days. In my opinion, I could be wrong. That seems like more volatility than was due for the volatility of the macro conditions. And so, I think is something that accentuated those moves.

What is next for the Fed

Bilal Hafeez (00:32:23):

And then how are you looking at the business cycle right now? You were recording this before the Fed meeting. Fed’s expected to go 25, the market’s pricing quite a fair number of hikes over the course of six or seven hikes. People are worried about inflation. There’s a debate around transitory or not to some extent. There’s some murmurs of recessionary risks, at least in Europe, perhaps, maybe even the US. How are you seeing the cycle in general?

Andy Constan (00:32:48):

I think we’re at a very unusual time in which policy makers have what I would call a… They’re on a nice edge at some level, which is it’s going to be very difficult to navigate over the next year. I’m not a conspiracy theorist or a gold bug, or I think if the central banks have credibility. They make mistakes, of course, as we all do. But I look at them and think that they are by and large trying to do a complex job in a good way. And so, given how difficult it is, I suspect caution because the moving parts and the risks around it, and they could engineer whatever landing you want. They could certainly over-restrict monetary conditions causing both an asset and an inflation. And in the goal of taming goods inflation create an asset deflation and a economic downturn recession, possibly. And at the same time, they could fail to address the problems that they’re faced adequately, and we could have more inflation for longer.

But let me step back and say that the interest rate hikes that are priced seem fine. Is it going to be seven? Is it going to be four? At this point, give them that fifties on the table at any meeting in my opinion. I like to think in basis points. Is it 125 basis points? Is it 200 basis points? I think it’s by and large fine. What isn’t clear is, and I wrote about this in December in something called the drumbeats of QT. On December 15th, there was a Fed presser, meeting and presser. And in that presser, J. Powell mentioned that they had been looking at the balance sheet. And at that point I tweeted. I think I was the first to notice it. There were not that many people that did notice it, but QT was a game changer. And in late December, I wrote my thoughts up of about that, and said that as long as the drumbeat of QT occurs and gets louder. And then finally, when QT actually occurs, asset prices are going to have quite a bit of difficulty.

Unfortunately, I’ve been buying the dip along the way, ignoring my own advice though that’s working out fine for the year, not buying the dip part, that’s still not working out. But I do think as we look at where asset prices have come, which is bonds are lower, equities are lower, commodities are higher, gold is higher, risk premium expansion is what QT will cause. And what that means is that, that portfolio that I described of beta is going to get cheaper across the board. Yesterday we saw every asset class fall. That’s what QT does, and that’s what QE did in reverse. Asset inflation is what QE creates. Asset deflation is what QT creates. Neither of the wealth effect of those things has a weak impact on consumer prices, but isn’t the way to fight consumer price inflation or deflation.

Why did they do QE? Because they didn’t have rates to cut. Rates were already zero. So they had to come up with something that would have an act on goods, but it’s only through the wealth effect, and the wealth effect only happens when wealthy people with this newfound asset holders who are by and large wealthy people sell and consume, and it’s weak. And similarly, those same rich people who will see QT affect their asset portfolio. Will it affect their marginal spending that much? Probably not much. And so, it’s important to know that QT and QE are not good levers for inflation. QE was used because it was the only choice. In this case, QT doesn’t have to be used. It will be. It doesn’t have to be used because it’s weak as an inflation fighter. It’s strong as an asset inflation fighter, but it’s weak as a goods inflation fighter through that wealth effect channel.

Rises do work, and they have that tool from zero to what infinity and beyond. They have that tool, and the Fed has said that they will do that. So what I conclude is rates are where they are. They seem to roughly anticipate what the dot plot may look like tomorrow. We’ll see if that does cool inflation, who knows? We can come back to that. But the real important thing about the future, the second half of assets for assets markets is the details of QT. So, that’s what I’m focusing on most.

Bilal Hafeez (00:37:19):

Yeah, no, no, that’s really interesting. I mean, so one challenge I found is that the time they started to talk about QT towards the end of last year, the policy rate expectations also picked up at the same time. So, the market was also saying actually the Fed’s going to hike as well. So how do you disentangle the two effects? Because there may well be actually stocks and risk markets were selling off because the market’s pricing more Fed hikes. So, it may not be the balance sheet. So, the QT may be working through a stingling mechanism for future policy rate hikes rather than a portfolio effect.

Andy Constan (00:37:50):

That’s true. And you can’t. It’s not that simple that you can… And people try to do that. Like I saw some ridiculous analysis that indicated that… I don’t want to quote it wrong. I think there was QT was going to generate 250 basis points increase all up without, but for QT in 10 year notes, which that’s wacky in terms of what the long history of 10 notes impact would be. Anything’s possible, but I don’t think that one is. So, connecting how much QT means in terms of what is the amount of QT that would generate 25 basis points of hikes and vice versa and what those things would do to asset markets is not something I can quantify well, and I don’t think it’s quantifiable, and there are lots of models to do it.

What I think is true is that QT is a pressure. And when you think about assets and you say, “Do you want to own assets?” When the treasury is financing… Remember QT, all that happens is that in the first phase, which is roll off, all that happens is the treasury, the Fed gets a maturity payment and they don’t have any more bond. What they had been doing, and what they’re still doing is reinvesting that maturity payment. And so, they’re buying a bond. What they will do during roll off is they won’t buy a bond. They’ll just burn the cash essentially. And the cash has to come from somewhere and that’s going to come from the treasury issuing a new bond and having somebody else buy it.

And so, that process is going to result in people who are happy with their portfolio right now having to say, “I’m willing to lever up my portfolio, risk up my portfolio to buy some of these bonds that are now in the market, and that competes with all the things they own and they’re going to choose the things they want to sell based on that, and that’s a pressure and it’ll last… It’s been front run, certainly part of the price. I don’t know how much, but part of the price action between January when the minutes woke everyone to the drumbeats of QT to today. Part of that has been front running by people who say, “I don’t want to compete with this issuance. So I’m going to sell now.” And then there’ll be the actual issuance and that’ll create its own headwind. The question is what’s discounted, and whether what portfolios look like now, are they prepared to absorb what could be a trillion dollars of more supply over the course of the 12 months following QT’s announcement? And I don’t know the answer to that. It is a pressure.

Whether equities are overvalued?

Bilal Hafeez (00:40:23):

You mentioned with QT and all these pressures, risk premia has increased. So, what we’ve seen is PE ratios have fallen quite noticeably for stocks around-

Andy Constan (00:40:34):

Which is exactly the inverse of that, right?

Bilal Hafeez (00:40:37):

Yeah, which is the inverse of that, which fits into that thesis. So, on the valuation side many people were complaining that stocks are too expensive and so on, but now, I mean, how do you look at stock valuations? I mean, now are we at levels where valuations are attractive or not, or is it simply a case of value is no longer a factor not to be worried about so it’s neutral.

Andy Constan (00:41:03):

No, I mean, I think stepping back valuation matters, but it’s not something that standalone as a trading stick. You can’t make money having with a valuation model in markets. There’s too much volatility associated with expectation. There’s the potential you could be wrong, all sorts of things. It’s very difficult to make money on valuations. However, valuations are something I still have in my quiver, and I use a approach that… So, PE is bad for a variety of reasons, but the thing that bothers me most about PE is that it doesn’t scale with interest rates.

So, in normal interest rate environments, Europe and Japan are a different beast, but in normal interest rate environments, when interest rates fall are at a lower level, PEs should be at a higher level, all else being equal. Now, interest rates fall for different reasons, but comparing the PE for instance of stocks today versus the PE of stocks when interest rates were at 6%, I would assume simply from discounted cash flow analysis that the present value of future earnings in lower interest rates is higher than that same earning stream in higher interest rates environments, so the PE would be higher for the same earnings. And so, my rough heuristic for the quick and dirty is to look at long term interest rates, nominal interest rates. There’s lots of different discussions on that. Nominal interest rates versus earnings yield. Earnings yield being the inverse of PE and see how that plays out through time. And right now we’re not super cheap, not obviously rich. We’re in a range that makes sense to me. My models are saying that model says that between 4,500 and 4,600 is probably fair value.

Europe’s tight financial conditions

Bilal Hafeez (00:42:53):

Do you have a view on valuation say on Europe or China because their valuations seem more attractive?

Andy Constan (00:43:01):

Yeah, China’s not my lane. I can’t speak intelligently about that at all. The problem with Europe is very straightforward. Any analysis that looks at valuation, particularly one that takes interest rates into account would show that European stocks are cheap. But I think that’s because European financial conditions are actually extremely tight relative to the United States. And what I mean by that is people say, “Well, the interest rates are negative. How could that be true?” And that’s because the level of interest rates is not what’s important to determine monetary tightness or ease. You can have very tight monetary conditions at 2% yields and very easy monetary conditions at 10% yields. That seems counterintuitive.

Really, why that is because when the Fed sets its interest rate, if 2% is the interest rate and without the Fed, it would be one and a half percent meaning if the Fed didn’t set interest rates at 2%, but the demand for loans was actually only going to clear the market at one and a half percent. That would be tight monetary conditions because no one would borrow when the right market was one and a half, but the Fed set it artificially high. And similarly, if at 10%, the Fed set interest rates and what really was the market clearing price was 11%. There would be tremendous appetite to lend at 10%, which would be very accommodative because they would normally lend at 11, but the Fed is offering them this great deal at 10.

Bilal Hafeez (00:44:42):

And how do you go about measuring this? How do you determine what the non-central bank influence market clearing rates is?

Andy Constan (00:44:47):

Yeah. I mean, lots of ways. There’s lots of ways to do it. Financial conditions indexes are a popular way. Some of those are coincidental because they depend a lot on market prices. Some of them are predictive. My own strategy is to look at the availability of money and credit, which is savings and the ability to lever compared to the supply. The first thing is a demand. The supply of financial assets. And when there’s supply is high, monetary conditions are easy. And when supply is low, when there’s not a lot of bonds around, and not a lot of stocks around, then financial conditions are easy. And when money and credit is free, anyone can borrow no matter what their standards are, financial conditions are easy.

And so, I tend to look at those things. And when there’s no… Like 2008 banks wouldn’t lend, there was no credit available. And so, monetary conditions were very tight even though rates were very low. And so, I look at it at that macro level as well as market pricing, which tends to be coincident and not predictive, and then what it’s likely to change and how that is likely to change. And that’s my process.

Oh, so anyway, back to Europe, the reason why I think Europe is in a difficult situation is because negative interest rates were not negative enough in that framework, are not negative enough to be stimulative. And so, if you have a tighter than it should be monetary condition, risk premiums are going to be higher. Valuations are going to be lower, PEs, the inverse of risk premiums are going to be lower. And so, it’s not that cheap. What you have to do is get real easing and that can happen fiscally, or it can happen through QE, or it can happen through interest rates. Those are the levers. Europe can’t pull the fiscal side because it’s not a fiscal union and interest rates are near zero or negative. And QE seems to be on its way out.

Japan is an interesting case. Same thing applies. Rates that just never got negative enough. They never did QE in an adequate way. They did a tonne of it, but it wasn’t enough so valuations are cheap, but Japan, they cut out the middle man and buy stocks. They’re willing to do that. That directly hits the wealth effect without having to go through this convoluted purchase of bonds. If they were to do what they did in 2015, which is they call the three arrows. Combination of structural reform, which may or may not ever have happened. But monetary easing and fiscal spending, they could ignite the Japanese economy, which by far is the worst performing economy.

We’ll see if they do. The BOJ meets later this week, I think. We’ll see if they do. The Yen is acting like they might be easier in the meeting than expectations, but they could fire three missiles. Arrows aren’t going to do it anymore to help their economy, and that could significantly impact Japanese stocks and the Yen. Depreciate the Yen, rally the Japanese market, and we’ll see. They are of course speaking the same language as everybody else around inflation, but they’re the ones that are… If you want to think about stag inflation risk, they’re the ones that are most at risk for that. And they have no tools except on the fiscal side to fight that.

Bilal Hafeez (00:48:11):

Yeah. And we haven’t explicitly talked about the Russia-Ukraine situation. When an event like that happens, commodity prices shot up recently, they’ve fallen back down again, but how do you incorporate that into your view?

Andy Constan (00:48:24):

Terrible loss of life, terrible impact on society, potential scary implications associated with escalations both within Ukraine toward weapons of mass destruction, and certainly escalating outside the borders of Ukraine are all things that we all think about. As it relates to markets, I would be less concerned. The impact on global trade, the impact on global asset prices, the impact on the US economy in particular. Sure, it’s short term inflationary, but these things tend to like oil go up and go down and we’ll see. But without being crass, I’d like to say it’s mostly lean noise. Not insensitive to what’s happening there, but more a source of alpha for me than a signal.

View on inflation

Bilal Hafeez (00:49:13):

And we touched on early inflation. I mean, do you have a core view on the inflation regime that we’re in? There’s a big debate in the market around is this transitory? As in a couple of years even transitory, and are we going back to the ’70s or something, or are we going to return back to the time type of low inflation regime we had before the pandemic?

Andy Constan (00:49:35):

I think the world is still trying to get comfortable with the idea of a one time pricing increase, and that one time may take a year and a half versus ongoing year over year, over year price increases. What I think that requires, that second thing requires is somebody willing to lever up year after year after year because simple, it requires more consumption to generate more price increases.

And so, I’m ignoring the supply chain challenges. We can come back to that if you want, but it just doesn’t seem to me that either at the government debt level or at the private sector level, both corporations and individuals that successive levering up is a likely response over the next 10 years, given the level of deaths. And so, that principle driver to me of levering up to buy isn’t present. Plus, there’s a demographic issue regarding demand, which is secular, which continues to be negative for inflation, and then there’s supplies and supply constraints are going to resolve one day. I don’t know when, but then there’s the Fed and central bankers and the regular actions of demand curtailment that occurs when both interest rates and prices are going up. And so, if they want to fight inflation, they’re going to win is my basic point.

Bilal Hafeez (00:51:32):

And on the second inflation side, I mean, one spin here is the whole energy transition issue where there’s a move away from fossil fuels. So, that potentially is an additional cost in some ways where you’re introducing a price for an externality, carbon price implicitly in some ways. And then also that’s also a potential source of government spending and even corporates could spend in that arena.

Andy Constan (00:51:53):

I think ESG has to take its fair share of responsibility for what’s happened. Certainly, the trend to divest of energy assets that started years ago, but really came in hard in the last few has made financing difficult to get for building infrastructure in the oil and gas industry and that’s impacted supply. And I don’t think that’s necessarily going to change anytime soon. We’ll see. They’re very good reasons why somebody who believes that the environment is under threat would like to see oil prices higher because that would cause the transition. So, I think that supply constraint from oil is probably going to stick with us for a long time. At the same time, there’s a demand problem, and I think this is what you were alluding to regarding government spending, which is sustainable energy sources require minerals that are in short supply already. Conductive minerals, rare earth minerals, battery components, all of the various things that one needs to have an electric and sustainable, whether it’s wind or solar source of energy and storage. And so, that demand is likely to persist. And so, I agree. I think that those have become secular. We’ll see, but they certainly are there for sure.

Favourite trades

Bilal Hafeez (00:53:17):

And how are you positioned at the moment in this market? Do you have any favourite trades or views at the moment?

Andy Constan (00:53:23):

Right. So I’ve been far more active in all the various markets that I trade than normal over the last few months, principally because markets are moving the amount that I might expect in a month in a day. And so, that’s caused some more rapid trading that I’m used to. I generally trade around 40 times a year across various asset classes. I’m probably going at one and a half times that right now. I just bought the bond market, the 10-year note yesterday after trading back and forth through that whole mortgage convexity thing I just bought that.

About a week ago, I bought puts on the Yen when it was around one 116.9 expecting it to take at 120. I also bought Nikkei based on a couple of things including something I wrote about regarding auto-callables and the impact of those on the market. Nikkei upside. I’m short the Euro. I’ve been strategically short the Euro for a long time. And unfortunately, I continue to own SPX and NDX, which my current position is April 4,400 strikes on the SBX, and approximately. I don’t ever disclose what exactly I’m doing, but call it that. And NDX spreads about four or 5% out of the money struck another 3% overwritten on those.

Bilal Hafeez (00:54:44):

What’s your rationale for the long US equity position here?

Andy Constan (00:54:48):

It’s been long for a long time for all quarter. So, that’s an excellent question. The answer to that is that I believe that the nominal growth combination of 2% GDP growth for the year, and at least 4% inflation will generate large nominal growth, and that equities are a nominal asset, and that’ll generate, and they have operating leverage in that some of their costs are fixed and don’t fluctuate with inflation generating earnings growth that’s above expectations. So, there’s an earnings level, that’s an earnings level thing. And I think that the window is closing between details on QT, some responses that I’m following regarding how the treasury will act during QT. That headwind is worrisome, but at the same time, risk premiums have expanded a lot.

So, I think between now partly due to March monthly and quarterly end, and what I think is fairly aggressive hawkishness both for QT and rate hikes that we could see a relief rally that takes us to my targets of 4,500 to 4,600 before these options in April expire. And then we’ll see how the QT plays out. I could imagine being bullish or bearish depending on those details. And the one last thing is we’re talking about commodities. One of my favourite trades has been adding to… Starting and adding as this relationship went crazy the last few days. Short dated oil, I happen to use June, and long three year oil, and that spread, that backwardation is 30 points, right? I haven’t looked today, but let’s call it 30 points where you can sell three month oil for 100 and buy three year oil for 70. And given all the things we’ve said, I think three year oil at 70 is a gift. And so, hedging it by shorting one month oil. If the backwardation flattens out sum in either direction, I’m sure I’ll take that off, but right now that’s one of my favourite ways to express a longer term secular and value relationship in oil.

Bilal Hafeez (00:56:57):

Yeah. No, I like that trade, yeah. Okay. So, that’s great. I mean, I do like to round off our conversation with a few personal questions. So, one is what’s the best investment advice you’ve ever received?

Andy Constan (00:57:06):

I would say the all-weather framework is probably the most valuable thing, and that is number one. Number two would be… I know you asked me for one, but that would be number one. Number two would be that you probably don’t have alpha.

Bilal Hafeez (00:57:20):

Okay. That’s quite sobering there, but important to for the average investor. And then on time management and productivity, obviously you mentioned earlier that when you were on the buy side, you had a strategy to manage your information flow. I mean, do you have a system now?

Andy Constan (00:57:36):

I don’t. I’m fairly prolific on Twitter. I’m researching 24/7. My kids have grown up, so I have plenty of time, and I do exercise and do things like that, and cook and have hobbies, but by and large turned onto the market 24/7. Wake up thinking about it, and right now I’m trying to be a sieve, distiller, and synthesiser for my clients, and just loving that experience right now. Being a content creator is very different than being exclusively a portfolio manager.

Books that influenced Andy

Reminiscences of a Stock Operator (Lefevre), The Handbook of Fixed Income Securities (Fabozzi), Options, Futures, and Other Derivatives (Hull), Principles: Life and Work (Dalio) and Liar’s Poker (Lewis)

Bilal Hafeez (00:58:12):

And I see you have lots of books behind you. Are there any books that have really influenced you over your career?

Andy Constan (00:58:17):

Those are all cookbooks.

Bilal Hafeez (00:58:20):

Oh, okay. Oh, I can see Noma over there, yeah.

Andy Constan (00:58:23):

Many of them had big influences, but I’ve always been a fan of Reminiscences of a Stock Operator, but I’ve read all the texts: Fabozzi and Hull. A lot of rates stuff. And then Liar’s Poker and things like that gave you a sense of the culture of years that we’ve gone through like Dalio. So, yeah, I studied it all. I also like reading history, too.

Bilal Hafeez (00:58:48):

Okay, great. No, that’s good to know. And if people wanted to follow you, what’s the best way they can do that?

Andy Constan (00:58:54):

Yeah. So, my Twitter handle, which I was grown from 500 to 30,000 people in the last year. It’s the best way. It’s @dampedspring. I also have a website, which offers some more content. That’s also dampedspring.com, and I have some client paid models both for institutions and for high net worth, and for people who just want to learn more about markets that are available on that website. So, I’d go to follow me on twitter @dampedspring and go to dampedspring.com to see the rest of the things I offer.

Bilal Hafeez (00:59:24):

That’s great. I’ll include links to all of those as well. Just one question, Damped Spring, where does that name come from?

Andy Constan (00:59:29):

So, Damped Spring is a physical system.

Bilal Hafeez (00:59:32):

Oh, okay. This is your engineering background.

Andy Constan (00:59:34):

That’s from my engineering, and that’s for another conversation, but it’s basically the way I conceptually only… This is not a practical model, but conceptually look at the world in terms of springs, which depending on their tuning create volatility when the system is shocked with news and dampers, which tend to… Or shock absorbers, which tend to quell that volatility. And so, by understanding the springs, what makes financial conditions, investors more likely to respond violently or less violently or ignore or whatever, the tightness of the spring, so to speak. And then what people like. Things like circuit breakers and counter cyclical policymaker results in the damper. And so, I have a conceptual model that I use to think about current conditions and what that might mean for the path one takes from one equilibrium state to another as news hits the market.

Bilal Hafeez (01:00:35):

Yeah. No, that’s great. Okay. No, that’s a nice story there. Okay. So, with that, I mean, it’s been great speaking to you, and I do urge people to follow Andy on Twitter. I’ll include the links and everything and sign up to the service as well. So, once again, thank you very much, Andy.

Andy Constan (01:00:48):

Thanks, Bilal. It was a pleasure.

Bilal Hafeez (01:00:53):

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Bilal Hafeez (01:02:06):

Thanks for listening to the episode. Please subscribe to the podcast show on Apple, Spotify, or wherever you listen to podcasts. Leave a five star rating and a nice comment and let other people know about the show, too. We’d be super grateful. Also, sign up to become a member of Macro Hive at macrohive.com. We’ll be back soon, so tune in then.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)