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CPI Surprise In The Cards
Welcome to The Observatory. The Observatory is how we at Prometheus monitor the evolution of the economy and financial markets in real time. The insights provided here are slivers of our research process that are integrated algorithmically into our systems to create rules-based portfolios.
If you haven’t already, check out Episode 5 of the Prometheus Podcast! For this episode, we have another exceptional guest for you- Bob Elliott. Bob is the Co-Founder and CEO of Unlimited- a company that uses machine learning to replicate hedge fund strategies in a low-cost ETF format. Before starting Unlimited, Bob spent over a decade at Bridgewater Associates, one of the largest and most successful macro hedge funds, and was integral to building their systematic process. Bob brings a rich mixture of economic analysis, portfolio construction, and systematic thinking to this episode, which is not to be missed! Aahan & Bob cover almost every aspect of macro in their discussion and provide a rigorous framework for thinking about the current environment. If Alpha was ever available on a podcast, it’s this one!
Now, let’s dive into our observations. Summarily:
Our systems tell us that CPI will likely surprise expectations to the upside.
Our estimates for future real GDP growth remain bleak.
Markets continue to price stagflationary nominal growth & tightening liquidity conditions. Shorting asset remains a preferred orientation; we show our short-only candidates.
Conditions continue to push us towards stagflation amidst one of the sharpest monetary tightening in history. We discuss all these points below:
i. CPI is likely to surprise expectations to the upside, but we don’t see this as a significant opportunity. Our systems estimate that CPI will increase 0.36% versus the prior month, while consensus expects a 0.2% increase. The primary driver of our forecast is Housing inflation, with a contribution of 0.15%. Based on the historical performance of our forecasts, our systems estimate a 71.84% probability of a surprise. We show our historical estimates versus realized CPI below (we smooth realized CPI for a better visual representation):
Additionally, we show the fit of our estimates versus realized future inflation:
As we can see, our estimates have generally been good predictors of monthly changes in CPI. However, unlike the last CPI print, we don’t see this print as a large opportunity (despite a 72% chance of a surprise). The reason we believe so is that there is a significant amount of stagflationary pressure built into markets, and the surprise required to generate a large move is quite large. This dynamic contrasts significantly with the setup going into the last CPI print, where consensus estimates expected deflation. Therefore, while we expect a surprise, we think the reward for the risk of betting on a surprise isn’t large relative to the last print. Nonetheless, we enter the print shorting equities & long the dollar.
ii. Real GDP Growth is weak, & likely to get weaker. Our latest Real GDP Nowcast places economic growth at 0.8% versus one year ago. Our latest estimates of future growth show real GDP moving into negative territory over the next six months:
As we can see above, our estimates have generally done a good job of flagging large cyclical slowdowns in real GDP ahead of time. For a more detailed understanding of the factors driving these estimates, check out our latest Month In Macro note:
The outlook presents an environment that doesn't favor equities or credit.Prematurely deploying risk can result in significant drawdowns, and economic conditions simply do not make a case for increasing long exposure to pro-cyclical assets.
iii. The current environment continues to favor short positions over long positions. Below, we show our estimates of today’s expected return environment (above cash):
As we can see, the environment is skewed towards shorting. Recent history has convinced investors that passive long-only investing can generate returns over active performance— this is one of the key drivers of underperformance today. Below, we show how adding a short-only strategy, in the form of our Prometheus Short-Only Strategy, can add immense value during downturns like today:
Above, we show the performance of equities, our short-only strategy, and the combination of the two. The short-only strategy may not seem like much by itself, but when added to a long-only equity portfolio, it massively improves performance and reduces drawdowns. Given that this is a time for opportunistic shorting, we show the current menu of options for shorting today:
We show the prospective sizing of these positions as well:
Recall, that shorting is a highly active endeavor— and while these positions reflect the potential shorts we think will do well in this environment, they need further timing signals to catalyze positions. If these strategies would be of interest, let us know in the comments below. For those unable to short/efficiently short assets, we continue to think that higher cash levels will generate outperformance in this environment. Stay nimble.