Barry A. Goodman, Millburn’s Co-CEO and Executive Director of Trading
Please see important disclosures appearing here.
There is a concept in leadership theory called “VUCA”, which stands for Volatility, Uncertainty, Complexity and Ambiguity. It was initially developed by the Army War College to address challenges inherent in a multilateral world following the Cold War.
The decade-plus following the Global Financial Crisis (GFC) was entirely un-VUCA like in nature. It was characterized by monetary expansion, volatility suppression, and geopolitical quietude. Defaults were few, credit spreads were tight, and growth dominated the narrative. Sectors and strategies reliant upon expansion and easy credit thrived - such as technology and private equity - and excess liquidity played no small role in the emergence of new asset classes, such as crypto. Policy easing made for easy money across most markets.
COVID-19 disrupted that ease, at least temporarily. In response, governments injected trillions of dollars in new stimulus to mitigate any downside potential for economies and markets. This made things even easier for businesses, investors, and consumers.
After this period of relative calm for markets and militaries, 2022 ushered in a new era of VUCA. A combination of central bank largesse and supply chain disruptions led to heightened inflation readings across much of the world. Russia’s invasion of Ukraine not only put post-WWII Pax Americana on tilt but also significantly impacted FX and commodity markets. China’s ongoing implementation of its “re-centralization” plan combined with its COVID-zero policies to create geopolitical stresses of its own. Amidst it all, the U.S. Federal Reserve (the Fed) embarked upon its most aggressive rate-hiking cycle in history, which some believe have stoked instability in banks and other financial institutions.
“...After this period of relative calm...2022 ushered in a new era of volatility, uncertainty, complexity and ambiguity...”
This confluence of events is unprecedented, and the implications are as far-reaching as they are unpredictable. This brings to mind another concept from organizational theory called the “disruption vortex,” which describes a continually developing chain reaction that grows and swirls in different directions and dimensions. We believe navigating this new backdrop will prove the ultimate challenge for many investors over the next years and decades.
Over the past several years, investors have experienced a form of “hyper-normalization,” a term coined by Russian professor Alexei Yurchak in his book Everything was Forever, Until it was No More: The Last Soviet Generation. The term was used to describe how everyone in the Soviet Union knew the system was failing, but no one could imagine an alternative to the status quo, and politicians and citizens alike were resigned to maintaining the pretense of a functioning society.
Markets post-GFC were similarly hyper-normalized. Historically low interest rates allowed risk to run and infinite amounts of debt to be issued. Everyone knew the game would eventually end - everything is forever until no more - but we had no choice but to maintain the pretense of functioning markets in the meantime. As former Citigroup CEO Chuck Prince infamously observed in 2007, “...as long as the music is playing, you’ve got to get up and dance.”.
The first part of that Prince quote noted that “when the music stops, in terms of liquidity, things will be complicated.” Well, the music has now stopped, entering us into a brave new world of investing.
Risk assets are being repriced as we enter a long overdue period of normalization, putting pressure on traditional as well as alternative strategies. Further complicating matters is a new type of policy path normal. Historically, recessions were directly combated by central banks. But this time a recession is arguably being manufactured by policy designed to thwart inflation.
Even when inflation begins to cool, it may linger above the Fed’s 2% target for some period. This can be expected thanks to an aging workforce that continues to remove itself from the labor supply and increased production costs associated with the restructuring of manufacturing capacity. Then we have the Fed’s plans to meaningfully reduce the size of its balance sheet. All of this may conspire to keep rates elevated for longer than many expect.
For the past 40 years, known as the Great Moderation, investors could count on yields falling in the future. They could also safely rely on long-term government debt to perform as a risk-off asset during periods of heightened equity market volatility. Treasuries are now performing more as a risk-on asset as markets grapple with this new paradigm. While the directionality of rates is rare enough—even during the stagflationary 1970s, duration worked as risk-off—the ferocity of this move is without precedent.
Not only do higher rates impact government finances but companies are affected too. Not surprisingly, corporations were active in capitalizing on cheap financing. In fact, more than 40% of S&P 500 companies have negative tangible equity values today, which compares to just 5% twenty years ago. We can, therefore, expect to see more discussion of “zombie companies” as recessionary pressures increase.
Rates on 30-year fixed mortgages are close to the highest they’ve been in 20 years. Returns on long-term government debt are near 50-year lows. Despite last year’s selloff, equity valuations are still rich relative to historical levels. And though volatility remains relatively suppressed judging by the VIX, more than 20% of S&P 500 companies have seen their shares decline by at least 30% over the past year.
Geopolitically, Russia’s struggles in Ukraine may prolong supply chain disruptions and further complicate macro conditions. Then we have the question of what plans China may have for Taiwan, which is causing Japan to re-militarize. Any movement there could usher in a new era of great power conflict that would have extraordinary implications for a range of assets and sectors. Add to this growing tensions in the Middle East and this all combines to form an era of VUCA that feels especially precarious.
This is a challenging environment for investors to navigate. But some of the most compelling opportunities arise during periods of transition, and those willing to adopt an exploratory mindset may be best positioned to manage this new world of VUCA. To paraphrase Marshall Goldsmith, whatever strategies got investors here will not get them there.
We believe a few areas merit further exploration in this context. One is to look for assets and sectors undergoing positive inflection, where investors can buy into tailwinds created by the disruption vortex currently swirling.
A good example is commodities, where we are contending with ongoing supply chain disruptions and ESG-induced imbalances. Decarbonization involves underinvestment in the traditional variety of dirty inputs and overinvestment in new, cleaner sources. This has the dual effect of creating capacity constraints when servicing near-term energy needs while manufacturing fresh, long-term demand for a host of specialized commodities. The resultant dynamism is difficult to find elsewhere across the asset class spectrum today.
Another approach may be to seek diversified sources of uncorrelated, liquid alpha. Instead of strategies reliant upon levered beta, investors could seek exposures that are less sensitive to overall market moves such as market neutral or managed futures strategies. These approaches have historically been positioned as providing potential correlation benefits to investor portfolios. But in a more normalized future, we believe their value-add has the potential to extend beyond just diversification.
Complex systems are found in many domains, from economies to markets to biological ecosystems. They often involve a large number of interacting elements, each with its own idiosyncrasies. This can make them difficult to understand and predict. But despite their challenges, complex systems offer great potential. By harnessing the power of their interactions, we believe one can model approaches that are more adaptive and resilient than any single element alone. Rather than looking for the “key drivers” of market behavior, we believe these approaches might be better characterized as seeking “key interactions” by learning the way complex systems function.
As quintessentially complex systems, markets are, as Gökçe Sargut and Rita McGrath put it, “…imbued with features that may operate in patterned ways but whose interactions are continually changing.” Markets that used to operate independently are now hyper-connected and reflexive. This is where systematic approaches might play a more pronounced role.
For example, the human brain is a pattern-seeking machine. A natural instinct in moments like this is to examine historical context in search of lessons that can be applied to today. While it is important to remember that no two situations are exactly alike, there are often similarities that can be drawn. We believe that one can gain insights into how the current situation might unfold by understanding how past events played out.
Some are gravitating to the 1970s as the closest historical parallel to today, largely guided by the path of interest rates and state of energy markets. But there may be key differences to consider. During that period, inflation peaked three times, and the U.S. economy experienced four separate recessions. Oil quadrupled in price from 1973-1974 yet hasn't even doubled thus far in the current environment. Central bank mandates back then had several competing objectives, including GDP growth versus the dual mandate of price stability and employment of today. And rates weren’t exactly catapulting from a zero base like they did recently.
It could very well be that the current environment is new but not entirely unique. Some of what is happening now has happened before, some of it hasn’t. Being able to learn and refit continuously is therefore crucial. Thankfully, the human brain has a remarkable ability to change and adapt with experience. However, our brains are not infinitely malleable, and complexity often lies beyond our cognitive abilities.
George Soros once said, “I try to change my style to fit the conditions.” But it can be difficult for investors to do this in an expedient fashion, which may be required when markets are as dynamic as they’ve become today. This is due to some combination of processing power and cognitive bias.
“...the human brain is a pattern-seeking machine. A natural instinct in moments like this is to examine historical context in search of lessons...”
Machine learning can help fill this void by dispassionately finding patterns even when the data are novel or complex. Not many investors remember the 1970s, but machines do. And they can provide an ability to look subterranean, to fully comprehend the activities underfoot that inform movements in the soil. This can be especially valuable in times of heightened uncertainty and volatility, when our human brains may be less efficient at spotting patterns.
Applying a systematic multi-factor model that accounts in real time for things like momentum, seasonality, and volatility can be useful in this environment—something that incorporates an intimate understanding of interactions amongst factors, all of which can vary in terms of relevance.
None of this is to suggest that machines should be left to their own devices in “set-it-and-forget-it” fashion. These models need to be constantly tested, challenged, and refreshed. And there are moments like March 2020 that present truly unprecedented scenarios that cannot be modeled effectively in historical terms. In this case, it helps to have human oversight to serve as a real world judgment brake. As the old military saying goes, “If the map tells you one thing but your eyes another, trust your eyes.”
Simple times reward simple strategies, whereas complex ones tend to reward nuance. While prior conditions favored a straightforward, linear approach to investing, this new backdrop may reward more nuanced, nonlinear ways of engaging with markets as opportunities emerge in different sectors, markets, and at different times. Passive investing has been dominant in recent years, but this may change as active approaches become more attractive against this new, more normalized backdrop. Further, the focus on passive has, in many cases, resulted in a systemic underinvestment in active, which may amplify opportunities. Dynamic, alpha-generating strategies that are less reliant on singular market factors and can fluidly go where inefficiencies are greatest may become more prevalent in investor portfolios.
This view may run counter to what has become conventional wisdom. Static approaches that benefit from binary outcomes have worked well in the past. But when faced with periods of upheaval characterized by a fast-changing mix of factors and influences, embracing a more continuous, non-binary approach that can asynchronously shape itself to evolving conditions may prove beneficial. Markets are complex, adaptive systems that often bring nonlinear outcomes, so incorporating sophisticated nimbleness into one’s strategy mix may be called for against today’s more disruptive backdrop.
Diversified, opportunistic, liquid, AI-powered and data-driven. We believe this is the future of alternative investing in a normalized world.
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