2023 Investment Playbook

The year to dump (wild) Tina for (wholesome) Tara?

TINA stands for “There Is No Alternative” (to equities). It is motivated by FOMO (Fear of Missing Out). Tara stands for “There Are Reasonable Alternatives” (to equities). It is motivated by JOMO (Joy of Missing Out).

Recession is all but guaranteed for 2023 (because historically, every rate hike leads to a recession, — see chart below). The brightest minds place this in the second-half.

Recessions are inherently deflationary and indeed, the current yield curve paints a (horrifying) picture of a decade of deflation:

In deflationary times, cash is king. Even if the Fed abandons its intended February rate-hike upon sighting of Black Swan(s), it will take more than one rate-cut for the Fed Funds Rate to fall much below the terminal rate of 5%. Locking up cash in 6–12 month T-Bills with the best yields to Maturity (perhaps by laddering) is a no-brainer.

1–5 year T-Notes currently show deep inversion. Historically, the 2-year note always peaks higher than the terminal fed funds rate (5%). It is currently significantly below that. This suggests sharp steepening of the yield curve in the first half of 2023. As that happens, consider locking up cash for 2 years.

Beyond that, the 2023 playbook depends entirely on where long dated bond yields are headed. Most pundits cite the adage “long bond yields always go down during recession”. 10-year Treasury bonds yield historically declined by 1.5% during recession (10-Year Breakeven Inflation Rate was 2.26% in December of 2022). Kyle Bass expects the 10-year yield to drop from the current 3.6% to 3%. Felix Zulauf thinks 10 and 30 years T-Bonds will be the most profitable trades (predicated on inflation dropping below terminal Fed Funds rate). These pundits’ conviction is further enforced by the fact that the already gargantuan and ever-growing debt level is inherently deflationary, thus bound to drive long bond yields further down (as capital rotate out of stocks into bonds in anticipation of continued decline in long bond yields).

Accordingly, these pundits bid up 20-Y Treasuries via the TLT ETF in a big way all though Nov 2022 (see chart below). Alas, half of that gain was promptly lost in Dec. So were they wrong? (Inverted yield curve reflects the bond market’s recessionary outlook. But if persistent inflationary forces overwhelm recessionary deflation, bond buyers will boycott until the yield curve un-inverts, — which seems to be the direction in Jan, 2023.)

After all, we have to be mindful that recession does not “officially” start until the 2–10 spread reverts positive again (see chart below). This suggests the 10-year yield will likely rise from here.

Truth is, short of full-on monetization of government debt by the Fed, the free-market will demand higher rates to fund continuing deficit spending by the federal government. As well, if JGB rates rise (i.e. BOJ Yield Curve Control finally fails), then Mrs. Watanabe will cease buying our long bonds. Long bond rates may stay elevated instead of meaningfully drop. In that scenario:

• Elevated debt service expenses will add to inflationary pressures on corporations and (subsequently passed on to) consumers
• The horrible 2022 bond bear market will continue into 2023

Even if long bond yields merely stay elevated as opposed to further rise, the US dollar may have peaked last November, in which case gold has a long way to go up as the US dollar resumes its multi-decade down trend (especially as the Fed pauses just when other central banks ramp up their tightening):

And instead of fleeing to the bond market, capital may instead rotate out of long duration equities (read: Techs) into short duration equities (read: Dividend-paying staples); and out of US stocks into emerging market stocks:

Rotating out of US stocks into European and emerging market stocks makes particular sense because:

• China is stepping up investment of its huge savings in The Global South (as opposed to building ghost cities and highways/bridges to nowhere domestically) in 2023, — pressing the “pedal to the metal” on its BRI Grand Plan. This means “credit impulse in China” does not equal “commodity bull market”. But it will marginally benefit commodities AND German/Korean imports. Above all, China’s re-opening after 3 years of lockdown benefits the S.E. Asian countries most, — through tourism and trade (the latter in part a way around U.S. sanctions).
• Ever since Putin’s IEF speech in 2022, EM countries have been on notice to divest of U.S. holdings and dollars (in preparation for new commodity-backed currencies). Since that speech, gold has risen sharply (read: fortification by EM central banks) in tandem with a falling U.S. dollar index.

Notwithstanding my 2023 outlook, the global picture is very murky as of this writing, — with many cross currents at work. Ergo, my playbook is very “if then else”-like — subject to later “audibles”:

• Start laddering in short term Treasury Bills/Notes right after either the March or May FOMC, — depending on evolving probability of May hike (0.25% hike in March is already baked in). The bond market (see chart below) is pricing in June/July pivot (not just pause). That is inconsistent with the view that the world has returned to a sustained 70s-like high-inflation regime not seen for 5 decades. These regimes do not change overnight, and last for decades. So peak-inflation may well be ephemeral and inflation may well pick up mid-2023. Let’s assign a 20% chance to this inflationary view and allocate 20% of cash to 2Y notes to lock in higher yield. If pivot comes to pass, I can always get out with capital gains as rates drop. Another 20% should be allocated to 1Y bills to allow re-evaluation in mid-2024 (by then deep in recession). 60% should be allocated to max yield (currently 6M) bills, which takes us out to Nov 2023. FFR will still minimally be above 4% (but possibly a LOT higher, per the Taylor Rule) then:

• As the Bills and Notes mature, proceeds should be layered into TLT to benefit from declining rates per the deflationary view (of which I am more in the camp). Watch TLT closely for inflection, — which may be delayed by “higher for longer”, but is inevitable because of deflationary pressure from back-breaking debt (see 3rd chart from top).
• Long AU ONLY IF USD continues its downtrend.
• Keep shorting the Qs and R2K, and maintain a 3:2 short/long positioning ratio. When inflation is still in the 6%+ range (despite month-on-month disinflation), any equity rally is premature because the Fed is obligated to keep hiking toward its stated goal of 2% inflation (the earliest it can pause is when inflation reaches 4%), — thus clubbing equities like a baby seal again. That said, Qs and R2Ks are most shorted and susceptible to short-squeezes. So keep sizing small particularly in congestion (such as wedge) patterns.
• Long China re-opening via EWG and VNM/THD (see chart below). Many believe the China re-opening play will be a short-lived one (because of global recession and China’s own deeply ingrained structural woes) that peters out by the end of Q1. As well, a big part of the EU/EM trade may already have been priced in. Lastly, ECB is playing catch up on rate hikes so the Euro will strengthen, making it harder for Germany to sell their autos. So keep positions small.
• Long SCCO not only as a China re-opening play but because irrespective of deflationary pressure, we are moving from a world of abundance to one of scarcity (they use 40 lbs of copper in a normal car, never mind an EV or a house!). Recession will be a counter-force. So again, keep position small.
• Long oil and gas via OXY until USO inflects up (an indication that supply constrained is trumping demand destruction), then switch to the commodities themselves. This is essentially long China re-opening “inflationary” play (see right half of chart below). Recession will be a counter-force. So keep position small.
• In the first half, DXY should continue down in anticipation of (late to the party) EU and Japan rate hikes. If so, short (via UDN). In the second-half, DXY should revert up as USD-Carry trades unwind with felt global recession. If so, long (via UUP).
• Consider long healthcare via MRK or LLY in the 2nd half, subject to price pullback (they are richly priced right now). In the same breadth, keep an eye on staples and high dividend utilities for the 2nd half as long bond rates decline. There is this thesis out there that healthcare will outperform info-tech in the coming decade. Keep an eye open on that.