Attack the Week (ATW)

April - Panic, May - Rebound - What comes in June?

Sunday Thoughts

Hope everyone is enjoying their well-deserved weekend. May is now firmly behind us as we look forward to the closing stages of the first half of the year, which has been quite eventful and tiring. “Is it the new normal?” a reader recently asked me.

The concept of "normal" is indeed an intriguing one, carrying different meanings depending on the lens through which we view it. Philosophically, "normal" is often tied to ideas of society, conformity, and what is considered acceptable or typical within a given context. In the realm of ethics and metaphysics, normality is subjective — what is normal for one group or individual may not be for another. The philosopher Michel Foucault, for example, explored how society constructs norms and uses them to regulate behaviour, often marginalising those who deviate from these norms. In this sense, normality is not a fixed truth but rather a social construct that changes over time and culture, influenced by power structures, historical contexts, and collective values.

I don’t think there is a normal, certainly not in financial markets. We are being educated about normal distributions and their application, but anyone who has been in this game for long enough knows that we are dealing with abnormality both in risk and reward terms. Similarly, I don’t think there is any normality in life. We are all experiencing a very unique life, with its ups and downs.

I have written about ergodicity before. In finance, this concept challenges traditional views of normality in the context of distributions, particularly when considering the returns of investments over time. A classic example is the performance of a portfolio during a market downturn. Under the assumption of normality, one might expect that the returns of an asset will follow a bell curve, with most outcomes clustering around the average. However, in an ergodic context, we understand that individual experiences can vastly differ from the overall distribution due to path dependency, meaning the journey or sequence of events matters. For example, if an investor experiences a significant loss early in their investment horizon, they might never recover to the "average" return despite the broader market potentially returning to a normal distribution over time. This highlights that, while a normal distribution suggests that most outcomes will be around the average, the real-world outcomes may be heavily skewed due to time and sequence effects. Ergodicity reveals that the long-term averages of a system are not always representative of the individual experience, challenging the simplicity of normality in distribution models.

Source: Dall-E

So what’s normal? I think that’s possibly the wrong question. The better question is what, in the current context of the observable nature or regime in financial markets, can potentially be drawn from past experiences, and if there is no precedent, what likely scenarios can be drawn for the journey ahead. In addition, I always ask myself the question, not what can be reasonably expected, but also what can be almost certainly excluded in the coming months and quarters.

Who would have thought only four years ago that we would drive rates globally up by multiple percentage points and leave nearly no marks on economies? I certainly didn’t expect this outcome, but here we are, and we perceive this as normal. Can we therefore say that the years at zero or even negative rates are non-normal, even though we also perceived things to be normal back then? I read economists depicting the present as normal and declaring the impossibility of rates ever returning to zero. Careful, what you wish for, but I wouldn’t exclude anything.

Complex adaptive systems like financial markets are shaped by dynamic feedback loops where perceptions and expectations influence outcomes, often more than economic fundamentals. In these markets, investor sentiment, driven by psychological factors and collective behaviour, can create self-fulfilling prophecies that distort reality. Unlike traditional economic models that rely on formulas and equilibrium, financial markets operate on shifting perceptions, making them less predictable and more volatile.

Today, overall market capitalisations have grown so large that they dwarf real economies, rendering traditional economic policies and monetary tools less effective. As a result, financial markets ultimately dictate outcomes, and monetary policy struggles to have a meaningful impact, leaving economies vulnerable to market-driven forces. The question of normality in that sense misses the point that monetary policy setting through setting interest rates has potentially lost its bite. Do you really think economies will be in a different state if the Fed were to cut rates 100 bps or more? I doubt that. Would it be different if they hiked 100 bps? Perhaps more so, as nobody is currently expecting such an outcome, but I think we would adapt to that new regime over time.

What do we do with this? Screw normative statements. Scan for possibilities and invest in macro visions not yet entangled in systems that are seemingly pricing outcomes to perfection. That’s not easy, but it's always worth a try.

Building a solid investment framework is what I believe is the most important thing you can strive for. Everybody can get a few trades right and declare victory. That’s kids’ play. What you want is something way more than that. You don’t want average returns; you want to be compounding and performing way better than that.

My vision of the core tenets of a successful investment approach hasn’t changed:

1. Understanding Path-Dependence: How wealth accumulates over time depends significantly on the sequence of returns, not just the average return.

2. Avoid Ruin: Adopt strategies that minimise the probability of catastrophic losses, recognising that recovering from a significant loss requires disproportionately high returns.

3. Consider Time Horizons: Align investment strategies with the time horizon, understanding that risk characteristics can change over time.

4. Embrace Diversification: Diversification can help mitigate non-ergodic risks by spreading exposure across multiple independent opportunities.

This is what this space is all about. And we are not striving to be normal.

If you are curious and want to be part of the journey, join the pack today.

Below are additional thoughts from Macro D on the current state in US and European politics, before we scan the weekly macro calendar, check a few interesting chart setups and update the weekly asset allocation model for its latest change and performance.

Wishing you all a successful start to June! I’m still on holiday for another week but will opine if and when I see something interesting shaping up.