So there we sit, mon ami, with our espressos going cold, watching a spectacle not a single European leader—nor poor President Zelenskiy—saw coming: President Trump 2.0’s entourage kicking back with Sergei Lavrov in Riyadh, politely drafting a plan to end the war in Ukraine. Yes, Ukraine, whose president wasn’t even invited—perhaps a clerical oversight, but one that spurred Zelenskiy to cancel his own Saudi trip in protest. The bigger irony is that the occupant of the White House seems convinced he can wrap up a war unilaterally, as if the side that started it can sign off without the side still fighting it. Yet from the markets’ vantage point, even a hint of a ceasefire—real, half-real, or purely rhetorical—can’t be ignored. Any sign of calm can jolt everything from airline plays and Eastern European banks to chemical giants thirsting for stable gas supplies.

In a bid not to look thoroughly irrelevant, Emmanuel Macron rushed to convene an “emergency summit,” which, if we’re honest, resembled more of a book club lamenting how the main event was happening halfway across the globe without them. Meanwhile, Secretary of State Marco Rubio, National Security Advisor Mike Waltz, and envoy Steve Witkoff flashed smiles in front of cameras, tossing around phrases like “lifting sanctions,” “ending conflict,” and “future cooperation.” One wonders if the occupant of the White House is aiming for a foreign-policy victory lap before Macron can even say “sacrebleu.” But if calm does emerge—sending markets sprinting into “peace-trade” mode—it’s worth owning a bit of tactical risk on our books. After all, illusions of sovereignty aside, Europe’s crises are a fertile ground for trading opportunities.

Mean Reverting War Premium

Ever since Russia ramped up its offensive in 2022, the consensus was that sky-high energy costs and a booming defense sector were here to stay. But if the occupant of the White House manages to cut a deal that actually stops the shooting, all those assumptions might get tossed in a hurry. A credible ceasefire could entice investors back into Eastern European and German markets—long hammered by conflict jitters (and energy policy regrets)—especially given Europe’s comparatively modest valuations (around 15× earnings in the Euro Stoxx 50 versus almost 27× for the S&P 500). Of course, defense names and utilities enjoying windfall margins might take a hit if rearmament mania wanes, and none of this is guaranteed to last if Zelenskiy refuses to sign off on a pact that overlooks Ukraine’s core interests — let’s not forget Ukraine gave away it’s nukes for security guarantees.

Still, even the hint of peace can reshuffle capital flows in a hurry, and easing tensions might soften Europe’s elevated energy premiums—though it won’t magically piece together its energy puzzle. (For a deeper dive into these entrenched energy issues, see my prior article, “The Roundtable Hold of EU Trades – Greens With a Side of Thermal” where I dissect Europe’s reliance on imported fossil fuels and the region’s patchwork approach to renewables.

Meanwhile, should the occupant of the White House succeed in trimming the U.S. trade deficit or gently weakening the dollar, a shift of investors toward cheaper non-U.S. equities could help narrow the stubborn valuation gap. That might sound like a green light for broad ETFs such as VGK or FEZ, but splashing money across Europe may leave you overexposed to sectors that thrived purely on wartime realities. A more targeted approach—picking companies set to benefit from resumed trade routes, cheaper gas, and recovered consumer demand—might serve you better.

More arguments for the convergence of valuation multiples between U.S. equities to Non-U.S. equities can be found here:

For note, any idea expressed below I am setting up with 6 month to 1 year options and depend highly on an agreement in Ukraine being hammered out. The total premium across all ideas maxes out at 2.5% of NAV and I intend to not let the size grow above 3% after which I take profits (or let it whittle away into nothingness).

European Industrials: Flirting with Cheap Gas

We’re rummaging through the numbers, tracing how Europe’s 2022 energy crisis hammered core industrial output and prompted unprecedented cost surges across steel, chemicals, fertilizers, and building materials. Even as we enter 2025, the aftershocks remain visible in financial statements. By Q3 2023, many energy-intensive sectors still showed pronounced revenue declines versus the early-2022 highs—Lanxess’s 2023 sales sank 17% to €6.71 billion, Covestro’s top line fell ~20% to €14.38 billion, and BASF’s revenue slid 21% to €68.9 billion, well below its €87.3 billion peak. Profits likewise remain subdued. Covestro’s EBITDA for 2023 slipped to about €1.08 billion, further pressured by a second consecutive net loss in its European operations, and ArcelorMittal’s EBITDA halved in 2023–24 from the $14 billion range. Some companies, like Lanxess, managed to boost free cash flow by slashing expensive inventories built up when gas prices soared, yet many continue to see net income near breakeven or below historical averages. Although 2024 brought partial relief, with European gas costs easing from their 2022 extremes, the damage to margins and capacity lingered. EU industrial gas usage in Q3 2022 was down ~25% year-on-year, leading to a roughly 8% output dip in fertilizers, steel, and base metals that carried through 2023. Europe even became a net importer of chemicals for the first time on record. Surveys show 25% of German chemical companies and 16% of automakers cut production in 2023, with some only slowly restoring volumes through 2024. Meanwhile, smaller operators—in aluminum smelting, zinc refining, or glass—either closed permanently or operated at half-capacity just to avoid repeating the meltdown that hammered them two years prior.

On the “unhedged” or heavily exposed side, ArcelorMittal (AMS:MT), Covestro (ETR:1COV), Lanxess (ETR:LXS), BASF (ETR:BAS), and Heidelberg Materials (ETR:HEI) continue to show muted results, with recurring references to how 2023–24 sales and earnings remain 10–20% below pre-crisis levels. Covestro reported a near-20% top-line decline in 2023 and posted another net loss, though narrower than its 2022 red ink. Lanxess’s 2023 sales fell 17% from 2022, and by 2024 its EBITDA margin dipped into the high single digits—far from its 2019–20 marks. Although some free cash flow rebounded in 2023–24 as they offloaded expensive inventories and cut discretionary capex, these companies still wrestle with compressed margins, high net debt (Lanxess is hovering above 4× net debt/EBITDA), or forced capacity closures—such as BASF’s permanent downsizing at Ludwigshafen. Meanwhile, more resilient or flexible names—Holcim (SWX:HOLN), Saint-Gobain (EPA:SGO), Wienerberger (VIE:WIE), Yara (OSL:YAR), and Linde (NYSE:LIN)—have, on the whole, kept healthier balance sheets and margin profiles into 2024–25. Holcim’s net income rose further in 2023, aided by relatively contained petcoke and coal costs plus strategic hedges. Saint-Gobain just concluded a year of double-digit operating margins thanks to ongoing energy coverage, a record €48–50 billion in sales, and fresh acquisitions in high-growth insulation lines. Yara, though forced to idle as much as 35% of its European ammonia capacity in 2022, improved 2023 EBITDA to over $2 billion once fertilizer prices moderated but stayed profitable. Linde’s global pass-through contracts and continuing share buybacks underscore how effectively it hedged local volatility. Although all these “hedged” names also endured some 2024 volume weakness, their multi-year swaps, integrated supply, or ability to pass through costs in real time curbed the bulk of the crisis’s impact, leaving them less encumbered by debt or impairments.

That difference underpins a potential paired trade. Going long the battered cluster—ArcelorMittal, Covestro, Lanxess, BASF, and Heidelberg Materials—targets companies still suffering margin pressures or working down high-cost inventory from 2022, yet poised to rebound if EU energy prices keep sliding and volumes normalize further in 2025. If natural gas returns to the teens or low €20s/MWh and lost capacity restarts (Covestro’s core polymer lines, ArcelorMittal’s mothballed blast furnaces, BASF’s scaled-down ammonia plants), these could quickly reprice. Meanwhile, shorting the “energy fortress” group—Holcim, Saint-Gobain, Wienerberger, Yara, and Linde—allows investors to fund those longs in a market-neutral position. The rationale is that, should Europe’s crisis premium fade, the advantage these hedged names enjoyed when gas was 6–10× normal levels will erode. Indeed, recent 2023–24 earnings show how robust hedges or pass-through soared in 2022–23 but began waning once costs and selling prices both eased. By going short these disciplined industrials and long the battered, an investor could ride any upside from an eventual end to the war in Ukraine or a resurgence of Russian gas flows—pushing TTF back down and reversing the cost burdens that hammered unhedged industrials, all while avoiding direct macro bets on the broader European industrial market and it’s cyclical tendencies.

Travel & Tourism: Eagerly Eyeing an Eastern Revival

One of the more dramatic transformations of the war was how quickly airlines had to abandon Ukrainian routes or circumvent Russian airspace. Now, with the occupant of the White House and the Kremlin forging a new “understanding,” carriers like Wizz Air (LON: WIZZ) are salivating at the prospect of reopening 30 or so routes they had in Ukraine pre-war. They’ve publicly stated they could do it within weeks if a stable ceasefire emerges. That’s an immediate tailwind to Wizz’s bottom line, if it materializes.

Ryanair (NASDAQ: RYAAY), the giant low-cost airline, also stands to benefit from any broad rebound in Eastern European travel, though it doesn’t have quite the direct Ukraine exposure that Wizz does. And then we have Finnair (HEL: FIA1S). Before the war, Finnair’s unique selling point was short Asia-Europe travel via Russian airspace over the top of the globe. With that airspace shut, Finnair had to operate lengthy detours, killing its cost advantage.

If these US–Russia talks lead to a partial reopening of Russian skies, Finnair might reclaim that profitable niche. The big question is whether a newly minted peace arrangement includes a side deal on aviation. If the occupant of the White House is serious about normalizing ties with Russia, anything’s possible.

Banks in the Region: War-Sponsor Lists and Cheering Relief

A “peace soon” scenario offers a powerful jolt for banks active in Eastern Europe or saddled with Russian operations. Trump 2.0 seems keen to remove “irritants” like sanctions, which have forced certain lenders to freeze or exit profitable but politically fraught businesses. Austria’s Raiffeisen Bank International (VIE: RBI / OTC: RAIFY) shows how lucrative that can be: it’s the largest Western bank still in Russia—where, by late 2024, nearly 60% of RBI’s revenue originated—and also has a deep footprint in Ukraine. With war raging, this double exposure has been a regulatory headache. But if peace arrives, RBI might recoup value from its Russian unit, plus capture financing opportunities as Ukraine rebuilds. Investors clearly anticipate some upside: the stock soared ~80% in late 2023 on the mere possibility of reconstruction.

Hungary’s OTP Bank (BUD: OTP) finds itself in a similar predicament. It was blacklisted by Kyiv as a “war sponsor” for keeping ties with Russia, though Ukraine has reportedly suspended that label. If Washington or EU donors tie reconstruction funds to removing OTP from blacklists, the bank’s shares might reprice—assuming Zelenskiy, who wasn’t exactly invited to these “peace” talks, goes along.

Italy’s Intesa Sanpaolo (BIT: ISP) also stands to benefit. Though its Ukraine exposure is smaller than Raiffeisen’s, Intesa owns Pravex Bank (45 branches, 780 staff) and continued supporting Ukrainian customers through the conflict. That on-the-ground presence might position Intesa to finance major Italian (and broader EU) contracts in a post-war economy. On the Russian side, Intesa had historically facilitated over half of Russia–Italy commercial transactions, so a deal could restore some lines of business (Italy’s Melony has cozied up to Trump, I expect that will pay off for Italy in an agreement with Russia).

UniCredit (BIT: UCG / OTC: UNCRY) rounds out the cast: it too runs a Russian subsidiary that produced around 8% of group profit as of late 2024—a precarious but potentially valuable asset if sanctions ease. In addition, UniCredit’s broad network in Central Europe means it can help funnel reconstruction dollars or EU-backed guarantees into Ukraine. All these banks, however, must navigate a thicket of political demands. If Zelenskiy or the EU balk at any “peace deal” hammered out without Ukraine’s input, the whole scenario might implode, leaving these stocks languishing. But in the short term, Trump seeking a deal to cement his reputation as the great dealmaker, could lift the clouds hanging over them. War-sponsor labels might be erased, Russian units could be spun off more profitably, and new cross-border loans or donor-backed guarantees might turbocharge the region’s credit growth. In short, a genuine ceasefire—however uneasy—would likely spark relief rallies for these Eastern-exposed lenders.

Defense Stocks: Might the War Premium Dip?

It’s no secret that Europe’s defense spending has skyrocketed in recent years, hitting an eye-watering $345 billion across Central and Western Europe in 2022—eclipsing even the old 1989 peak. Germany alone whipped up a €100 billion war chest, Poland is leading the charge with some 5% of GDP on its military, and Finland’s 36% budget jump in 2022 shows just how alarmed everyone got after Russia marched into Ukraine. All this money doesn’t just vanish into the bureaucratic ether: it flows straight into corporate coffers at the likes of Rheinmetall, BAE Systems, Leonardo, Saab, Thales, and Airbus Defence & Space, turning them into juggernauts with record surges in revenue, free cash flow, and multi-year backlogs. BAE’s top line soared over 20% since 2020 to £23.1 billion, Rheinmetall’s soared 22% to €7.2 billion, and Saab clocked an incredible 46% bump to SEK 51.6 billion, just to name a few headliners. Meanwhile, we’re seeing 11–12% EBIT margins and order books so fat that they’re worth anywhere from two to five times annual sales—Rheinmetall alone has racked up nearly €40 billion in backlog (over five times its 2023 revenue), while BAE is sitting on a comfortable £77 billion pipeline. Factor in the EU’s newfangled R&D grants, cross-border fighter jet collaborations (like FCAS and GCAP), and the not-so-subtle “please build more ammo” requests from multiple ministries, and it’s hard to overstate how golden these days are for Europe’s arms makers.

On top of that, numbers don’t lie: from multi-billion helicopter deals (Leonardo’s AW149 contract in Poland) to full-blown expansions in Sweden (Saab hiring thousands to meet NATO-level production), the new defense mania has catapulted net profits and free cash flows. Companies are reinvesting in capacity—more lines for artillery shells, more workers for next-gen fighter jets—and still rewarding shareholders with dividends and buybacks. Thales’s EBIT cracked €2.1 billion in 2023 on €18.4 billion in sales and an expected 6.5% growth on the year when they report their Q4 2024, BAE’s operating profit rose to £2.57 billion with a robust 11% margin, and Airbus Defence & Space bagged a 15% increase in new orders, crossing €15.7 billion even though it competes with its better-known commercial sibling. Throw in France’s Big Three (Thales, Dassault, MBDA) collectively raking in €27.7 billion in revenue and over €101 billion in backlog, or the unstoppable backlog expansions at Saab, and you get a picture of an industry on multi-year upswing—fueled by NATO expansions, fear of further aggression, and full-blown EU policies that practically beg these firms to keep cranking out tanks and jets.

Yet all that “war premium” could unravel in the short term if a ceasefire is negotiated with Moscow. Markets that have priced in a perpetual arms boom may pivot the moment headlines hint at peace, penalizing stocks like Rheinmetall—up nearly fivefold since 2022 on the back of 12.8% operating margins and €535 million net profit in 2023. A sudden lull in new contracts or a perceived break in hostilities might tempt investors to lock in gains across the Euro military industrial complex at any U.S.-brokered “compromise” that underpinned Europe’s reorder cycle. That’s why I’m eyeing short positions on select defense names—particularly Rheinmetall—via six-month options to catch a knee-jerk sell-off. Be warned, though: multi-year budget laws, 2–5% GDP targets, and unstoppable advanced R&D pipelines mean these companies could roar back once the peace euphoria fades. So the trade is all about timing that initial correction—beyond that, the fundamental drivers of Europe’s defense renaissance still look locked in for years.

Quick Macro Round

• Long EUR and GBP: A credible peace deal in Ukraine would remove one of the biggest geopolitical overhangs on the euro, which has traded at a “war discount” ever since energy prices soared and recession fears took hold in Europe. Lower energy costs would immediately help cool Eurozone inflation, giving the ECB scope to slow or pause rate hikes—particularly with nominal German 10-year yields already near their cycle highs around 2.5%. Meanwhile, the euro’s correlation with gas prices suggests a strong bounce if Russian supply fears ease: natural gas could drift back to the low €20-25s per MWh, and that tailwind should quickly flow into the euro’s exchange rate. Sterling (GBP) would similarly stand to benefit, despite the UK’s “twin deficit” vulnerabilities. While gilt yields have climbed partly due to fiscal concerns, a more stable European environment plus reduced global risk aversion could lift the pound off its recent lows—especially if the Bank of England pivots from tightening as economic pressures and inflation expectations recede. In short, both EUR and GBP have room to appreciate when Europe is no longer the epicenter of a high-stakes geopolitical crisis.

• Long European Bonds: Beyond currency appreciation, an end to hostilities in Ukraine would likely catalyze a bullish move in European government bonds. Peace lowers tail-risk scenarios, reduces inflationary energy shocks (but let’s remind our selves more in Europe is leaning deflationary), and alleviates some of the market’s term-premium anxiety. From the data, German Bund yields have already priced in a hawkish ECB stance (2y yields near multi-year highs), yet a plunge in gas-driven inflation could shift the monetary policy outlook dovishly. That sets the stage for rallies in both German core duration and peripheral markets like Italy (BTPs), where spreads have widened from 100bp to 120bp, despite Italy’s relatively stable political situation and service-oriented growth resilience. A quick drop in inflation expectations also reduces the risk that central banks will have to maintain restrictive rates for long—traders may even start pricing faster cuts through 2025. Taken together, the combination of receeding energy inflation coupled with lagging growth (although cheaper energy should be a boost to growth, but European fiscal drama likely outweighs this benefit), receding geopolitical tensions underpins a near-term bullish case for European bonds, making long positions (especially in the 2-year segment) an appealing risk-reward proposition over the next 6 months.

• Short Taiwanese Semi’s: less obvious but depending on the type of agreement struck, it could embolden further Chinese aggressions on Taiwan; specifically semi’s given they are their most high value add and high multiple industry which also works as a hedge for both our U.S. tech exposure and our Chinese tech exposure simultaneously. (More on this when I cover Chinese equities, we have been long BABA with calls as mentioned in the Chat and broad Chinese Tech Equities)

• Long Gold, plenty of reasons we have gone into to own Gold and we remain gold in case no deal comes up. Do not expect a deal on Ukraine falling through would materially impact the price though positively and if a deal comes up, I’ll own more long term OTM calls. (this has been a 5% of NAV in 1+ year option premium position and will maintain it as long as the curve is structurally steepening.)

• You could also short some energy companies that benefited from the windfall of war though higher energy prices and remapping energy flows, my views here remain bullish for these equities given our last article on European energy issues, so I am not putting a short on these. Remaining long is also a hedge to a no-deal scenario.

Infrastructure and Construction: The Next Marshall Plan

Ukraine’s reconstruction needs now hover around $486 billion—far exceeding the country’s economic capacity given that its GDP is only forecast to reach about $183.59 billion by the end of 2025. In the immediate term, efforts focus on repairing damage in safer areas—restoring basic services, clearing debris, fixing housing that absorbed $80 billion of losses, and stabilizing core infrastructure amid periodic attacks on power grids and transport routes. Medium-term plans revolve around ramping up large-scale projects for roads, railways, bridges, and utilities, with a blend of donor funding (G7, IMF, World Bank) and private capital drawn by new war-risk insurance frameworks and a proposed “reconstruction bank” designed in partnership with BlackRock and JPMorgan. These measures aim to close persistent funding gaps and reduce corruption risks (good luck with that), allowing broader rebuilding even while the conflict remains unresolved in some regions. Execution still faces steep hurdles—demining vast areas, procuring building materials in quantities rarely seen on a single front, and mobilizing both a depleted domestic workforce and international firms brave enough to operate in a high-risk environment.

From an investor’s perspective, a set of publicly traded names stands out. Heavy-machinery leaders like Caterpillar (NYSE: CAT) and Volvo Group (STO: VOLV-B) appear poised to supply bulldozers, excavators, and trucks needed to reconstruct highways, clear rubble, and restore farming infrastructure. Building-materials giants CRH (NYSE: CRH) and Holcim (SWX: HOLN) should see soaring cement demand; CRH has already expanded its Ukrainian cement capacity. ArcelorMittal (NYSE: MT) can ramp up steel output at its Kryvyi Rih plant for rebar and beams once large-scale housing and industrial projects come online. Engineering and consulting specialists such as AECOM (NYSE: ACM) and Jacobs Solutions (NYSE: J) can secure project-management roles, while Schneider Electric (EPA: SU) and Siemens (ETR: SIE) will likely modernize outdated/damaged electrical systems. In logistics, Maersk (CPH: MAERSK-B) and Deutsche Post DHL (ETR: DPW) are well-positioned to handle the flood of raw materials across Poland and Romania, and energy companies like RWE (ETR: RWE) or Ørsted (CPH: ORSTED) could benefit if Ukraine’s future power grid relies more on renewables and decentralized technology. Although war-time conditions persist, the scale of the rebuild—essentially Europe’s largest in generations—suggests these firms may tap a substantial revenue stream once the bulk of donor money and private investment starts flowing into major contracts.

I have no trade here but an idea that some could enjoy the risk/reward of, I don’t think this can be appropriately expressed with options. Spot only strategy would work best. I would likely wait for real progress to be made and move the 2.5% to this bucket for longer term investment. Not all the companies mentioned above would make for good trades btw. Just initial ideas while we wait and see how things take shape.

Our Espressos are Stone Cold by Now

So yes, mon ami, our espressos are stone-cold and the Trump team is off forging a “peace” that forgets to invite the side still under attack—yet from a purely mercenary vantage, the whiff of a ceasefire might whip markets into a frenzy, sending battered industrials, airlines, and Eastern European banks soaring just as defense darlings and scarcity-chasing energy firms deflate like an old soufflé. Of course, if Zelenskiy denounces this diplomatic theater or Europe breaks out in a moral rash at letting Russia claim any gains, we’ll pivot right back to risk-off—and the Trump may refocus to a new spectacle altogether. But for the moment, it seems likely that capital will allocate to the range of “peace trades,” buoyed by the idea that cheap gas and open air routes are a necessary part of a European deal (keeping in mind American energy has strongly benefited from this war with increased costly LNG exports to the EU). At it’s core, this situation is darkly comedic: Trump once scorned for ignoring alliances is now waltzing with Russia, leaving Ukraine on the sidelines and Europe grumbling in the background. Meanwhile, I’ll keep swirling my Bordeaux, half-expecting the White House to auto-declare a Nobel Prize, while the EU scrambles to remember its strategic autonomy. Still, c’est la vie; keep your cynicism and your trading discipline tight—because if this deal-in-name-only gains traction, markets could indulge in a giddy rally before confronting geopolitical realities. Bon courage.

Cheers!

We regulate minutiae—like plastic bottle caps shaped to reduce litter (and yes, probably the shape of cucumbers, too)—yet beneath this meticulous policymaking, we juggle a trio of major headaches: a war in Ukraine that shattered illusions of perpetual peace, a likely Trump 2.0 with an allergy to trade deficits (bad news for the EU’s prized exports), and an energy debacle that has factories and households paying record-high bills. As if that weren’t enough, we’re also determined to push green energy agendas, insisting we can decarbonize and keep the lights on economically—despite shuttering nuclear reactors and passionately embracing wind and solar. Welcome to modern Europe, where illusions of sovereignty crumble around what feels like a continent-sized museum.

Figuring Out What European Sovereignty Means

For decades, we assumed the Cold War’s end let us shift budgets from tanks to social good. France, Germany, Italy—all savored the “peace dividend,” kindly underwritten by the leader of the free world. Then 2022 arrived, bringing Russian forces shelling Ukrainian cities. Suddenly, Europe realized it needed an actual army, not just parades. Germany launched a special €100 billion fund to fix its famously under-equipped Bundeswehr. Poland jumped to spending 4% of GDP on defense. Ministers clamored for artillery shells, drones, advanced jets. Investors, in turn, showered European arms makers—like Rheinmetall and BAE Systems—with capital, doubling or tripling their share prices in under two years.

Yet behind triumphant announcements about new tank orders lies an awkward truth: modern defense production devours energy. Steel mills for tank hulls, chemical plants for explosives, aluminum smelters for aircraft frames—these processes are exceptionally power-hungry. If your kilowatt-hour price is two- or three-times the global average, courtesy of costly imported gas, you’re building a “strategic” army on a very wobbly economic footing. Meanwhile, the White House might slam 25% tariffs on your biggest exports unless you sign a contract for F-35s. There’s the tension: do we plow new defense euros into American gear so they spare BMW or Hermès from tariffs, or attempt a purely European defense buildout, even if our electricity costs are sky-high?

Why Trump 2.0 Will Likely Target Europe

Washington has already shown it’s willing to tariff neighbors like Canada and Mexico—close allies who basically have to follow along. Europe, in contrast, can be a messy friend, often squabbling about digital taxes, climate policies, or ignoring U.S. pleas to buy more U.S. jets. For an administration that sees trade deficits as an insult, Europe’s large surplus (especially in autos, luxury, chemicals) is a sitting duck. It’s not hard to imagine a White House ultimatum: “Buy my missiles, or I’ll slap 25% on your cars and handbags.” For smaller EU states specialized in a single export niche, that’s disastrous. For bigger ones like Germany, losing the U.S. car market can complicate the next election. In a flourish, officials might accept large Lockheed Martin or Raytheon deals to appease Washington—despite loud claims of wanting a pan-European defense project.

But consider our deeper problem: an overdependence on foreign energy that, by 2022, covered over 62.5% of our total consumption. Historically, we had cheap Russian gas while we wrote “green transition” laws, closing domestic coal mines and nuclear plants faster than new renewables could fill the gap. Then the Ukraine invasion cut off that pipeline flow, sending prices five- to tenfold higher. So just as the White House could brandish tariffs, we can’t easily retaliate by banning American LNG. We rely on it now! If a new Trump standoff emerges, it’s the U.S. that holds the bigger leverage—thanks to our lingering energy vulnerability.

Still, there’s a silver lining for Europe’s broader markets: if U.S. data continues to show ~150k jobs added per month, stable productivity, and subdued inflation, the overall risk environment often favors both equities and bonds simultaneously. Historically, that has led to strong inflows into under-owned European stocks and government debt, especially from countries like France or Italy that have a mild “credit” component.
(starting to form a deflationary impulse case for the U.S. which I will dig into more after we get the next CPI and PPI prints)

2022 Energy Crisis is Still Here Today

In the blink of an eye, Europe’s “energy sovereignty” mantra went from polite dinner talk to a screaming siren. For years, we told ourselves that scaling wind and solar—plus some Russian gas as a “bridge”—would suffice. Then that “bridge” became a weapon for Moscow in 2022. We learned we couldn’t pivot to renewables overnight: reaching 50% or more of the grid with intermittent power demands robust storage, backups, and strong interconnectors. Meanwhile, Germany and others had already closed nuclear plants, phased out local coal under climate pledges, and cut gas production in the Netherlands. So when the crisis hit, we lacked fallback options. TTF gas soared above €300/MWh, metals and fertilizer plants shut, and governments spent hundreds of billions on subsidies.

Wind and solar power compensated for about one-third of the shortfall, coal and gas plants covered another 10%, but using scarce gas to produce electricity meant we still had to cut electricity demand by around 5%. Now that we pivoted to LNG from the U.S. and Qatar, we’re somewhat more diversified but remain heavily import-dependent. Even if peace arrives in Ukraine tomorrow, returning to cheap Russian supplies is politically unlikely. That suggests we’ll keep paying higher prices for alternative sources, hoping renewables ramp up fast enough to stabilize costs. The deeper paradox: we champion a green transition, but until we solve intermittency and baseload generation, we’re tethered to fossil imports—especially from new suppliers like the U.S. That’s an uneasy place to be if Washington starts threatening duties in other areas.

Europe’s Green Side Quest vs Reality

It’s not that our green ambitions lack merit. We’ve built a robust framework for decarbonization, from emissions trading to the European Green Deal, boosting renewables to 41% of EU electricity in 2022. By 2030, we aim for at least 42.5% of total energy from renewables. That, in principle, reduces reliance on imported fossil fuels. But the transition so far has been disorderly: some states closed local gas fields (for environmental reasons) faster than new technologies arrived, meaning in 2021–22 we still needed massive Russian gas to keep German factories running. Then we lost that pipeline supply and discovered our wind turbines can’t fill gaps during calm weather—prompting a coal usage spike or greater LNG imports.

We have limited gas storage, minimal battery capacity, and a smattering of cross-border interconnections. Whenever a big lull in wind occurs—like the infamous German Dunkelflaute—we resort to gas or coal, draining reserves just when we need them most. Our local fossil production keeps shrinking, and although we add solar and wind aggressively, we still rely on global fossil markets. That’s not exactly robust “sovereignty.” For now, energy prices will continue at a premium in Europe.

Even so, from a market perspective, Europe’s under-owned, lower-valuation profile can still draw capital—particularly when global growth is “not too hot, not too cold” and inflation hovers near central bank targets. In past cycles (like early 2019), that dynamic led to strong risk-adjusted returns for European stocks.

When the Wind Don’t Blow and the Sun Don’t Shine…

Against this fraught backdrop, two nations stand at a crossroads, epitomizing Europe’s tangled energy future. Germany, the self-styled renewable champion, is suddenly exposed by the very revolution it heralded. Meanwhile, Norway—long hailed for its clean hydropower—continues to derive significant prosperity from oil and gas, leaving it tethered to the old-energy world.

Germany’s Energiewende was seen as a beacon, supposedly guiding the planet toward a wind-and-sun-powered utopia. But the winter Dunkelflaute of 2025 unmasked painful vulnerabilities: renewable generation plunged to 5 GW on February 5—far below the levels of December 2023—compelling coal, dismissed as a relic, back online at 8.1 GW (its highest usage since early 2024). Because Germany is integral to Europe’s interconnected grid, any shortfall there sends shockwaves throughout the region. When Berlin must import electricity, neighbors like the UK and France see prices spike, exposing just how dependent everyone remains on stable baseload. Natural gas still props up the rest, yet it’s hardly the pristine solution once pitched.

Amid Germany’s coal resurgence, Norway emerges as Europe’s reluctant savior. Harnessing hydropower for 90–95% of its electricity, Norway plugged the gap again in 2024 by exporting 9 TWh to the UK and 14 TWh to Germany whenever German renewables fell short. But this altruism strains domestic reserves. Norwegian electricity prices rose 35% year-on-year, fueling public outcry over “exporting away” cheap power. The Centre Party withdrew support for Oslo’s energy policy, while Prime Minister Jonas Gahr Støre proposed price freezes to placate voters. Underlying it all, Norway depends on oil and gas for about 15% of its GDP. A sudden slump in global gas demand could jolt Norway’s economy, while an EU energy meltdown might intensify calls to clamp down on exports—potentially fracturing Europe’s fragile unity.

Paradoxically, Norway is also pushing the decarbonization envelope in offshore oil and gas. By electrifying fields like Sleipner, cutting 300,000+ tonnes of CO₂ annually, and pioneering the Hywind Tampen floating wind farm (which powers oil platforms with renewable electricity), Oslo pulls off the neat trick of burning fewer hydrocarbons to produce hydrocarbons. Battery-powered supply vessels reduce offshore emissions further. Yet behind this green veneer, Norway’s wealth hinges on fossil exports. Even “bridge fuel” natural gas might fall from grace if Europe’s climate fervor accelerates, raising profound questions about Norway’s long-term energy identity. Every TWh diverted abroad drives up local utility bills, triggering political backlash and tarnishing Norway’s once-unassailable reputation as an eco-paragon.

Germany’s quick pivot to coal, meanwhile, underscores the precariousness of leaning heavily on intermittent renewables without robust backups. Norway’s simmering domestic tension spotlights how being Europe’s “green battery” comes at a steep political cost. Ultimately, this tug-of-war reveals a sobering fact: transitioning from fossil fuels is infinitely more complicated than glossy policy brochures suggest. If solidarity frays—perhaps Norway caps exports to safeguard its own citizens, or Germany doubles down on coal for grid security—Europe’s dream of a seamless renewable future faces mounting challenges. These two nations stand on the front line of a puzzle the entire continent must resolve: how do we reconcile lofty climate ambitions with the unyielding demands of energy security?

New Defense Spend, Old Energy Fault Lines

So, can we truly rearm while saddled with high energy costs? If steel, aluminum, or chemicals are battered by gas bills, producing artillery or advanced drones becomes pricier. Some states—like France, with 70% nuclear electricity—are less exposed to gas shocks. But many rely on gas-fired power, and a White House ultimatum might coerce smaller EU nations into buying American arms just to dodge new tariffs. It’s hardly the ideal blueprint for a cohesive European defense industry, already fragmented by local job protection and procurement feuds.

EU policymakers now scramble to fix these glaring gaps: more strategic gas reserves, new LNG terminals in Germany built in record time (they had none before), and a possible partial nuclear revival in once-nuclear-shy states. The Ukraine war accelerated all of this. But it doesn’t magically lower near-term power bills. Our domestic fossil output keeps shrinking; renewables, though scaling quickly, can’t cover the full shortfall anytime soon. We remain net importers for ~63% of our total energy—limiting our scope to retaliate if the U.S. brandishes tariffs. They know it, we know it—so guess who holds the stronger hand?

Even so, if global investors continue to see decent productivity gains in the U.S. and moderate inflation readings, risk appetite can support both European credit and sovereign bonds. In prior periods of stable 1.5–2% growth and ~2% inflation, bonds from countries like Italy and France delivered strong, predictable returns—a trend that might repeat if energy worries subside.

Could a Peace in Ukraine Spark a Mean Reversion?

One might hope a Ukraine ceasefire helps global energy prices dip, removing the “war premium” and letting battered European equities rebound. Historically, the end of conflict in Europe can deliver a “peace dividend,” lifting cyclical sectors, restoring business confidence, and nudging the ECB to friendlier rate stances if inflation cools. That scenario would see BASF or steelmakers reactivating capacity, consumer shares rallying, and maybe the euro strengthening as war risk fades.

But we likely won’t revert to cheap Russian pipeline deals. Politics and trust are shattered—especially in Eastern Europe. So the best we get is partial relief: enough for cyclical names to bounce off lows, but not enough to fix structural supply gaps. Our precarious green transition lurches on, with short-term reliance on LNG at steep prices. Still, in a “goldilocks” global setting—steady U.S. job growth, mild inflation, modest global GDP—European equities historically flourish. A partial Ukraine peace could amplify that rally by easing energy jitters.

Greens With a Side of Thermal

One might assume Europe’s policy chaos is cosmic punishment. But for markets, these swirling tensions aren’t just comedic fodder: they produce investment opportunities. Our scramble to square the circle—go green but still burn coal, protect trade while risking tariffs, build up defense while energy costs soar—creates winners and losers. Below are the near-term trades that could thrive as the Old Continent wrestles with modern crises.

A Barbell Philosophy: Rebound Plays vs. Energy-Secure Winners

Underneath these specific trades, there’s a unifying strategy: two-speed Europe. On the one hand, companies in energy-reliant countries (like Germany, Italy, Czechia) got pummeled by the 2022 crisis and could rebound strongly if energy normalizes. On the other, energy-secure economies (France, Iberia, Norway) and their flagship firms may continue chugging along—or even flourish—thanks to stable domestic resources or structural policy support.

How It Works:

1. Rebound Potential in Hard-Hit Industrials
   Think of chemical and manufacturing giants like BASF (Germany) or steelmakers like ArcelorMittal (with major EU exposure). If gas prices keep easing and costly imports fade, battered margins could jump back. The risk is that some capacity has permanently moved overseas, but a decent stretch of stable gas would still give these firms a hefty upswing off depressed share prices.

2. Steady Gains for Energy-Secure Markets
   Meanwhile, Norway’s Equinor or Spain’s Iberdrola enjoy robust domestic supply or diverse renewables. Even if Europe’s gas troubles flare up again, they remain comparatively shielded—and might even capitalize on the next scramble for non-Russian supply. This half of the barbell provides a hedge if cyclical, high-energy industries fail to bounce.

Use this dual approach as a guiding principle across the trades outlined below. It helps reconcile the tension between short-term cyclical rebounds (in hammered industries) and long-term structural advantages (in resource-rich or renewables-savvy economies).

Coal Producers: The Zombie Industry

(Potential Winners: Glencore (GLEN.L), Peabody Energy (BTU), RWE (RWE.DE), Whitehaven (WHC.AX), Yancoal (YAL.AX), Thungela (TGA.L)) - Not my favored area but a small allocation might be warranted

It’s a paradox for the ages: the more the EU talks up net-zero ambitions, the more it resorts to extending or restarting coal-fired plants whenever Russian gas falters or the wind refuses to blow. Glencore and Peabody Energy saw record profits thanks to Europe’s scramble in 2022–23, while RWE continues to rely on its “dirty” coal fleet to balance renewable capacity. The short-term story is clear: nobody wants to admit Europe still needs coal, yet that’s exactly what keeps happening each winter.

Why They Benefit

• Fallback Hero When Gas Is Costly
  As long as gas prices remain elevated—and renewables remain intermittent—coal serves as the unwanted-yet-essential Plan C. Countries like Germany may announce coal phaseouts, but those targets often slide once cold winters or energy shortfalls loom.

• Asia’s Demand Outweighs Europe’s Decline
  Europe gets the headlines for phasing out coal, but the real growth engine is Asia. China and India, in particular, continue building new coal plants to meet surging electricity demand. Even if Europe slightly curbs its usage, Asia’s expansions more than offset those reductions. This keeps the seaborne coal market tight and price-supportive.

  

• Chronic Underinvestment Keeps Supply Tight
  Investor pressure, ESG mandates, and a widespread narrative of “coal is doomed” have starved the sector of capital. That ironically sustains higher prices: few new mines, minimal exploration, and cautious producers mean global supply can’t ramp quickly when demand spikes. The result? Coal remains a reliable cash generator for those who still produce it.

• Thermal and Met Coal Both in the Picture
  While thermal coal (power generation) grabs the spotlight, metallurgical (coking) coal for steel is equally crucial. Cities keep rising, infrastructure expands, and steel remains indispensable in emerging markets. Many coal companies (e.g., Peabody, Whitehaven) tap both thermal and met markets, enjoying a more diversified earnings base.

• The Zombie Resource
  Coal is the zombie of energy generation, the tomb-stone has been planted but its still slowly walking around. Even as Europe claims the moral high ground by trimming usage, global seaborne markets remain firm. Combine that with cost inflation and production constraints, and coal often becomes the reluctant fallback whenever anything else fails. No matter how disliked, it’s still there in the corner—thriving on necessity.

Risks to Keep in Mind

• Regulatory Crackdowns & Sin Taxes
  Coal is the easiest political target in the EU, so watch for sudden taxes, forced early closures, or strict emissions penalties that could hammer profits. Australia’s Queensland royalty hike shows how local governments can swoop in on windfall earnings.

• Reputational & ESG Pressures
  Even if fundamentals are bullish, reputational risk can depress valuations. Many funds simply refuse to hold coal, shrinking the pool of potential buyers—though the flip side is that low valuations can present outsized return potential for those willing to stomach the stigma.

• Demand Shocks or Policy Swings
  A synchronized global recession could momentarily cut power demand and steel consumption, denting coal prices. Meanwhile, any big breakthrough in renewables-plus-storage—or a genuine nuclear renaissance—could reduce coal’s fallback role over time.

LNG Majors: Ride the Transatlantic Gas Express

(Potential Winners: Equinor (EQNR), Shell (SHEL), TotalEnergies (TTE), Cheniere Energy (LNG) - plenty more dyor) - Higher conviction here than Coal

Why They Benefit

Europe’s Gas Lifeline: The Pivot to LNG

Russia’s invasion of Ukraine shattered Europe’s energy assumptions. Almost overnight, pipeline gas from Moscow—once the backbone of Europe’s energy system—was no longer an option. Desperate to keep the lights on and factories running, European governments turned to liquefied natural gas (LNG)—a market previously dominated by Asian buyers.

U.S. exporters like Cheniere and global trading houses like Shell and TotalEnergies found themselves in the trade of a lifetime. With Europe scrambling for supply, LNG prices soared, and sellers dictated the terms. Norwegian energy giant Equinor, traditionally a pipeline supplier, also saw its influence grow, stepping in as Europe’s new “reliable gas champion” amid the chaos.

The Reality: Europe Still Needs LNG

Even as the immediate crisis subsides, Europe’s dependency on LNG isn’t going away anytime soon. Governments are spending billions on regasification terminals, betting that Russian pipeline gas is a thing of the past. And while renewables are ramping up, they’re not yet reliable enough to replace the role gas plays in heating, industry, and power generation.

For companies like Cheniere, this means locked-in demand for years to come. LNG exporters with existing infrastructure—especially those with operational terminals—are in a sweet spot: Europe can’t afford to wait for new projects to come online, so it’s stuck paying a premium for existing supply.

Limited U.S. Shale Expansion Keeps the Market Tight

Investors hoping for a surge in U.S. shale gas production to flood the LNG market may be in for a disappointment. Top-tier shale fields are maturing, and supermajors are favoring share buybacks over aggressive drilling. That means the pipeline of new LNG projects remains constrained—good news for incumbents like Cheniere and Equinor, who will continue to command strong margins.

The LNG Majors Are Locking in the Future

Knowing that today’s tight market won’t last forever, LNG giants are locking in long-term contracts at highly favorable rates. The Qataris, who boast the world’s lowest-cost LNG, are aggressively expanding, but most of their new supply won’t be online until later this decade. In the meantime, Shell and TotalEnergies are securing multi-decade deals with Asian and European buyers, ensuring steady cash flows even if spot prices fall.

Risks

What if Russian Gas Makes a Comeback?

If Europe finds itself warming up to Russian pipeline gas once again, even in limited amounts, other sources of LNG imports could fall sharply, hammering prices. While trust in Moscow is deeply damaged, economic pragmatism can be a powerful force—especially in energy-hungry, price-sensitive economies.

Europe’s Shift from “Crisis Buyer” to “Phase-Out Mode”

While LNG demand remains high today, Europe has no intention of being this dependent on fossil fuels forever. The EU’s energy transition is accelerating, with massive investments in renewables, energy efficiency, and electrification. This means that by the late 2020s, Europe could be buying far less LNG than it does today—potentially leaving suppliers with a surplus.

A Global Supply Glut Is Coming

Over the next few years, massive new LNG projects in Qatar, the U.S., and Canada will come online, potentially tipping the market into oversupply. If Europe’s demand peaks just as new supply floods the market, LNG prices could nosedive, slashing profits for today’s biggest winners.

Regulatory & Political Risks

Governments are already taxing windfall LNG profits, and new regulations—such as carbon border taxes—could increase costs for high-emission gas producers (like those in the U.S.). Political pressure to accelerate the shift away from fossil fuels could also lead to premature shutdowns of LNG infrastructure, forcing companies to adapt faster than they’d like.

Midstream & Energy Infrastructure: The Unlikely Rock Stars

(Potential Winners: Snam (SRG.MI), Engie (ENGI.PA), Excelerate Energy (EE))

You wouldn’t think pipelines and floating storage units would steal the limelight, but in an era of “sovereignty at any cost,” that’s precisely what’s happening. Italy’s Snam, France’s Engie, and U.S.-based Excelerate (the FSRU specialist) are capitalizing on Europe’s frantic push to plop down new terminals wherever coastline exists.

Why They Benefit:

Europe’s LNG Infrastructure Boom

Europe didn’t just start buying LNG—it built an entire import network from scratch. Governments threw billions at new terminals, storage facilities, and pipelines, ensuring that even if Russian gas returned, they’d never be fully reliant on it again.

Companies like Snam and Engie are now at the center of this transformation, owning and operating critical gas infrastructure across the continent. Excelerate Energy, which specializes in floating storage and regasification units (FSRUs), found itself in high demand as countries rushed to add import capacity overnight.

FSRUs: The Ultimate Flexibility Play

FSRUs—essentially floating LNG terminals—became Europe’s quick fix for supply shortages. Germany, Finland, and the Netherlands all rushed to lease them, with Excelerate Energy reaping the rewards.

The beauty of FSRUs? They can be moved. If European demand falls, Excelerate can simply relocate these assets to Asia or South America, ensuring continued utility and profitability.

Stable, Utility-Like Cash Flows

Many of these infrastructure assets operate under regulated return frameworks or long-term contracts, meaning that even if LNG throughput fluctuates, revenue streams remain stable. For investors seeking low-risk exposure to the energy transition, Snam and Engie offer an attractive, predictable alternative to commodity-price-sensitive producers.

Risks:

Overcapacity and Stranded Assets

Europe may have overbuilt LNG import capacity. If demand falls faster than expected, some of these assets could become underutilized or even obsolete, forcing midstream operators to write down investments.

Demand Destruction from Renewables

As wind and solar scale up, gas-fired power plants will lose market share, reducing pipeline and terminal utilization. Electrification of heating could further erode demand for natural gas infrastructure—a risk that midstream investors must weigh carefully.

Regulatory and Political Uncertainty

European policymakers may decide to cap fees, impose stricter emissions regulations, or even accelerate the decommissioning of fossil gas infrastructure. Midstream companies that fail to adapt (e.g., by integrating hydrogen capabilities) could find themselves at a serious disadvantage.

OSV & Offshore Drilling: The Under-the-Radar Upcycle

(Valaris [their warrants are interesting], TDW, SDRL among others) - think this will be one interesting place to allocate for these next 2-3 years

While Brussels preaches “net-zero at any cost,” a quiet offshore revival is charging ahead—driven in part by Europe’s sudden hunger for non-Russian hydrocarbons. Deepwater and North Sea projects are back in the spotlight, ironically powered by the same European majors who pledge green ambitions on Monday and sign new offshore drilling deals on Tuesday. Global rig utilization now hovers near 90%–94%—a stark shift from the 2015–20 glut—while dayrates for top-tier drillships flirt with $450k–$500k/day. Offshore Support Vessel (OSV) operators, which deliver everything from drilling fluids to crew, report 70%+ hikes in charter rates since late 2021. With practically no new rigs or OSVs under construction, supply remains tight and ripe for a multi-year run.

Why They Benefit:
Energy Security Frenzy: Europe’s scramble to replace Russian pipelines has North Sea drilling back on the agenda (climate PR be damned). Meanwhile, European majors like TotalEnergies and Equinor are doubling down on deepwater fields (Brazil, Guyana, West Africa) and need more rigs and OSVs than ever.

Underinvestment Hangover: After years of cold-stacking and scrapping rigs, the fleet is drastically smaller—just as Europe decides it actually needs oil supply. That shortage buoys dayrates for rig owners and keeps vessel utilization tight for OSV firms.
Big Corporate Wallets: Operators flush with 2022–23 oil revenue are greenlighting multi-year drilling campaigns. That locks in rig capacity at dayrates reminiscent of 2014’s heyday, giving OSV providers stable revenue and plenty of headroom to push rates higher.

Risks:
ESG & Cost Inflation: For all Europe’s renewed talk of “energy security,” a quick political U-turn could throttle offshore permits. Meanwhile, reactivating or building rigs is more expensive than ever, so if dayrates don’t track inflation, margins can get crushed.
Oil-Price Wobbles: An abrupt recession or OPEC mischief can sink oil prices. That would freeze final investment decisions (FIDs) on big offshore fields, pulling the rug from under this rig-and-OSV party.
Possible 2027 Oversupply: If rates stay sky-high, eventually someone orders a newbuild flotilla or reactivates cold-stacked units en masse. By 2027, a fresh wave of capacity could dampen the upcycle just when it seems unstoppable.

In the end, Europe’s vow to “move beyond fossil fuels” curiously requires more offshore drilling—particularly if U.S. shale stalls and liquefied gas remains pricey. A well-timed bet on OSVs and rig contractors could pay handsomely if these contradictory policies keep fueling a market starved of modern assets. Welcome to Europe, where a pipeline snipped in the East can catapult dayrates in the West.

The Steel Boom That Just Became a Fizzle

(Potential Names: ArcelorMittal (MT), U.S. Steel (X), Tenaris (TEN.MI)) - 25% blanket U.S. tax might create a great buying opp on EU names…. but keeping in mind demand is weak - no trade here for now

Conventional wisdom said that if Europe was busy building LNG terminals, upgrading defense gear, and resurrecting industrial lines, then steel producers would be popping champagne. Except, in a twist that’s almost too on the nose, the White House slapped a fresh 25% global import tariff on steel and aluminum—just in time to snuff out that optimism.

Why It Still Half-Works:
There is indeed a structural bump in steel demand for defense hardware and energy infrastructure. Companies like Tenaris thrive on pipeline orders, and ArcelorMittal might still see volumes creep up. But coking coal costs could stay lofty if global miners keep underinvesting. While Europe’s steel output might shrink, Asia (especially India) is forging ahead—keeping metallurgical coal markets tight and ironically hiking input costs for EU mills. So, a fleeting uptick in steel volumes could get whacked by expensive raw materials.

Risks:
U.S. tariffs create cross-border friction, hurting mills already burdened by insane Euro power bills. A steel “trade war” could overshadow the underlying demand story, leaving this once-promising tailwind more like a mild breeze. But this might create a great buying opportunity down the line after some pain. I am waiting on this one.

Defense Contractors: Weapons, the New European Language

(Potential Winners: Lockheed Martin (LMT), Raytheon (RTX), Rheinmetall (RHM.DE), BAE Systems (BA.L), Thales (HO.PA), Rolls-Royce (RR.L))

If there’s one bright spot in a region that once bragged about pacifism, it’s arms manufacturing. Germany is plowing a special €100 billion into the Bundeswehr, Poland’s spending spree is off the charts, and even the holdouts are scouring the catalogs for advanced drones or fighter jets.

Why They Benefit:
The rearmament wave is real; Europe’s appetite for American hardware looks insatiable—especially if that’s the only way to dodge tariffs on Porsches and Hermès scarves. Meanwhile, EU-based players like Rheinmetall and BAE soared on tank orders, Thales profits from avionics expansions, and Rolls-Royce supplies the engines that keep fighter jets airborne.

Risks:
A Ukraine peace might reduce urgency, but spooked governments rarely undo defense budgets overnight. So, arms makers might bask in multi-year tailwinds, all while politely ignoring Europe’s prior talk of “peace dividends.”

Bonus round:

Heat Pump Makers: Europe’s Next Holy Grail—or Just Hot Air?

(Potential Winners: NIBE Industrier (NIBE-B.ST), Daikin (6367.T), Carrier Global (CARR) - Carrier is best positioned here and benefited from a Trump Election pullback for entry-demand is not going anywhere for now though. The first two are higher risk recovery plays.

You’d think Europe’s big dream—kicking natural gas out of every house in favor of sleek heat pumps—would be the triumphant badge of “energy sovereignty.” Naturally, that’s turned into a messy scramble of subsidies, new regulations, and a frantic wave of consumer confusion: “Wait, I have to replace my boiler with a what?” Enter the heat pump makers, who stand poised to convert Europe’s fear of gas bills into scorching sales. But dig deeper, and you’ll find some drafts of reality wafting through the hype.

Why They Benefit

• Europe’s “No More Gas, Ever” Obsession
  Brussels and countless national governments have unleashed a flurry of pledges and deadlines to ban new gas boilers by 2025, 2027, 2035—pick a year, any year. Even if half these mandates slip, that’s still a colossal market for heat pumps. Every homeowner who used to sign up for a shiny new gas boiler might be forced into a heat pump unit. Manufacturers like NIBE and Daikin are practically licking their chops at the legislated demand.

• Subsidy Candy
  From Germany to France, subsidies for installing heat pumps can reach thousands of euros, turning home retrofits into a discount bonanza. Governments want to brag about “decarbonizing home heating,” so they’ll shovel money at anything that hums on electricity instead of gas. Providers who can jump through the bureaucracy hoops get to charge top dollar—sorry, top euro—on systems suddenly made affordable by taxpayer generosity.

• Rising Electricity Reliance
  The old fear was that electricity prices might cripple heat pumps’ advantage. But with pipeline gas no longer cheap (thanks, Russia!) and Europe frantically building out more renewable capacity, policymakers are banking on stable-to-lower electricity costs. If that bet holds true, it cements the operating-cost argument for heat pumps. Manufacturing margins improve as volumes scale, creating a tidy virtuous cycle—for the pump producers, at least.

• Eco Image + ESG Capital
  Heat pumps are the new ESG darling. Even if they’re powered partly by coal-tinged grids (who’s checking?), they’re still sold as planet-saving upgrades. As a result, big institutional investors with net-zero pledges like plowing money into “clean tech” stories. Heat pump makers can ride a wave of cheap capital to expand capacity—even if the actual carbon math is a bit fuzzy.

Risks to Keep in Mind

• Grid Strain & “Oops, The Power Went Out”
  Replacing millions of gas boilers with electric devices is sort of like hooking a thousand new Tesla Superchargers into local distribution grids. Are those wires up to snuff? Maybe not. If winter demand spikes and local grids can’t cope, expect frantic political finger-pointing—and potential slowdowns or halts in new heat pump mandates. Nothing kills a policy craze faster than rolling blackouts.

• Pricey Installations & Sticker Shock
  Sure, subsidies help, but heat pump installations can run double or triple the cost of a boiler, especially in older homes requiring major insulation. People might balk—even with rebates. There’s a real risk that once the first wave of “eco-passionate” homeowners is done, mass adoption stalls unless governments keep sweetening the pot. And if budgets tighten? Goodbye lavish subsidies, hello resurgent gas boilers.

• Raw Material & Supply Chain Hiccups
  Heat pumps need compressors, refrigerants, specialized electronics—and a ton of copper piping to move heat around. If supply chain drama rears its head (again), or if raw material prices surge, these units get costlier to produce. The industry can pass on higher costs only so far before politicians cry foul or consumers run for the cheapest alternative. Meanwhile, new environmental regulations on refrigerants could force pricey design changes, hammering margins.

• Possible Tech Shifts & the Hydrogen Wildcard
  A few years ago, hydrogen boilers were the Next Big Thing—some governments still flirt with that idea. If hydrogen or another magical technology emerges (or if Europe invests heavily in hybrid solutions that keep partial gas usage), the heat pump mania could deflate. Companies that bet everything on heat pumps might be stuck with warehouses of specialized parts no one wants if policymakers pivot again.

Cheers!

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I was halfway through drafting an article titled “AI CapEx is Dead, Long Live AI” while driving across France toward the Alps. My plan was simple: soak in the panoramic views of Mont Blanc, reflect on those days when some well-timed puts saved my portfolio, and finalize fresh insights on AI-driven capital expenditures. But—call it a real Veni, Vidi, Tariff moment—President Trump suddenly unveiled 25% tariffs on imports from Canada and Mexico (with a partial carve-out for Canadian energy) and 10% on Chinese goods, and my AI conversation had to shift to second priority. It’s the kind of environment where, yes, I hope you bought your life jacket.

In a last-minute twist, Trump also agreed to a 30-day delay for tariffs on Canada, mirroring a one-month reprieve granted to Mexico. Canadian Prime Minister Justin Trudeau says this buys time for further negotiations, though the White House insists that both neighbors remain under threat of duties if they fail to address U.S. demands. For now, the peso and loonie both rebounded against the dollar, while U.S. stocks erased some of their initial losses—but my sense is that the tension hasn’t evaporated; it’s merely postponed.

When tariffs this broad come into play, even if some are temporarily delayed, they can reorder global supply chains, rattle markets, and reshape the narrative around government deficits and foreign capital flows. Indeed, the price of everyday goods—including cars—now looks set to rise, with inflationary pressure hitting American consumers who were already feeling the pinch in areas like food and housing. While many still assume these moves are a negotiating ploy that might be reversed any day, the complacency in equity markets seems dangerously high if those assumptions prove false. This is starting to smell like the beginning of the end for the World Trade Organization (WTO) and the entire post-war consensus on global free trade—a moment that could send us sailing into uncharted waters. That, in turn, has ramifications for nearly every asset class and we will do our best to keep an eye out for good risk-reward trades along the way.

I’ve repeatedly noted—especially in my earlier piece, The Tech Equities Odyssey: Riding the Sirens’ Liquidity Song—that abundant liquidity can mask all kinds of structural vulnerabilities. Even if these tariffs prove temporary, they might accelerate the very liquidity drain I warned about, particularly if foreign investors reprice the risks of parking capital in American assets. So I’m paying close attention to this development, because whether we see an immediate or delayed pullback in equities could hinge on the outcome of trade negotiations and potential ripple effects on liquidity flows.

The Two Big Gaps: Government Shortfalls and External Flows

When Budget Overruns Become a Tailwind

Since COVID, the U.S. has repeatedly deployed outsized government spending to shore up economic growth. Whether one calls it stimulus or pro-labor policy, the effect has been to inflate corporate earnings, consumer demand, and overall liquidity—effectively turning the budget deficit into a powerful engine for risk assets. Add to this the muscle memory companies gained during pandemic supply shocks—where they got comfortable raising prices without losing customers—and the result is a persistent inflation tailwind.

However, if higher deficits are fueling inflation, the government might tighten the spigot. That would yank away a crucial support for equities, particularly those whose valuations ride on easy capital. This tension also reflects a broader pivot toward reindustrialization, where domestic wages and manufacturing capacity hold greater political priority, even if it means structural changes (and cost pressures) for corporations.

We have extensively touched on the themes of the shift to pro-labor from pro-capital and the Fiscal Spending put in prior works. I recommend giving those a quick glance as the themes will remain relevant moving forward:

The External Trade Gap as a Source of Liquidity

Now Trump is not a fan of the word “deficit” and has created a department of government efficiency to reduce the one we talked about above, but his trade war against the world is meant to tackle the current account deficit. For decades, the U.S. thrived under a system in which it imports real goods but exports financial assets. Foreign suppliers—China, Mexico, Canada—collect dollars from selling goods to American consumers, then reinvest those dollars in Treasuries, corporate bonds, or equities (this helps them avoid selling those dollars to buy back local currency and keep their currency competitive). This arrangement effectively lowers U.S. borrowing costs and inflates U.S. valuations across the risk curve.

This is probably my favorite chart on the subject which I read on the MacroTourist’s article on twin deficits and illustrates this idea beautifully:

But if the White House truly shrinks the trade gap (via tariffs or onshoring) while also cutting deficits to contain inflation, it risks choking off that synergy. I’ve seen some studies suggesting that even a 25% tariff on all imports from Canada and Mexico might only generate some $200 billion in “savings,” nowhere near enough to eliminate the U.S. external deficit (can’t find the source anymore given my very mobile set-up). Meanwhile, such a move can hammer Mexico, which sends $500 billion of goods a year to the U.S.—a huge share of its <$2 trillion GDP—and also ding Canada, whose economy is more diverse yet still reliant on cross-border auto parts and energy exports. For Americans, that likely translates into higher consumer prices—which can quickly morph into both lower real purchasing power and a potential shift in how foreigners see the U.S. as a destination for their capital.

And if trade becomes a political tool for all manner of policy—perhaps culminating in threats to exit the WTO—global investors might not view U.S. assets with the same uncritical fervor. That’s precisely the synergy I underscored in The Tech Equities Odyssey: Riding the Sirens’ Liquidity Song: big deficits plus a free flow of foreign capital have buoyed valuations. Undermine either, and the foundation of lofty equity prices starts to wobble.

Enter the Tariff Storm: Risks of Shifting Capital Flows

Over the past few days, I watched what many wrote off as bluster morph into real policy: 25% tariffs on Canada and Mexico (with adjustments for Canadian energy) and 10% on Chinese goods. Now we hear about 30-day extensions for both neighbors. Yes, these might vanish in a swirl of last-minute negotiations, but I wouldn’t bet my bitcoin on it. If the administration is serious about re-shoring production or using tariffs to fund deficits, these delays are merely short-term concessions.

Shocks and Retaliation

Tariffs tend to hurt both sides, but the degree of pain varies. I recall the 2018 washing machine tariffs, studied by Flaaen, Hortacsu, and Tintelnot, which revealed how manufacturers used the new levies to justify not only higher washer prices but also dryers—even though dryers weren’t directly tariffed. This is a classic example of how tariffs spark broader inflation: domestic companies raise prices “just because they can,” and that cost is shouldered by the consumer.

Those researchers also found that while some U.S. manufacturing came back, the cost to consumers per job created was roughly $800,000 a year—a hefty price tag (for the profit margin of your most beloved equities). Whether or not one deems that “worth it” misses the broader economic point: it’s inflationary, contractionary, and stokes major uncertainty. Multiply that by an entire supply chain (like autos, consumer staples, electronics), and you get a scenario reminiscent of stagflation: rising prices and stagnating growth. The market isn’t priced for that, in my opinion.

Moreover, I see no reason why Canada, Mexico, and China would just swallow the pain. Retaliation can cut into U.S. companies’ margins, especially if they depend on exports or cross-border supply chains. And let’s not forget the financialized nature of the U.S. system—where a significant drop in equity or bond markets can reverberate into the real economy far more than linear economic math would suggest.

The Larger Story: Balancing Liquidity and Real-World Headwinds

The fundamental question remains: how long can liquidity alone sustain markets if structural pressures keep piling up? In latest note on liquidty, I pointed out that high-flying valuations rely heavily on abundant capital. If tariffs erode global confidence in U.S. trade policy—especially if they widen into new fronts—liquidity could retreat far quicker than many expect. Should government deficits also contract to fight inflation, two key liquidity pillars could crumble simultaneously (although I think government deficits would likely still go up in an inflationary scenario and the Fed would end up being a policy taker under our fiscal dominance framework).

The Mechanics of Fiscal Dominance

Fiscal dominance arises when fiscal priorities—namely deficit financing—dictate systemic liquidity flows, reducing the effectiveness of monetary policy as the primary driver of economic conditions.

There’s a valid argument that reindustrializing America justifies these tradeoffs, possibly revitalizing places like Appalachia or the Rust Belt. From an investor standpoint, though, that path raises production costs, fosters higher consumer prices, and erodes corporate margins (if it was more capital efficient to do it, it would have been done) —especially if wages get priority over capital returns. Pair that with potential retaliation from major trading partners, and we’re staring at a stagflationary mix: persistent inflation, lower growth, and a market increasingly concerned about risk premiums.

I’ve heard the refrain that “Trump will fold if the S&P falls 20%,” but I’m not so sure. That complacency alone concerns me. This is why I’m examining ex-U.S. opportunities—if the White House genuinely pursues a lower trade deficit, the U.S.’s old synergy of massive deficits plus abundant foreign capital might end, forcing a reevaluation of valuations across the board. I remain strongly invested in China and Brazil now for 7% of book along with some other like Colombia which have substantial tailwinds; I went over some of the ideas in the article below and will elaborate more (soon-ish).

Gold is also highly attractive in this environment as reasoned through in this piece:

Time to Sail Away Before the Lake Runs Dry?

That one-month extension for both Mexico and Canada shows how fast tariff decisions can flip, allowing the peso and loonie to rebound while U.S. stocks (futures and post market trading) pare losses. But these fleeting reprieves don’t erase the core tensions: 25% duties still loom if neighbors don’t meet U.S. demands, a 10% levy on Chinese goods remains in play, and the administration has signaled it’s willing to expand this policy arsenal further.

Meanwhile, my earlier warnings in The Tech Equities Odyssey: Riding the Sirens’ Liquidity Song feel especially timely: once the liquidity pond starts receding, it can evaporate faster than most imagine. If tariffs truly shift cross-border flows—or if the government reduces deficits to combat inflation—two critical liquidity streams could dry up simultaneously. Markets keep banking on a quick return to normal trade. I’m not so sure.

So for now, I remain cautious. A broader re-rating of valuations might await if these tariffs don’t just fade away or if major trade partners decide to respond in kind. Think of the 2018 washing machine tariffs, where higher prices bled into unrelated products and created a big consumer tab per job saved. Scale that up to automotive or electronics, and it’s easy to see how inflation meets decelerating growth. That’s a combination the market has barely accounted for.

If you’re counting on the White House folding the minute the S&P sinks, remember that the stated goal is lowering the trade deficit, not necessarily propping up equities. Even if the market wobbles, it may not force an immediate reversal of this agenda. The complacency embedded in current valuations only heightens the risk. Because, as I wrote before, when valuations hinge on liquid capital, the pond can vanish just when you’re most transfixed by your own reflection.

The Investor’s Playbook: Managing the Trade & Deficit Crosscurrents

Below is how I’d think about positioning, keeping in mind that day-to-day negotiations can briefly soothe or inflame volatility, but the broader risk of a structural shift in trade policy remains.

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Now, let me set the scene. I’m 30,000 feet up (in the first half of this article), typing this on my tablet thanks to Qatar Airways’ shockingly good Wi-Fi (seriously, why is airplane Wi-Fi better than half the cafés I’ve been to?) and then I remind my self that I explained why in our Space Economy primer.

I’m sipping an relaxing gin&tonic, watching the deepseek drama from above monetizing some hedges over the Mt.Blanc, and honestly, all I’m thinking is: stay hedged, hodl cash, and wait for something truly worth buying (yesterday should be seen as a black friday deal and I used 1/4 of my cash on the plane).

Being away from my usual setup has its perks. Instead of iterating code and crunching data, I’m just stepping back and thinking about narratives and how a simple Ctrl+H can wreck the party. Case in point: AI-adjacent (and some ai-hyped-energy-names) equities. Investors went all-in on the AI-is-gonna-change-everything hype, and now? Yeah, they’re rethinking those capex and opex numbers, but the good news is that AI can only get more epic (and commoditized?) from here.

If you haven’t already, check out our prior Tech Equities Odyssey note—it’s a little cheat sheet for understanding why these stocks are acting like they’ve got whiplash.

The Rise of Fiscal Dominance

As the Federal Open Market Committee (FOMC) gathers to deliberate on its policy path, it does so in an environment where the dynamics of economic policy are gradually shifting toward fiscal dominance. Traditionally, the Federal Reserve’s control over funding markets and liquidity conditions—evident in its recent efforts to combat post-COVID inflation—has placed it on equal footing with the Treasury in shaping financial stability. Yet rising debt service costs and structurally large deficits are slowly positioning the Treasury, rather than the Federal Reserve, at the center of liquidity flows. This gradual shift is altering how financial conditions evolve, with profound implications for markets—particularly tech and growth equities. Maybe American exceptionalism relies on exceptionally fiscally out-spending the rest of the world.

This FOMC meeting is widely expected to mark a pause in the interest-rate cutting cycle. But the real spotlight should be on what the Treasury does in the coming months. As the costs of financing federal debt continue to climb, the Treasury’s decisions on cash management and debt issuance will play an outsized role in shaping liquidity, leaving the Fed with diminished influence over financial markets.

The Mechanics of Fiscal Dominance

Fiscal dominance arises when fiscal priorities—namely deficit financing—dictate systemic liquidity flows, reducing the effectiveness of monetary policy as the primary driver of economic conditions. At the heart of this shift lies the Treasury General Account (TGA), the Treasury’s operational account at the Federal Reserve. Traditionally a passive tool for cash management, the TGA has become a powerful lever for liquidity, reshaping the financial system’s inner workings.

This is not the first time fiscal dominance has shaped economic outcomes. The post-World War II period offers an early example, when the Federal Reserve was compelled to maintain low interest rates to accommodate the government’s massive borrowing needs. This era saw inflationary pressures emerge as the central bank’s ability to act independently was constrained by the sheer scale of fiscal requirements. Similarly, the inflationary surge of the 1970s highlights how expansionary fiscal policy, combined with monetary policy accommodations, can lead to destabilizing price pressures when fiscal priorities take precedence.

Fast-forward to today, and the dynamics are familiar. During the recent debt ceiling standoff, the Treasury was forced to draw down its TGA balance, injecting liquidity into the banking system. Every dollar spent from the TGA reappears as reserves in commercial banks, temporarily easing liquidity pressures created by the Federal Reserve’s ongoing Quantitative Tightening (QT) program. For risk assets, including the tech-heavy Nasdaq, these liquidity injections have provided a tailwind, mitigating the tightening pressures from QT and rising interest rates. Now that the debt ceiling is back in place, we already see the TGA draining with the Treasury spending down its cash without offsetting it with debt issuance to maintain cash balance, we therefore have a continued broadly bid on equities and will continue to see passive flows.

But history shows that these periods of liquidity relief are fleeting. Latin America provides a cautionary tale, with nations like Argentina demonstrating the long-term risks of fiscal dominance. Repeated cycles of government debt monetization have led to chronic inflation, currency devaluation, and economic instability. Similarly, during the debt ceiling disputes in 2021 and 2023, prolonged delays in the U.S. drained the TGA entirely, flooding the financial system with liquidity.

Once those disputes were resolved, the Treasury rapidly rebuilt its cash buffer, issuing substantial volumes of debt that pulled liquidity out of the banking system. These liquidity whiplashes left markets vulnerable, especially as the Federal Reserve’s Reverse Repo Program (RRP)—a key liquidity buffer—absorbed excess cash. However, with RRP balances now standing at just $118 billion, down from over $2.5 trillion at their peak, this buffer is nearly exhausted, leaving little room to cushion future liquidity shocks.

A Fragile Balance

The interplay between fiscal and monetary policy has reached a critical juncture. The Treasury’s liquidity injections, driven by its need to manage the TGA, have temporarily masked the tightening effects of QT, propping up asset prices and delaying the full impact of monetary policy. But as the TGA drawdown ends and the Treasury pivots to replenishment, this dynamic will reverse, intensifying the liquidity drain from QT and creating new challenges for markets.

Compounding these challenges is the structural decline in reserve balances. As reserves approach critical thresholds—historically around 8% of GDP—the risk of funding volatility rises. This echoes the 2019 repo crisis, when a sudden spike in funding rates forced the Federal Reserve to intervene to restore stability. Today’s near-depletion of the RRP further limits the system’s ability to absorb shocks, leaving markets exposed to a potential liquidity crunch.

Adding to this delicate balance is the significant foreign ownership of U.S. equities. A substantial portion of U.S. stock market capitalization is held by international investors, who have historically sought the relative safety and growth potential of U.S. assets. However, as global macroeconomic conditions evolve, these foreign owners could look to repatriate capital back to their home markets if higher returns or improved stability elsewhere arise. Such repatriation flows would exacerbate liquidity pressures in the U.S. market, creating additional headwinds for sectors already strained by tighter domestic monetary conditions.

These patterns of fiscal dominance carry echoes of the "unpleasant monetarist arithmetic" described by economists like Sargent and Wallace. When fiscal deficits grow large enough, they force monetary policy to accommodate fiscal needs, limiting the central bank's ability to control inflation. The lessons of the 1970s remain relevant here, as persistent inflation eroded economic stability and exposed the risks of insufficient coordination between fiscal and monetary authorities.

For tech and growth equities, the risks are clear. The sector’s sensitivity to liquidity conditions makes it particularly vulnerable to the tightening cycle ahead. While fiscal dominance has temporarily insulated markets from the Fed’s tightening campaign, this insulation is rapidly eroding. The confluence of QT, TGA replenishment, and long-term debt issuance represents a powerful tightening force that could reshape the investment landscape in 2025.

The Liquidity-Market Nexus

Tech and growth equities remain highly sensitive to liquidity conditions, thriving on the availability of cheap capital as their valuations hinge on future earnings expectations. When liquidity is abundant, capital flows sustain speculative, growth-oriented investments. In the current environment, where liquidity remains supportive, risk assets continue to find a bid, even in the face of sector-specific adjustments like the recent AI capex growth forecast revision driven by DeepSeek.

The selloff in AI capex/opex growth equities was clearly driven by adjustments to growth forecasts, not a broader re-rating of equity multiples. This distinction is crucial: the downward pressure was localized to a subset of equities directly tied to AI capex themes, while broader market indices like the Dow saw no such impact. The Dow’s positive close during the same period illustrates its lack of correlation to this theme, as it remains largely insulated from the specific drivers affecting AI-linked sectors. Liquidity-driven flows into equities, particularly through passive vehicles, continue to bolster indices broadly, neutralizing isolated headwinds from sector-specific recalibrations.

Importantly, the neutral stance in crypto flows throughout this selloff further underscores that this was not a systemic liquidity event but a targeted adjustment within a niche of high-growth equities. Passive flows, which indiscriminately allocate to indices like the S&P 500 or Nasdaq, have helped stabilize markets broadly, reinforcing the resilience of risk assets in the face of localized volatility.

However, this liquidity-driven stability depends on the current fiscal and monetary backdrop. As the Treasury continues its TGA drawdown, injecting liquidity into the banking system, and passive flows sustain market demand, the immediate outlook for risk assets remains supported. Yet, this dynamic is inherently cyclical. Once the Treasury pivots to replenishing the TGA and issuing longer-term debt, the resulting liquidity drain will amplify the tightening pressures of Quantitative Tightening (QT).

The pivot toward longer-duration debt issuance under Treasury Secretary Scott Bessent could introduce new pressures. While aimed at reducing rollover risk, this strategy will increase the supply of long-term bonds, requiring higher yields to attract buyers like pension funds and insurers. This steepening of the yield curve could weigh on growth-sensitive equities, particularly those trading on elevated valuations.

For now, liquidity flows continue to support risk assets broadly, masking the impact of sector-specific corrections like those in AI capex equities; I am a buyer of this pullback with a focus on Nat-Gas names and Software. But the delicate interplay between fiscal-driven liquidity injections, Treasury issuance strategies, and macroeconomic tightening remains pivotal. Investors should monitor these dynamics closely, as any shift in liquidity conditions could significantly alter the trajectory for equities, particularly in sectors with stretched valuations.

Like ancient mariners lured by the sirens’ song, investors in tech equities are drawn to the shimmering promises of growth—mesmerized by valuation mirages that gleam under the golden light of liquidity. Yet, as Narcissus once gazed into his own reflection, transfixed, so too do many forget that the pond dries up when liquidity wanes, leaving only cracked earth where dreams of infinite returns once flourished.

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Given the recent increase in readers, I would also like anyone reading this publication to take some time to review the Disclaimer, carefully crafted by my personal legal team at claude.ai… Now, onto less serious topics…

Empirically, the greatest returns have come from investing in compounding human innovation. As a thematic investor, much of my time is spent understanding new technologies—their mechanics, applications, and funding. Exploring these innovations is central to my process, and I often immerse myself in tools and frameworks to glimpse the near future. Recently, I’ve been captivated by AI agents, particularly the GitHub project elizaOS. However, investing in innovation is far from straightforward, especially for active investors seeking consistent returns across varying market conditions. The challenge lies in balancing long-term vision with near-term macroeconomic realities. I stay focused until a significant macroeconomic shift appears imminent, which is why this publication emphasizes macroeconomic analysis. With such a shift potentially underway, we’ll explore a key question: where will equity valuation multiples go next?

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Let’s Not Talk About Revenues…Yet…

Valuations have become increasingly reliant on optimism about AI adoption and industrial policy driving revenue growth, yet they appear unaware of the significant costs associated with training and operating these AI models. The bullish case assumes AI will surge within the next 12 months, driving productivity gains, or that deregulation and policy initiatives will deliver immediate growth. But this optimism discounts the friction inherent in these transitions. AI, while undoubtedly transformative, demands substantial computational resources and energy to train and infer, making scalability an expensive and complex endeavor. Similarly, industrial policy’s potential impact is not a quick fix; geopolitical tensions and demographic shifts present considerable hurdles.

This topic is extremely interesting and well worth a standalone article, which can also lead us to understand the next AI trade once multiples get a chance to contract (I hope…because I am extremely excited for the industrial revolution that is ahead of us)

Pandora’s Bonds: Unpacking the Risks of Rising Yields

Our economic framework allowed us to determine early on that tail end yields would rise despite the Fed embarking on a growth-scare fueled cutting cycle kicking things off with a Big-Mac rate cut.

This prompted our research on the constituents of inflation where we formed a view of heightened inflation volatility with a rising structural floor but steering clear of inflation spike alarmism.

Most recently we have studied the likely impact of a treasury issuance shift from bills to bonds which further supported our rising long-end yields thesis.

In that article we initiated the topic of the impact from this yield curve steepening on equities and recommended to keep hedges close to our chest. One such hedge was our pre-NFP trade designed to smooth over negative reaction of equities to continued inflation.

For now, enough ink has been spilled discussing the why behind rising yields let’s focus on one core consequence regarding what everyone cares about; risk asset valuations and ask:

Wait… What Do You Mean My Future-Proof Growth Stock Is Some Antique Bond?

Some stocks are best thought of as zero-coupon bonds with an uncertain payoff far in the future—especially those where most of the value is tied to cash flows expected years down the line. Think of a tech startup pouring money into growth today, banking on profits much later. The further out those cash flows are, the more sensitive the stock’s value is to changes in interest rates. In finance-speak, these are "long-duration" stocks, a term borrowed from bond analysis.

Why does this matter? Because rising interest rates don’t just make borrowing more expensive; they also shrink the present value of distant payoffs. Growth stocks, with most of their value weighted toward the future, feel this impact acutely. A higher discount rate means the future is worth less today, plain and simple.

Contrast that with traditional high-capex businesses, like utilities or industrial manufacturers. These companies generate steady cash flows year after year, with less of their value tied up in distant, speculative growth. They’re more like coupon-paying bonds—consistent, reliable, and less influenced by rate changes. Their "shorter duration" means they’re less sensitive to fluctuations in interest rates, making them feel a bit more grounded when rates rise.

The Intuition for Big Tech

When we look at big-tech companies like Microsoft, the bond analogy becomes more nuanced. Microsoft generates substantial recurring cash flows from its core businesses, such as software and cloud services, making this part of its profile resemble a short-duration bond—steady and less sensitive to rising rates. However, Microsoft is also investing heavily in AI infrastructure and large language models, positioning itself for speculative, long-term growth. This part of its valuation behaves like a long-duration bond, highly vulnerable to higher discount rates.

This hybrid profile—part cash cow, part long-term growth bet—creates a unique dynamic. Rising yields may compress the valuation of Microsoft's future-oriented AI investments, while its core businesses provide stability, tempering the overall impact. In this framework, big tech occupies a middle ground between traditional growth stocks and high-capex industrial firms, balancing near-term cash flow resilience with exposure to rate-sensitive, long-term growth opportunities.

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Deriving the Intuition:

Skip to the next section for charts and data.

This bond-like framing provides a foundation to rigorously analyze how rising yields affect equity valuation multiples, particularly for companies with mixed-duration cash flow profiles. At its core, this is a problem of discounted cash flow (DCF) sensitivity to changes in the discount rate, which we can quantify using tools borrowed from bond math.

Let’s express the fair value of an equity today:

Where:

The required rate of return is composed of the risk-free rate expressed by the return an investor could earn on a risk-free asset (Treasury Bills, Notes and Bonds); and the additional return demanded by investors for bearing equity risk which we call equity risk premium (ERP)

hence:

When either the risk free rate or the ERP rises, the required rate of return increases, raising the discount rate and reducing the present value of future cash flows. This effect is particularly acute for growth stocks, where valuations rely heavily on distant, speculative cash flows. Conversely, lower risk free rates or risk premiums reduces the required rate of return​, enhancing cash flow valuations and boosting stock prices—especially for long-duration assets like growth stocks.

Ok… But How Do I Link This To Multiples?

Equity valuations in practice are often discussed in terms of valuation multiples, such as the Price-to-Earnings (P/E) ratio or EV/EBITDA. While these are typically derived from near-term earnings or cash flows, their sensitivity to macroeconomic variables—particularly interest rates and the ERP—is often overlooked. Let’s bridge this gap by expressing these multiples explicitly in terms of macroeconomic factors. Let’s start with the king of equity valuation multiples:

The Price to Earnings ratio

The P/E ratio is a cornerstone of equity valuation, defined as:

For the simple case of a dividend paying company

with:

Assuming a steady-state growth model where dividends grow at a constant rate g, this simplifies to:

with E being earnings and b the retention ratio. We can then directly express the P/E ratio given our simplifying assumptions as:

for a Big-Tech type company; we can extend this to (again with simplifications):

with b here having the interpretation of being money from free cash flow being re-invested into the business and g = b x ROE with ROE being the return on equity.

An other useful multiple is the EV/EBITDA

In a steady-state scenario, a company grows its EBITDA at a constant rate g indefinitely. The Enterprise Value (EV) in this case is the present value of all future EBITDA flows, discounted at the company’s Weighted Average Cost of Capital for both equity and debt blended (WACC).

For constant growth, where EBITDA grows at a rate g this infinite series simplifies to:

We then express our desired ratio as:

The WACC reflects the company’s blended cost of funding its operations, incorporating both equity and debt:

where:

yielding our final form:

I think what we have just put together is pretty cool; we essentially conjured (with the help of some very liberal assumptions) a framework to think about equity valuation multiples relative to macro-economic variables. I would not toss these formulas into some code to systematically trade my money; but rather to develop intuition when looking at readily available data.

Now let’s go into the final piece of this puzzle which is understanding the ERP.

Equity Risk Premium (ERP): A Decomposition

The Equity Risk Premium (ERP) represents the additional return investors demand for holding equities over a risk-free asset, compensating for the inherent risks of equity investments. We can therefore define it as:

where:

For a specific firm, the ERP can be broken into:

1. Systematic Risk: Exposure to market-wide factors that cannot be diversified away.

2. Idiosyncratic Risk: Firm-specific risks that are unique to the company.

Systematic Risk Component

The systematic risk component reflects the firm’s exposure to broad market movements and macroeconomic factors. This is commonly expressed using the Capital Asset Pricing Model (CAPM):

where:

While CAPM is widely used, alternative models provide more nuanced representations of systematic risk. With Arbitrage Pricing Theory (APT) we can generalize CAPM by allowing for multiple risk factors:

where:

Fama-French Multi-Factor for example is an example of this extension.

Idiosyncratic Risk Component

The idiosyncratic risk component captures firm-specific risks that are uncorrelated with the broader market. The contribution of these risks to ERP is given by:

where:

However, we will focus on understanding systematic risk. Idiosyncratic risks are best left to financial statements and proper private-equity-style analysis.

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Looking at the Data:

I’ll try to keep this less verbose than I usually do (something to work on; I’ll likely be re-joining the corporate world in a couple of months and need to optimize my information-per-ink ratio)

In the broader context of valuation multiples; where do we sit historically right now? To put it simply; it does not get much more expensive than this.

But as we’ve explored through our fixed-income analogy, the most insightful way to understand equity valuations is by dissecting these ratios into their fundamental components. Rather than viewing metrics like P/E or P/S in isolation, we can examine how macroeconomic factors—such as interest rates, the equity risk premium, and growth expectations—interact to shape these valuations. This approach allows us to see beyond surface-level trends and understand the structural forces driving current multiples, especially in an environment where valuations are pushing historical extremes. Let’s break these ratios down into their key elements to uncover what’s really under the hood.

One well known measure for the ERP is the Shiller Excess CAPE Yield which has broadly the same interpretability as what we have derived. We can understand it as the excess return over risk free yields we can expect from equities.

Seems like it is almost time to buy government bonds; shame that despite the PPI and CPI coming in cooler we are still not constructive on treasuries (I’ll possibly soften my stance next print). To intuit the relation of the index with the risk free rate, I added the TLT long duration bond ETF to the chart; the joint pattern is striking.

Now we did not spend time fabricating some math to not make an attempt at calculating the ERP our selves. So here we go:

This chart gives us an important context, that the technology index has seen its risk premium erode faster than the broader SP500 in the last few months. Without needing to dig too far, the explanatory factor behind this is that the Nasdaq ascending valuation is it’s significantly higher growth prospects than the broader S&P. And artificial intelligence here is to blame. Now; I am all on board with lofty projections of innovation and an economic revolution driven by artificial intelligence. I could also believe that new technologies can reduce the lower bound on structural inflation counter-acting fiscally driven inflation. However as we have derived previously; prospects of future growth elongate the duration of the equities and increase their sensitivity to rates (not to mention.. AI is not cheap…).

And look at that; using our little math squiggles in the prior section we can get this this chart which really tells quite the story. I used NVDA EPS as a proxy for hyperscalar capex spend (I know that’s not right; my gaming laptop with some RTX something or other chipped in) but as the big-tech names piled into capex - they effectively front-loaded negative cashflows and created substantial anticipation for future revenues. Will it be worth it? I think that yes; but that’s why I like to hedge with ZB futures instead out outright Q’s. Even though the CPI made a dent in my ZB short track record; I maintain rolling forward my ZB shorts to try isolating the valuation multiple component of the price; I would not dare bet against AI powered growth it self.

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Some Things to Think About…

Given the increased duration of big tech coupled with rising yields and despite that, rising prices and expanding multiples, we need to offer some explanations for this:

Earnings Growth Expectations: The Rocket Fuel of Belief

Investors are betting the farm (or at least their portfolios) on the belief that AI is the next Industrial Revolution. The market narrative is that future earnings growth will accelerate so rapidly that it not only justifies, but demands, a re-rating of valuations. Investors aren’t pricing today’s tech companies based on what they earn—they’re pricing them on the potential of an AI-augmented tomorrow. It’s as if the Nasdaq collectively told the bond market, “Sure, rates are rising, but have you seen our growth curves? They laugh at your puny yields.”

Equity Risk Premium Compression: Confidence Wears Prada

Risk is in the eye of the beholder, and right now, investors are squinting through rose-tinted glasses. When optimism takes over, the equity risk premium (ERP) compresses because, frankly, investors don’t feel the need to demand extra compensation for holding stocks. AI-fueled dreams of transformative growth make stocks feel like a safer bet than they are. In this environment, a compressed ERP acts like an anesthetic, numbing the pain of higher discount rates.

Liquidity: The Silent Enabler

Rising yields are supposed to drain liquidity, but pockets of the market still slosh with cash. Retail inflows remain resilient, and corporate buybacks provide a steady bid under stock prices. We also have sovereign wealth funds and institutional players, flush with cash, are snapping up tech stocks like limited-edition sneakers (with career risk in mind). And let’s not forget foreign investors wanting a bit of American exceptionalism for them selves in order to forget anemic growth or balance-sheet recessions at home! This liquidity creates a cushion, making it easier for valuations to stay aloft even as the yield tide rises.

Coming up: The Tech Equities Odyssey: Riding the Sirens’ Liquidity Song
Like Narcissus staring into the reflection of their own valuations, they forget the pond dries up without liquidity.

The Narrative Monopoly: FOMO on Steroids

AI isn’t just a growth story; it’s the only growth story right now. This scarcity of investable narratives drives what I call the “narrative monopoly.” Investors are pouring capital into tech not because they love the valuation math, but because there’s nowhere else to go. The fear of missing out (FOMO) amplifies this dynamic, turning every dip into a buying opportunity. It’s like a reverse short squeeze—only in this case, everyone’s squeezing to stay long.

Technical view on Mag 7

According to the fundamental, self-evident, and natural laws of technical analysis—which rival election pollsters in their predictive prowess—a notable 'Ascending Schrödinger Mirage' pattern appears to be forming on the monthly chart of American technology companies. While this technical formation may not yet have made its way into the CFA curriculum, it strongly suggests that valuations are teetering on the edge of a trendline supported by hope, American exceptionalism, and the lingering traces of abundant liquidity still sloshing through the system.

Thank you for making it this far! Please drop a <3 and share with those who you think would find this note interesting; or else i’ll be </3. For the bourgeois subscribers, I’ll be sharing the specific list of equities I’ve allocated to in the space theme, along with some quick insights on the space industry. Upgrading your subscription not only gives you access to additional valuable research and analysis but also helps support this independent effort—funding data purchases, specialized reports, and the development of tools (like the Schrödinger Mirage indicator) to continue delivering high-quality insights.

My goal is to have a reasonably robust open-source analysis package for macro data and company valuation by 2026 and to drill down into explanations here.

Wrapping Up With Our Space Theme

Now that we have illustrated our thought process for how to approach equities in the coming months, it is worth quickly making some finishing thoughts on our flagship (because it is the only one at this point) thematic equity note, of which we exited 3/4 of the position booking 50% returns since early November.

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Let me start with a confession: this note is half-baked, and for good reason. As we publish this, the NFP print is moments away, and the market’s collective pulse is quickening. But sometimes, a dish straight out of the oven captures the essence of the moment better than a perfectly plated gourmet. So, here’s a hot take on what this jobs report could mean for markets navigating the treacherous terrain of tightening liquidity.

The Liquidity Backdrop: Systemic Buffers Are Fading

The real star of today’s show isn’t the jobs number—it’s liquidity. After two years of exceptional support through the Reverse Repo Program (RRP), TGA drawdowns, and short-term Treasury issuance, markets are facing a stark new reality.

1. The Decline of the Reverse Repo Program
   The RRP once served as a $2.5 trillion reservoir of excess liquidity, allowing MMFs to recycle cash into short-term T-bills. This helped stabilize short-term funding markets and masked some of the effects of QT. However, with balances now at $250 billion, the RRP is no longer a meaningful buffer. Its depletion signals a transition where future QT will directly reduce bank reserves, tightening liquidity across the financial system.

2. Bank Reserves: Still Adequate, but Potential to Trend Lower
   Reserves remain above stress-inducing thresholds for now, but the path forward is clear. With the RRP nearly tapped out and the TGA drawdown concluding, reserves will soon face unbuffered declines. Historically, falling reserves have amplified funding market volatility, though we aren’t yet at the levels that sparked the 2019 repo crisis. Instead, the current environment increases the system’s sensitivity to shocks—a crucial consideration as markets digest today’s NFP data.

3. Treasury’s Long-End Shift
   Scott Bessent’s pivot from short-term T-bills to long-term bonds adds a new layer of complexity. T-bills, historically favored by MMFs, provide operational flexibility and liquidity. Long-term bonds, by contrast, depend on slower-moving institutional demand, which requires higher yields to absorb increased supply. This dynamic tightens short-term liquidity while steepening the yield curve, creating challenges for both bond and equity markets.

The NFP Scenarios: Market Reaction Framework

The consensus for today’s NFP stands at 160,000 jobs, with whispers edging higher. Here’s how each scenario could play out, given the current market setup:

Scenario 1: Overshoot (>160k)

A stronger-than-expected print would confirm labor market resilience, reinforcing inflationary concerns and raising the likelihood of prolonged Fed tightening. The immediate market reactions:

• Bonds: Yields rise as markets price in higher terminal rates and steeper term premiums. Long-duration Treasuries, already under pressure from increased supply, face additional selling pressure.

• Equities: Rising rates compress valuations, particularly in growth-oriented sectors. Liquidity constraints further amplify downside volatility, especially in stretched positioning scenarios.

This scenario aligns both legs of the trade for maximum payoff, with simultaneous pressure on bonds and equities.

Scenario 2: Undershoot (<160k)

A weaker print points to cooling economic momentum, easing inflation fears but raising concerns about slowing growth. The likely market reactions:

• Bonds: Rally as expectations for future rate hikes soften, providing a tailwind for duration.

• Equities: Decline modestly as recession fears emerge, though downside may be tempered by hopes of eventual Fed easing.

This mixed outcome balances the trade, with equity short gains offsetting potential losses on the bond short leg.

Scenario 3: Near-Consensus (160k ± 20k)

A consensus print would initially appear uneventful, but in today’s liquidity-constrained environment, even minor surprises can trigger volatility. Markets are stretched, and systemic buffers are gone, leaving little room for complacency.

The Trade: Dual 15-Delta Puts on Bonds and Equities

To navigate the asymmetric risks posed by today’s release, I’ve structured a trade using 15-delta puts with 30-day maturities on 30-year Treasury bonds and S&P 500 futures (ES).

Why Short Bonds?

Long-duration Treasuries sit at the intersection of inflation expectations and supply dynamics. A strong NFP print would push yields higher, driven by expectations of persistent inflation and additional long-end supply from Treasury issuance. This leg captures downside risk in an inflationary scenario while capping potential losses in a bond rally with the defined-risk structure.

Why Short Equities?

Equities face valuation compression as rates rise and liquidity tightens. Growth-oriented sectors are particularly vulnerable to higher discount rates, while liquidity constraints amplify selloffs in overbought markets. Even in a weaker NFP scenario, equities could decline on growth concerns, making this leg a hedge against scenarios where bonds and equities decouple.

Why This Note is Half-Baked (and Why That’s OK)

Let’s be honest: publishing this just before the print ensures it will either age like fine wine or curdle faster than milk in the sun. But that’s the nature of markets—reaction often matters more than prediction. What’s undeniable is that today’s NFP lands in a financial ecosystem with fewer safety nets and greater potential for volatility. Whether the print delivers a shock or aligns with expectations, the liquidity story is just beginning to unfold, and it’s one that will dominate 2025.

For now, I’ll leave you with this slightly undercooked, hopefully satisfying, take. Let’s see how the market digests its first big data release of the year.

The Treasury market is bracing for its New Year’s detox—necessary, overdue, and mildly uncomfortable. After years of Janet Yellen’s fondness for short-term borrowing, 2025 brings a maturity wall with billions of dollars in Treasury bills set to roll off the books. Enter Scott Bessent, the long-end enthusiast and vocal critic of short-term overindulgence, ready to take the reins with a strategy that swaps short-lived fixes for more durable excesses. As the Treasury shifts gears to refinance on the long end, the supply surge looms like a treacherous mountain pass, testing the resolve of investors as they shoulder the weight of a long and uncertain journey. Meanwhile, the short end might be the last homely house amid the chaos—offering solace, if only the Fed resists the temptation to tinker with its inflation expectations yet again (our book should favor this outcome).

Our end-of-year tactical rates trade, structured to capitalize on the final FOMC meeting of 2024, proved highly rewarding amid the inflation tinkering we had anticipated since the first Big-Mac rates cut. Looking ahead, I expect inflation forecasts will require frequent and substantial revisions throughout 2025, aligning with our increased inflation volatility thesis. Revisiting this trade could provide valuable insights for the year ahead, as similar tactical opportunities are likely to arise.

Fed’s Holiday Playbook

Let’s now focus on what the Treasury is about to do and some trade implications.

Tails and Covers

Our first hint at investor malcontent emerged during the Treasury’s final TIPS auction of 2024—a $22 billion reopening of 5-year Treasury Inflation-Protected Securities (CUSIP 91282CLV1). Demand faltered, marked by a 7-basis-point tail, a striking divergence from the auction's expected yield of 2.05% that ultimately settled at 2.121%. The bid-to-cover ratio dropped to 2.1, its lowest since 2019, reflecting investor hesitation amid uncertainty about inflation and the allure of nominal Treasuries yielding 4.44%. Yet, as often happens in troubled times, those who acted found an unexpected reward: a real yield exceeding inflation by 2.121% and a price below par. It was a chance, perhaps fleeting, to secure a measure of stability while others waited, reluctant to tread paths where the way seemed uncertain.

The Fellowship of the Bills: A Quest for Cheap Financing

Under Janet Yellen’s tenure as Treasury Secretary, the Treasury leaned heavily on short-term Treasury bills (T-bills) to fund deficits—a strategy born of historically low interest rates and the urgent fiscal demands of pandemic-era stimulus. “The priority is to finance at the lowest cost to taxpayers,” Yellen asserted, highlighting the agility and efficiency of short-term borrowing. She added that “short-term securities provide critical flexibility in managing the nation’s financing needs,” particularly during periods of elevated fiscal churn.

The playbook was elegantly simple: issue an avalanche of short-duration debt to tap into a financial system brimming with reserves parked in the Fed’s Reverse Repo Program (RRP). At its peak, the RRP ballooned to $2.5 trillion, serving as a reservoir for excess liquidity during quantitative easing (QE) and anchoring short-term rates. By deploying T-bills, Yellen effectively redirected cash from money market funds (MMFs) out of the RRP and into government debt, unleashing a flood of liquidity into financial markets and the real economy. This maneuver counterbalanced the Fed’s quantitative tightening (QT) efforts. Remarkably, in 2023, T-bills financed over 100% of the fiscal deficit—a feat rarely seen outside recessions in the past quarter-century.

A Reverse Repo Story

The result was a powerful liquidity injection that fueled stock market momentum and kept a lid on bond yields. Think of it as liquidity crack for markets—cheap, fast, and dangerously effective. Yet, this heavy reliance on short-term debt planted the seeds for a looming refinancing headache in 2025. With a significant chunk of this short-term debt coming due, the Treasury now faces the unenviable task of steering through a precarious funding landscape, where flexibility may be in short supply, and costs are anything but.

The Shadow Beyond the Wall: A Looming Battle for Fiscal Stability

Scott Bessent, the incoming Treasury Secretary, has taken a critical stance on the heavy reliance on short-term debt. While Janet Yellen’s approach delivered flexibility and kept borrowing costs low in the near term, Bessent sees it as a precarious balancing act, exposing the Treasury to refinancing risks and the mercurial nature of short-term markets. He has likened the $3.6 trillion maturity wall in 2025 to a structural fault line in the nation’s fiscal stability—an ominous feature that demands immediate reinforcement. “Issuing at the long end reduces rollover risk and provides a more stable funding base,” Bessent remarked, outlining a decisive shift toward longer-term debt issuance as the linchpin of his strategy.

The RRP has operated as a liquidity sponge, soaking up excess reserves in the financial system, particularly during the Federal Reserve’s quantitative easing (QE) era. Money market funds (MMFs) flocked to the RRP, attracted by its risk-free nature and yields directly tied to the Fed’s policy rate. At its peak, the RRP held a staggering $2.5 trillion in 2021-2022, reflecting a surplus of reserves and the lackluster appeal of alternative short-term investments like T-bills, which often offered lower yields during this period. By enabling MMFs to park cash securely, the RRP indirectly bolstered the Treasury’s capacity to issue short-term T-bills for deficit financing, all while leaving bank reserves largely untouched in a system awash with liquidity.

As quantitative tightening (QT) gained momentum and Treasury issuance ramped up, short-end yields, including T-bills, began to outpace the RRP’s rate. This sparked a migration of funds from the RRP back into T-bills, as MMFs pursued higher returns in the Treasury market. The RRP balance has since dwindled to $250 billion, reflecting this reallocation. While this shift has reduced liquidity held at the Fed, its broader impact has been more about redistributing liquidity across financial markets. Notably, this reallocation has mitigated some of QT’s tightening effects by enhancing short-term market liquidity. However, the overall financial conditions remain shaped by a complex interplay of factors, including reserve levels, Treasury General Account (TGA) operations, and the pace of Treasury issuance.

As the Treasury shifts from refinancing maturing T-bills to issuing longer-term bonds, market flows will adapt. Long-term bonds, less attractive to MMFs due to their duration risk, will rely on demand from pension funds, insurers, and mutual funds, which draw liquidity from sources like bank deposits, corporate cash reserves, or portfolio reallocations. This transition reduces MMF participation and channels liquidity from shorter-duration instruments into longer-term securities, tightening short-term liquidity availability. In a market already grappling with elevated yields and constrained reserves, this reallocation could intensify pressures, reflecting a shift in liquidity distribution rather than its overall mechanics.

Front End of the Curve

The interaction of short-term yields, liquidity conditions, and capital flows will undergo significant shifts as the Treasury refinances maturing T-bills with longer-term bonds. The expected reduction in T-bill issuance is set to create scarcity, driving yields lower as robust demand from money market funds (MMFs) intensifies. While the Reverse Repo Program (RRP) theoretically remains an alternative, its yield disadvantage compared to T-bills, particularly in an environment of steepening, discourages a reallocation of MMF cash. T-bills also offer critical operational advantages, such as superior liquidity, tradability, and portfolio management flexibility, making them indispensable tools. As anticipated Fed rate cuts further erode the competitiveness of the RRP relative to T-bill yields, MMFs will prioritize T-bills, exacerbating the scarcity and placing continued downward pressure on short-term yields.

Over the past two years, the decline in RRP balances has mitigated the impact of QT on overall system liquidity, acting as a critical buffer that absorbed excess liquidity and prevented acute disruptions in short-term funding markets. However, with RRP balances now nearing depletion and the Treasury’s General Account (TGA) also reducing, this cushion is rapidly diminishing. These reductions have temporarily slowed the decline in bank reserves, but once the RRP is depleted and the TGA drawdown concludes, reserves will have no buffer left, leaving them with no direction but downward. Historically, reserves approaching critical thresholds, such as 8% of GDP in 2018, have amplified funding market volatility. While reserves currently remain above these levels, the depletion of the RRP and the end of TGA reductions increase the risk of reserves falling to stress-inducing levels. This evolving dynamic will amplify competition for scarce high-quality assets like T-bills, further shaping the equilibrium in short-term funding markets.

The importance of this administration’s progress on bank deregulation also becomes evident here. By easing regulatory constraints, banks have retained greater flexibility in navigating tighter liquidity conditions, delaying the onset of systemic funding stress. However, as reduced T-bill supply intersects with tighter reserve balances, short-term rate volatility becomes increasingly likely. In this environment, competition for scarce high-quality assets like T-bills will intensify, with the evolving dynamics of the RRP, TGA, and reserve levels shaping the short-term funding landscape.

Trade: Long ZT with half year 20delta calls which serves as a hedge for monetary tightness affecting corporates, namely main-street small businesses. (35bps NAV)

The Tail End of the Curve

The tail end of the yield curve—anchored by longer-dated Treasuries such as 10- and 30-year bonds—will bear the weight of the Treasury’s pivot from short-term refinancing to longer-term issuance. The increased supply of long-term bonds will place upward pressure on yields, driven by the fundamental mechanics of supply and demand (sometimes Econ 101 really is enough). Investors tasked with absorbing this surge in long-duration debt will demand higher term premiums to compensate for heightened interest rate risk, inflation volatility, and fiscal uncertainties tied to elevated debt-to-GDP ratios.

Compounding the challenge is the current scarcity of natural buyers for long-term Treasuries at prevailing yield levels. Unlike T-bills, which enjoy robust demand from money market funds and liquidity-driven investors, long-term bonds depend on participation from pension funds, insurers, and mutual funds. These buyers, while steady, are less agile in responding to abrupt issuance shifts, especially when yields fail to adequately reflect inflation risks and increased supply. To clear the market, the Treasury will need to offer more attractive yields, effectively steepening the yield curve and introducing additional cost pressures for servicing the federal debt.

The Treasury’s management of the General Account (TGA) becomes a critical lever in moderating these pressures. A significant TGA drawdown could inject temporary liquidity, easing upward pressure on yields. However, the scale of maturing debt and ongoing fiscal requirements severely limit the Treasury’s ability to rely on this strategy for long-term stabilization. Without a marked reduction in issuance, the trajectory for long-term yields remains biased upward, driven by structural supply-demand imbalances, tightening liquidity, and investor unease over fiscal sustainability.

Trade: Continue the short on ZB, this serves as a hedge for equity multiples contracting from liquidity reducing

Reverberating to Risk Assets

Quantitative tightening (QT) adds another layer of complexity to the long-end dynamics. As the Federal Reserve continues reducing its balance sheet, the absence of a major institutional buyer for longer-term Treasuries shifts the burden onto private markets. This exacerbates liquidity pressures, particularly as declining reserve balances constrain market participants' capacity to absorb the additional supply. Unlike the RRP, which primarily parks excess reserves, the absorption of long-term bonds actively drains liquidity from the financial system, requiring investors to reallocate funds from other assets or increase leverage to finance purchases.

Until now, the decline in RRP balances has largely offset the impact of QT on total liquidity, preventing significant disruptions in financial markets. However, with RRP balances nearing depletion, future QT will directly reduce bank reserves, tightening liquidity more acutely. This shift increases the risk of funding stress, particularly as reserves trend toward critical thresholds where interbank markets become more sensitive to shocks. While the Fed has introduced tools like the bank reserve monitor to track stress, their ability to react preemptively remains uncertain, raising the stakes for risk assets.

The resulting upward pressure on long-term yields will ripple through the broader economy and financial markets. Elevated yields raise borrowing costs for corporations and households, curbing investment and consumer spending. For equity markets, higher discount rates disproportionately affect growth-oriented sectors, where valuations hinge on future earnings expectations. Credit markets face similar challenges as wider credit spreads emerge, reflecting heightened risk aversion and competition from increasingly attractive Treasury securities.

Trade: Mix of March/April 20 delta puts on ES and NQ (85bps NAV total). After such a green day, well worth to load up on cheap hedges. Currently working with a 30% cash position while waiting for an outsized opportunity. This is a time to be hedged and focus on high conviction trades

Cheers!

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Welcome to a series where first-principles thinking and just enough over-caffeination collide to demystify capital flows.

In the new section called The Quant Foundry, we’ll build models, test theories, and craft strategies to make sense of markets—and maybe even keep ourselves sane when they inevitably misbehave. This segment will focus on two key pillars: first, creating mathematical frameworks that can be empirically tested and used to develop real-time indicators, enabling us to explain the world economy and, ideally, spot trends before they hit Bloomberg or the FT. Second, we’ll aim to build parametric models that provide intuitive insights into the "why" behind market movements. As much of my time is dedicated to discretionary trading and investing, this trading journal is both a practical tool and a space to translate theory, modeling, and computation into trades that can be explained in plain language.

In this first iteration, we’ll explore the dynamics of capital flows into specific assets like gold and Bitcoin, chosen for their scarcity, durability, and independence, making them ideal foundations for our framework. We begin with gold—the elder statesman of safe havens, shaped by scarcity, inflation, and the occasional geopolitical drama. Its supply is constrained by physics and geology, while its demand thrives on its role as a hedge against uncertainty, creating a steady upward price bias that is far from random. Bitcoin, its rebellious digital counterpart, will have its turn in due course, but for now, gold takes center stage—earned through millennia of proving its value. The goal is to understand these assets such that when markets shift, we respond with clarity, not guesswork.

Right now we are trying to understand the relationship hinted at in the below chart. We will first focus on guessing a reasonable framework and then run some computing in later notes.

Wait, so bitcoin is not just magic internet money for degenerates to overpay for pizza on network fees but could be a logical addition to a global-macro portfolio? Full disclosure I have more exposure to bitcoin (via unlevered spot) than Gold (via derivatives on futures) but tactically allocate in and out of the two.

Inflation and the Yield Curve

Understanding the relationship between inflation, currency debasement, and yields is foundational to discerning when it is optimal to own gold. These dynamics highlight the interplay of macroeconomic forces, investor psychology, and structural market factors, dictating the ebb and flow of gold’s appeal as an asset.

Market-Driven Inflation Modeling

Inflation, often modeled using economic indicators, can also be inferred directly from financial market data. Market-driven inflation measures leverage real-time information embedded in asset prices, offering a dynamic view of inflation expectations relative to observable market variables. This interpretability makes these models particularly valuable, allowing me to assess whether the market is underpricing or overpricing inflation compared to my economic inflation models. By incorporating these approaches, I can gauge how well market participants’ inflation expectations align with underlying economic realities and identify potential mispricings. Below are several key approaches to modeling inflation using market data, each capturing different facets of inflationary dynamics.

Linear Yield Curve Slope Model

The simplest approach ties inflation expectations to the slope of the yield curve, a well-established proxy for macroeconomic trends.

Where:

Intuition:

Exponential Yield Curve Model:

This nonlinear model accounts for disproportionate inflation responses to large yield curve movements.

• Captures sharper inflation spikes during periods of steep curves.

• Suitable for volatile environments where inflation reacts more aggressively to yield changes.

Taylor Rule-Based Inflation Estimate

If monetary policy rates are included, use a Taylor Rule-style adjustment:

with:

Breakevens

The breakeven inflation rate, derived from the difference between nominal Treasury yields and TIPS yields, reflects market expectations for inflation over a specific horizon.

Where:

• Breakeven inflation is directly derived from market prices and offers a forward-looking inflation measure.

• Independent of yield curve dynamics, focusing solely on inflation pricing in the bond market.

Hybrid Yield Curve and Breakeven Model

Combining yield curve steepness with breakeven inflation provides a more comprehensive view.

Where:

• Balances macroeconomic signals (yield curve) with direct market pricing (breakeven rates).

• Useful in cases where either the breakeven rate or yield curve alone may be insufficient.

Yield Curve and Commodity Prices

Commodities, particularly energy and metals, are leading indicators of cost-push inflation. Adding commodity price changes enhances inflation modeling.

Where:

• Rising commodity prices often precede inflation, particularly in energy-intensive economies.

• This approach incorporates both financial and real-world cost drivers of inflation.

Term Structure of Inflation Expectations

Build inflation expectations from a term structure model, akin to Nelson-Siegel for yields:

Here, τ is the time horizon, and the β coefficients describe the level, slope, and curvature of the inflation term structure. This allows inflation expectations to vary with time horizons.

Market-Derived Phillips Curve

Link inflation to unemployment rates and yield curve spreads (a proxy for growth expectations):

with U(t) being the unemployment rate or a broader measure of labor slack. With its gamma being the sensitivity of inflation to changes in unemployment (inverse Phillips curve relationship)

I’ll elaborate on inflation models in a subsequent post in the Quant Foundry.

Components of Demand

The total demand for gold can be expressed as:

Where:

We will leave out looking at speculative demand for this analysis on gold and focus on it more when looking at Bitcoin. The reason for this is that as of today, the core forces driving demand for gold is the perpetual bid and active management, while the dominant demand forces for bitcoin are active management and speculative with limited perpetual bid (for now).

Perpetual Demand

Gold enjoys a few consistent sources of perpetual demand: central banks, long-term institutional holders, and individual investors seeking a hedge against economic instability. Central banks, in particular, have significantly increased their gold reserves, responding to economic fragility, geopolitical uncertainty, and the pursuit of financial independence. In 2022, central banks added approximately 1,136 tonnes of gold to their stockpiles—the highest annual purchase since 1967. This momentum carried into 2023, with another 1,037 tonnes acquired, marking the second-largest annual total in history. Such levels of accumulation highlight gold’s enduring relevance in an era defined by global unpredictability.

As nations rise and fall, gold remains a constant—a timeless bulwark against monetary excesses and global instabilities. Its universal acceptance, finite supply, and immunity to external control have made it indispensable to central banks navigating a rapidly changing financial order. Understanding the motivations behind this renewed interest not only highlights gold’s unique attributes but also sheds light on the shifting strategies of countries in a volatile world.

Gold as a Strategic Asset

Hedge Against Inflation and Currency Debasement

Gold's inherent scarcity ensures its status as a hedge against inflation and monetary debasement. When fiat currencies falter—whether from persistent inflation or policy missteps—gold serves as a stable store of value, preserving purchasing power. This is particularly relevant in an era of aggressive monetary easing and rising sovereign debt levels, where traditional financial assets face heightened risks.

Geopolitical Independence

The dominance of the U.S. dollar in global trade grants the United States immense power to impose sanctions, often disrupting access to international markets. In response, nations like China, Russia, and Turkey have turned to gold to reduce reliance on the dollar. Gold’s physical nature and immunity to sanctions or asset freezes foster financial autonomy, enabling nations to maintain trade flexibility and safeguard reserves during geopolitical tensions.

Crisis Asset

In a world increasingly shaped by wars, trade disruptions, and financial shocks, gold’s counterparty-free nature makes it a dependable reserve asset when confidence in other systems falters. Its universal acceptance and historical role as a "safe haven" further solidify its value during periods of global instability.

The Historical Arc of Central Bank Gold Demand

The Era of Net Selling: 1990s–2000s

The 1990s and early 2000s were marked by historic gold sell-offs, particularly by European central banks. Several factors contributed to this trend:

1. Economic Optimism and Falling Prices
   The 1990s saw robust global growth and declining gold prices, which dropped from $850/oz in 1980 to under $300/oz by the late 1990s. These conditions eroded gold’s appeal as a safe haven, with many central banks prioritizing yield-generating assets.

2. Yield Focus
   Gold, which earns no yield unless lent out, became less attractive compared to interest-bearing instruments like U.S. Treasuries. Reserve managers, under pressure to maximize returns, saw little value in holding large gold reserves.

3. European Sales
   European central banks, burdened with historically large gold reserves, became the dominant sellers, coordinating their efforts under the Central Bank Gold Agreement (CBGA) to avoid disrupting markets.

   • Key Sales:

     • CBGA signatories sold over 400 tonnes annually between 1999 and 2007.

     • Switzerland reduced its holdings by 1,550 tonnes from 2000 to 2008.

     • The UK sold 395 tonnes between 1999 and 2002, reducing gold’s share of reserves from 17.8% in 1999 to 14.7% in 2009.

The broader sentiment was shaped by confidence in fiat currencies, stable financial markets, and a perception that gold’s disadvantages—no yield, high storage costs, and volatility—outweighed its benefits.

The Shift to Net Buying: Post-2008

The 2008 financial crisis transformed the narrative. Central banks became net buyers of gold for the first time in decades, driven by these key factors:

1. Global Financial Crisis and Renewed Safe-Haven Demand
   The crisis highlighted vulnerabilities in fiat currencies and financial systems. Gold’s counterparty-free nature and historical reputation as a "safe haven" asset made it a natural choice for central banks seeking stability during unprecedented economic turbulence.

2. Emerging Market Accumulation
   Rising foreign exchange reserves in countries like China, India, and Russia led to significant gold purchases for diversification and risk management.

   • India: Purchased 200 tonnes from the IMF in 2009, raising gold’s share of its reserves from ~4% to ~7%.

   • China: Increased its gold holdings by 454 tonnes between 2003 and 2009—a 76% rise.

   • Russia: Boosted gold’s share of reserves from 3% in 2007 to 5% by 2010, emphasizing its role as a crisis asset.

3. Geopolitical and Currency Risks
   Concerns over the U.S. dollar’s stability and eurozone debt crises further boosted gold’s appeal. From 2001 to 2009, the dollar lost 38% of its value against the euro, prompting central banks to hedge against depreciation and reduce reliance on fiat currencies.

4. Reserve Rebalancing
   Rapidly expanding foreign exchange reserves diluted gold’s share, prompting central banks to restore balance. For example, China’s gold reserves, which accounted for 2.2% of total reserves in 2002, fell below 1% before a 454-tonne addition in 2009.

By 2009, annual net sales had plummeted to just 44 tonnes, with emerging markets driving the shift to net buying. This renewed focus underscored gold’s enduring relevance in a volatile world.

Gold’s perpetual demand from central banks, institutions, and individuals is a testament to its enduring value. The 1990s and early 2000s saw significant selling as gold lost its luster in a stable global economy. Yet the financial crisis of 2008 marked a turning point, reigniting interest and driving record levels of accumulation in recent years.

Today, gold remains a cornerstone of central bank strategy. Whether as a hedge against inflation, a crisis asset, or a tool for geopolitical independence, its appeal is timeless. As nations navigate an era of economic uncertainty and shifting global power dynamics, gold continues to shine as a symbol of stability, resilience, and strategic foresight.

The Differential Equation of Demand:

To capture the dynamics of persistent demand, we model its evolution as a differential equation. This approach allows us to represent how demand responds to changing economic conditions continuously, while ensuring flexibility for future extensions or simulations.

This approach allows the following benefits:

• Dynamic Representation:

  • Instead of treating demand as static, the differential equation captures the gradual changes driven by real-world forces like inflation and yields.

• Continuous Adjustment:

  • Persistent demand doesn’t shift abruptly—it accumulates or declines based on sustained pressures, such as prolonged inflation or geopolitical shocks.

• Generalizable Structure:

  • Using a differential framework, we can integrate new factors (e.g., central bank behavior or currency-specific shocks) without breaking the core model.

The simplest form for the change in persistent demand is given by:

Where:

Drivers of Persistent Demand:

Integrated Form:

To find the total persistent demand over time, we integrate the differential equation:

This formulation explicitly accounts for how macroeconomic conditions and price momentum shape the accumulation or reduction of persistent demand.

Intuitive Alignment with Historical Trends

Inflation and Monetary Debasement

• Historical Context:

  • Gold serves as a hedge against inflation and monetary debasement, particularly during periods of aggressive monetary easing (e.g., post-2008 financial crisis).

  • Central banks, especially in emerging markets, have increased gold reserves to counterbalance the risks of fiat currency erosion.

• Model Alignment:

  • In the model:

    inflation π(t) directly drives persistent demand. For example:

    • Post-2008 quantitative easing and rising inflation expectations would naturally increase perpetual demand, consistent with the shift to net buying after the financial crisis.

Geopolitical Risks and Financial Independence

• Historical Context:

  • Nations like China, Russia, and Turkey have sought to reduce dependence on the U.S. dollar and safeguard reserves amid geopolitical tensions.

  • Gold's immunity to sanctions and asset freezes has made it a key reserve asset for financial autonomy.

• Model Alignment:

  • Geopolitical instability geo(t) is a core driver:

    Rising geopolitical risk increases perpetual demand, reflecting gold’s role as a hedge during global uncertainty.

    • Events like Russia’s pivot to gold reserves align with this mechanism.

Opportunity Cost of Yields

• Historical Context:

  • In the 1990s and early 2000s, gold was less attractive due to falling inflation, robust economic growth, and rising yields. Central banks prioritized yield-generating assets.

  • For example, Switzerland and the UK significantly reduced gold holdings during this period.

• Model Alignment:

  • In the model:

    where higher yields y(t) reduce demand by increasing the opportunity cost of holding a non-yielding asset like gold.

    • The decline in perpetual demand during the 1990s is captured by this term.

Price Momentum and Reserve Rebalancing

• Historical Context:

  • Persistent demand isn’t entirely price-insensitive. Rising gold prices often signal heightened economic instability, prompting central banks to rebalance reserves in favor of gold (you can always count on the government to buy high and sell low for the good of the people…).

  • Post-2008, price momentum and the need for diversification led to significant gold accumulation by countries like China and India.

• Model Alignment:

  • The price momentum term accounts for this dynamic:

    • Positive price trends attract more demand, while negative trends reduce accumulation or trigger selling.

Cyclical Nature of Gold Demand

• Historical Context:

  • Gold demand cycles between net selling and net buying, influenced by macroeconomic conditions. For example:

    • Net Selling (1990s-2000s): Strong growth, low inflation, and high yields.

    • Net Buying (Post-2008): Financial crisis, inflation fears, and geopolitical uncertainty.

• Model Alignment:

  • The differential equation inherently captures cyclical behavior by allowing demand to rise or fall dynamically based on macroeconomic inputs:

Alternate Formulations to the Differential Equation of Perpetual Demand

Saturation and Threshold’s

Momentum-Dependent Scaling

We can include a scaling factor that adjusts the sensitivity of all inputs based on recent momentum in demand or price:

Momentum effects amplify or dampen demand depending on recent dynamics:

Strong upward momentum increases the impact of inflation, yields, or geopolitical risks.

Reversals dampen sensitivity to these drivers.

Mean-Reverting Dynamics

Introduce mean-reverting behavior to capture long-term equilibrium tendencies:

Captures the tendency of central banks and long-term holders to maintain target allocations of gold (e.g., as a percentage of reserves).

Ensures that perpetual demand does not grow without bounds and reverts to an equilibrium absent strong macroeconomic drivers.

Coupled Dynamics with Active Demand

Model perpetual demand as partially influenced by active demand dynamics:

Volatility-Adjusted Demand

Incorporate market volatility as an additional driver:

High price volatility may trigger risk-averse entities (e.g., central banks) to increase gold holdings as a hedge.

Conversely, persistent low volatility might signal reduced risk and lower the need for gold as a safe haven.

Additional Inputs to Consider

Active Demand (This is where we allocate)

While perpetual demand for gold stems from structural, long-term drivers like currency debasement, geopolitical risks, and central bank reserve strategies, it remains relatively stable over time. Perpetual demand reflects gold’s role as a hedge against systemic risks rather than a response to transient economic signals. As such, the yield curve indirectly influences perpetual demand through its impact on inflation expectations and monetary debasement, but it does not directly dictate allocation decisions.

In contrast, active demand for gold arises from the strategic decisions of investors who dynamically adjust their exposure based on the macroeconomic environment. Unlike the steadiness of perpetual demand, active demand fluctuates in response to factors like yield curve dynamics, inflation risk, and monetary liquidity. Crucially, active demand can also turn negative, as investors sell gold when economic conditions favor alternative investments.

To model active demand, we begin by identifying three key drivers:

• Opportunity Cost of Yield (Short End of the Curve):

  • The short end of the yield curve (e.g., 2-year Treasury yield) reflects the immediate opportunity cost of holding a non-yielding asset like gold. Higher short-term yields make holding gold less attractive, while lower short-term yields reduce this opportunity cost.

• Inflation Risk (Long End of the Curve):

  • The long end of the yield curve (e.g., 10-year Treasury yield) captures the term premium, often reflecting inflation expectations and uncertainty. A steeper curve signals higher future inflation risk, increasing gold’s appeal as an inflation hedge.

• Monetary Liquidity (Money Supply):

  • An abundance of liquidity (e.g., increasing money supply) tends to drive active demand for gold, as excess money flows into alternative assets, including gold. Conversely, tightening monetary conditions reduce gold’s appeal.

• (Optional) Fiscal Environment:

  • Expansionary fiscal policies, such as deficit spending, may increase inflation risk and indirectly support demand for gold. However, this is often reflected in the yield curve, so fiscal dynamics can be treated as an implicit factor.

Yield Curve Regime Classification: A Bond Portfolio-Based Approach

First keep in mind that market implied means you contract away the work of figuring out what is the current state of the world to the market. The bond shorts we have put on were by contrasting the economic picture to the market implied picture and determining there was a mispricing and an opportunity to short bonds.

Fed and China go big or go home

Fed’s Holiday Playbook

The yield curve is a powerful indicator macroeconomic conditions, but interpreting its movements—whether it is steepening, flattening, or shifting up or down—requires a structured framework. In this approach, we construct simple bond portfolios whose changes in value directly reflect the behavior of the yield curve. By carefully balancing the sensitivity of these portfolios to different parts of the curve, we can classify the yield curve into clear regimes: Bull/Bear and Steepener/Flattener.

This is a crucial framework to have in case the market moves faster than you at pricing a change in regime such that you can de-risk first and think later (but don’t put on risk first and think later).

Building the Bond Portfolios

To measure yield curve dynamics, we construct two bond portfolios:

1. Bear/Bull Portfolio: Measures whether yields are rising or falling across the curve.

2. Steepener/Flattener Portfolio: Measures changes in the slope of the yield curve.

Each portfolio combines long-duration bonds (e.g., 10-year Treasury bonds) and short-duration bonds (e.g., 2-year Treasury bonds). To ensure both ends of the curve contribute equally, the positions are duration-adjusted.

For every one long-duration bond in the portfolio we will need to scale the exposure to short-duration bonds by the ratio of the duration on long duration bonds to short duration bonds. We will denote the duration by kappa:

Bear/Bull Portfolio

The Bear/Bull Portfolio of being long both the long and short end of the yield curve captures directional movements of the yield curve:

Simplifying:

Where we interpret:

Steepener/Flattener Portfolio

The Steepner/Flattener Portfolio of being long the long end and short the short end of the yield curve isolates changes in the slope of the yield curve.

Simplifying:

Where we interpret:

Index Formulation

To classify regimes, we normalize the portfolio price changes into indices bounded between −1 and 1:

Bear/Bull Index:

Steepner/Flatner Index:

And we define the index vector:

where:

• (+,+): Bull Steepener.

• (+,−): Bull Flattener.

• (−,+): Bear Steepener.

• (−,−) Bear Flattener.

Here are some formulations which naturally follow to express this indicator:

General form:

Integrated Changes:

Smooths short-term noise by aggregating rate changes over time, emphasizing trends. Suitable for identifying persistent yield curve shifts.

Momentum-Based Changes:

Measures the acceleration (momentum) of yield changes, capturing inflection points or rapid movements. Useful for detecting shifts in market sentiment or policy.

Exponential Sensitivity:

Amplifies significant movements while reducing sensitivity to small rate changes. Ideal for periods of high market volatility or stress.

Convexity Adjusted

While the above framework captures first-order effects via duration, large yield changes introduce second-order effects through convexity:

Where:

Convexity-Adjusted Bear/Bull Portfolio

Convexity-Adjusted Steepener/Flattener Portfolio

Where the index is normalized

Relative Gradient Approach

Instead of focusing solely on rate differences, use the gradient of the yield curve over multiple maturities to derive the dynamics.

• First derivative ∇: Reflects the steepness of the curve.

• Second derivative ∇-squared: Captures how quickly the curve is changing, adding depth to the steepener/flattening dynamics.

Human Interpreted Interplay of the Yield Curve Dynamics on Gold Demand

• Bull Steepener (Falling Short-Term Rates, Steepening Curve):

  • Falling short-term rates reduce the opportunity cost of holding gold, making it more attractive.

  • The steepening curve reflects rising term premia and higher long-term inflation expectations, further boosting gold's appeal as an inflation hedge.

  • This regime typically signals accommodative monetary policy and economic uncertainty, both of which increase demand for gold.

• Bear Steepener (Rising Short-Term Rates, Steepening Curve):

  • Rising short-term rates increase the opportunity cost of holding gold, reducing its attractiveness.

  • However, the steepening curve reflects growing long-term inflation risk, which offsets some of the negative effect of higher opportunity costs.

  • In this regime, gold demand is moderate, as the inflation hedge appeal competes with the higher yield-driven opportunity cost.

• Bull Flattener (Falling Short-Term Rates, Flattening Curve):

  • Falling short-term rates reduce opportunity costs, which is favorable for gold demand.

  • A flattening curve, however, signals subdued long-term inflation expectations or economic tightening, diminishing the inflation-hedge appeal of gold.

  • Demand for gold in this regime depends on whether the opportunity cost benefit outweighs the lower inflation concerns.

• Bear Flattener (Rising Short-Term Rates, Flattening Curve):

  • Rising short-term rates sharply increase the opportunity cost of holding gold, strongly reducing its appeal.

  • The flattening curve reflects suppressed inflation expectations and potentially tighter monetary policy, further lowering gold’s attractiveness as an inflation hedge.

  • This regime is typically the least favorable for gold demand, as both opportunity cost and inflation risk work against its appeal.

Formulation of Active Demand

Where:

Opportunity Cost

Gold, as a non-yielding asset, competes with interest-bearing instruments. When short-term yields rise, gold becomes less attractive due to the higher opportunity cost of holding an asset with no inherent return. Conversely, falling yields increase gold's relative appeal. To model this relationship, we anchor the formulation in two components:

with:

We can express these relations with some alternative formulations:

Momentum-Based Opportunity Cost

• The static linear model ignores how quickly yields are moving, focusing only on their level. However, rapid changes in yields (positive or negative) often have an outsized psychological and economic impact on investors.

• By including the rate of change (momentum) of short-term yields, this formulation captures how sudden yield movements affect gold demand:

  • Rapidly rising yields create urgency to shift away from gold due to rising opportunity costs.

  • Rapidly falling yields may amplify demand for gold as holding cash or bonds becomes less attractive.

Risk-Neutral Opportunity Cost (for those who hate themselves and my preferred way)

Using the Breeden-Litzenberger formula to derive a risk-neutral probability density function (PDF) from option prices provides a nuanced approach (although more computationally expensive) to calculate the opportunity cost of holding gold. By incorporating the market’s implied expectations for the distribution of future rates, this method can reflect not only the baseline yield levels but also the range and likelihood of possible rate outcomes.

When traders price options on short-term rates, they implicitly embed their expectations about future rate movements. These expectations are not limited to a single point estimate (e.g., the forward rate) but encompass the entire distribution of possible outcomes, including:

• Baseline expectations (mean rate level).

• Uncertainty (variance).

• Directional biases (skewness).

• Tail risks (kurtosis or fat tails).

Core Concept: Breeden-Litzenberger Formula

The Breeden-Litzenberger formula allows us to extract the risk-neutral PDF of an underlying rate r at a specific time T from the prices of European call options:

Where:

This formula assumes a continuum of strike prices. In practice, discrete strikes are interpolated or smoothed to approximate the PDF.

The opportunity cost of holding gold, can be dynamically adjusted based on the full shape of the risk-neutral distribution. Let’s break this down:

With the PDF p(r) in hand, we can construct the opportunity cost of holding gold, by integrating over the full distribution. The formula takes the form:

Where:

We can be as dull as one can imagine with the weight function of 1 where we find once again our old friend in its option implied form of:

the difference between this form and the first expression of opportunity cost in this section is that instead of looking at the current short term yield, we are looking at the option market implied short term yield at the time of our chosen option maturity.

We can amplify contributions from rate levels far from the mean, highlighting periods of high uncertainty with:

Capturing moments

Using the risk neutral distribution we can express our opportunity cost in term of its moments.

Where:

We use this to rewrite the opportunity cost function:

where:

With the first few moments, we can capture significant behaviors of our risk-neutral distribution

Baseline Mean Adjustment

The baseline expectation for the short-term rate is given by the expected value of the risk-neutral distribution:

This reflects the central tendency of the market’s expectations for future rates.

We can also use the formulation for the Momentum-Based Opportunity Cost with this expression, which gives it some interpretability based on options market-implied expectations of rate drift.

where:

Variance Adjustment:

Variance in short-term rates, often interpreted as a measure of uncertainty, has a dual and context-dependent relationship with the opportunity cost of holding gold. On one hand, higher variance signals a wider distribution of potential rate outcomes, which might include scenarios where short-term rates significantly rise. This prospect increases the appeal of yield-bearing assets relative to gold, a non-yielding asset, thus raising the opportunity cost. On the other hand, if the variance reflects broader market instability or policy uncertainty, it can increase gold's attractiveness as a safe-haven asset. In this case, the opportunity cost of holding gold diminishes, as investors prioritize its stability over the speculative appeal of alternative investments. Therefore, the impact of variance depends critically on whether it reflects the potential for higher rates or systemic instability.

We can incorporate variance into the opportunity cost function in a flexible way, allowing it to either increase or decrease the opportunity cost depending on the prevailing market regime.

Where:

To make the expression dynamic, we can express the coefficient as follows:

Where:

• Skew(p(r)): Skewness of the risk-neutral PDF, capturing directional bias in rate uncertainty.

• Geo(t): Geopolitical or systemic instability measure, reflecting safe-haven demand.

Skew Adjustment

The skew reflects asymmetry in the rate distribution where a positive skew (long tail on the right) increases opportunity cost, signaling potential for higher rates.

Kurtosis Adjustment

Measures the "tailedness" of the distribution where a high kurtosis indicates greater tail risk, which can influence the perceived opportunity cost. We can also adjust the coefficient for skew to dynamically represent the market regime we are in regarding the variance.

Inflation Risk

Inflation is a dynamic force in the financial system, shaping how investors perceive risk and allocate assets. For active gold demand, inflation interacts with broader market conditions, such as the yield curve, to influence short-term investment decisions. The inflation cost function captures these effects by responding to both the momentum of inflation expectations and macroeconomic signals embedded in the yield curve.

Revisiting our Yield Curve Indicator

Now that we have provided some intuition and initial formulations on the risk-neutral framework; let’s use this to provide an option market implied forward view to our yield curve indicator. We derive our risk-neutral distribution for short and long rates respectively:

Where:

The mean and momentum of rates for short- and long-duration rates are computed as:

which allows us to write our index as:

This allows us to look beyond realized changes in the spot rates curve and glimpse into the option market implied changes to the yield curve. But always remember that this formulation offloads the work of estimating yield curve changes based on economic data to the market. Market-implied indicators have the great advantage of being live compared to economy-implied indicators, which require now-casting.

We could conceptually also extend our earlier market implied inflation estimation using this framework at no additional computational cost once we already did the work of calculating the yield curve change index with the above method.

The Inflation Cost Function

The inflation cost function, is designed to reflect the nuanced relationship between inflation and gold demand. It combines inflation momentum with yield curve dynamics to offer a comprehensive view of how inflation-related risks shape active demand for gold.

Where:

The first term captures inflation momentum, which measures the rate of change in inflation expectations over time. This term highlights the dynamic nature of investor behavior: positive inflation momentum indicates accelerating inflation expectations, prompting a stronger demand for gold as a hedge against eroding purchasing power. Conversely, negative momentum reflects decelerating or falling inflation expectations, reducing the urgency to hold gold. This component aligns with short-term investor strategies, emphasizing how rapidly evolving macroeconomic signals influence gold allocations.

The second term incorporates the steepener/flattening dynamics of the yield curve. This captures the relative movements between short- and long-term rates. A steepening yield curve suggests rising long-term inflation expectations or easing monetary policy, both of which enhance gold’s appeal as a hedge. A flattening curve, on the other hand, signals subdued inflation expectations or tightening monetary policy, reducing gold demand. This term focuses on the relative adjustments across the yield curve, providing insights into how investors perceive inflation risks and their impact on term premia.

By combining inflation momentum and yield curve slope dynamics we balance short-term and regime-specific signals. Inflation momentum ensures sensitivity to immediate changes in inflation expectations, while the Steepener/Flattener index reflects broader macroeconomic conditions that influence demand. Together, these components create a robust, dynamic measure of inflation's impact on active gold demand.

Money Liquidity Index: A Combined Market-Economic Hybrid

The monetary liquidity component captures the relationship between the availability of money in the financial system and its influence on the active demand for gold. Unlike perpetual demand, which responds to structural monetary trends over long horizons, active demand is highly sensitive to short-term changes in liquidity conditions. In an environment of expanding liquidity, excess money tends to flow into alternative assets like gold, increasing demand. Conversely, when liquidity tightens, gold demand typically declines as investors prioritize higher-yielding or more liquid instruments.

Here is a possible formulation of the liquidity index. This is a portion of my research where I am doing significant active work. How to model/represent monetary liquidity conditions?

Where:

Change in Money Supply
The money supply reflects the total liquidity injected into the economy by central banks, captured through aggregates like M1 or M2. An expanding money supply signals that central banks are easing monetary policy, creating excess liquidity that often flows into alternative assets like gold. For example, during periods of quantitative easing, central banks flood the system with money, making gold more attractive as a store of value. Conversely, when the money supply contracts due to tightening policies, liquidity dries up, reducing the appeal of holding gold.

Debt-to-GDP Ratio
This measures a country's fiscal sustainability and its long-term risk of monetary instability. A rising debt-to-GDP ratio reflects increasing fiscal pressure, often leading to inflation fears or concerns about the government’s ability to meet obligations. As such, gold demand typically rises during periods of fiscal stress. For instance, during debt crises in developed economies, gold often serves as a hedge against currency depreciation. On the other hand, a declining ratio indicates fiscal stability, making gold less necessary as a protective asset.

Change in Private-Sector Credit
Private-sector credit measures the flow of borrowing by businesses and households. Rapid credit growth often signals optimism and confidence in economic conditions, reducing demand for defensive assets like gold. For instance, when private credit is expanding, investors tend to allocate more to higher-yielding investments. Conversely, a contraction in credit reflects tightening financial conditions or economic stress, making gold more attractive as a safe haven during these periods. A good example of this dynamic is during financial crises when banks pull back lending, and investors turn to gold.

Change in Central Bank Reserves
Central bank reserves reflect the amount of liquidity held by commercial banks with central banks. When these reserves rise, it often indicates that central banks are injecting liquidity into the financial system, boosting confidence and supporting gold demand. During crises, central banks increase reserves to stabilize markets, indirectly supporting gold demand. However, falling reserves reflect tightening liquidity conditions, where gold demand may decline as the system prioritizes liquidity for immediate needs.

Additional Considerations

To enhance the liquidity indicator, we can integrate other components that reflect broader monetary, fiscal, and financial market dynamics. These additions would complement the existing focus on money supply, debt-to-GDP, private-sector credit, and central bank reserves.

Velocity of Money

• What It Measures: The rate at which money circulates in the economy, calculated as the ratio of nominal GDP to the money supply (e.g., M2).

• Why It Matters: A declining velocity of money suggests hoarding or reduced economic activity, often increasing demand for gold as a safe-haven asset. Conversely, rising velocity reflects a more dynamic economy, reducing gold demand.

• Example: During economic contractions, the velocity of money often declines, coinciding with increased gold demand.

Cross-Border Capital Flows

• What It Measures: Net inflows or outflows of capital across borders, reflecting global liquidity conditions and risk sentiment.

• Why It Matters: Large outflows from emerging markets often drive demand for gold as investors seek to hedge against currency depreciation or financial instability.

• Example: During times of global financial stress, capital flows into safe-haven currencies and assets, including gold.

Gold Lease Rates (GLR)

• What It Measures: The cost of borrowing gold in the interbank market, typically reflecting gold’s availability relative to demand.

• Why It Matters: Rising lease rates indicate tighter liquidity in the gold market itself, often coinciding with increased demand for physical gold. Falling rates reflect easier liquidity conditions, reducing gold’s appeal.

• Example: During the 2008 financial crisis, gold lease rates spiked as demand for gold surged.

Central Bank Balance Sheet Growth

• What It Measures: The growth or contraction of central bank balance sheets as a measure of monetary stimulus or tightening.

• Why It Matters: An expanding balance sheet signals monetary easing, increasing gold demand. Conversely, a shrinking balance sheet reflects tightening liquidity conditions, often reducing demand.

• Example: The Federal Reserve’s balance sheet expansions during quantitative easing programs significantly supported gold prices.

Global Trade Volumes

• What It Measures: Changes in global trade activity, often reflecting economic health and liquidity conditions.

• Why It Matters: Declining trade volumes signal slowing economic activity and reduced liquidity, increasing gold demand. Rising trade volumes reflect economic dynamism, reducing gold’s appeal.

• Example: Trade slowdowns during geopolitical crises or recessions often align with higher gold demand.

Shadow Banking Indicators

• What It Measures: Metrics like total assets under management in shadow banking institutions, including money market funds and securitization vehicles.

• Why It Matters: A contraction in shadow banking liquidity signals stress in the broader financial system, driving demand for gold. Growth reflects ample liquidity, reducing demand.

• Example: Shadow banking contractions during the 2008 financial crisis significantly drove gold demand as traditional liquidity mechanisms failed.

Real Effective Exchange Rate (REER)

• What It Measures: A country’s currency value adjusted for inflation relative to a basket of other currencies.

• Why It Matters: A declining REER indicates weakening currency competitiveness, often driving gold demand as a hedge against currency devaluation.

• Example: Declining REER values for the U.S. dollar during periods of aggressive monetary easing have historically aligned with rising gold prices.

Financial Stress Index

• What It Measures: A composite index that combines credit spreads, equity market volatility, and funding market stress.

• Why It Matters: Rising financial stress often aligns with tighter liquidity and increased gold demand as a safe-haven asset.

• Example: Financial stress indices spiked during the 2008 crisis, coinciding with a surge in gold prices.

Sovereign CDS Spreads

• What It Measures: Credit default swap (CDS) spreads for sovereign debt, reflecting market-perceived risk of sovereign default.

• Why It Matters: Widening CDS spreads indicate growing concerns over fiscal sustainability, often boosting demand for gold.

• Example: During the eurozone debt crisis, widening CDS spreads for countries like Greece drove up gold demand.

To put everything together, we can reference back to the work we did on perpetual demand to express different ways to join the dynamics of opportunity cost to holding gold, inflation risk and monetary liquidity into one active demand formula differential equation which will allow us to estimate changes in demand sensitive to market changes from today.

Conclusion and Future Directions

This analysis synthesizes existing frameworks and market phenomena to build practical models that inform investment strategies. The interplay of inflation, yield dynamics, and monetary liquidity offers well-trodden paths to understanding asset demand, particularly for gold and Bitcoin. By documenting these relationships, the goal is not to reinvent the wheel but to operationalize established concepts for tactical allocation and portfolio management.

Gold, with its unique combination of scarcity, historical reliability, and utility as a hedge, provides fertile ground for applying these models. The focus on demand drivers, from inflation to opportunity costs, translates directly into actionable insights for trading decisions. Incorporating live market data—such as yield curve regimes, breakeven inflation, and risk-neutral metrics—serves as a way to refine execution timing and identify mispricing opportunities.

Looking forward, the work naturally extends into two critical areas:

1. Supply-Side Dynamics: Building on the demand-side focus, integrating supply constraints into the framework—such as mining output for gold or algorithmic issuance for Bitcoin—will add depth to the models. This will provide a more comprehensive basis for anticipating price moves based on shifts in supply-demand balance.

2. Asset Pricing Models: The ultimate objective is to translate these insights into robust pricing strategies. By leveraging the interplay of supply and demand with market data, the goal is to identify relative value opportunities across asset classes and monetize misalignments efficiently.

Rather than uncovering new truths, this process is about systematically applying known principles to better navigate market volatility and capture returns. The exercise here is one of disciplined implementation, turning abstract relationships into concrete, profit-driven investment strategies.

Cheers!

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The Fed’s final meeting of the year is shaping up to be the headline act of this holiday season, and markets are already trimming the tree in anticipation. With a 25-bps rate cut priced in at a near-certain 97%, it’s as if Jay Powell has donned his Santa hat and sent advance word that the presents will be delivered on time and be plentiful. But as every good economist knows, it’s not just what’s in the box—it’s how it’s wrapped and what’s scribbled on the gift tag (and if the price tag is still on). Three scenarios sit under the tree, and each one carries its own surprises for the yield curve.

Here’s the thing: we’re not here to play Fed oracle—that’s a job for the STIR traders still obsessing over their dot plots. Instead, our job is to prepare portfolios for whatever comes down the chimney, an approach far less stressful and (hopefully) much more rewarding.

Here’s the game plan: First, I’ll walk you through a low-cost, asymmetric hedge that’s worth unwrapping ahead of the meeting. It’s a small price to pay if the Fed delivers the expected cut, but it provides a bit of protection in case Powell swaps the Santa suit for a Krampus mask. Then, in the next note, I’ll unveil the ultimate structural hedge—a timeless, shiny package that defends against both growth scares and inflation volatility, no matter how the Fed guides its sleigh into 2025.

So sit back, pour the eggnog, and let’s get tactical. The Fed’s message might bring holiday cheer—or it might come with a lump of coal for markets. Either way, we’ll (try to) be ready.

Recap of the inflationary ghost.

Feel free to skip this section if you also complain to your shrink about inflation…

A core position in the portfolio has been our inflation volatility hedge: a short on long-duration bonds, first unwrapped after the Fed’s September Big Mac rate cut—a gift that’s been anything but standard fare. Historically, 30-year yields tend to drop 10-50 bps in the months following the Fed’s first rate cut, like clockwork. But this time? Yields climbed a head-turning 40 bps. The last time we saw anything remotely similar was in 1995’s elusive soft landing, and even that pales in comparison.

To be clear, this is the largest post-cut rise in 30-year yields on record, a flashing neon sign of market skepticism toward the Fed’s ability to juggle growth and inflation. When markets normally roll out the red carpet for easing, long bonds have instead been met with a frosty reception. Below is a quick recap conveniently wrapped up with a bowtie of the key arguments from previous notes:

1. Pro-Labor Shift and Implications for Capital Markets
   The pivot toward pro-labor policies signals a structural shift: prioritizing domestic manufacturing, reducing trade deficits, and boosting employment. This marks a sharp departure from the pro-capital, globalization-driven era that turbocharged financial assets. A labor-centric framework comes with trade-offs—higher costs, compressed corporate margins, and pressure on earnings, particularly for sectors reliant on cheap global supply chains. However, targeted fiscal stimulus to offset these labor costs could soften the blow, opening opportunities in infrastructure, energy, and industrial equities poised to benefit from reshoring and domestic investment tailwinds.

   

   Post-Election Implications and Trades

2. Fiscal Spending Put and Inflation Volatility
   The administration’s pro-labor agenda strengthens the fiscal spending put, making deficit spending the go-to tool for averting economic slowdowns and preserving full employment. What was once considered wartime-level deficit spending has become the new baseline, funneling liquidity into the real economy to provide a growth backstop—albeit at the cost of heightened inflation volatility. As a result, inflation is now structurally anchored at or above 2%, posing a persistent challenge to the Fed’s price stability mandate even as it grapples with the economic trade-offs of this fiscal shift.

   

   Quick rates update

3. Reverse Repo Program and Liquidity Mechanics
   The interplay between the Fed’s Reverse Repo Program (RRP) and Treasury General Account (TGA) is crucial for understanding monetary liquidity dynamics. The RRP, which has shrunk to $118b from its peak ($400b when we first talked about it!), has been a significant absorber of excess liquidity in the financial system. Concurrently, Treasury issuance and TGA drawdowns inject liquidity into the real economy. This dual mechanism offsets the liquidity-draining effects of quantitative tightening (QT) and provides a net easing effect on financial conditions. As fiscal deficits rise, the TGA balance is expected to contract further, directly supporting liquidity and creating inflationary pressures.

   

   A Reverse Repo Story

4. Dollar Weakness, Inflation Risks, and Strategic Contradictions
   Weakening the dollar to enhance export competitiveness aligns with the pro-labor agenda but risks stoking inflation through higher import prices. This approach conflicts with Trump’s and Bessant’s stated objectives of maintaining a strong dollar and preserving the U.S. dollar’s reserve currency status. The contradiction highlights a key tension: a strong dollar supports global confidence in U.S. financial assets, while a weaker dollar boosts domestic production at the expense of inflationary pressures. Staying alert to policy nuances and their execution will be critical in assessing the broader implications for capital flows and inflation volatility.

   

5. Mispriced Term Premium Creates Asymmetry on the Long End
   Long-duration bonds remain a glaring mispricing, offering meager compensation for rising inflation risks and ballooning deficits. Despite persistent inflation volatility driven by fiscal largesse and pro-labor policies, the term premium remains stubbornly low, a sign of market complacency. The irony? Rate cuts, far from easing Treasury pressures, loosen financial conditions, fueling even larger deficits and speculative excess. Investors then demand higher yields to fund the debt, creating a toxic feedback loop. The disconnect is clear: short rates fall, but long yields climb—a warning shot from the bond market that policy easing without fiscal discipline is self-defeating. This dynamic makes short positions on 30-year Treasuries (via ZB or TLT) an attractive risk/reward play, as deficits steepen the curve and structural inflation volatility takes center stage.

We tactically closed our short position on long-duration bonds—our core inflation hedge—following Scott Bessent’s Treasury appointment, a move that signaled fiscal restraint to markets. While I remain skeptical about meaningful spending efficiencies materializing (even with the D.O.G.E.’s tech-driven ambitions), I wasn’t keen on fighting the new narrative. That said, I quickly reloaded the hedge—via a May 2025, 115 put on ZB futures—just ahead of last week’s CPI and PPI prints, aligning with our inflation volatility thesis. The trade climbed 30%, and while taking profit now could prove prudent, the structural risks remain firmly intact.

The Bessent and Lighthizer Dilemma

Are these bond bears you talk about in the room with us?

One concern with the trade is the growing crowding in bearish bond sentiment, which has begun to undermine its asymmetric appeal. The iShares 20+ Year Treasury Bond ETF (TLT) serves as a telling proxy for investor positioning. Despite its price relentlessly falling since early 2022—a direct consequence of rising yields—it continued to attract inflows as investors sought safe havens during growth scares. This dynamic reflected a persistent belief in long bonds as a hedge against economic slowdowns and disinflation risks, even as inflation volatility surged.

Now, however, that sentiment has flipped. We are witnessing the largest outflows in TLT’s history, leading to the deepest drawdown in its assets under management since inception. This sharp reversal signals a broad capitulation on long bonds, as skepticism surrounding Treasuries becomes increasingly mainstream. With investors exiting en masse, the trade’s edge could be diminished. A crowded trade becomes vulnerable to short squeezes, sudden positioning reversals, and narrative shifts, particularly if growth fears return or the Fed signals dovish intent. While the structural case for shorting long-duration bonds remains intact, the growing consensus around this view demands a more tactical approach.

This can also be observed in the put skew for bond options. Hedging costs for a selloff in the long end of the Treasury curve have ticked notably higher over the past week. The options skew on the 30-year bond has tilted decisively toward puts—now pricing at the widest premium since early November—reflecting heightened caution among investors. This shift coincides with 30-year yields touching their highest levels since mid-November earlier this week.

A reality of historical tightness guiding the Fed…

While inflation remains a persistent concern, the U.S. economy faces a dual reality: weakening growth on one side and robust fiscal spending on the other, which risks reigniting inflationary pressures. This tension creates a tricky backdrop for the Fed’s upcoming decision, where a rate cut is a valid possibility as policymakers may tilt their focus toward the employment mandate over price stability, particularly with monetary conditions still historically tight.

The case for a 25-basis-point cut this week rests on the restrictive nature of current policy. Despite the cumulative 75 bps of easing delivered so far, the real Fed Funds rate remains near +2%—a level of tightness last seen in 2007. For context, core PCE inflation has cooled to 2.5% year-over-year, meaning monetary policy continues to run well above underlying price pressures. Historically, such elevated real rates have preceded economic slowdowns. With the labor market showing early signs of moderation, the Fed may opt to manage risks preemptively, shifting toward a neutral stance without destabilizing the broader economy.

The private sector’s resilience adds support to this approach. U.S. private sector debt-to-GDP stands at roughly 145%, the lowest level since 2003, reflecting a decade of deleveraging. Combined with robust nominal wage growth, this lowers the economy’s sensitivity to higher interest rates, giving the Fed room to ease without sparking immediate imbalances. Moreover, current market expectations see terminal Fed Funds rates settling around 3.50% in three years, a shift reflecting confidence in higher neutral rates amidst private sector resilience and nominal growth trends. However, the government’s fiscal position paints a starker picture: deficits remain stubbornly elevated at over 6% of GDP, and higher refinancing costs at current rates have added further strain.

The Fed’s final meeting of the year might not feel merry

Markets are all but certain Santa Powell will deliver a 25-bps rate cut, but the real intrigue lies in the message he leaves under the tree. Will he hand out a hawkish pause like Krampus slipping coal into stockings? Will he deliver the expected cut but pair it with a stern “don’t get greedy” warning for 2025? Or will he surprise us all and promise a deeper easing cycle, channeling his inner Santa with a sack full of future rate cuts? Each scenario brings its own curve dynamics and market implications, so let’s break down what’s at stake as Powell and his team prepare to close out the year.

The hawkish pause: Krampus comes to town

Let’s begin with the least likely—but most disruptive—scenario: the hawkish pause. Markets have assigned almost zero probability to this outcome, so if Powell decides to channel his inner Krampus and leave rates unchanged, the reaction would be swift and brutal. Short-term yields would be the first to reprice higher. Traders, caught on the wrong side of easing bets, would scramble to unwind positions, pushing the 2-year yield up 10–15 bps in a single session. This isn’t just about repricing expectations for this meeting—it would represent a broader reassessment of the Fed’s willingness to cut into an economy that, while showing signs of moderation, is hardly in freefall.

What about the long end? Here’s where it gets more nuanced. A hawkish pause might introduce some upward pressure on the term-premia as concerns about lingering inflation volatility take hold. After all, staying restrictive signals that Powell remains wary of cutting too soon while deficits run hot. However, risk-off flows—investors fleeing equities and riskier assets—could partially offset this move. Long-duration Treasuries often act as a safety net when markets get jittery, providing a counterbalance to rising yields on the short end.

The result? A bear flattening of the yield curve, with short-term yields rising faster than the long end. This is classic hawkish policy in action: monetary conditions remain tight, the curve flattens, and markets are left scrambling for cover.

The broader implications are clear. A hawkish pause would reinforce the message that the Fed isn’t in a rush to cut rates. Equities—already priced for holiday cheer—would not react kindly to this lump of coal, and risk assets across the board would likely see sharp corrections. Meanwhile, the bond market would deliver its own warning shot: restrictive policy isn’t going anywhere, and Powell isn’t here to hand out gifts just because it’s December.

The cut with a 2025 pause: santa’s here, but don’t get greedy

This is the Fed’s version of “splitting the wishbone”—a 25 bps rate cut, as expected, but with a stern message: don’t expect more goodies in 2025. Powell gets to play Santa this meeting, handing out the long-anticipated rate cut, but he’ll also drop a hawkish pause into the stocking to keep the kids (read: markets) in line. Call it a dovish cut with hawkish guidance—just enough cheer to avoid a tantrum, but a warning not to overindulge.

For the yield curve, the outcome is relatively measured. Short-term yields (think 2-year) would likely drift modestly higher—call it 5–7 bps—as traders rein in their overly ambitious rate-cut bets for next year. After all, if Powell signals a prolonged pause, there’s no need for short-term yields to keep pricing in an aggressive easing cycle. Markets would grumble a bit but stop short of full-blown disappointment.

The long end? Largely unmoved. A single rate cut is unlikely to sway the 30-year yield much, as the balance of forces at play—growth stabilization from immediate easing versus persistent inflation risks—keeps things roughly neutral. There’s no bear steepener here, no major moves in duration. Instead, we get a bear-neutral curve: the short end drifts slightly higher, while the long end remains flat, mirroring the mixed signals of a cautious Fed.

The bond market will parse every word of Powell’s guidance, searching for cracks in the Fed’s resolve. A hawkish pause signal caps just how far short-term yields can fall, limiting the upside for bond bulls. But the long end remains vulnerable to fiscal realities. Powell may want to stabilize the curve, but deficit spending isn’t slowing down, and inflation volatility isn’t going anywhere.

For equities, this outcome is like Christmas morning with a note attached: “One gift only—don’t ask for more.” Stocks would likely cheer the rate cut, but gains could be tempered by Powell’s restraint on 2025 easing. Risk assets love dovish surprises, but this isn’t one—it’s Powell threading the needle between growth concerns and inflation realities.

So what’s the takeaway? This outcome gives us a small reprieve but no lasting solution. Short-term yields edge higher, term-premia remains steady, and markets are left hoping Santa Powell’s sleigh returns next year. But with fiscal largesse and inflation still at the party, investors would do well to temper their expectations. Powell might be cutting rates, but he’s not ready to hand out endless candy canes—and the bond bears are still lurking by the punch bowl.

More cuts for 2025, Santa decides to move in with you

Now, what if the Fed not only cuts by 25 bps but also signals a deeper cutting cycle in 2025 than the market expects? Picture Jay Powell channeling his inner Santa, delivering not just this year’s 25-bps gift but stuffing the market’s stockings with promises of more in the year ahead. Such a move would leave short-term yields hopping on the sled downhill, with the 2-year likely dropping 5–10 bps as traders price in a continued easy policy.

The long end of the curve, however, wouldn’t join the celebration. Long-duration Treasuries would likely sell off, as markets grow wary of what more cuts really mean—with inflationary pressures getting a second wind. Investors, now tasked with funding ballooning deficits amid looser financial conditions, would demand higher yields as compensation for long-term debt, steepening the curve in a bear steepener dynamic. This mechanic would be added to Bessent’s likely push towards focussing on issuing on the long end unlike his predecessor (but more on that in a following note).

This scenario creates an uncomfortable tension. The front end throws a party for easier monetary policy, while the long end sulks, skeptical that fiscal discipline will follow. It’s the bond market’s version of an extended family Christmas dinner: short-term yields toast to rate relief with a bit too much boxed wine, while 30-year yields shoot side-eye across the table, muttering about inflation risks and deficits.

For bond traders, the implications are sharp: a dovish pivot amplifies curve steepening and exposes duration to outsized downside risks. At the same time, equity markets—who, let’s be honest, never met a rate cut they didn’t like—might rally initially, only to confront rising long yields, which quietly sabotage lofty valuations.

Well… what is the trade?

To be clear, I do not hold a specific view on whether a cut or pause is the appropriate policy path; I think the tensions between economic weakness and inflation provide plenty of ambiguity and nuance to meditate through. That being said, with a cut fully priced in and our extensive work building the case for structural inflation, a pause appears underpriced at the market-implied probability of just 3%.

To balance the near-term risks of hawkish surprises with the longer-term structural pressures, I’m structuring a two-legged hedge as follows:

1. Short ZT (2y bonds) via Jan 24 ATM puts

   • Objective: This leg hedges against a hawkish outcome—either a pause or a cut with hawkish guidance. In both cases, short-term yields would reprice sharply higher as markets unwind aggressive easing bets. A pause, in particular, could trigger a swift repricing of 10–15 bps on the front end, offering strong asymmetric risk/reward.

2. Short ZB (30y bonds) - taking profits on our short and allocating to the 2y leg

   • Objective: This leg targets the third scenario—a dovish Fed that signals deeper cuts in 2025. While short-term yields would drop, the long end remains highly vulnerable to rising term premium and deficit-driven issuance. Deeper cuts would loosen financial conditions, exacerbating fiscal pressures and stoking inflation volatility, forcing long-duration bonds to sell off in a bear steepener dynamic.

   • Bonus Protection: This position also serves as a hedge against a “Liz Truss moment”—where additional tax cuts or fiscal stimulus are implemented without a commensurate reduction in spending. Such policies would amplify deficit pressures and demand for long-term debt, causing a rapid repricing higher in yields.

I will have equal duration adjusted exposure on both legs (to keep things simple) and have the whole structure at 85bps of NAV.

This approach creates a balanced trade that navigates both near-term volatility and longer-term trends. It’s a hedge against complacency on the front end and a reassertion of our core thesis: inflation volatility, fiscal realities, and policy risks leave duration highly vulnerable to repricing. The hedges I put on are always executed with the idea of hedging a lazy long equity book, the first two scenarios we laid out might continue the equity weakness we have seen today. I will however keep my tap-dancing shoes on and take off the 2y leg if Santa decides to move in with us.

Typical financial disclaimers, use your brain or a financial advisor. This article is just jolly good fun and not financial advice etc etc…

Cheers!

Scott Bessent: Wall Street’s Comfort Blanket

Markets have embraced Scott Bessent’s appointment as Treasury Secretary, interpreting it as a signal of renewed fiscal discipline. A seasoned Wall Street figure with a history of advocating for balanced budgets, Bessent’s “holy trinity” of goals—3% real economic growth, a 3% budget deficit by 2028, and 3 million barrels of daily U.S. oil production—has catalyzed a rally in Treasuries. The market’s enthusiasm reflects confidence in a Treasury Secretary who aligns with the narrative of spending efficiency.

This narrative has been further supported by the creation of the Department of Government Efficiency (DOGE), led by Elon Musk and Vivek Ramaswamy. Their mission to trim excess government expenditures through tech-driven solutions and streamlined operations reinforces the perception of a government focused on fiscal prudence. However, as I noted in “Post-Election Implications and Trade Sketches,” this newfound emphasis on efficiency stands in stark contrast to Trump’s broader policy objectives, which remain structurally pro-labor and growth-oriented.

Short-Term Optimism is Overdone

Markets are treating Bessent’s appointment and the establishment of DOGE as harbingers of a new era of fiscal restraint. However, as I’ve written previously, Trump’s economic priorities are rooted in Main Street-focused initiatives—reshoring, pro-labor policies, and protectionist trade strategies. These are fundamentally inflationary and require significant government spending to support industrial and economic revitalization.

The current bond rally, while understandable, reflects optimism disconnected from these structural realities. As I emphasized in the prior note, fiscal discipline is unlikely to take precedence over pro-labor economic imperatives, and inflationary pressures will persist. While markets are temporarily enthralled by the fiscal discipline narrative, reality will eventually reassert itself.

Fighting the Prevailing Narrative is Expensive

Markets run on narratives, and the current storyline—centered on fiscal discipline under Scott Bessent and the newly established Department of Government Efficiency (DOGE)—is dominating sentiment. While this narrative may eventually clash with the broader policy realities, challenging it prematurely can be costly. The rally in bonds reflects the market’s embrace of this perceived shift toward austerity, even if it’s at odds with the administration’s underlying priorities of growth and labor protection.

Tactically stepping aside and taking profits on the trade we set up when the Fed cut 50bps in the article titled: Fed and China go big or go Home allows me to avoid the expense of pushing back against a sentiment-driven narrative at its peak. Instead, I’ll wait for the disconnect between perception and policy outcomes to surface, presenting a more opportune moment to re-engage.

Why I’m Still Long-Term Bearish on Bonds

Robert Lighthizer: Trump’s True Spirit Animal

Robert Lighthizer, Trump’s long-time trade advisor and advocate for protectionist economic policies, exemplifies the administration’s broader vision. His focus on tariffs, reshoring, and trade realignment underscores the inflationary core of Trump’s economic strategy. While Bessent’s fiscal restraint narrative may dominate headlines, Lighthizer represents the administration’s deeper commitment to pro-labor, pro-industry policies that inherently drive inflation.

Lighthizer’s trade policies are structurally aligned with Trump’s economic vision, prioritizing American labor and domestic production at the expense of cost efficiency. This makes his influence a critical counterbalance to the perceived austerity of Bessent’s Treasury leadership. The result is a dual narrative: fiscal prudence as a short-term market driver, but inflationary labor and trade priorities as the long-term structural reality.

The Illusion of Government Efficiency

Efforts to address the U.S. federal budget through efficiency initiatives face significant hurdles. While politically appealing, the structural realities of federal spending severely limit the potential impact of the Department of Government Efficiency (DOGE). Here’s why these efforts are unlikely to succeed, leaving fiscal deficits as a persistent feature of the U.S. economy:

1. Discretionary Spending is Too Small to Move the Needle

The vast majority of federal spending is concentrated in mandatory programs—Social Security, Medicare, Medicaid, and interest payments—which account for 72–78% of the budget. Even if the entire remaining discretionary budget were eliminated, it would barely cover the current deficit.

2. Structural Drivers of Spending are Inflexible

• Aging Demographics: The growing retiree population is placing increasing pressure on Social Security and Medicare. Social Security payouts already exceed contributions, with the trust fund projected to be depleted by 2033.

  

• Healthcare Costs: Medicare and Medicaid expenses are growing at 7% annually, far outpacing GDP growth. This trend shows no signs of abating, driven by rising enrollment and healthcare inflation. You can reference the Centers for Medicare & Medicaid Services guidance with their NHE Fact Sheet

3. Rising Interest Costs

Federal debt servicing costs have doubled since 2021, reaching over $1 trillion annually. With higher interest rates being rolled into new Treasury issuance, interest payments are becoming the fastest-growing component of federal outlays. This dynamic reinforces a vicious cycle: deficits drive higher borrowing costs, which in turn exacerbate deficits.

4. Political and Legislative Constraints

Many spending programs, especially entitlements, are statutory and require Congressional approval to alter. While the DOGE and Bessent might achieve marginal gains, addressing the core drivers of deficits requires legislative consensus and coordination between branches of the Federal bureaucracy.

The Holy Trinity May Not Be Fully Achievable

Breaking down the holy trinity:

• 3 million barrels of oil per day: Achievable and consistent with Trump’s energy independence goals.

• 3% real economic growth: Difficult without significant fiscal expansion, as I’ve discussed in “Fed and China Go Big or Go Home.” Sustained growth at this level would require substantial government spending, adding inflationary pressures.

• 3% budget deficit by 2028: A political challenge, given the competing priorities of infrastructure spending, defense, and reshoring. Fiscal restraint faces inherent limits in a policy framework designed to support employment and wages.

This disconnect between the aspirations of the holy trinity and the realities of policy execution underscores why my long-term bearish outlook on bonds remains intact.

Inflation Risks Are Brewing

As I explored in prior articles, inflation risks are embedded in the shift toward pro-labor economic policies (this would have been true under either presidential candidate). Trump-specific policies of tariffs and reshoring industrial production could lead to increased production costs as an inflationary driver, even in the face of potential deflationary energy price declines. The structural forces at play ensure that bonds will struggle to maintain stability over the long term due to inflation volatility, even if the market temporarily overlooks these risks.

Pivoting to U.S. Bank Stocks

Exiting the ZB short trade aligns with a broader realization: the short-term narrative driving Treasuries higher—a perception of fiscal restraint under Scott Bessent—is dominating market sentiment. Yet, this very policy narrative also creates an exciting structural opportunity elsewhere: U.S. bank equities.

Scott Bessent’s appointment as Treasury Secretary and his explicit advocacy for deregulation herald a policy environment where financial institutions are poised to thrive. While bond markets rally on optimism about fiscal discipline, bank stocks stand to gain from the long-term structural shifts these same policies are set to unleash.

Bessent’s views on removing regulatory burdens align seamlessly with Trump’s broader deregulatory agenda. In his own words, Bessent has championed a “big push in bank deregulation,” emphasizing the need to “get a lot of the lending back into the banking system, and let our banks lend.” This vision underscores the critical role of banks in driving private-sector-led credit creation—a cornerstone of the administration’s strategy to sustain economic momentum amid a reduction in government spending.

The Role of Bank Lending in Trump’s Economic Strategy

At the core of Trump’s economic vision lies a significant shift in the source of money creation, moving from government-led deficit spending to private-sector-driven credit expansion. This desired transition makes banks indispensable to achieving the administration’s ambitious policy goals. To understand their role, it’s essential to delve into the mechanics of money creation and why banks are positioned at the center of this strategy.

Quick Mechanics of Money Creation

In any economy, money creation happens through two primary channels:

1. Government Deficit Spending:

   • By spending more than it collects in taxes, the government directly injects liquidity into the economy. This spending is financed through borrowing, typically by issuing Treasury securities. The proceeds flow into the hands of businesses, households, and state/local governments, stimulating demand and supporting economic activity.

   • This method gained prominence during the COVID crisis, when fiscal stimulus programs such as direct cash transfers, enhanced unemployment benefits, and small business loans were deployed at an unprecedented scale. While effective in averting an economic collapse, this approach significantly increased the federal debt, pushing it to levels that are now raising alarm over sustainability.

2. Private Sector Credit Creation:

   • When banks issue loans, they essentially create new money. Here’s how it works: A bank extends a loan to a customer, and simultaneously credits the customer's deposit account with the loan amount. This action increases the money supply, as the loan becomes new purchasing power in the economy.

   • Unlike government spending, private-sector credit creation depends on demand for loans and the willingness of banks to lend. This process is driven by the availability of creditworthy borrowers and banks’ confidence in the economic outlook. As businesses and consumers borrow to invest, spend, and grow, economic activity is organically stimulated.

Trump’s government appointees’ having common guidance on fiscal discipline suggests a deliberate pivot away from government-driven liquidity injections toward private-sector credit creation. If the desire is for government spending to contract, a robust lending activity becomes essential to sustaining economic momentum, positioning banks as the linchpin of this strategy. Now, keep in mind, that policy can fail to implement spending deficit reductions but achieve to loosen regulations around banks.

Why Bank Lending is Critical

Trump’s policy framework relies heavily on banks to expand credit and drive economic growth. This reliance is not just a preference but a necessity in an environment of shrinking government deficits. Here’s why bank lending is so vital:

• Bridging the Liquidity Gap: Without sufficient private-sector lending, a reduction in government spending would lead to a contraction in the money supply, slowing economic activity. Banks must step up to bridge this gap, ensuring liquidity remains adequate to support growth.

• Empowering Local Economies: As Bessent noted, banks are sitting on “plenty of liquidity” but remain hamstrung by regulatory hurdles. Easing these restrictions will enable banks to lend more effectively to small businesses, infrastructure projects, and community initiatives—directly supporting Trump’s pro-growth, pro-labor agenda.

• Sustaining Employment and Wages: Expanding credit fuels business growth, which in turn supports job creation and wage increases. Robust lending activity is particularly critical for labor-intensive industries such as manufacturing and small enterprises, aligning with Trump’s promise to deliver a higher standard of living for American workers and providing credit lines to re-shore industrial production.

The Economic Stakes of Credit Expansion

The stakes are high. If banks fail to expand lending sufficiently and the government manages to step back spending, the broader economy risks stagnation or even contraction. This is the clear bear case for banks and equities broadly.

Historical data highlights the importance of loan growth if government spending steps back:

• Before the Global Financial Crisis (GFC): Real bank loan growth ranged between 4% and 11% averaging at around 8%, fueling strong economic cycles.

• Post-GFC: Regulatory overhang has averaged loan growth at approximately 4%, limiting banks’ ability to drive the economy forward.

Bessent’s deregulation agenda aims to reverse this trend, empowering banks to return to pre-GFC loan growth levels and tying in directly with our rotation trade to RTY.

Why U.S. Bank Stocks?

This combination of structural necessity and policy alignment makes U.S. bank equities a particularly compelling investment opportunity. Here’s why:

• Deregulation as a Growth Catalyst: Over a decade of stringent post-crisis regulation has constrained banks, capping both profitability and loan growth. With Bessent leading Treasury, these barriers are set to be dismantled, unlocking growth potential.

• Filling the Gap in Money Creation: With a reduced government footprint, the private sector must lead credit creation. Banks are pivotal to this transition, and Bessent has explicitly emphasized this, stating: “Our banks are dying to make loans, but regulatory restrictions prevent them from meeting local demands.”

• Attractive Valuations: U.S. banks, trade at significant historical discounts to the broader market. This undervaluation, paired with deregulation-driven growth, presents a strong upside case for a convergence in multiples.

  

  

• Regional Banks Positioned to Benefit: Smaller regional banks, often burdened by commercial real estate exposure and heavy regulatory oversight, are positioned for outsized gains as they capitalize on enhanced lending capabilities and regulatory relief.

Long Term Investment Implications beyond the exit of ZB shorts

The alignment of policy priorities, leadership focus, and market opportunity makes U.S. banks a cornerstone of Trump’s economic strategy. Deregulation under Bessent’s leadership is not merely a boon for the sector; it’s a structural necessity for the administration’s broader vision. As Bessent himself stated:

“We need a big push in bank deregulation to unlock the growth potential that’s been held back for too long.”

This trade is not new and has been fueled since the election outcome, but I believe there is room to run for years to come on a multiples convergence basis and further revenue expansion from what is currently priced in. In no way a contrarian trade but one that pairs nicely with our bearish view on bonds which I expect to re-enter if market conditions align as can be seen in the two following basic scenarios:

Banks and Falling Bond Prices (Rising Yields)

1. Positive Impact: Improving Net Interest Margins (NIMs):

   • Rising bond yields often signal higher interest rates, which can improve banks’ net interest margins. Banks borrow at short-term rates (e.g., deposits) and lend at long-term rates (e.g., mortgages, business loans). When long-term rates rise faster than short-term rates, this "steepens" the yield curve, boosting profitability.

2. Negative Impact: Mark-to-Market Losses on Bond Portfolios:

   • Banks hold significant bond portfolios for liquidity and regulatory purposes. When bond prices fall (yields rise), these portfolios may experience mark-to-market losses, especially for securities classified as "available-for-sale."

   • While unrealized losses don’t always affect earnings, they can hurt equity valuations and weaken regulatory capital positions, as seen during the 2023 regional banking crisis. I do expect this to have raised awareness to hedge ones duration risk???

3. Impact on Credit Demand:

   • Rising yields can discourage borrowing as loans become more expensive. This can slow credit growth, which is a key driver of bank revenues. The extent of the slowdown depends on whether yields rise in a controlled environment (e.g., strong economic growth) or a crisis setting (e.g., a credit crunch). I expect that we will be in the former and deregulation to counteract tighter financial conditions which benefit out short long duration leg of the trade.

Banks and Rising Bond Prices (Falling Yields)

1. Negative Impact: Squeezed Net Interest Margins:

   • Falling bond yields, often associated with lower interest rates, can compress banks’ NIMs, particularly if short-term deposit rates don't fall as quickly as long-term loan rates. If yields do come down hurting our bearish view on bonds, I believe that the credit expansion from both lower borrowing costs and deregulation outweigh tightening NIMs.

   • This is a common challenge during economic downturns when central banks lower rates to stimulate the economy.

2. Positive Impact: Gains on Bond Portfolios:

   • Banks benefit from rising bond prices through unrealized or realized gains on their bond holdings. This can boost earnings, especially during periods of declining interest rates. I don’t expect this to be a plus given the expected hedges but digging into this for a potential bank specific thematic equities note.

3. Impact on Credit Demand:

   • Lower yields often stimulate borrowing by reducing the cost of credit, which can support loan growth and offset some of the margin compression. This is the objective for the Trump administration and one that can be achieved independent of yields with de-regulation.

Given the doubts over the administration achieving its fiscal deficit reduction goals, there is an other inflationary risk to the economy which I had not mentioned before and supports this pair trade:

Trump’s pivot toward private credit creation reflects a broader economic philosophy of empowering the private sector while reining in government expenditures. However, this dual goal requires a delicate balance. The success of this strategy depends on banks stepping up as robust credit providers without triggering excessive risk-taking or financial instability. At the same time, the administration must grapple with the reality that fiscal discipline is difficult to implement, as entrenched structural deficits make deep cuts to government spending politically and economically challenging. If deficit reductions fail to materialize, deregulation could still succeed, resulting in increased lending and credit expansion while fiscal deficits persist. This scenario would likely amplify inflationary pressures, aligning with a secular bearish view on long-duration bonds.

This duality underscores a key point: even if deficit reduction efforts falter, deregulation and enhanced credit creation could still drive significant economic activity, keeping banks at the center of the administration’s strategy. For investors, this makes U.S. bank stocks a compelling play, while also reinforcing a bearish long-term outlook on long-duration bonds as inflationary pressures continue to loom.

Current Implementations of Trade Ideas from "Post-Election Implications and Trade Sketches"

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The week of November 4, 2024, was one for the books and possibly more significant than November 2016. During Trump’s first mandate, the major policy change his administration ushered in was a shift in China relations. This became apparent during VP Pence’s October 2018 Reagan-like speech criticizing China’s “whole government” approach to rivaling the U.S., denouncing the Uighur treatment, debt diplomacy strategy to acquire strategic assets in emerging markets, and plans for tech dominance by 2025. This stance on China, previously entrenched to select political class members in the swamps of Washington, is now mainstream on both sides of the aisle.

Trump also put on the public’s radar the possibility of protectionist economic policies in the hopes of a made-in-America industrial revolution. The primary tool to incorporate this economic policy shift was the China trade war, tariffs on steel and aluminum, 30-50% on washing machines, and tariffs on French Wine and Cheese (Sacrébleu!). The tariffs were implemented along with a tax and jobs act, designed to reduce the the tax burden and “right to work” policies in conjunction with broad de-regulation around banking, the environment and healthcare. Tax burden and “right to work” policies combined with broad de-regulation around banking, the environment, and healthcare. None of the policies instituted on the economy were fundamentally groundbreaking regarding their impact. The first trump administration also embarked on a mission to remove its military umbrella from its allies. However, this remained mainly in the domain of rhetoric, save for some 12k troops moved out of Germany.

In this second term, we will likely see a re-invigorated, more focused, and more widely supported president. If the first term ushered in the most significant China-U.S. policy shift since Kissinger’s arrival to China in 1971.

It was also potentially a geopolitical shift in the league of the Marshall Plan, the 1990s shift to globalization, and the war on terror. What could be achieved with this second round?

I want to note that my job is not to agree or disagree with policy or politics nor debate what should be done. My job is to estimate the most likely paths of policy implementation and their ramifications in markets. What I do think is that Trump’s economic and geopolitical agenda, agree or not, good, bad, or nuanced, will create exciting and impactful trading and investment opportunities across geographies, which we will seek to capture.

So what can be achieved in this second trump presidency?

My wild guess is that Trump will come into office to finish what he has started. I expect a decisive and durable shift towards pro-labor economic policies away from pro-capital with protectionist policies. We have discussed the impacts of such pro-labor policies on various occasions focused on the notion of a federal fiscal spending put (à la Fed monetary policy put), and this political and social shift in the electoral climate has been one of our arguments justifying setting up the 2s10s bull-steepner since April, along with shorting on the 30-year and buying long-dated gold futures around the first Fed cut.

Quick rates update: one month anniversary

There will be fiscal spending put (a la Fed put), which will smooth over recessionary pressures. This is due to a shift from pro-capital economic policies to pro-labor. Governments, whether democratic or autocratic, realize that there is little tolerance for inequality-generating economic adjustments such as contractions in labor demand or wages. Fiscal spending which directs liquidity into the real economy has a direct and supportive impact to reduce the effects of economic impulses that increase inequality in a first order view.

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Quick rates update post NFP

Our view on inflation comes from a pro-labor environment in which governments prioritize deficit spending in lagging sectors of the economy over fiscal discipline at the expense of growth in those industries. The objective behind this politically popular economic policy shift is to avoid corrections in the labor market, both in quantity and wages, by providing capital for those industries that would contract otherwise and maintain full employment and growing wages. The tradeoff of policy shifting away from being pro-capital to pro-labor comes in the shape of the structural risk in the economy moving away from growth to inflation. We concluded in the prior note that U.S. inflation will maintain above the 2% target while its volatility will remain heightened (hence our view to short long duration bonds).

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Fed and China go big or go home

A compelling argument in favor of a pickup in inflation comes in the form of the shift in economic policy from being pro-capital to being pro-labor, where stagnation in wages in real terms (both adjusting from inflation and international purchasing power from FX) is little tolerated by the electorate. Policies that provide fiscal stimulus by increasing spending and borrowing in order to smooth over recessionary impulses, hence, a reduction in the quantity of employment and purchasing power are taking the front seat in driving the economy.

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I also expect the U.S. military umbrella to shrink dramatically, forcing U.S. allies, namely Europe, to increase spending, improve coordination, and work to secure strategic autonomy, first with defense and energy but also access to computing, artificial intelligence, and the space economy. We kicked off this discussion around the space economy and European autonomy with our first thematic equities primer. Following a detailed review of the industry, the universe of solutions Europe provides to the space problem still has a long way to go before being competitive with the U.S. and China.

Thematic Equities: Star Wars – A New Hope

Europe’s defense strategy has always been a bit… scattered. But with increasing security concerns, the EU is finally seeing the importance of stepping up its own defense game. In 2023, the EU hit €265 billion ($281 billion) in defense spending, equal to about 1.55% of the region’s GDP. Sure, it’s not quite at NATO’s target of 2%, but the trajectory is pointing up. Major players like Germany, France, and Poland are ramping up their defense budgets by 10% or more every year through 2025, trying to reduce their dependence on the U.S. and bring more capabilities under the European roof.

Read More

The next Star Wars article focused on the defense sector will review the European military-industrial complex’s competitive advantage and why we have a thematic equities basket allocated explicitly to the European push towards defense autonomy.

One thing is certain: regardless of what is achieved during this presidency, fiscal deficit spending is here to stay and will likely accelerate.

What world order will we leave behind?

One of Trump’s main gripes and campaign focus points is the U.S. trade deficit.

The balance of trade is currently at a $80bn deficit, one of its lowest historical points. However, as a percent of GDP, it has actually been rangebound since the 08 GFC, with 2005 being the year when the trade deficit had its heaviest weight as a percent of GDP.

If we split the balance between goods and services, we note that the U.S. is an exporter of services while increasingly dependent on imported goods.

From his economic agenda, he is clearly laser-focused on addressing the goods part of this equation. This makes sense, as it is not the jobs of Mag-7 salaried employees that “need” re-shoring but that of blue-collar workers, the pillars of this socio-political shift towards pro-labor policies.

One piece of the puzzle that seems to fly under the radar and not accounted for in the campaign calculus is that the U.S. is an exporter of financial assets. Let’s let some graphs speak for themselves:

This relationship between America and the rest of the world where the U.S. exports services and financial assets while importing goods makes apparent one thing. The dollar’s strength is in part due to this dynamic. As foreign countries export goods to the U.S., they park the dollars they receive into American financial assets. Which leads us to another gripe on the weakness of foreign currencies relative to the USD:

As for most things in the natural world, there is a tradeoff. While the U.S. could obtain cheap goods today in exchange for the promise of more dollars in the future, putting an eternal bid on the USD; it created a bifurcation in the economy between the haves and the have-nots. The haves are those who work in services that are exported globally, able to benefit from both increased economic growth and cheaper goods. The have-nots are the blue-collar workers who had their jobs exported or their wages compressed in exchange for those more affordable goods.

This was the pro-capital world where financial assets and capital could trade with minimal friction and allow wages and economic output compression and expansion. This meant that it would be less and less likely to work your way into the American dream; the key was being an owner of equity as return on equity was being generated at the cost of return on labor. The second part of this relation is precisely what the incoming Trump administration will attempt to reverse, hence a move to pro-labor economic policy. This will be a fundamental change to the structure of the U.S. economy if achieved and with dramatic re-pricings of assets across the board.

I believe in a simple economic idea: if it is more profitable for corporations to do something, they are likely already doing it. If they are constrained to adapt their economic approach, someone will bear the burden of this transition. The current status quo has been a blessing to American corporations relative to the rest of the world, benefiting from flexible labor forces worldwide.

Here are some questions I have that will be clarified as policy takes shape.

• Will the pro-business deregulations sufficiently counter the pro-labor shift’s impact on the bottom line for U.S. manufacturing companies?

• Are U.S. equities going to be negatively impacted by protectionist policies that reduce the trade deficit and, hence, the allocation of earnings in USD to U.S. financial assets?

I want to explore trades that don’t require further clarification from the data we have today. These ideas have the most asymmetry and benefit from the general direction of policy rather than its specific implementations.

What trades does a pro-labor and protectionist U.S. provide?

U.S. treasuries will be in a secular bear market and the curve will further steepen

Reference our various articles on the subject:

• Quick rates update: one month anniversary

• The macro setup for equities

• Quick rates update post NFP

• Fed and China go big or go home

• STIR butterflies from Yield curve flip flops

I am interested in the 2s10s steepner and short the 30-year outright. Our current profit-taking target for the outright short is when the 10-year yield gets to 5%. This was modeled by ignoring Trump-specific policies and only focusing on fiscal deficit spending, which was common to both presidential candidates. I expect the protectionist policies will accentuate further inflation volatility, and hence, our price target could be moved up. I also take profit on the trade to keep the short at 3.5%-4% of NAV (I use long-dated 25-10 delta put spreads on ZB to express this trade). I use those profits to put on the 2s10s steepner which is now at 3% of NAV.

But let’s not forget that the Japanese invented yield curve control in September 2016. Given Trump has at length criticized the Fed for embarking on a path to raise rates, it is not inconceivable that Trump finds the right people to put on the Fed board that would be willing to act not only on the short end but across the curve to control borrowing costs.

The dollar/YEN will enter a secular bear market and possibly the dollar more broadly.

This is an explicit policy objective of the Trump administration: to improve goods exporting competitiveness and incentivize corporations to bring labor back stateside. Remember when we talked about who bears the burden of the costs of this transition? An obvious one is increased prices on imported goods due to the weakening dollar, which impacts consumer spending. We did a deep dive on consumer health in this report, if anything changes substantially, it will be updated.

What is the likely path for growth now? – What is my credit card limit?

To understand the current state of the economy and estimate which sectors are set to outperform this cycle, we need to take a look at where everything starts… the American consumer. After all, what’s the point of credit card debt if not to buy H100 pro max’s?

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But how will weakening the world’s reserve currency work? Given the continued real growth of the U.S. economy and the strength of its service sector, which is a sponge for foreign capital, the frictionless path for the dollar is to remain where it is.

The first thing that comes to mind is a Plaza Accord round 2.

The Plaza Accord of 1985 was an first of its kind deal between the United States, Japan, West Germany, France, and the United Kingdom to tackle some serious economic headaches of the time. By the mid-1980s, the U.S. dollar had become so strong that American goods were priced out of international markets, creating a huge trade deficit and putting pressure on U.S. manufacturing jobs. Meanwhile, countries like Japan and West Germany had economies heavily dependent on exports to the U.S., and this imbalance was straining everyone. The solution? An ambitious, coordinated effort to bring down the value of the dollar and boost other currencies, aiming to level the playing field and ease some of these global pressures.

Under the Plaza Accord, the five nations agreed to take action in the currency markets, actively working to lower the dollar’s value and raise the value of the Japanese yen and German Deutsche Mark. It worked—within two years, the dollar dropped by around 25%, which made U.S. exports cheaper and somewhat improved the trade balance. But while this was good for American exporters, it threw a wrench in Japan’s export-driven economy.

The Plaza Accord was both a triumph and a cautionary tale. On the one hand, it showed how much could be achieved when major economies worked together—proof that currency intervention could work if everyone was on the same page. On the other, it highlighted the risks and unintended consequences of such a move. Japan’s struggles in the wake of the Accord underscored how even well-coordinated policies can ripple out in unexpected ways.

The Plaza Accord’s impact on Japan was transformative, sparking drastic economic shifts backed by stark numbers. After the agreement, the yen appreciated from 240 yen per dollar in 1985 to 128 yen per dollar by 1988—a nearly 50% rise that severely impacted Japan’s export-driven economy. To offset this shock, Japan’s central bank slashed interest rates, dropping from 5% in 1985 to 2.5% by 1987, which fueled an investment frenzy. The result was a historic asset bubble: the Nikkei 225 stock index soared from roughly 13,000 points in 1985 to nearly 39,000 by 1989, while commercial real estate values in Tokyo tripled. When the bubble burst in 1990, Japan’s economy fell into turmoil. The Nikkei lost over 60% of its value from its peak, urban land prices plummeted, and GDP growth slumped to below 1% by 1995, far from the 4–5% growth rates of the early ’80s. Japan’s debt-to-GDP ratio also surged, doubling from around 50% in the mid-1980s to over 100% by 1997 as the government tried to revive the economy. The Plaza Accord’s legacy remains a cautionary example of how sweeping currency adjustments can reshape an economy for decades.

A Mar-a-lago accord (plaza round 2) might be more challenging to install than its predecessor, given the potential to repeat the Japanese experience, and that is without mentioning that China would need to be a part of any agreement of this kind. I suspect the trump administration will use the threat of trade wars against various countries to attempt such coordination, but some goods exporting/manufacturing countries might prefer to bite the bullet of tariffs rather than currency appreciation.

Okay, great. Given the uncertainty in executing this Dollar devaluation, why put on a short USD long Yen trade? This is likely the most asymmetric currency pair for a few reasons. I’ll jot out some bullet points, but this deserves a full primer.

• It is a form of protection against another carry trade unwind, so we can look for it as a hedge against our long positions in U.S. tech and services.

• The BOJ has a line in the sand at 160; further weakening in the yen could complicate already weak consumer spending in Japan and raise energy prices, impacting the JCC (Japan Crude Cocktail / Japan Custom Cleared) in dollar terms which has been higher than the central bank target for the past 3 years.

• I don’t mind buying some cheap yen now to make sure I get a good bang for my buck on my next Japan trip.

• Central bank benchmark rate differential between the Fed and BOJ will be narrowing (although I suspect that the Fed won’t be able to cut as much as they anticipate due to inflation and the BOJ to hike as much as they would like)

I also acknowledge that a long yen position is somewhat at odds with my bearish view on long-duration U.S. treasuries, but that also makes it a convenient hedge to our treasury shorts.

There is a reason for this relationship. Japan was a pioneer in the purchases of U.S. Treasuries for its reserves rather than gold, which began in the 1980s and grew rapidly as Japan’s trade surplus with the U.S. surged, hitting over $46 billion by 1985. This trade imbalance brought vast inflows of U.S. dollars into Japan, which the Japanese government often used to buy U.S. Treasuries after intervening in currency markets to keep the yen from appreciating too much. By selling yen and buying dollars, Japan could stabilize the yen’s value, making its exports more competitive. Treasuries offered Japan a safe, liquid way to hold its dollar reserves, making them ideal for managing these large inflows without disrupting exchange rates.

This approach helped Japan build a significant buffer of foreign reserves—essential for economic stability, especially after the 1997 Asian Financial Crisis underscored the need for such protection. By 2000, Japan’s foreign exchange reserves were near $350 billion, with a large portion in Treasuries, and by 2012, Japan’s Treasury holdings had surpassed $1 trillion. These reserves acted as insurance against speculative attacks on the yen. Today, Japan consistently holds around $1.1 trillion in U.S. Treasuries, making it one of the largest foreign holders, often trading the top spot with China. This explains the correlation between the Yen and U.S. treasury yields. This leads us to our last bullet point supporting the trade.

• This correlation is what I expect to break during Trump’s second mandate due to a fundamental change in trade relations between the U.S. and the rest of the world that directly impacts Japan. This is how I cognitively justify bearish views on U.S. treasuries but bullish on the Yen. If the correlation does not break due to failed trade policy changes, we could have at least an effective hedge against being wrong on Treasuries from inflation volatility, potentially moderating.

Commodity exporting economies

Given my bearish view of the dollar, one natural extension of this thesis is through equities in geographies that are net exporters of commodities. Two core ideas back this thesis.

• The trading multiples on U.S. equities and Foreign equities will start converging.

  • The U.S. has sustained a growing trade deficit, reaching $916.8 billion over the last year. This nearly trillion-dollar gap means the U.S. imports significantly more than it exports, with foreign countries accumulating and reinvesting these dollars in U.S. financial markets to fill the funding gap.

  • Foreign holdings of U.S. financial assets—including Treasuries, stocks, and corporate bonds—have grown to over $33 trillion as of 2023. These substantial inflows have been pivotal in driving up demand and supporting high asset valuations in U.S. markets.

  • U.S. stocks trade at a significant premium over global markets. The S&P 500’s P/E ratio is 27.5x earnings, while Europe’s Euro Stoxx 50 is around 15x, and emerging markets often have P/E ratios closer to 10x. This premium is partly fueled by steady foreign capital flows seeking returns in dollar-based assets.

  • A weaker dollar boosts the appeal of international equities for U.S.-based investors, as currency gains add to potential returns. This can lead to increased capital flows out of U.S. markets, pushing U.S. and international valuations closer together.

  • Since high U.S. stock valuations are largely supported by consistent foreign inflows tied to the trade deficit, reducing this deficit could bring U.S. P/E ratios closer to global averages. A shrinking dollar advantage could make international equities more attractive, driving capital outflows and reducing the valuation premium on U.S. stocks.

• A weaker dollar leads to stronger commodities and strengthens commodity exporting countries

  • Commodities priced in dollars become cheaper globally when the dollar weakens, boosting demand. For example, the U.S. Dollar Index (DXY) fell about 10% from mid-2020 to early 2021, during which time oil prices rose nearly 80%, from $40/barrel to over $70/barrel, reflecting increased demand fueled by dollar weakness.

  • Gold, oil, and agricultural products often surge with a weaker dollar as they’re dollar-denominated. Historically, a 1% drop in the dollar index has corresponded with an average 0.5-1% increase in gold prices. This relationship supports commodity-exporting economies, as higher global demand boosts their revenue from exports.

  • Commodity-exporting nations experience increased revenue in local currency terms as prices rise. In 2022, Brazil—a major exporter of soybeans, iron ore, and oil—saw its export revenues grow by 19% with a weaker dollar boosting commodity prices, contributing to 2.9% GDP growth that year despite global headwinds.

  • Currency appreciation for commodity-exporting countries like Canada, Australia, and Russia often follows a weaker dollar, as demand for their exports grows. For instance, during a dollar decline in 2017, the Canadian dollar appreciated by 8%, benefiting from rising oil prices, which contributed to 3% GDP growth that year for Canada.

  • Emerging markets with commodity-heavy exports, such as Chile (copper) and Indonesia (nickel and palm oil), often outperform when the dollar weakens. In 2021, Chile’s copper exports reached $53 billion, a record high, as copper prices surged over 25% with dollar weakness, fueling GDP growth of 11.7%.

These two views converge to propose a unique macroeconomic setup that could spell a multi-year run for commodity-exporting countries.

Brazil seems especially well positioned to benefit

Brazil’s economy is heavily dependent on global commodity markets, with exports of soybeans, iron ore, oil, coffee, and sugar making up nearly 60% of total exports and contributing around 10% to GDP. In 2023, Brazil achieved $335 billion in export revenues, benefiting from robust demand in commodities. As the world’s largest soybean exporter and a major exporter of iron ore and oil, Brazil’s economic health remains closely tied to global demand, particularly from China, its largest export partner, which absorbs over 30% of Brazil’s exports. This deep connection to global commodities provides Brazil with both growth opportunities and risks, depending on international market trends.

The Brazilian real’s strength often mirrors global commodity cycles and dollar fluctuations, with significant impacts on inflation and trade. For example, in 2023, periods of dollar strength pressured the real, making exports more competitive but raising import costs and driving inflation up to 5.6%. In contrast, a weakening dollar phase strengthened the real, helping to stabilize inflation and improve affordability for imported goods. This currency sensitivity directly affects economic stability, as inflation and purchasing power respond closely to dollar movements.

Despite this dependency on commodities, Brazil’s stock market, the Bovespa Index, trades at a discounted valuation, with a P/E ratio around 9x, compared to the S&P 500’s 27.5x. This low valuation reflects both market risks and potential for growth, particularly if commodity demand remains strong. Domestic sentiment toward Brazilian equities, however, remains pessimistic; a dramatic rotation from equities to fixed income has taken place as the Brazilian Central Bank’s tightening raised real rates to 6.2%. This has fueled local investors’ preference for bonds, which, by comparison, would yield nearly 9% nominal—an attractive proposition in a historically fixed-income-dominated domestic market. However, with real yields high and sentiment at lows, Brazilian equities may offer substantial upside potential.

Brazil’s economy is moderately diversified, with 65% of GDP from services and 20% from manufacturing, but commodities remain crucial. The country thrives during commodity price booms, such as in 2021, when Brazil’s economy grew by 4.6%. Conversely, downturns in commodity prices present risks to GDP growth, trade balances, and inflation. The ongoing high real rates could slow domestic inflation, making space for the Brazilian Central Bank (BCB) to ease rates, which could attract new equity inflows as rate cuts are anticipated.

Politically, Brazil faces potential shifts, especially with the 2026 election on the horizon. If, as many anticipate, Brazil swings back to the right with a pro-business successor to Bolsonaro, the market may experience a boost similar to Argentina’s Milei effect. This scenario could offer substantial upside given Brazil’s deeper financial markets and higher liquidity, which would allow for larger institutional inflows compared to Argentina. In this context, the Brazilian equity market offers convexity: if political reforms align with a pro-business agenda, Brazil could attract major foreign capital inflows, particularly if sentiment around fiscal stability improves. Even if political conditions remain steady, Brazil’s fortunes will likely still hinge on commodity performance, limiting downside risks.

The EWZ ETF provides a diversified entry into Brazil’s economy, yielding around 7% in dividends, allowing investors to benefit from Brazil’s growth potential while collecting income. With notable cross-currency divergences and foreign investors reducing allocations to Brazilian equities, the setup resembles past buying opportunities, where both local and foreign sentiment was low. Combined with Brazil’s economic sensitivity to global commodity cycles and potential political shifts, Brazilian assets offer a compelling case for growth-oriented investors. A key downside to monitoring the Brazilian story is China’s balance sheet recession covered at length here:

Fed and China go big or go home

This story can be summarized with the term: balance-sheet recession (idea formulated by Koo in 1996). What is it? A typical recession, as the one investors are currently worrying about in the US, is caused by overproduction or rising inventories, decreasing consumer spending, inflationary pressures, and corporations being profit-maximizing; this forces job losses, productivity declines, and reductions in growth. Now, balance sheet recessions have the odd behavior that corporations stop being profit-maximizing but rather debt-minimizing, even with extremely low or zero interest rates.

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Here is an other interesting geography to consider:

Argentina, ARGT

• Primary Commodities: Argentina’s economy is driven by exports of soybeans, soybean products, corn, wheat, beef, and increasingly, lithium. Together, agriculture and commodities contribute around 10% of GDP and account for over 60% of total exports. Soybeans and soybean products alone make up roughly 30% of Argentina’s exports, positioning the country as one of the world’s leading exporters of these critical crops. Demand from major importers like China directly impacts Argentina’s trade balance and economic stability, given its sensitivity to global agricultural prices.

• Emerging Mining Sector: Argentina is making substantial moves to expand its mining sector, particularly in San Juan Province, which is now positioned as one of the country’s premier mining regions. The province has attracted significant foreign investment due to its pro-mining policies and abundant mineral resources, especially in lithium and precious metals. Argentina’s lithium reserves, largely located in the Lithium Triangle, are crucial as global demand for electric vehicle (EV) batteries continues to rise. In 2023, lithium exports grew significantly and are expected to account for an increasing share of export revenue, making lithium a valuable diversification from agriculture and a hedge against agricultural price volatility. San Juan’s gold and copper mining projects further add to Argentina’s portfolio, supporting the broader narrative of Argentina as a diversified commodity exporter. Argentina is also diversifying with a growing industrial and energy sector, including oil production in the Vaca Muerta shale formation.

• Inflation Pressures: Argentina’s economy is highly inflationary—recently recording inflation rates near 120% annually—and fluctuations in agricultural prices or adverse weather conditions, like droughts, can strain fiscal positions and exacerbate inflationary pressures. With the mining sector’s growth, Argentina has another avenue to accumulate foreign currency, which could provide more stability to the peso and help manage inflation pressures.

• With two more years of Milei in power, there is still room for the Argentine trade to run. I would focus on its mining opportunities for additional torque.

Along the trump v2 repricing theme, here are other trades that I find interesting, which I will leave here without too much additional explanation (potentially future notes)

• Sibanye Stillwater, South African platinum group metals miner with additional exposure to Gold and uranium.

  • Strong Leverage to Precious Metals Upside Amid Depressed PGM Prices: Sibanye is a major player in PGMs (platinum, palladium, rhodium) and gold, with substantial upside as these metals rebound from multi-decade lows. PGMs, trading at historic discounts, offer significant asymmetry; for example, platinum is trading at a 60% discount to gold—the largest discount on record. With supply constraints and strategic demand from hybrid vehicles, Sibanye is well-positioned for price recovery.

  • Strategic Geographic Hedge and Production Diversity: Sibanye’s U.S. operations, comprising 21% of PGM revenue, provide a hedge against political risk in South Africa, which produces 80% of global platinum. Although U.S. operations are currently loss-making on an all-in basis, their potential closure could tighten the palladium market by 7%, supporting prices. This operational flexibility mirrors strategies in other commodities, such as Cameco’s uranium production management.

  • Structural “Economic Moat” from Low-Cost, Debt-Free Assets: Post-restructuring, Sibanye holds assets at a fraction of replacement costs, creating an economic moat. For instance, its $16 million per OSV replacement cost is significantly below the $70 million newbuild cost, giving it a competitive advantage as new market entrants face prohibitive initial costs, limited shipyard space, and financing burdens.

  • Robust Supply Constraints: PGM supply growth is flat, with platinum production capped at 7.1 million ounces in 2023 (of which 1.5 million ounces came from recycling). With no significant new supply expected, PGMs are set up for a supply-demand imbalance, particularly if hybrid vehicles continue to outpace EVs. Hybrid engines require 10-15% more palladium than traditional ICE vehicles due to more frequent start-stop cycles, adding an unexpected demand tailwind for palladium and rhodium.

  • Resilience in South African Political Environment: Despite South Africa’s political volatility, recent coalition changes have eased risks of nationalization and over-taxation. Sibanye’s management, led by experienced CEO Neal Froneman, has a track record of successfully navigating this challenging environment. Furthermore, the company’s significant operations in South Africa, combined with proactive security investments, allow it to continue operations effectively despite regional risks.

  • Liquidity and Cost-Cutting for Downside Protection: Sibanye maintains over $1 billion in cash and a $1 billion undrawn credit facility (maturing in 2026), providing ample liquidity. The company has implemented strategic cost cuts, including shaft closures and asset restructuring, enhancing its financial stability and positioning it to weather continued price weakness.

  • Optionality in Uranium and Rhodium Markets: Sibanye offers additional upside through its 59.2 million pounds of uranium resources and a significant position in rhodium (22% of global production). With South Africa producing 85% of the world’s rhodium, Sibanye can leverage this niche, high-demand market, particularly in an environment of constrained supply and stringent emissions regulations.

• M&A beneficiaries with an energy angle. Along the line of deregulation, I expect Trump to put more M&A-friendly people in decision-making positions. As M&A activity picks up, we should see investment bankers work hard for their year-end bonuses. One sector which I find is at the crossroads of the energy push and M&A are Offshore Service Vessels (OSV’s). This really deserves a full length note but here are some quick thoughts:

  • Tight Supply and Limited Shipyard Capacity: Global shipyard capacity has fallen 60% since 2008, with current capacity levels similar to those seen in 2001. Most capacity is occupied with containerships and LNG carriers until late 2027, leaving dry bulk, tankers, and offshore vessels, including OSVs, competing for the limited remaining shipyard space. This capacity squeeze extends build times and raises costs for new OSVs, tightening supply and supporting higher charter rates.

  • Aging OSV Fleet and Low Newbuild Orders: The OSV fleet includes 4,160 vessels, of which 943 are currently laid up. Only a third of these are “premium” vessels (under 15 years old), with the remaining vessels aging rapidly. The OSV order book is below 5% of total fleet size, indicating limited new supply. With rising scrapping rates due to age restrictions, a constrained supply of newer, capable OSVs supports continued rate inflation in the sector, making existing assets more valuable.

  • Increasing Costs and Replacement Value of OSVs: The cost to build a new premium OSV has risen by 30-40% over the past three years, with newbuild costs for high-quality vessels estimated at around $60 million. Yet, companies like Tidewater and Seacor Marine are trading at 41% and 55% of newbuild parity, respectively, with Seacor’s fleet valued at around $11 million per vessel. This substantial discount to replacement value makes current OSV valuations attractive, offering upside potential as demand strengthens.

  • Higher Day Rates from Industry Consolidation: Recent mergers, such as Noble’s acquisition of Diamond Offshore, consolidate market power and create larger players with improved pricing leverage. For OSVs, consolidation could lead to a “seller’s market,” where fewer, larger operators can command higher day rates for their assets. The rumored merger between Transocean and Seadrill illustrates this trend, with combined scale potentially allowing greater control over fleet utilization and pricing, which would benefit OSV operators indirectly as support demand rises.

  • Lack of Appetite for Newbuilds Sustains Demand for Existing Assets: Due to uncertain contracting and high capital costs, there’s minimal interest in new offshore rig and OSV builds, with shipyards instead prioritizing higher-margin projects. This sustained lack of new supply supports higher rates, particularly as demand for offshore assets rebounds. 86% of marketed drillships are already in use, and demand for reactivating cold-stacked rigs is growing, with reactivation costs ranging from $75 million to $150 million per rig, further limiting supply.

  • Beneficial M&A for Balance Sheet Strength and Access to Contracts: M&A activity, such as a potential Seadrill-Transocean merger, would strengthen the balance sheet of leveraged companies, improving Debt/EBITDA ratios and access to cheaper financing. For Seadrill, merging with Transocean would provide access to a robust backlog of contracts, reducing “white space” (idle periods) and stabilizing revenue. This improved financial structure could attract more favorable lending terms and reduce refinancing costs, ultimately supporting profitability in a recovering market.

  • Discounted Asset Prices and Limited Downside Risk: OSVs are currently trading below replacement costs, with Tidewater’s fleet valued at around $25 million per OSV, or 41% of newbuild parity. Seacor Marine, while more leveraged, has an attractive asset base, with 55 OSVs valued at approximately $11 million per vessel. Investors have an opportunity to acquire assets at a significant discount with potential upside as day rates increase, while downside risks are mitigated by the low supply of new OSVs and the high cost of replacement.

  • I also see Valaris warrants as being particularly interesting

• The Japanese Bank complex

  • Inflation and Rising Interest Rates Boost Profit Margins: Japan’s core inflation has been steadily rising, hitting 3.1% year-on-year as of mid-2024—one of the highest levels Japan has seen in over three decades. As inflation persists, the BOJ has started relaxing its yield curve control (YCC), allowing 10-year JGB yields to reach 0.65%. This shift enables Japanese banks to expand their net interest margins (NIMs), which had been squeezed for years under a near-zero-rate environment, directly enhancing profitability.

  • U.S. Protectionism Drives Domestic Investment in Japan: As the U.S. continues to push for supply chain diversification away from China, Japan has emerged as a preferred alternative, especially for industries tied to U.S. markets. Japan’s FDI inflows, although still relatively low at $250 billion in cumulative stock compared to China’s $4 trillion, are starting to rise as global companies seek stable, geopolitically secure production hubs. Japanese banks stand to benefit from increased loan demand as companies finance new projects domestically, tapping into Japan’s competitive wage and property costs, which are now on par with much of developed Asia.

  • Potential Investment Boom Driven by Pro-Investment Policies: Similar to the government-led tourism boom, Japan is well-positioned for a domestic investment surge if policymakers enact pro-investment reforms. In recent years, Japan’s tourism sector has turned a deficit into a surplus, with inbound tourism spending exceeding $33 billion annually. If similar policies target industrial investment, Japanese banks could see substantial growth in lending activity, as industrial production is still at 1984 levels, leaving significant room for expansion and modernization.

  • Yield Curve Control (YCC) Adjustments Favor Bank Profits: As the BOJ gradually relaxes its YCC policy, Japan’s yield curve is steepening, with the 10-year JGB yield hovering around 0.65% and forecasted to increase further. This steeper curve improves banks’ NIMs by widening the spread between short-term funding costs and long-term lending rates. While U.S. Treasuries signal potential recession with the 2-year yield dropping to 4.85% amid economic concerns, Japan’s JGB market reflects optimism, allowing Japanese banks to benefit from rising rates without severe economic contraction fears.

  • Pro-Labour Economic Environment Supports Bank Lending: Japanese wages have been gradually increasing, with recent reports showing 3.1% growth year-on-year, supported by pro-labour policies that aim to improve household purchasing power. This wage growth, combined with inflationary pressures, creates a favorable lending environment for banks, as households and businesses are more likely to seek credit in a rising-income landscape. In a reversal from the 1980s-2000s low-wage, pro-capital era, Japan’s tighter monetary policy is supportive of long-term loan demand.

  • Stable Economic Signals from Japanese Markets: Japan’s high-yield and JGB markets are showing resilience, contrasting with recessionary indicators in U.S. Treasuries. Japan’s JGB market has historically been a reliable indicator of economic stability, with Japanese 10-year yields now showing strength and domestic credit markets stable. This stability reflects Japan’s advantageous position in the current geopolitical environment, as global demand shifts away from China. For Japanese banks, these dynamics mean steady growth in capital inflows and a supportive environment for expanded lending opportunities.

• XME / XLB / XLE Metals and Mining / Materials / Energy ETF’s

  • Moving back stateside, it seems wise to maintain exposure to the areas in the crosshairs of Trump’s labor revival. I suspect this sector will be a primary fiscal beneficiary over the next four years. One way to hedge inflation is to allocate to companies that will benefit from fiscal deficit spending. Moreover, I expect deregulation around these companies to take shape. The green transition agenda is rapidly losing steam, and no prominent world leader plans to attend the next COP meeting. This is unsurprising, given that rising geopolitical concerns and economic risks are taking the forefront of discourse. People will only care about the energy transition in times of calm and prosperity. I would likely be more picky than just allocating to these ETF’s broadly. On the energy segment, I particularly like names operating in liquid natural gas, considered a transitional energy source. Note I would stay away from utilities and focus on producers.

• Russell come back?

  • Pro-Business, Domestic-Focused Policies: Trump’s economic policies favor deregulation, lower corporate taxes, and pro-manufacturing initiatives, particularly for U.S.-based companies. This could benefit smaller, domestic-focused firms in the Russell 2000, which have less international exposure than tech-heavy Nasdaq companies. By incentivizing U.S. production and reducing dependency on global supply chains, a Trump presidency might shift capital flows towards smaller-cap, domestically-oriented firms.

  • Rising Interest Rates and Inflation Concerns: Smaller-cap stocks in the Russell tend to be more sensitive to changes in U.S. fiscal policy and domestic economic trends. Should a Trump administration lean into policies that drive inflation or necessitate further rate hikes, it would make the case for high-multiple, growth-heavy Nasdaq stocks harder to justify, pushing investors toward value-driven, economically-sensitive sectors like those in the Russell.

  • Economic Nationalism and Infrastructure Spending: Trump’s past emphasis on infrastructure spending and economic nationalism may continue in a second term, spurring sectors like industrials, energy, and materials. Many of these sectors are more prominent in the Russell 2000 than the Nasdaq, which is tech-heavy. A focus on domestic investment could make smaller-cap industrial and service firms more attractive to investors.

  • Historical Parallel: Early 2000s Rotation: A significant rotation from the Nasdaq to the Russell last occurred after the dot-com bubble burst. From March 2000 to early 2003, the Nasdaq declined by nearly 80% from its peak, while the Russell 2000 fell by only 45%. As investors fled overvalued tech stocks for smaller, undervalued companies, the Russell 2000 gained traction, and from 2003 to 2006, it outperformed the Nasdaq with a cumulative return of 70%, compared to the Nasdaq’s 50%. Stimulus-driven, pro-growth policies helped smaller-cap stocks recover faster and outshine tech-heavy indices, a trend that could repeat under a second Trump administration if fiscal and regulatory policies favor the domestic economy.

  • I expect to layer in 25 delta LEAP call options for about 2% of NAV on this trade.

• European Military Industrial Complex

  • With the shift towards a more isolationist U.S. foreign policy, Europe has started investing heavily in defense autonomy, improving the bottom line of European defense contractors. (coming up in the next thematic equities primer)

That is probably enough trade idea’s to chew on for now.

Cheers!

We recently had two important reminders of the state of our world. First, our childhood sci-fi, space exploration fantasies are real-world projects with capital and rocket-catching chopsticks. Second, and much less enjoyable for those of us constrained to living on the blue planet, we live in a world with increasing geopolitical tensions where mechanical warfare is somehow still a reality.

I have written extensively about hedging inflation risk in your lazy equity long portfolio and touched on equity and volatility hedging strategies, which are structural sources of risk. Given the escalating tensions in the Middle East, China-Taiwan, and the ongoing war in Ukraine, amongst others, I would wager that in a long enough time horizon, the probability of an armed conflict dragging in NATO is close to one. I will not spend time trying to predict the who, when, and where of future conflicts; instead, I want to focus on understanding the companies that help governments prepare for this idiosyncratic risk.

One can take many paths to hedge geopolitical risk. I recently attended a gold trading conference where a key theme was to buy physical gold stored in tax-advantageous and geopolitically neutral jurisdictions to protect wealth in the event of an armed conflict. War is clearly on investors’ minds, and a helicopter view of the industry can prove insightful. Unfortunately, I don’t think this theme only serves as a hedge but as a standalone and valid theme for investing, which marries well with our view of continued and accelerating fiscal expenditures globally. I want to focus here on constructing a basket of equities set to benefit from increased spending in the defense sector while sprinkling in much-needed sci-fi hope and human awesomeness.

This is not meant to be read as a pitch to buy things that go boom before the Third World War but as a framework for understanding the defense industry and providing resiliency to portfolios across market cycles and unpredictability. Moreover, I find that the profit-seeking nature of defense contractors is cognitively at odds with pursuing peace. I do, however, appreciate how competition in the industry can yield improved outcomes and more technological advancements, which also provide improvements for everyday life. War is a complicated theme, and I much prefer discussing how to make a superb Mojito (the best one I had was in Bogota) while watching the original Star Wars trilogy. Let’s start with something cool.

Brief history of space exploration

Space exploration has been a tale of evolving frontiers, beginning with the intense, government-driven competition of the Cold War. In the mid-20th century, space became the ultimate arena of rivalry between the United States and the Soviet Union. The Soviet Union’s launch of Sputnik in 1957 signaled the dawn of the Space Age and an era where superpowers invested vast public funds into space technology, often driven by a blend of scientific ambition and defense strategy.

The United States responded by founding NASA in 1958 and achieving landmark accomplishments like the Apollo moon landing. During this era, space programs symbolized technological supremacy and military strength. However, the closing chapters of the Cold War brought with them shifting national priorities and budget constraints, driving the gradual emergence of private players in space.

Internationally, this era set the stage for other nations to enter space. The European Space Agency (ESA) was founded in 1975 to provide a cooperative framework for European countries. Meanwhile, China developed its national space program, achieving notable milestones such as the launch of its first satellite, Dong Fang Hong 1, in 1970, and expanding significantly in the 21st century with a series of ambitious lunar and Mars missions. This internationalization laid the groundwork for future global cooperation—and competition—in space.

The Rise of Private Space adVentures

The early 2000s marked a significant shift, as private enterprises took center stage in space exploration. This change was led by entrepreneurs in the United States, and also private players in Europe and Asia. Elon Musk’s SpaceX and Jeff Bezos’s Blue Origin broke ground on affordable, reusable rocket technology, setting new standards for cost efficiency and innovation. SpaceX, with its reusable Falcon rockets, transformed the economics of space and disrupted traditional players like Lockheed Martin (LMT) and Boeing (BA). SpaceX’s successful launches and contracts with NASA and the Department of Defense showed that private companies could compete in areas historically dominated by government agencies.

Adding to the speed at which advancements across the industry are the compression in costs per kilo being launched.

In Europe, firms like Arianespace, a subsidiary of the European aerospace giant ArianeGroup, provide launch services for ESA and commercial clients worldwide. Arianespace has developed the Ariane rocket series, which attempts to compete with SpaceX and is now preparing for its next-generation Ariane 6 launch vehicle, aiming to improve cost-effectiveness and launch frequency although without reusability. Meanwhile, European companies like OHB SE (ETR: OHB) focus on satellite construction, and Thales Alenia Space, a joint venture between Thales Group (Euronext: HO) and Leonardo (BIT: LDO), delivers satellite solutions to both commercial and defense clients.

China’s space program, run by the China National Space Administration (CNSA), has similarly fueled private enterprise by opening portions of its industry to domestic companies. Beijing-based private players like Galaxy Space and iSpace are competing to develop their own LEO satellites and reusable launch capabilities. China’s launch services company, CASC (China Aerospace Science and Technology Corporation), also works alongside private entities, though the space sector remains tightly integrated with national defense initiatives.

The Satellite Landscape: From GEO to LEO

The satellite industry has undergone rapid transformation with the rise of new constellations challenging traditional satellite models. Historically, the market was dominated by geostationary satellites (GEO), operated by legacy companies like SES S.A. (Gettex: SES), Eutelsat (Euronext: ETL), Viasat (VSAT), EchoStar (SATS), and Telesat (TSAT), positioned at approximately 35,786 kilometers (1.17408e+8 feet for my American colleagues) above Earth. These satellites provide high-capacity services over wide areas, suitable for broadcasting and telecommunications, but with higher latency and high deployment costs. Many legacy GEO operators in the United States and Europe are under financial pressure due to high debt loads and maintenance costs, and they face challenges as consumer needs shift toward on-demand services and high-speed data.

To address these shifts, European companies like SES and Eutelsat are exploring new Low Earth Orbit (LEO) and Medium Earth Orbit (MEO) systems. SES, for instance, operates an MEO system (O3b) targeting high-speed connectivity applications, and Eutelsat recently announced plans to merge with OneWeb to gain access to LEO assets. In the LEO landscape, U.S. players like SpaceX’s Starlink and Amazon’s Project Kuiper, as well as U.K.-based OneWeb, which is partially owned by the U.K. government and Bharti Global, are rapidly deploying thousands of satellites to provide low-latency, high-speed internet and data services. Meanwhile, emerging players like AST SpaceMobile (ASTS), which focuses on direct-to-cell connectivity, and small-satellite manufacturers like NanoAvionics, based in Lithuania, are capitalizing on the demand for agile, high-tech satellite applications.

China’s space ambitions have also spurred a push toward LEO, with government-backed CASC developing its own LEO network, Hongyun, and private firms like Galaxy Space, Commsat, and Guodian Gaoke planning similar constellations. As China ramps up its LEO and MEO capabilities, it becomes evident that both private and government-led Chinese enterprises view space as an essential domain for communications and defense capabilities. Japan’s Sky Perfect JSAT (TSE: 9412) has also joined the mix, investing in LEO technology to supplement its GEO operations in Asia.

Defense and the New Space Race

Space is now a contested domain where commercial and military interests intersect globally. As governments recognize the strategic importance of space assets, they are leaning on private-sector innovations in surveillance, reconnaissance, and secure communications. In the United States, Northrop Grumman (NOC) and Raytheon Technologies (RTX) have taken on crucial roles in developing secure satellite infrastructure, while specialized firms like L3Harris (LHX) and Kratos Defense & Security Solutions (KTOS) provide critical support in satellite communications and anti-jamming technology. The establishment of the United States Space Force and the Chinese People’s Liberation Army’s Strategic Support Force exemplify the growing military focus on space.

Europe is also emphasizing space as a defense asset. The European Union recently unveiled its EU Space Program, which includes the European Defense Fund to invest in space-related defense technologies. Companies like Airbus Defense and Space (Euronext: AIR) play significant roles in Europe’s space-defense infrastructure, developing secure satellite communications and space-based surveillance for defense agencies. Thales Alenia Space also contributes to Europe’s defense capabilities, supporting secure, resilient satellite systems critical for NATO communications and surveillance.

China’s defense focus in space has grown steadily, with military and dual-use applications being prioritized in its space initiatives. As private Chinese space firms grow, many align closely with government defense objectives, offering satellite communication solutions for both civilian and military applications. This includes the expansion of secure LEO constellations to support surveillance and low-latency communications.

Star Wars is here

Space has transformed from a government-led domain to a dynamic, international ecosystem where public and private players compete and collaborate. Companies like SpaceX, Airbus, and China’s CASC, alongside firms like Maxar and Planet Labs, redefine what’s possible in commercial and defense applications. As new technologies reshape the industry across LEO, MEO, and GEO, the implications for both commerce and defense are profound. Today’s space economy is not merely an arena for exploration but a highly contested strategic asset, driven by innovations in data, defense, and satellite communications on a global scale. The emergence of private enterprises and international players marks a new era of competition, cooperation, and economic complexity in space.

Let’s celebrate this great human accomplishment for now.

Helicopter view of the Space Defense Sub-sector

Looking at sub-sector spending reveals where priorities really lie. In the U.S., RDT&E has outpaced other categories, growing at 7% annually, with a heavy focus on AI, autonomous systems, and hypersonics. The DoD dedicated $1.8 billion to AI research alone in 2024, betting on AI’s game-changing potential for defense. Meanwhile, unmanned systems—spanning everything from drones to autonomous submarines—received $12 billion in funding, a 5% bump from the previous year, with companies like Northrop Grumman and General Dynamics (GD) at the forefront.

In Europe, air and missile defense is growing the fastest, with a nearly 10% annual growth rate. Key companies Rheinmetall (ETR: RHM) and MBDA (a leading European missile maker) are central to these efforts, developing systems like the Medium Extended Air Defense System (MEADS) and counter-drone technologies. These advances are crucial as the EU continues to adapt to new and evolving security challenges on the continent.

Key Areas of RDT&E & procurement investments and their beneficiaries

In both the U.S. and Europe, defense spending has clearly pivoted toward modernization, cybersecurity, and space capabilities, as both regions work to adapt to current and future threats. For the U.S., this means pushing ahead with advanced R&D and space initiatives to stay ahead strategically, while Europe is focused on boosting its own regional security to guard against immediate threats. For defense firms operating in these high-growth areas—like Raytheon, Northrop Grumman, Thales, and Rheinmetall—this shift in defense budgets offers substantial opportunities, positioning them to play key roles in shaping the future of both national and global security.

Here is a quick map of some of the major players in the defense sector. Given space is a more nascent field with potentially more convexity in the long run in addition to increased government focus and spending, I find it worthwhile to segregate space companies. It’s also the focus of this note.

The U.S. leading the charge in space:

The United States is putting its money where its mouth is with a $30 billion budget for the U.S. Space Force in 2024. That’s a 15% bump from last year, signaling that space is no longer just a backdrop for sci-fi — it’s becoming one of the frontlines of defense. This budget isn’t just about flashy rockets; it’s about investing in secure satellite communications, missile detection, and keeping tabs on what’s happening up there in the “final frontier.”

L3Harris Technologies (NYSE: LHX), for instance, is all-in on satellite communications and missile warning systems. Their work means real-time data and reliable alerts for the military, which is crucial for staying ahead of potential threats. Then there’s Kratos Defense & Security Solutions (NASDAQ: KTOS), which focuses on satellite ground systems and management software, essentially making sure our satellite networks can talk to each other smoothly and securely. Maxar Technologies (formerly MAXR), known for its Earth observation satellites, also plays a big role in space situational awareness — think tracking what’s floating around up there and spotting any potential risks.

On the equipment side, Ball Corporation (NYSE: BALL) supplies the optics and sensors — precision instruments that are sturdy enough to survive space but accurate enough for defense-grade data. And AeroVironment (NASDAQ: AVAV) is on hand for satellite integration, making sure all these fancy tools can be launched and deployed without a hitch.

Then there’s the commercial launch scene. Companies like Rocket Lab (NASDAQ: RKLB) and Astra Space (formerly ASTR) (and SpaceX but we cant invest easily) are innovating to make satellite launches cheaper and more frequent. Rocket Lab’s Electron rocket is one of the few reliable, small-satellite launch vehicles, while Astra is out to create a low-cost, high-frequency launch system, though it’s still ironing out some tech issues. They’re expanding space access, allowing for more affordable and more regular satellite deployment, which ultimately benefits both the military and the commercial sector.

The E.U. working on closing the gap for security autonomy

Europe’s defense strategy has always been a bit… scattered. But with increasing security concerns, the EU is finally seeing the importance of stepping up its own defense game. In 2023, the EU hit €265 billion ($281 billion) in defense spending, equal to about 1.55% of the region’s GDP. Sure, it’s not quite at NATO’s target of 2%, but the trajectory is pointing up. Major players like Germany, France, and Poland are ramping up their defense budgets by 10% or more every year through 2025, trying to reduce their dependence on the U.S. and bring more capabilities under the European roof.

That’s translating into more R&D focus in areas like cybersecurity, air defense, and especially space — fields that will be pivotal to ensuring Europe’s security in the coming years. More importantly, it’s part of a longer-term plan to stand on its own two feet, to be less reliant on non-European powers for defense and security.

Europe’s realized that space isn’t just for the big players like the U.S. and China. With €1.5 billion ($1.6 billion) earmarked for space in 2024 — an 8% bump over last year — the EU is investing in things like secure satellite communications, space situational awareness, and anti-jamming tech to keep its assets safe up there. Essentially, Europe wants to control its own slice of space.

Leading this charge, we’ve got heavyweights like Airbus Defense and Space (Euronext: AIR) and Thales (Euronext: HO). Airbus is out there building satellites and tech for orbital tracking, which helps keep tabs on threats. Thales, meanwhile, focuses on satellite resilience and secure military communications, which is critical when you’re trying to keep communications secure across an entire continent. Leonardo S.p.A. (BIT: LDO) and OHB SE (ETR: OHB) are key players, too, developing satellites and Earth observation tech to ensure Europe’s got a reliable eye in the sky.

Then you have SES S.A. (Gettex: SES) and Eutelsat (Euronext: ETL), which are pivoting some of their commercial satellite capabilities toward military needs. They’re ensuring that, if push comes to shove, these satellites can switch to secure, military-grade communications on the fly — adding a needed layer of redundancy to Europe’s defense setup.

Independent launch capability is a big part of the puzzle, too. Arianespace has been the go-to for decades, and its upcoming Ariane 6 rocket will be Europe’s mainstay for dependable space access, although SpaceX will likely be the first call for european commercial firms. But fresh faces like Rocket Factory Augsburg and PLD Space are stepping up with smaller, more nimble launch options that promise more affordable, regular access to space for both public and private sectors. This independence effort is crucial for Europe, as it gives them reliable access to space without needing outside help.

The space economy and company spotlights

The overall space economy is expected to grow faster than GDP as space deployments accelerate and become cheaper. We are at the early stages of this new economy but have already seen a clear bifurcation between the legacy players from the first round of innovation in space technology relative to the new entrants. I will provide a more detailed company-by-company analysis given the more speculative nature of this segment compared to the more well-established defense companies we have reviewed in prior sections.

This expansion is driven by advancements in satellite technology, reusable launch systems, and increased private sector involvement. Projections suggest that the industry could surpass $1 trillion by 2040, reflecting annual growth rates of 5-7%.

In the United States, the space sector is a major driver of this growth, with government funding through NASA and the Department of Defense reaching nearly $25 billion in 2023. These funds underpin major projects in lunar exploration, Mars missions, and satellite constellations, forming the backbone of U.S. aerospace infrastructure. The private sector is also a force in the U.S. market: companies like SpaceX, Amazon’s Project Kuiper, and Blue Origin have lowered launch costs to as little as $1,500 per kilogram, making space more accessible and economically viable. By 2040, the U.S. share of the space economy could reach around $800 billion, reinforcing its leadership position.

Europe’s space sector is expanding on a similar trajectory but with a more coordinated, government-led approach. The European Space Agency (ESA) allocated €7.2 billion in 2023 to climate monitoring, sustainable satellite networks, and Earth observation. Europe currently represents around 20% of the global space market, and with estimated growth of 5-6% annually, the region’s space economy could reach an estimated $200 billion by 2040. As European companies strengthen sustainable space practices and debris-reduction policies, they are setting industry standards that may become the benchmark globally.

Commercial services are also transforming the industry landscape, with an influx of small satellites and rising demand for satellite-based internet, live imagery, and machine-to-machine communication. Analysts predict that by 2040, commercial services could account for over 75% of total space industry revenue. Even space tourism, though early in development, could contribute over $5 billion annually within the next two decades, opening an entirely new market of space travel for consumers.

As access to space increases, and with it a surge in demand for Earth observation and communication services, the space economy will continue its steady climb. By 2040, it could become a core economic sector, with new roles in climate science, agriculture, and communications that impact daily life on Earth, reshaping opportunities both on the ground and in orbit.

Quick macro note on investing in small space companies

Investing in high-debt tech companies carries substantial risks, particularly under two macroeconomic scenarios: rising inflation leading to higher interest rates, and a recession where liquidity tightens. Both situations put significant strain on companies with heavy debt loads and negative cash flow, particularly those in growth-focused, cash-burning sectors like tech.

1. Rising Inflation and Higher Interest Rates: If inflation makes a comeback and central banks respond by raising rates, high-debt tech firms face a double blow. First, as interest rates rise, the cost of servicing debt increases, eating into already strained cash flows. For companies with floating-rate debt or those needing to refinance, higher rates can drastically increase interest expenses, forcing tough choices between covering debt obligations and funding critical R&D or growth initiatives. Additionally, as rates rise, valuations typically compress, making it harder for these companies to raise equity on favorable terms. Investors tend to shift toward safer, income-generating assets, leading to capital outflows from speculative tech names. This environment can leave debt-laden tech firms vulnerable to liquidity issues, even if they continue to grow their revenues.

2. Recession and Tightened Funding Access: In a recessionary environment, access to capital for cash-burning tech companies becomes significantly constrained. As risk appetite declines, both equity and debt markets tend to tighten, leaving these companies with limited options to fund operations. Companies reliant on external funding to sustain growth may find themselves in a cash crunch, especially if they lack profitable operations to support self-financing. High debt, coupled with negative cash flow, amplifies this risk: interest payments must be met regardless of declining revenues, putting intense pressure on balance sheets. In severe cases, this can lead to insolvency or forced asset sales at distressed prices. The tech sector, already under pressure from potential valuation declines, could see many high-debt firms struggle to survive without substantial restructuring or strategic shifts.

In both scenarios, high-debt tech companies face significant risks, as they may be forced into defensive positions—cutting back on R&D, shelving growth plans, or even downsizing operations. For investors, these companies represent a high-stakes bet that their growth trajectory will outpace macroeconomic headwinds and that they can manage liquidity effectively in times of financial stress.

Here are some notes on our macro views:

Quick rates update: one month anniversary

I want to put some quick estimations around the rates term structure to frame the likely path for rates and what needs to happen to move them beyond their path of least resistance. This is also to respond to a couple of conversations regarding the long end of bonds being a good place to diversify an equity portfolio for growth scares.

Read More

The macro setup for equities

Saying that structural risks are shifting away from economic growth to inflation does not preclude economic contractions, but it does imply that a fiscal spending put (à la Fed put) is to be expected, which will attempt to limit the scope and frequency of economic contractions.

Read More

Launching Services – Uber in space

The launch services industry—basically, the business of sending stuff like satellites, cargo, and people into space—is a booming market these days. This is the foundational step for the other sectors of the space economy. Governments used to run this show, but now we’ve got private companies, public corporations, and a mix of international collaborations jumping in. It all works on contracts: companies and governments pay launch providers to haul their payloads to specific orbits, whether that’s low Earth orbit (LEO) for things like internet satellites or geostationary orbit (GEO) for those communication beacons hovering over us. Thanks to SpaceX and Rocket Lab and their reusable rockets, costs have come way down, opening the door for many new players. Suddenly, getting to space doesn’t seem quite so sci-fi.

In the U.S., SpaceX (privately held, valued at around $210 billion) is the major player. Its reusable Falcon 9 and Falcon Heavy rockets have a huge chunk of the market, and that’s not changing anytime soon. For publicly traded options, there’s Rocket Lab (NASDAQ: RKLB, ~$4.7bn billion), focused on smaller payloads with a flexible launch schedule through its Electron rocket. Meanwhile, Northrop Grumman (NYSE: NOC, ~$68 billion), best known as a defense contractor, is also building out its space segment, especially since it acquired Orbital ATK. Over in Europe, Arianespace has been leading the market with its Ariane and Vega rockets; it’s a subsidiary of ArianeGroup, which is itself a joint venture between Airbus (EPA: AIR, ~$111 billion) and Safran (EPA: SAF, ~$62 billion). Italy-based Avio (BIT: AVIO, ~$350 million) also supplies the Vega rockets and serves European clients.

Reusable rockets, the key to American space dominance

The space elephant: SpaceX ($210bn valuation)

SpaceX needs no introduction at this point. SpaceX is practically dominating the launch and LEO satellite services industry; in 2023, they pulled off 110 launches—over half of the global total—marking an 850% jump from just 13 in 2019, and by payload mass, they accounted for around 87% of everything sent to orbit, thanks to their reliable Falcon 9. Much of that payload was their own Starlink satellites—now over 6,400 strong—since almost every launch had some Starlink onboard, giving SpaceX a unique advantage in satellite deployment. Their “rideshare” program has also opened up space access to over 130 customers, effectively squeezing out a lot of competing launch providers and making it easier for smaller players to get into orbit. On top of that, SpaceX made history as the first private company to transport astronauts to the ISS with its Dragon spacecraft, and they’re ambitiously developing the Starship, a massive rocket with Mars in its sights. In short, SpaceX is not just the dominant force in launches today—they’re leading the future of space exploration and infrastructure.

Future of Space’s estimates that by 2035, ‘space’ could be a $1.8 trillion revenue industry from today’s $630bn (a 9% CAGR, which is comparable to the semi industry). If we apply to this revenue estimate the EV/Sales multiples from the semi industry of 4.5x (making the parallel to semi given both are manufacturing heavy, high tech, capex intensive and have a perceived added value to human existence). At this rate, the implied valuation of the 2035 space sector could reach $8.1 trillion. I certainly appreciate that by 2035 satellites could be a utility-like sector, but even for internet utilities like Verizon multiples are in the 2.25-2.75x range for a 4.5tr valuation. For additional context, the Mag-7 market cap is of $16.5tr for $1.8tr of revenues, so we have some room for more expensive valuations to be possible. If we discount that hypothetical 2035 $4.5tr to $8.1tr value back to today with a 12% cost of capital (TSMC’s cost as proxy), then we get a pricing for today’s industry given growth expectations of $1.16tr to $2.08tr. Sticking with the 1.16tr for the sake of argument, SpaceX’s 18% market value share relative to its 50% share of global rocket launches and 60% share of satellites currently in orbit make me wonder if I should have used my Math degree for something else than gambling in financial markets and maybe be lucky enough to get some SpaceX private placements… Given SpaceX is the most dominant player in the space, we can see there is room across the industry to try getting some real estate above our heads at what could be relatively cheap valuations.

Rocket Lab (RKLB, $4.7bn market cap)

Rocket Lab has been making waves as one of the top players in the “small satellite” game, giving the space industry a different approach compared to giants like SpaceX. Instead of big rockets with huge payloads, Rocket Lab is all about launching smaller satellites, especially for customers who need frequent and flexible access to space. Its Electron rocket is designed for payloads up to 300 kg, making it the perfect solution for niche missions that don’t need a full-sized rocket. In fact, Rocket Lab handles around 64% of all non-SpaceX launches, which is no small feat for a company that’s carved out this niche in a sector dominated by heavy-lifters.

Financial Performance: Strong Growth with Some Trade-Offs

Rocket Lab’s financial story lately has been one of strong growth but also continued investment. Let’s dig into the numbers a bit.

Revenue growth has been impressive, to say the least. In Q2 2024, revenue shot up 71% year-over-year, going from $62.0 million to $106.3 million. That’s a $44.2 million jump, mostly thanks to a big increase in its space systems revenue ($37.3 million) and a $6.9 million boost from more frequent launches. For the first half of 2024, revenue climbed 70% to $199.0 million from $116.9 million in H1 2023, showing that Rocket Lab’s scaling up on both fronts — launch and space systems.

But with growth, of course, comes costs. The cost of revenues rose 67% year-over-year in Q2, hitting $79.1 million, mostly because of a $27.5 million increase in space systems costs and another $4.1 million from ramping up launches. Over the six-month period, costs reached $147.7 million, up 54% from last year. So while Rocket Lab is raking in more revenue, it’s also shelling out quite a bit to make that happen.

On the upside, gross profit is on a strong upward trend. In Q2 2024, gross profit jumped 86% to $27.2 million from $14.6 million in Q2 2023, and over the first half of 2024, gross profit rose 145% to $51.3 million. So, the company’s getting more efficient as it grows, which is a good sign that it’s finding ways to operate profitably down the line.

Operating expenses are up, largely because Rocket Lab is doubling down on R&D, especially for the much-anticipated Neutron rocket. R&D costs rose 29% in Q2, driven by Neutron’s development, including the Archimedes engine, which recently passed its first hot-fire test — a key milestone that’s keeping the project on track for its first flight in mid-2025. And while selling, general, and administrative (SG&A) expenses only rose 6% in Q2, the company is still making necessary investments to keep up with its revenue growth and prepare for bigger things.

Rocket Lab’s net loss is shrinking, though profitability is still a bit off. Net loss decreased by 9% in Q2 2024, coming in at $41.6 million compared to $45.9 million last year. For the first half, net loss fell 6% to $85.9 million. In other words, Rocket Lab is still running a deficit, but it’s heading in the right direction as revenues grow and expenses start to level out.

Decent Cash Position and Strategic Moves

Rocket Lab is also sitting on a pretty decent cash pile, which gives it flexibility to fund its growth. At the end of Q2 2024, the company had $340.9 million in cash and another $202.3 million in marketable securities. This liquidity gives it breathing room, especially as it ramps up spending on Neutron and other space systems. The company also signed an initial funding agreement with the Department of Commerce under the CHIPS and Science Act, potentially bringing in $23.9 million in support. The state of New Mexico is pitching in too, committing up to $25.5 million to back Rocket Lab’s efforts, which strengthens its financial footing even more.

When it comes to debt, Rocket Lab’s in a manageable position. It has $355 million in outstanding convertible senior notes with a 5% interest rate and another $64.2 million under the Trinity loan agreement with a much steeper rate of 14.8%. But with its cash reserves, the company seems well-equipped to handle these obligations, even as it invests heavily in new initiatives.

The Road Ahead: Building for Broader Horizons

Rocket Lab’s future hinges on expanding its service offerings and targeting larger markets with the upcoming Neutron rocket, designed to fill the gap between small-payload and heavy-lift launches. This new vehicle could attract clients needing more capacity than Rocket Lab’s Electron but not the scale of a SpaceX Falcon. Alongside its push for bigger launches, Rocket Lab is also growing its space systems division, recently landing a ten-launch contract with Japan’s Synspective. This deal underlines its ambition to evolve into a full-service space company, managing launches, satellite deployment, and orbital operations—an approach aimed at driving recurring revenue from clients seeking regular, reliable space access.

Financially, Rocket Lab has a solid runway for investing in technology and market expansion, with recent financials showing progress on both revenue and cost control. Profitability may still be on the horizon, but if Neutron succeeds and space systems revenue grows, Rocket Lab could carve out a strong niche in the small to medium-lift market, one that’s currently underserved. While cost management remains a challenge, its innovations and rising demand for small to medium payloads position Rocket Lab as a promising contender in commercial space. I think this is an exciting company due to its potential and a clear niche that SpaceX has no current plans to enter, but I will not dare assign a target valuation. I will place an initial bet on the company and keep close track of its cash runway, continued revenue growth, and reducing OPEX per flight. I’ll be watching its cash flow and operational efficiency closely, betting that it could become a lasting player in the space race.

Europe’s solution to launch services, lost in space

ArianeGroup via Safran 50% (SAF, $87bn) and Airbus (AIR , $111bn)

ArianeGroup, Europe’s leading launch provider with its Ariane rocket line, faces intense competition, particularly from SpaceX. ArianeGroup’s goal with Ariane 6 is to offer a cost-effective, flexible solution, but its choice to avoid reusability has led to questions about Europe’s future competitiveness in space.

Formed as a 50-50 joint venture between Airbus and Safran in 2015, ArianeGroup combines Airbus’s aerospace systems expertise with Safran’s propulsion technology, reinforcing Europe’s independent access to space. Airbus and Safran each report their share of ArianeGroup’s financials through the equity method, reflecting the venture’s strategic importance for European space autonomy and their own institutional contracts.

Ariane 6 has faced delays and economic challenges:

• Launch Delay: Originally set for 2020, Ariane 6’s first flight is now pushed to 2024 due to technical issues and rising costs.

• Modular Design: Ariane 6 offers flexibility with two configurations: Ariane 62 (medium-lift) and Ariane 64 (heavy-lift), serving different payload needs.

• Non-Reusability: Unlike SpaceX’s reusable Falcon 9, Ariane 6 will not be reusable, a choice meant to control development costs but one that limits its ability to compete on price, as SpaceX’s lower-cost, reusable model reshapes commercial expectations.

Market Position and Demand

European institutional demand remains strong, with contracts like ESA’s Galileo satellites and France’s CSO military satellites keeping ArianeGroup active. However, SpaceX’s pricing appeal has attracted even European satellite operators, like SES, who are opting for more affordable, flexible options.

Cost Competitiveness

Ariane 6’s launch costs are expected to be around $80-100 million, translating to $7,600-$9,500 per kilogram to GTO. In comparison, Falcon 9’s $67 million launch cost equates to about $8,000 per kilogram for non-reusable flights, widening the cost gap for reusable launches and highlighting ArianeGroup’s commercial disadvantage.

Future Projects and Strategic Adjustments

• Prometheus Engine: ArianeGroup is developing a low-cost, reusable engine, Prometheus, powered by liquid oxygen and methane, though it remains in early R&D.

• MaiaSpace Subsidiary: ArianeGroup’s MaiaSpace is creating a partially reusable small rocket, Maia, aimed at the LEO market by 2026, signaling a gradual shift toward reusability.

Competitive Challenges with SpaceX and Other Global Players

SpaceX’s frequent, cost-effective launches (nearly 60 per year) set a high bar, with Falcon 9’s reusability allowing faster, cheaper operations. ArianeGroup’s reliance on ESA and government contracts, while strategically significant, limits its flexibility compared to SpaceX’s aggressive commercial approach. Emerging European players like Rocket Factory Augsburg and PLD Space, developing small, reusable rockets for LEO, also intensify regional competition.

ArianeGroup’s focus with Ariane 6 is on reliability and meeting Europe’s autonomous space needs. Yet, with the industry moving toward reusability, Ariane 6’s high costs and non-reusable design restrict its edge in the competitive commercial sector. Prometheus and MaiaSpace hint at a longer-term shift, but for now, Europe trails the U.S. and China. I hold a cautious view on ArianeGroup but see potential in Safran’s other businesses, which I’ll cover in a future note.

Satellite Infrastructure

What’s the Deal with GEO vs. LEO?

• GEO satellites have traditionally ruled the skies. Positioned roughly 36,000 km above Earth, these satellites match the planet’s rotation, allowing them to stay “parked” over one spot. This stable position makes them ideal for broadcasting to huge areas (like an entire continent) with just one satellite. If you’re watching satellite TV, for example, you’re probably relying on a GEO satellite. However, the sheer distance from Earth means that data takes longer to travel, introducing around 600 milliseconds of latency—a delay that might seem tiny but is noticeable for tasks needing real-time response, like video calls or gaming. This lag doesn’t work well with many of today’s applications where users expect fast, seamless interactions.

• LEO satellites are changing the game by bringing satellites closer to us. At altitudes between 500 and 2,000 km, they’re much nearer, which cuts down the signal travel time, slashing latency to under 50 milliseconds. That’s fast enough for most broadband applications, making LEO ideal for high-speed internet, live-streaming, and emerging tech like the Internet of Things (IoT). Because LEO satellites are so close, each one covers only a small slice of Earth. To provide broad, reliable coverage, companies need hundreds, if not thousands, of LEO satellites working in unison as a “constellation.” This setup might seem complicated, but it allows companies to deliver reliable internet coverage to every corner of the planet.

Why All Eyes are on LEO Now

• Growing Demand for Connectivity: The need for fast, always-available internet isn’t just a “nice-to-have” anymore—it’s a necessity, especially in rural and remote regions. In places where it’s tough or too costly to install ground infrastructure (think: laying fiber optic cables in mountainous areas), LEO satellites can step in to bridge the gap. This capability is particularly valuable for connecting people in rural communities, providing internet to planes and ships, and helping underserved areas finally get reliable internet access. LEO’s reach is a huge deal for people who have historically been left out of the internet revolution, making it possible to stream, work remotely, and connect with others from almost anywhere.

• Real-Time Communication for New Tech: LEO satellites aren’t just about “faster internet” but are a key piece in the infrastructure supporting real-time, data-heavy tech. The Internet of Things (IoT), for instance, depends on rapid, low-latency connections, as do autonomous vehicles and smart city applications. GEO’s inherent delay can make these applications impractical, but LEO’s fast response time allows for split-second data transfers that these technologies rely on. This real-time capability is what makes LEO especially attractive for the future of “smart” everything, from agriculture to transportation, where fast data flow and constant connectivity are essential.

• Tech and Cost Breakthroughs: The cost of getting to space has plummeted thanks to reusable rockets, miniaturization, and improved satellite manufacturing. Companies like SpaceX, for example, have introduced rockets that can launch, land, and launch again, which has dramatically cut the cost per launch. Likewise, satellites are getting smaller and more affordable to produce, which makes deploying large constellations financially feasible. A decade ago, building and launching a LEO network would have been far too expensive to consider. Today, thanks to these advancements, deploying hundreds or thousands of LEO satellites is suddenly within reach for major players like Amazon, OneWeb, and of course, SpaceX. These cost cuts are not just a win for the companies but also for end-users who will benefit from the increased accessibility and affordability of satellite-based internet.

The legacy players

The new kids on the block

AST SpaceMobile (ASTS, $8.6bn)

AST SpaceMobile is developing the first space-based cellular network designed to connect directly to standard smartphones, without relying on traditional cell towers. Their approach involves deploying a network of satellites in low Earth orbit (LEO) to provide high-speed, low-latency mobile broadband, aimed especially at remote and underserved regions. It’s a significant undertaking with potential to improve connectivity in areas lacking infrastructure, but it also requires substantial capital, regulatory approval, and managing competition from established players like SpaceX’s Starlink.

AST has already shown it can make real strides with the right funding and time. The company achieved the first-ever 5G connection from space — a big proof-of-concept win that signals AST’s technology can be implemented on a small scale.

Financial Performance: Modest Revenue, Big Costs

AST’s financials are a bit of a mixed bag. Revenue is up, though still in modest territory. For Q2 2024, AST pulled in $900,000, compared to well… zero revenue for the same period last year. Over the first half of 2024, total revenue was $1.4 million. It’s not game-changing revenue yet, but it’s a start.

Operating expenses, on the other hand, are substantial. Engineering services costs decreased 7% in Q2 2024 to $21.2 million, though they’re up 4% to $40.7 million for the first half of the year. General and administrative costs saw a sharp rise, up 75% year-over-year to $17.8 million in Q2 and 50% to $30.1 million for the half-year, reflecting the higher staffing and infrastructure costs needed to support AST’s scaling. Research and development costs dropped significantly, down 59% to $4.5 million in Q2 and 68% to $8.7 million over H1, as the company shifted its focus from early R&D to deploying and commercializing its network.

One notable hit came from a $66.1 million loss on warrant liabilities in Q2, a stark contrast to a $6.5 million gain in the same period last year. Net loss attributable to common stockholders was $72.6 million in Q2 2024, significantly wider than the $18.4 million loss in Q2 2023. For the first six months, net loss was $92.3 million, up from $34.7 million a year earlier, underscoring AST’s high cost base and the challenges of launching a space-based network.

Balance Sheet: Growing Assets matched by Liabilities

AST’s balance sheet shows the weight of its ambitions. Total assets reached $579.6 million by June 30, 2024, up from $360.9 million at the end of 2023, reflecting its continued investment in satellite development and network infrastructure. Liabilities also rose to $337.8 million from $147.3 million, as the company takes on more debt to fuel its growth. That said, total stockholders’ equity climbed to $241.9 million from $213.6 million, signaling ongoing investor interest in AST’s potential.

Strategic Initiatives: Pushing Toward a Space-Connected Future

AST’s path forward is all about turning its space-based connectivity vision into reality. The company recently completed assembly and testing of five Block 1 BB satellites, set for launch in September 2024. It’s also moving ahead with the next generation of satellites, the Block 2 BB models, which promise more performance and capacity, thanks in part to AST’s new AST5000 ASIC chip. The first Block 2 satellite is targeted for launch in early 2025, setting the stage for AST to expand coverage and capacity.

Commercially, AST has locked in some impressive partnerships. A major agreement with AT&T aims to bring SpaceMobile Service to the U.S., and a Memorandum of Understanding (MOU) with Verizon includes a $100 million investment and prepayment commitment. These deals with two of the largest U.S. telecom players add serious weight to AST’s business case, suggesting that its technology could play a key role in extending coverage to areas where traditional networks fall short.

On the regulatory side, AST recently received a U.S. license to launch and operate frequencies for its first five Block 1 BB satellites. It’s also working on ground infrastructure development and aiming to integrate SpaceMobile Service directly into mobile network operators’ systems, making it easier for telecom providers to deliver service via AST’s satellites.

Funding the Mission: Raising Capital and Securing Support

Launching a space-based cellular network is no cheap feat, and AST has been proactive about raising funds. The company pulled in $110 million in January 2024 through convertible notes from major partners like AT&T, Google, and Vodafone, followed by another $35 million from Verizon in May. Additionally, it raised $93.6 million from a public stock offering and $14.1 million from underwriters’ options earlier in the year. Through its ATM equity program, AST secured an additional $79.4 million during the first half of 2024.

Looking ahead, AST plans to raise more capital through equity, debt, and strategic deals to support the design, assembly, and launch of up to 20 Block 2 BB satellites, aiming to create a constellation of 25 satellites overall. This phased deployment will allow AST to expand service gradually while minimizing upfront costs, though funding remains a critical priority.

The Road Ahead: Big Ambitions, Big Hurdles

AST SpaceMobile is at a critical stage, making progress with partnerships and regulatory approvals, but still a way off from full deployment. Funding this venture requires careful balancing of fundraising, cost control, and market expansion. If AST can manage its cash burn and continue gaining support from telecom giants, it could provide a transformative service for remote connectivity, opening up major new revenue streams. Yet, competition from other satellite providers is fierce, and AST will need to establish itself quickly in the space-based cellular market before it becomes too crowded.To me, ASTS at its $8-9bn market cap seems like a relatively worthwhile call option on the deployment of a one-of-the-kind LEO satellite communication infrastructure. Given the valuation SpaceX is seeing of which Starlink is a significant portion, this credible competitor provides exposure to the LEO connectivity theme.

In-flight connectivity – a shifting market

LEO satellites aren’t just the latest trend—they’re a revolutionary step for global connectivity. This technology enables people in the most isolated parts of the planet to access high-speed internet and participate in the digital world. Whether it’s connecting remote communities, supporting real-time tech, or simply providing affordable options for internet access, LEO constellations are setting a new standard in how we stay connected. One exciting example is in-flight connectivity.

In-flight connectivity (IFC) has come a long way, from patchy, low-speed connections to today’s high-speed satellite-based internet options. Traditionally, providers like Gogo were pioneers in the space, initially using an air-to-ground (ATG) network that connected planes to cell towers below. While this works well over land, it limits service on transoceanic flights and has lower bandwidth than satellite systems. Gogo’s later move into satellite-based IFC, which uses geostationary (GEO) satellites, brought more reach but still suffered from high latency due to the distance GEO satellites are from Earth. For passengers, this often means laggy connections, which makes streaming or real-time work apps a bit of a challenge.

SpaceX’s Starlink IFC, using low Earth orbit (LEO) satellites, has changed the game for in-flight internet by delivering high-speed, low-latency connections anywhere in the world—even over oceans and polar routes where traditional options struggle. Starlink satellites sit much closer to Earth, meaning data travels back and forth much faster, making it ideal for activities that need low delay, like video calls and gaming. United Airlines recently made headlines by announcing that it would install Starlink on its entire fleet, making it the largest airline to commit to Starlink. Starting in 2025, United passengers will have free, gate-to-gate internet that lets them stream, shop, or work as if they were on the ground. This is a big jump from typical in-flight Wi-Fi, which often cuts out or slows down once you’re out over the ocean​.

What really sets Starlink apart is its consistency and global reach. While other airlines have IFC through a patchwork of providers, like Gogo (GOGO $850m) or Viasat (VSAT $1.3bn), United’s Starlink partnership will bring a unified experience, supported by constellations of LEO satellites in constant motion above Earth. Passengers won’t just be able to connect on personal devices; United plans to integrate Starlink into its seatback screens, making it easier than ever to stay connected. For airlines that want to offer something competitive in the sky, SpaceX’s solution is setting a new standard, and United’s move suggests that the LEO approach could soon be the benchmark for inflight internet​.

Gogo (GOGO $850m)

Gogo Inc.’s latest financials paint a mixed picture for Q2 2024. Total revenue edged down slightly to $102.1 million from $103.2 million in Q2 2023, but the six-month total still saw a modest bump to $206.4 million compared to $201.8 million for the same period last year. Service revenue, a positive standout, rose to $81.9 million for Q2 (up from $79.1 million), showing solid growth, while equipment revenue fell to $20.1 million as hardware sales softened. It seems Gogo’s core connectivity services are gaining traction, even as hardware sales hit some turbulence.

On the profitability front, the company faced some challenges. Operating income dropped from $34 million in Q2 2023 to $21.7 million in Q2 2024, with net income taking an even sharper dip to $0.8 million (down from $89.8 million). Gogo’s adjusted EBITDA also declined, signaling pressure on margins as operational costs rose. However, free cash flow came in strong at $24.9 million for Q2 2024, nearly doubling from $13.3 million last year. This boost in cash flow suggests the company is managing its resources efficiently, possibly as a strategic move while it invests in upcoming tech.

Operationally, Gogo’s fleet metrics show steady connectivity engagement with over 4,200 ATG Avance and nearly 4,250 narrowband satellite-equipped aircraft. Average monthly service revenue per aircraft reached $3,468 for ATG and $335 for narrowband, indicating a stable revenue stream from its in-flight internet offerings. Moving forward, Gogo is investing in next-gen projects like Gogo 5G and Gogo Galileo, which they hope will drive long-term growth and keep them competitive in a fast-evolving IFC market. Overall, while there are profitability challenges, Gogo is betting on tech upgrades and stronger service revenue to steer future gains.

Given the shifting landscape and the already mixed financial performance for GOGO, I am interested in putting a short while monitoring their LEO efforts. I suspect they are far behind in that area and do not have the capital required to operate effectively in this new industry.

Viasat (VSAT $1.3bn)

Viasat’s recent financial performance showcases both notable growth and the challenges it faces in its strategic ambitions. For the quarter ending June 30, 2024, Viasat reported total revenues of $1.13 billion—a strong 44% increase from $779.8 million in Q2 2023. This growth was fueled largely by service revenues, which jumped 51% year-over-year to $820.7 million, and product revenues, which saw a 29% increase to $305.7 million. However, the company also reported a net loss of $32.9 million, reflecting heightened operating costs and setbacks from satellite anomalies.

A major setback has been the ViaSat-3 F1 satellite’s reflector deployment issue, which reduced its capacity for the Americas by over 90%, creating a significant operational gap in a critical market. Compounding this, the I-6 F2 satellite, developed with Airbus, faced a power subsystem failure that prevented it from functioning as planned. Despite these challenges, Viasat has been pressing forward with ambitious plans, including its transformative acquisition of Inmarsat in 2023. This acquisition has not only broadened Viasat’s global footprint but also diversified its network with a mix of GEO, LEO, and hybrid satellite fleets. The combined satellite resources enable Viasat to serve multiple frequency bands across consumer, enterprise, and defense markets.

Breaking down segment performance, the Communication Services segment saw revenues of $826.8 million, up 48% year-over-year, with operating profit improving significantly to $41.9 million from a previous loss of $9.9 million. Meanwhile, the Defense and Advanced Technologies segment generated $299.7 million in revenue (a 37% increase), with an operating profit of $84 million compared to a loss of $3.8 million a year prior. These gains underscore the growing demand for Viasat’s communication services, particularly in commercial and defense aviation.

Looking at operating expenses, the cost of service revenues increased by 49% to $516.7 million, aligned with the higher revenue from these services. Selling, General, and Administrative (SG&A) expenses rose modestly by 14% to $251.1 million, while R&D expenses reached $38.6 million, a 33% increase driven by next-generation technology development. Interest expenses also surged to $105.8 million, reflecting higher debt loads from recent investments, particularly the Inmarsat acquisition. Still, cash flow from operations was robust at $151.1 million, and the company has $1.8 billion in cash and cash equivalents, suggesting prudent cash management to fund ongoing growth initiatives.

In terms of its future, Viasat is focused on expanding its satellite fleet’s resilience and throughput capabilities, with additional ViaSat-3 satellites (F2 and F3) planned to enhance coverage across EMEA and APAC. With Inmarsat’s assets integrated, Viasat aims to leverage this expanded constellation to achieve comprehensive global coverage, providing high-quality broadband in underserved regions and scaling its in-flight connectivity (IFC) solutions for airlines. Looking forward, the company’s strategy includes navigating the operational challenges posed by its satellite issues, fully integrating Inmarsat’s offerings, and cementing its position in the fast-evolving global connectivity space.

Despite rapidly rising revenues, I have less confidence in their ability to manage costs. For now I am looking to short VSTS

The limitations of LEO connectivity

However, when investing in LEO, we need to be cognizant of its physical limitations relative to existing infrastructure in terms of connectivity.

Signal Interference and Obstacles in Urban Areas
LEO satellites need a clear line of sight for stable communication, making them vulnerable to interference from buildings, trees, and other obstacles. In dense urban environments with tall buildings and limited open sky, satellite signals can suffer attenuation or complete blockage, impacting reliability. By contrast, ground-based networks, such as 5G and fiber, use strategically positioned small cells and direct cabling, minimizing issues caused by physical obstructions.

Limited Bandwidth and Network Density
Unlike 5G networks, which use high-density small cells to handle high traffic volumes and optimize bandwidth, LEO constellations face capacity challenges in heavily populated areas. Each satellite in a LEO network covers a wide area, spreading bandwidth thin when many users attempt to connect simultaneously. This can lead to slower speeds and lower quality in urban areas, where thousands of users may need simultaneous, high-speed connectivity within a small geographical area.

Latency and Frequency Handoffs
While LEO’s low altitude reduces latency compared to GEO satellites, it still doesn’t match the low-latency capabilities of fiber and 5G, especially in latency-sensitive applications like gaming and high-frequency trading. Furthermore, because LEO satellites move rapidly across the sky, frequent handoffs between satellites and ground stations are required. These frequent transitions add to overall latency and pose challenges for maintaining stable connections in areas with high user density.

Limited Spectrum and Capacity Constraints
LEO networks operate within a limited spectrum allocation, often shared among multiple satellite operators and subject to regulatory constraints. In urban areas where there is heavy competition for frequency bands, spectrum congestion can arise, impacting the speed and reliability of LEO services. By contrast, 5G networks can leverage a broader spectrum range, including sub-6 GHz and mmWave bands, allowing more bandwidth to serve densely populated regions efficiently.

Cost and Energy Efficiency
Operating thousands of LEO satellites is both expensive and energy-intensive, requiring ongoing maintenance and regular replacement as satellites reach end-of-life (5-7 years). While satellite-based networks offer valuable coverage for remote areas, in densely populated regions, the cost-effectiveness and energy efficiency of LEO networks are inferior to that of fiber and 5G infrastructure. Terrestrial networks provide high-quality connections with far fewer infrastructure redundancies and maintenance costs, making them more scalable and sustainable in urban settings.

These limitations indicate that while LEO has a transformative role in connecting remote areas, in well-served regions, traditional terrestrial networks—5G, fiber, and even cable—remain more effective and efficient for delivering high-quality connectivity.

One way to hedge the risk of LEO underdelivering is having exposure to traditional tower and cable utilities. However there are plenty of reasons to avoid them for now which could be the content of an other note.

LEO – Beyond Connectivity

Low Earth Orbit (LEO) satellites are revolutionizing a range of industries beyond connectivity, finding applications in Earth observation, environmental monitoring, defense and intelligence, and scientific research. Positioned between 300 to 1,200 kilometers above Earth, LEO satellites have the advantage of shorter orbital periods and higher resolution imaging capabilities compared to satellites in geostationary orbit (GEO). This proximity to Earth enables faster data collection, greater detail in imagery, and lower latency, making LEO satellites a powerful tool across various fields.

Earth Observation and Environmental Monitoring

LEO satellites are essential for Earth observation, offering high-resolution imaging and multispectral sensing to monitor natural resources, land use, and climate change. They enable real-time tracking of deforestation, sea-level rise, and polar ice melt, while also supporting agriculture by assessing crop health, soil moisture, and pest activity. LEO satellites play a key role in disaster response, delivering timely images for damage assessment, wildfire tracking, and flood prediction to aid resource allocation. Additionally, new LEO constellations are enhancing navigation and remote sensing, improving positioning accuracy and offering redundancy in case of MEO satellite issues. They provide detailed elevation models, track ground movement, and support urban planning, construction, and mining through resource mapping and environmental impact analysis. With lower latency than MEO satellites, LEO satellites are advancing next-gen positioning services in areas demanding real-time accuracy.

• Planet Labs (NYSE: PL): Operates a large constellation for high-resolution Earth imaging, supporting agriculture, climate monitoring, and disaster response.

• Maxar Technologies (Private): Offers high-resolution imagery for natural resource management and urban planning.

• Airbus SE (EPA: AIR): Through its Defense and Space division, provides imagery for climate and land-use monitoring.

• BlackSky (NYSE: BKSY): Specializes in real-time geospatial intelligence using LEO satellites to capture high-frequency imagery of specific locations. BlackSky’s constellation is designed for rapid revisit rates, making it valuable for monitoring environmental changes, urban growth, and disaster impacts.

• Spire Global (NYSE: SPIR): Spire’s LEO constellation provides data on weather patterns, maritime activity, and aviation tracking. Its weather data is instrumental for climate research, environmental forecasting, and real-time weather monitoring in remote areas.

IoT and Machine-to-Machine (M2M) Applications

Beyond traditional connectivity, LEO satellites are driving the Internet of Things (IoT) and Machine-to-Machine (M2M) networks in remote or underserved regions. By providing a low-latency network for IoT devices, LEO satellites support industries such as oil and gas, maritime, and agriculture, where terrestrial infrastructure is sparse. Applications range from tracking shipping fleets and monitoring offshore rigs to collecting data from remote sensors in forests or agricultural lands. This data can be used for predictive maintenance, supply chain optimization, and operational safety, making IoT-enabled LEO networks essential for global industries seeking reliable, real-time data in remote environments.

• ORBCOMM (private): Operates a constellation for IoT and M2M applications like fleet management and remote monitoring.

• Globalstar (NYSE: GSAT): Provides IoT connectivity for asset tracking and industrial monitoring in remote areas.

• Iridium Communications (NASDAQ: IRDM): Offers IoT connectivity globally for applications from shipping to agriculture.

• Spire Global (NYSE: SPIR): Spire’s constellation supports IoT and M2M by providing global data on weather, maritime, and aviation metrics. These capabilities enable Spire to serve IoT needs in sectors like agriculture, logistics, and energy, where real-time data is crucial for operations in hard-to-reach locations.

Space Equipment and Support Industry

Companies specializing in satellite equipment and in-orbit services play a crucial role in maintaining and advancing satellite constellations. These firms provide essential components, systems, and services that ensure the durability, functionality, and sustainability of satellites used across Earth observation, communications, and navigation. From manufacturing critical satellite parts to offering in-orbit repairs and debris management, these companies support the long-term operational needs of the growing satellite industry.

• Redwire Corporation (NYSE: RDW): Supplies mission-critical components such as solar arrays, advanced materials, and in-space manufacturing technology, supporting satellite power systems and on-orbit repairs.

• MDA Space (TSX: MDA): Provides advanced space robotics, satellite systems, and radar solutions, offering high-precision sensors and radar for satellite imaging and telecommunications infrastructure.

• Astroscale Holdings Inc (TYO: 186A): Specializes in satellite servicing and orbital debris removal, focusing on satellite longevity and sustainable space operations to address the increasing challenge of orbital congestion. (not interested in this company for now, information is a bit scarce)

• Intuitive Machines (NASDAQ: LUNR): Advances lunar and deep-space missions with specialized landers and communications technology, facilitating satellite support for exploration beyond Earth’s orbit. Not much to do with earth based LEO, but are building a satellite network around the moon

Suppliers to the Space Industry

The companies providing essential parts to major space firms like SpaceX are the unsung heroes of the space industry, supplying advanced materials, electronics, propulsion systems, and structural components essential for mission success. These suppliers represent a stable pathway for investors who want exposure to the space sector without the high capital risk of pure-play operators. With stable, recurring contracts across launch vehicles, satellite components, and propulsion systems, these suppliers are positioned to benefit from the increasing cadence of space missions.

• Hexcel Corporation (NYSE: HXL): Hexcel is known for its lightweight carbon fiber composites, which are crucial for building fuel-efficient rockets and spacecraft for companies like SpaceX and Blue Origin. These high-performance materials allow for enhanced payload capacity, optimizing cost-efficiency in space launches.

• Applied Materials (NASDAQ: AMAT): Applied Materials offers critical semiconductor manufacturing equipment for high-performance microchips used in satellites, such as SpaceX’s Starlink constellation. Advanced satellite functionality and long-term durability depend on this high-quality manufacturing capability.

• Hexagon AB (STO: HEXA-B): Delivers high-precision sensors and geospatial technology essential for accurate positioning and mapping, supporting Earth observation, defense, and environmental monitoring applications.

• Ball Corporation (NYSE: BALL): Known for their aerospace segment, Ball provides precision optics, sensors, and satellite systems that support high-resolution imaging and data collection for space missions. Ball’s contributions help ensure reliable data acquisition and environmental resilience, crucial for Earth observation and exploration missions alike.

• TE Connectivity (NYSE: TEL): TE Connectivity produces high-durability connectors and sensors for launch vehicles and satellites, essential for managing electrical and thermal stresses during space missions. Their connectors and sensors ensure stable connections, maintaining power and signal integrity under extreme conditions.

• Honeywell International (NASDAQ: HON): Honeywell offers navigation, guidance, and control systems for the aerospace and space industries. Its technology provides precise navigation and stability for both rockets and satellites, helping maintain the mission integrity of launches and in-orbit operations.

• Ducommun Incorporated (NYSE: DCO): Ducommun supplies structural assemblies, electronics, and complex wiring systems used in launch vehicles and satellite platforms. Their products are integral to maintaining structural integrity and functionality under the high-stress conditions of launches.

• TransDigm Group Incorporated (NYSE: TDG): TransDigm provides critical aerospace parts, including highly engineered valves, pumps, and electronic control systems used in rocket propulsion and satellite operations. These components are engineered for resilience in space conditions, supporting long-term satellite functionality and high-thrust launch requirements.

• Woodward, Inc. (NASDAQ: WWD): Woodward supplies high-performance propulsion control systems and power management for aerospace applications. Known for its precision and reliability, Woodward’s technology helps manage energy efficiency and thrust control in challenging environments like space.

• Moog Inc. (NYSE: MOG-A): Moog supplies precision propulsion control systems used in the maneuvering and stability of launch vehicles, including SpaceX’s rockets. Their specialized hardware supports fine-tuned trajectory control, helping ensure each launch hits its target destination accurately.

Defense and Intelligence

In defense and national security, LEO satellites provide critical capabilities in reconnaissance, surveillance, and early warning systems. Their low orbital position enables them to capture highly detailed images and, when deployed in constellations, cover vast areas with rapid revisit times. This makes them ideal for tracking troop movements, monitoring borders, and observing maritime activity. Furthermore, their shorter latency period means that LEO satellites can send real-time alerts for missile launches or other potential threats. Many defense agencies are increasingly deploying LEO-based satellite constellations to enhance space situational awareness (SSA) and provide continuous coverage of areas of strategic interest, supporting mission-critical decision-making. I’ll leave the company spotlights for the next Star Wars, defense-focused article.

• Northrop Grumman (NYSE: NOC): Provides missile warning and reconnaissance satellites, especially for the U.S. Department of Defense.

• Lockheed Martin (NYSE: LMT): Develops LEO satellites for defense applications, including missile tracking and intelligence.

• BAE Systems (LSE: BA): Offers imaging and situational awareness for defense through collaborations on satellite-based intelligence projects.

• Thales (Euronext Paris: HO): Thales provides advanced satellite systems for defense and security, focusing on secure communications, Earth observation, and reconnaissance. The company’s satellite solutions support military and government clients with secure, resilient data for surveillance, intelligence, and space-based situational awareness, leveraging partnerships across Europe to enhance strategic defense capabilities.

• L3Harris Technologies (NYSE: LHX): L3Harris designs and manufactures high-resolution, multi-mission satellite systems for defense and intelligence, specializing in surveillance, missile tracking, and secure communications. The company supports U.S. and allied defense agencies with advanced geospatial and reconnaissance capabilities, focusing on real-time situational awareness and resilient space-based defense solutions.

• BlackSky (NYSE: BKSY): BlackSky’s high-frequency imaging capabilities support defense and intelligence needs, offering situational awareness and rapid response imagery. The company provides real-time data to government clients for reconnaissance and mission planning, with an emphasis on timely intelligence in sensitive areas.

• Kratos Defense & Security Solutions (NASDAQ: KTOS): Specializing in satellite communications, signal monitoring, and cybersecurity, Kratos supports defense and intelligence clients with resilient space and ground infrastructure. Their systems protect against jamming, signal interference, and cyber threats, ensuring secure communication channels for government and military satellite networks.

Company Spotlight

Planet Labs (PL, $650m)

Planet Labs has been pushing forward on growth, reporting a 14% revenue increase to $61.1 million for the three months ending July 31, 2024, up from $53.8 million the previous year. This jump is largely thanks to new customers, including those brought in through the recent Sinergise acquisition, and stronger traction in its Civil Government and Defense and Intelligence sectors. The company’s customer base grew by 7%, reaching 1,012 clients by the end of the quarter, which highlights the appeal of Planet’s high-frequency, Earth observation data across diverse applications.

However, scaling up hasn’t been without cost. Planet Labs saw a 5% increase in the cost of revenue, reaching $28.8 million, driven by severance expenses from a June headcount reduction and higher fees to solution partners and subcontractors. This workforce cut, reducing the global headcount by 17%, was part of a strategy to align Planet’s resources with growth areas and improve efficiency—though it came with a $10.5 million one-time charge for termination benefits. Operating expenses also nudged upward, with R&D expenses up 2%, sales and marketing up 6%, and G&A up 2%, reflecting Planet’s ongoing investments in analytics, data products, and platform enhancements to attract new clients and deepen relationships with existing ones.

Despite these efforts, Planet Labs still reported a net loss of $38.7 million for the quarter, close to the $38.0 million loss in the same period in 2023. On the positive side, the company has $148.3 million in cash on hand as of July 31, 2024, which, along with operational cash flows, they believe will be sufficient to meet obligations over the next 12 months.

In terms of strategy, Planet Labs remains focused on scaling within existing markets, expanding into new sectors, and enhancing its platform with additional data sets and sensors. It’s not all easy growth—balancing cost efficiency with high operational expenses like satellite maintenance and data processing is a challenge they’re working through. With consistent revenue growth, a growing customer base, and efforts to streamline costs, Planet is aiming to become a sustainable leader in Earth observation, even as they navigate the rocky road toward profitability.

Blacksky (BKSY, $190m)

BlackSky Technology Inc. operates a subscription-based business that provides real-time Earth observation and geospatial intelligence through its Spectra AI platform. With its high-frequency satellite imagery and analytics, BlackSky supports government and defense clients by delivering rapid intelligence, often within 90 minutes of image capture. In addition to subscriptions, the company earns revenue from professional services, where it delivers custom solutions for defense and intelligence projects.

In the second quarter of 2024, BlackSky saw a significant 29% year-over-year increase in revenue. Subscription revenue from imagery and software analytics grew by 14%, driven by client renewals and additional subscriptions, while professional services revenue surged 86.8% due to new contract wins. Cost efficiencies were evident, with a slight 0.7% decrease in service costs and a 32% reduction in professional services costs, thanks to streamlined material expenses. BlackSky also managed to cut SG&A expenses by 3%, although R&D spending rose sharply by 62.5% as the company invested heavily in satellite and AI enhancements. The balance sheet remains strong, with $25.6 million in cash and a $20 million credit facility to support ongoing growth and liquidity needs.

BlackSky is actively expanding its satellite constellation, aiming for 30 satellites by 2025. The launch of Gen-3 satellites in late 2024 is expected to boost imaging capabilities with advanced features like shortwave infrared imaging. Meanwhile, investments in Spectra AI continue to focus on integrating new data layers and enhancing analytics, allowing BlackSky to go beyond raw imagery and deliver actionable intelligence tailored to diverse industry needs.

Primary cost drivers include satellite operations, with substantial spending on launches and maintenance, R&D investments in technology upgrades, and data processing expenses for advanced analytics. BlackSky has achieved cost efficiencies in professional services and SG&A, reflecting efforts to balance growth investments with a path toward profitability.

Competition in the Earth observation sector is strong. BlackSky’s emphasis on real-time intelligence differentiates it from Planet Labs, which serves a broad commercial base, Maxar with high-resolution imaging, and Capella Space’s all-weather SAR capabilities. Partnerships, such as with Palantir, enhance BlackSky’s data analytics offering but also bring indirect competition in the intelligence space.

Recent growth shows BlackSky’s appeal, particularly among government clients needing rapid intelligence. However, the challenge of profitability remains, with BlackSky needing to control costs while expanding commercial reach to reduce reliance on government contracts. By focusing on real-time data and AI-enhanced analytics, BlackSky is well-positioned to capture ongoing demand in the competitive Earth observation market.

Spire Global (SPIR, $240m)

Spire Global’s business is built on a unique data model that goes beyond typical satellite imagery, focusing instead on radio frequency (RF) data and AIS signals from its constellation of over 100 satellites. This lets Spire track ships, planes, and weather conditions globally in real time. Clients—mainly in logistics, government, and aviation—subscribe to Spire’s data feeds, and there’s also a space-as-a-service option for clients who want to lease Spire’s infrastructure for their own payloads.

In Q1 2024, Spire’s revenue grew by 6% to $25.7 million, driven by recurring revenue from existing customers and some milestone-based projects, although NOAA revenue from weather services dipped a bit. New contracts with NOAA ($9.4 million) and the European Maritime Safety Agency (EMSA) (€8.4 million) bolstered their government demand. Gross profit dropped slightly to $13.1 million with gross margin declining from 57% to 51%, largely due to higher satellite depreciation. Operating expenses, however, were down by 12%, mainly due to cuts in sales, marketing, and G&A, though Spire still posted a net loss of $25.3 million. Adjusted EBITDA loss improved to $1.1 million from $6.7 million a year prior. To strengthen liquidity, Spire raised $40 million from investors, including a $10 million strategic investment from Signal Ocean, with whom Spire is collaborating on digitalizing maritime operations.

Spire’s competitive edge comes from its RF-based tracking and weather data, allowing it to offer unique insights that traditional imagery doesn’t capture. The company is doubling down on partnerships, working with NVIDIA for AI-enhanced weather modeling and integrating its data on Google Cloud and AWS to broaden access.

A recent achievement for Spire Global and OroraTech has been the awarded NASA contract to monitor wildfire risks using Spire’s satellite constellation and OroraTech’s thermal-infrared technology. This initiative will integrate OroraTech’s wildfire detection tech into Spire’s satellites, enabling early wildfire warnings and climate impact data, particularly in remote areas.

Globalstar Inc. (NYSE: GSAT, $2bn)

Globalstar Inc. provides reliable satellite-based mobile and data services, especially for industries operating in remote areas—think maritime, agriculture, oil and gas, and government sectors where regular network access just doesn’t cut it. Globalstar’s main business lines are in IoT, two-way satellite communications, SPOT messaging devices, and leasing wholesale capacity to other companies.

In Q2 2024, Globalstar’s revenue climbed 10% to $60.4 million, up from $55.1 million in the same quarter last year. This boost was largely thanks to a 25% jump in Commercial IoT revenue, as demand for IoT connectivity grows in areas like logistics and agriculture. Wholesale capacity services also surged, adding $9.2 million. However, Duplex revenue dropped by 22%, and SPOT service revenue slipped by 6%, pointing to some challenges in the personal and two-way satellite markets. For the first half of the year, revenue grew a modest 3% to $116.9 million—steady but with a mixed performance across service types.

Operating expenses went up significantly, reaching $61.8 million in Q2, up from $52.5 million in 2023. This was partly due to a $5.9 million increase in service costs from network expansion and more spending tied to new service agreements. Stock-based compensation also played a role, rising by $6.6 million due to executive incentives.

Globalstar is pouring resources into expanding both its satellite and terrestrial network. It recently signed a deal with MDA to purchase 17 new satellites, with launches slated for 2025 through a partnership with SpaceX. These satellites are expected to boost coverage and capacity, addressing growing demand for IoT and other services. Beyond that, a new government services contract could bring in up to $20 million annually by year five, marking a solid move into mission-critical government communications.

To fund these efforts, Globalstar secured a 2023 funding agreement covering up to 50% of the costs for new satellites, with remaining expenses to be covered by operating cash flows. Additional financing came through a 13% Senior Note issuance and Series A Preferred Stock, helping them manage the financial strain of these growth initiatives. As of June 30, 2024, Globalstar held $64.3 million in cash with $425.8 million in debt, a reminder of the capital-intensive nature of the satellite business.

The company has carved out a niche with its IoT focus and partnerships, like the deal with Apple for emergency SOS services on iPhones, which has boosted its visibility. However, competition is stiff from satellite IoT players like Iridium and ORBCOMM, not to mention the rapid rise of SpaceX’s Starlink in satellite connectivity. With rising expenses and significant debt, Globalstar’s challenge will be to balance growth ambitions with financial discipline. Looking ahead, its expansion into both IoT and government markets could pay off, but effective cost management will be essential to ensure sustainable growth.

Iridium Communications (IRDM, $3.35bn)

Iridium Communications reported solid growth across its core segments in Q3 2024, reflecting its balanced model of recurring services and targeted hardware sales. Total revenue rose 8% year-over-year to $212.8 million, up from $197.6 million in Q3 2023, with a notable improvement in operating income, which surged 95% to $54.9 million. Net income swung to $24.4 million from a $1.6 million loss in the prior-year quarter, driven by expansion in IoT and government services, strategic acquisitions, and tight cost control.

In Commercial Services, the Voice and Data segment’s revenue increased by 3% to $57.7 million, with subscriber numbers rising by 12,000 to 422,000, while ARPU remained stable at $46. IoT Data saw strong growth with a 14% rise in revenue to $43.7 million, supported by an additional 235,000 subscribers, bringing the total to 1.9 million, although ARPU declined slightly from $7.90 to $7.79. This growth reflects high demand for personal communication devices and a large new contract win. Broadband services, however, saw a minor 2% decline in revenue to $15.5 million, with ARPU decreasing to $309 from $322, potentially due to price competition or shifts in usage. Hosted payload and other data services rose 9% to $16.4 million, largely due to contributions from Satelles, although hosted payload revenue faced some impact from the revised lifespan of certain satellites.

Government services remained steady at $26.5 million, despite a slight dip in the subscriber base by 1,000, supported by a recent contractual rate adjustment in the DoD’s EMSS contract, enhancing revenue predictability. Subscriber Equipment revenue grew by 9% to $22.2 million on strong handset sales, though this was offset by lower Short Burst Data sales. Iridium’s engineering and support services displayed mixed results, with commercial revenues slightly down to $1.7 million, while government service revenue surged by 24% to $29.0 million, primarily from increased work under government contracts like the SDA contract, underscoring Iridium’s strong positioning in defense communications.

The recent acquisition of Satelles, Inc. cost $125.5 million for the remaining 80.5% stake, adding $7.9 million in revenue but leading to a $7.5 million net loss from the acquisition date through September 30, 2024. Satelles’ customer relationships were valued at $57.0 million with a useful life of 12 years, positioning Iridium for growth in timing and location services.

Iridium continued its shareholder return initiatives, repurchasing 4.7 million shares for $129 million in Q3 2024, leaving $552.2 million authorized for future buybacks. Additionally, Iridium paid $49.1 million in dividends in the first nine months of 2024, supported by a strong cash flow position, with cash on hand increasing substantially to $159.6 million from $71.9 million at the end of 2023. Depreciation and amortization expenses dropped by 33% to $51.2 million due to revised satellite useful lives, reducing operating costs. Interest expense fell 30% to $24.2 million, following the refinancing of Iridium’s term loan. Despite a $12 million rise in income tax expenses due to higher pre-tax income, Iridium’s profitability continued to strengthen.

Cash flow remained robust, with net cash from operating activities up $44.1 million to $271.2 million for the nine months ending September 30, 2024. Investing activities saw a substantial outflow of $156.3 million, mainly due to the Satelles acquisition, marking a considerable increase from $67.3 million the prior year. Cash used in financing activities fell significantly, decreasing by $232.2 million to $26.2 million, highlighting a shift in Iridium’s financial approach.

With ongoing growth in IoT, stable government contracts, and strategic acquisitions, Iridium is positioned strongly for balanced growth amid rising competition and evolving market dynamics.

Redwire Corporation (RDW, $525m)

Redwire Corporation, a U.S.-based aerospace company, provides infrastructure and manufacturing solutions across key areas like in-space manufacturing, digital engineering, and satellite servicing. Working with NASA, the DoD, and commercial space players, Redwire focuses on enabling long-term human and robotic space operations, advancing satellite life, and supporting the expanding space economy.

In Q2 2024, Redwire reported $78.1 million in revenue, a 30% increase over last year, driven by larger contracts and higher production volume in power generation offerings. However, cost of sales surged 47% to $65.1 million, with increased expenses in labor and materials, which compressed gross margin to 17% from 26% in the previous year. SG&A expenses rose to $18.1 million, mainly due to higher legal costs, and interest expenses also grew 13% to $3 million, tied to increased borrowing and interest rates. The quarter closed with a net loss of $18.1 million, up from a $5.5 million loss last year, primarily impacted by a $9 million adjustment in private warrant liabilities.

Redwire’s divisions show a mix of government and commercial revenue, with strong recent growth in contracts with SpaceX and Amazon’s Project Kuiper, which signals progress in reducing reliance on government funding. R&D costs were cut by 16% to $1.7 million, as resources were shifted to direct projects, though this could impact innovation pacing. Notably, Redwire’s book-to-bill ratio increased to 1.47 from 0.76, indicating improved demand and order intake.

On cash flow, operating activities saw some improvement, with a reduction in losses to $(6.7) million in the first half of 2024 from $(11.2) million previously, though the company remains cash-negative. Investing activities swung positive to $0.5 million, largely from lower capital spending, and financing activities improved, yielding $6.9 million in cash inflows. Backlog, however, declined slightly to $354.3 million from $372.8 million at year-end, reflecting a steady but competitive market environment.

Looking ahead, Redwire’s work in in-space manufacturing, especially with Archinaut One, biomanufacturing, and in-orbit servicing, aligns with industry demand for sustainable space solutions. Balancing growth potential with high CAPEX, R&D, and competitive pressure from larger players like Maxar remains essential. If Redwire can effectively manage costs while maintaining its innovation pace, it stands to capture a significant role in the evolving space infrastructure sector.

MDA Space (TSE: MDA, $2bn)

MDA Ltd., a leader in space infrastructure, showed strong growth in Q2 2024, with total revenue rising 23% to $242 million, driven by its key segments in geointelligence, satellite systems, and space robotics. The Geointelligence segment posted $54.9 million in revenue, up from $47.9 million a year prior, boosted by demand for Earth observation services through its RADARSAT-2 satellite and its upcoming CHORUS constellation, set to expand MDA’s data services.

In Robotics and Space Operations, revenue jumped to $78.3 million from $58.7 million, fueled by its high-profile Canadarm3 project for NASA’s Lunar Gateway, positioning MDA as a top player in autonomous robotics for deep-space missions. Meanwhile, Satellite Systems, the largest contributor, reported $108.8 million in revenue, up from $89.4 million last year. This growth reflects MDA’s pivotal role in large-scale LEO satellite projects like Telesat’s Lightspeed and Amazon’s Project Kuiper, tapping into the expanding demand for global satellite connectivity.

Financially, MDA’s gross profit reached $66.2 million for Q2, while the cost of revenue rose to $164.9 million from $127.7 million, mirroring increased project and production demands. Operating income climbed slightly to $22.1 million, and net income improved to $11 million, indicating solid top-line growth tempered by high project costs. SG&A expenses rose to $20.6 million, and R&D costs decreased to $8.8 million as key projects reached more mature stages.

On the balance sheet, total assets grew to $2.38 billion, with current assets reaching $586.5 million, providing a stable foundation for MDA’s high-capital projects. Liabilities increased to $1.28 billion, reflecting capital investment needs. Cash flow from operations was strong, at $149 million, significantly higher than the prior year’s $38.9 million, although cash used in investing remained substantial at $(59.8) million, underscoring the capital-intensive nature of its projects like CHORUS and Canadarm3.

As MDA navigates high CAPEX demands, it balances government reliance with commercial partnerships, including contracts with Telesat and Amazon, and remains well-positioned in space infrastructure. Yet, the company must manage competitive pressures and maintain cost efficiency to uphold its growth trajectory in a complex, high-stakes industry.

Hexagon (STO: HEXA-B, $25bn)

Hexagon AB, despite Q3 2024 challenges, continues to perform solidly in its space-focused applications and technology offerings. Net sales declined by 4% to €1,299.8 million, with organic revenue contracting slightly by 2% at fixed exchange rates, reflecting market pressures. However, recurring revenue rose by 7% to €564.9 million, underscoring stable demand for Hexagon’s data solutions, especially in geospatial intelligence, precision positioning, and environmental monitoring. The adjusted gross margin improved to 67.1% from 65.5% last year, thanks to efficiencies across Hexagon’s core segments, including Geosystems, which focuses on space-related applications. Adjusted operating earnings decreased by 4% to €376.6 million, with a steady operating margin of 29.0%, demonstrating Hexagon’s focus on profitability despite sales challenges.

Operating cash flow before non-recurring items increased to €165.9 million from €146.5 million, with cash conversion improving to 70%. Hexagon invested €213 million in R&D, capitalizing €120 million of it to advance space technologies like GNSS and digital twins. Capital investments reached €151.5 million, supporting long-term growth in space and geospatial solutions. Regionally, EMEA held stable, but sales in North America and China declined by 3% and 8%, respectively, reflecting mixed geographic performance.

In Geosystems, which includes space applications, revenue dropped by 4% to €373 million, though it maintained a robust operating margin of 32.6%. Space applications such as GNSS and digital twins continue to support demand in sectors dependent on geospatial intelligence and Earth observation. The Safety, Infrastructure & Geospatial segment held steady at €119.6 million with a 20.6% margin, driven by urban planning, defense, and environmental monitoring.

Hexagon has bolstered growth with new product launches like the ATS800 Absolute Tracker and GNSS Smart Antenna GS05, aligned with space and high-precision applications, along with strategic acquisitions of companies like Edge Tech and Voyansi to strengthen its geospatial capabilities. With robust recurring revenue and cash flows, Hexagon remains well-positioned for future expansion, with R&D investments and acquisitions set to fuel growth in high-value space applications for autonomous systems, navigation, and environmental monitoring.

Intuitive Machines (LUNR, $1.1bn)

Intuitive Machines, Inc. (LUNR) has been expanding its role in the lunar economy, showing robust financial growth while navigating the capital-heavy demands of space infrastructure. Revenue surged by 130% in Q2 2024 to $41.4 million, primarily driven by the OMES III contract launched in late 2023. Total revenue for the first half of 2024 climbed 216% year-over-year to $114.5 million, fueled by ongoing IM lunar missions and the growing need for lunar infrastructure, despite some fluctuations in NASA and commercial contracts.

On the expense front, costs have risen sharply, with the cost of revenue excluding depreciation increasing by 154% to $57.1 million in Q2 due to heavy spending on the OMES III contract and development of the IM-2 and IM-3 missions. For the first six months, costs rose 159%, reflecting significant investments in R&D and engineering to meet mission objectives. General and administrative expenses increased by 44% to $12.1 million in Q2, driven by higher share-based compensation, professional services, and workforce expansion to support new missions.

Operationally, Intuitive Machines has achieved critical milestones. The successful IM-1 mission in early 2024 marked the first soft lunar landing by a U.S. vehicle since 1972, validating LUNR’s lander technology and setting a foundation for future missions. The upcoming IM-2 and IM-3 missions, planned for early and late 2025 respectively, are expected to drive further contract revenue as clients demonstrate increased confidence in LUNR’s lunar capabilities.

LUNR’s Lunar Data Network (LDN) initiative, underpinned by a $719 million NASA contract to develop the NovaNet communications relay and navigation network, stands at the core of its future growth. This network aims to provide continuous, high-bandwidth data transmission between lunar missions and Earth, offering recurring revenue opportunities as lunar activity scales up. Future clients from NASA to private space ventures are expected to rely on this infrastructure for scientific research, navigation, and operational safety. The company’s expansion into orbital and lunar access services adds further diversification, with in-space repairs, satellite servicing, and lunar surface payload delivery capabilities attracting both commercial and government clients seeking extended mission durations and lunar exploration support.

Financially, Intuitive Machines continues to grapple with cash flow challenges. Net income in Q2 2024 was $16 million, down from $18.8 million in Q2 2023, and the first half recorded a net loss of $104.7 million compared to a smaller loss of $4.7 million the previous year. This decline reflects unfavorable changes in warrant liabilities and significant expense fluctuations. Adjusted EBITDA posted a loss of $25.8 million in Q2, slightly worse than last year’s, and free cash flow for the first half remained negative at $41.5 million, underscoring the high cash demands of LUNR’s current growth phase.

To manage liquidity, LUNR has been leveraging financing agreements such as the Cantor Purchase Agreement and Controlled Equity Offering Sales Agreement, which provide needed flexibility as it works through milestone contracts and mission objectives. Efforts to optimize costs are ongoing, with recent operational adjustments aimed at improving leverage as mission volume scales.

With recurring revenue from the LDN, an expanding NovaNet network, and strategic contract wins, Intuitive Machines is building a significant presence in lunar services. As it balances these growing revenue streams against the capital requirements and rigorous timelines of space infrastructure development, LUNR’s approach to financing and efficiency will be pivotal to maintaining momentum in the lunar economy.

We are now observing the one-month anniversary of the first U.S. rate cut, which occurred at the September 18 FOMC meeting. Back then, rate traders were pricing in a jumbo 50bps trim, and that is exactly what they got. Today, to celebrate the occasion, markets are pricing in a 25bps cut with 100% certainty in the next meeting. The point of this note is to put a number on what is being priced in by rates today as a quick numerical reference for future notes.

I apologize if this is starting to look like a macro blog – it is not; my study of the subject is the first part of identifying the equities I am interested in. A great company can be a terrible investment in the wrong environment.

A month ago, this repricing of rates provided an attractive entry point to short 30-year bonds to hedge inflation volatility.

While we put on an initial long on the 5-year to hedge against negative economic data subsequent to the repricing from the surprisingly positive NFP. This trade is thus far out of the money (hence I like to remind my self it is a hedge)

The rationale for taking on these trades has been laid out in the following notes:

Fed and China go big or go home

Due to this, I am long the short end (below 5y with ZT & ZF) to benefit from the continued steepening of the curve and short the long end (above 10y with ZN & ZB) to hedge against inflation picking up.

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Quick rates update post NFP

I am now interested in setting up an initial position (75bps of nav) on ZT’s (2y, 50%) and ZF’s (5y, 50%) now that our entering condition of closer to 25bps successive cuts in the STIR markets is much closer to being priced in. This position can serve as both a recession hedge from pricing in another significant cut, causing short rates to rally if negative data on growth comes in, and benefit from the cyclical goldilocks regime we currently are in of short-term stable inflation and continued growth.

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The macro setup for equities

Saying that structural risks are shifting away from economic growth to inflation does not preclude economic contractions, but it does imply that a fiscal spending put (à la Fed put) is to be expected, which will attempt to limit the scope and frequency of economic contractions.

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One month later, what is the state of the U.S. rates complex?

The STIR markets achieved on the 18th of October a remarkable level of certainty pricing in a 100% probability of a 25bps cut for the November meeting. This is in contrast to the 60% probability priced in wrapping up the FOMC.

Looking ahead to one year, how has the STIR market implied probability of the terminal rate evolved? The overall rate distribution has shifted up 50bps from a mode at 300bps top of the band (-2% from today’s 500bps) to 350bps top of the band (-1.5% from today)

The upward shift in probabilities (move down in STIR price) through the last month is logical given the string of positive economic data implying continued growth. The market mood before the first cut was that the Fed had missed the boat (frequent citations of Sahm’s rule) and that growth was likely to see a substantial slowdown due to the Fed’s inaction and that a 25bps cut was not enough. I did not agree and framed it as follows:

Now, the market seems to think the soft landing is upon us (this has been our view for a few months now, albeit with some inflationary concerns), and equities are rejoicing.

Data from last week:

We have argued at length in the prior notes the following:

• There will be fiscal spending put (a la Fed put), which will smooth over recessionary pressures. This is due to a shift from pro-capital economic policies to pro-labor. Governments, whether democratic or autocratic, realize that there is little tolerance for inequality-generating economic adjustments such as contractions in labor demand or wages. Fiscal spending which directs liquidity into the real economy has a direct and supportive impact to reduce the effects of economic impulses that increase inequality in a first order view.

• The flip side of government-led deficits will be a regime of increased structural inflation volatility with a floor of 2% (this does not equate to a sustained inflation spike). Given that bond sensitivity to inflation increases with duration and sensitivity to growth decreases with duration, we have a neutral to negative view on long-duration bonds while using the short end as a growth hedge.

Even right now with improving outlook for growth the Federal government is accelerating spending (probably an effect of the election as a last ditch effort). The total federal debt jumped some $500billion early October, now bringing the total at $35.75TN.

I want to put some quick estimations around the rates term structure to frame the likely path for rates and what needs to happen to move them beyond their path of least resistance. This is also to respond to a couple of conversations regarding the long end of bonds being a good place to diversify an equity portfolio for growth scares.

The chart below needs to stay in the background as we go through this exercise. I’ll make a few quick observations.

• The 30-year has been on a constant bull market for some decades. Owning duration far out has been a good way to hedge recession risk.

• Each time there is a recession, the 2s10s and the 10s30s steepen. That implies that the term premium for longer durations gets erased as capital moves to shorter durations.

• The steepening also reflects the pricing expectation that yields on the front end will rally from fed funds rate being cut while the long end projects that economic growth will return and the Fed will eventually raise rates.

When looking at the real cost of money in the system, the rate that matters is the benchmark rate adjusted for inflation. The Fed typically looks to target a fed funds rate some 75-100bps over inflation assuming inflation is moderated and growth is sustained. We have a quick model of the inflation distribution under continued but slow growth which averages some 2.67% inflation. Historically the 2 year tracks fairly well 50 bps over the Fed funds rate in periods of inflation below 3.5% with economic growth while there is no expectations of Fed rate hikes, which lines up with our view on the economy.

Given we expect some 2.67% average running inflation (keeping in mind our inflation volatility arguments from prior notes), we can expect the terminal Fed Funds rate to be 3.5% in line with the STIR market. Then we can expect the 2 year to price at 4% which is where it prices today.

Then to look at the 10 year, we need to model the 2s10s spread jointly with the two year yield distribution. We model this as a multivariate beta distribution. The choice of beta here is to avoid tails towards infinity but rather towards a reasonable structural upper bound.

This allows us to derive the long-run 10-year yield distribution, assuming continued growth and increased inflation volatility. Here, we diverge from the market, given the current pricing of 4.1% vs. our 5.0% expectation. However, we do attribute a 20% chance of moving towards lower yields than where they are today (not insignificant), which is a risk we need to be cognizant of when putting on the short longer duration bonds. Our quick model does show that there is not much room for long rates to move lower, hence our focus on shorting the long duration bonds. This exercise does, however, provide us with a framework to formulate an exit condition to our inflation hedge. As we move closer to the mean, we will start taking off the hedge.

I suspect that the market currently demands little to no term premium due to a lack of inflation worries. The term premium can be interpreted as the pickup in compensation for inflation dragging on real returns of the bonds. The risk of lending to the U.S. government is not credit risk but inflation risk. Right now the market is stating that the U.S. treasuries have neither risk. This is where I believe the market is mispricing risk, and where we will put on risk.

Now let’s move away from our base case and model recessionary impulses in the economy which are met by insufficient fiscal stimulus. The steepening of the curve (empirically some 200bps) counteracts any benefit of holding long duration bonds:

Here is the impact on the 10 year distribution with no steepening. Looks like a good hedge.

But with the average of 200bps of 2s10s steepening we typically see during a recession, the hedge looks much less effective and we still expect rates at longer durations to sell-off in the long run, just at a decreased magnitude and probability from our base case. The 2s10s spread is modelled looking at the month on month change in its speed as a function of both growth and inflation. The general direction is a faster positive speed in change of the 2s10s as growth slows and faster negative speed as growth accelerates. Simultaneously, for stable and relatively slow growth, 2s10s widens as inflation picks up; its sensitivity to inflation reduces as growth moves away from positive low single digits.

You would essentially need a catastrophic event and growth well into negative territory accompanied with deflation for the long end to behave as a recession hedge. And even then you don’t even get 100bps of rally in your long duration yields; a significantly worse performance to the short duration bonds. Given our view on the political climate that justifies sovereigns to issue deficit spending in order to stave away growth slowdowns, this is a more remote possibility now. I will note that the long end here is calibrated on prior recessions, I suspect given the fiscal puts we can expect globally, the long end will perform worse than what is implied historically. Our severe downside to being short the long end is relatively muted, as such the trade has an excellent risk/reward.

It seems simpler to me to focus on shorter duration and credit spreads. We discussed the credit spread hedge here:

STIR butterflies from Yield curve flip flops

I am not willing to bet that credit spreads will widen substantially anytime soon, and hope to make money on it. However, I would want to buy meltdown insurance for as little carry as possible, given the tensions in the broad market with CDS spreads being relatively tight (CDS spreads should remain at these levels given my base case as outlined in the consumer outlook piece linked above, but I like to suffer less when I am wrong).

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This is why we use the front end as a much cleaner representation of the recession risk, hence why we own bonds on the 2 and 5 year to hedge growth risk and short the long durations to hedge inflation, but this should be a great trade on its own.

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In the prior research report, we framed the paths for U.S. inflation and introduced a constructive view on risk assets broadly. In this note, we will provide a synthesis of the macroeconomic variables we are monitoring in the U.S. and interpret the latest economic data prints in preparation for our equity allocation views.

Fed and China go big or go home

A framework on how to think about U.S. inflation and the structural impact on rates and how to think about international capital flows in U.S. risk assets

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The two following reports provide frameworks that lay some of the groundwork for thinking about the impact of consumer behavior on economic growth and an overview of monetary balance-sheet policy, which is less in focus than but equally important to benchmark rates.

What is my credit card limit?

We review the health of the American consumer and how it relates to risk assets. The constructive view provided continues to be supported by the latest employment data.

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A Reverse Repo Story

We provide monetary balance-sheet mechanics that demonstrate the net easing of financial conditions, which started over a year ago via the Fed’s reverse repo facility and supported risk assets despite tight rates and a shrinking balance sheet.

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We have received both CPI and PPI numbers this week, showing a continued trajectory of broadly easing inflation but at a decreasing speed on the consumer side.

The picture becomes more nuanced by drilling into the index’s components. Here, we note that the energy component substantially contributes to the PPI’s cooler than anticipated print. Given the energy’s volatile contribution, it is helpful to look at PPI components individually. We note that services have remained on an upward trend since early this year.

It is a similar story when we look at the consumer side. Concerning factors to keep monitoring is inflation in shelter and services more broadly. This data supports our concerns over inflation volatility and our structural floor of inflation at 2% thesis. Due to this, we will continue to put a bias toward managing inflation risk over growth risk with a nuance which will be elaborated further in the note.

Putting things together and building off the conclusion from our quick rates update from Monday:

Saying that structural risks are shifting away from economic growth to inflation does not preclude economic contractions, but it does imply that a fiscal spending put (à la Fed put) is to be expected, which will attempt to limit the scope and frequency of economic contractions. Fiscal spending along with federal debt issuance can be observed in the treasury general account (TGA) which sits on the Fed balance sheet. We covered in depth the mechanics between the different accounts at the Fed and their interaction with the economy. The conclusion there is that given the expected increases in federal spending along with the debt ceiling waiver ending at the start of next year, the TGA balance will be forced to contract, injecting liquidity into the real economy and supporting inflation volatility while also supporting risk asset valuations.

This mechanic implies that signs of growth slowdowns will spur increased fiscal deficits and accelerate the TGA account’s draining, adding to the inflationary pressure and providing liquidity to risk assets. Due to this, equities will first be sensitive to changes in the speed of growth rather than inflation, conditional on the Fed’s rate cut path being along current expectations. We can expect increased equity volatility around economic growth data relative to inflation prints, while valuations and revenue growth are supported by liquidity expanding in the real economy. This expansion in liquidity will be supportive of inflation volatility and impede the Fed from reaching its two percent target.

This is why we put a focus on monitoring economic health, namely consumer health and behavior. The NFP number from the previous Friday (act. 254k, for. 147k, prev. 159k), with unemployment ticking down to 4.1% from 4.2%, supports our American consumer thesis laid out in mid-august that consumers remain broadly healthy and supportive of spending in the economy. However, concerns remain when looking at the margins with low-income households, where delinquencies are rising. We, however, can reasonably expect that the speed of rising delinquencies will decrease as monetary easing from lowering rates trickles up to higher APR debts and reduces the interest burden for low-income households.

One interesting measure to monitor is the delta between chargeoffs and delinquencies for consumer loans. We can observe that when chargeoffs start catching up to delinquencies (essentially if you are delinquent, your probability of going bankrupt increases), then that is a sign of difficult times ahead. In the 2020 covid shutdown-induced recession, the impact on delinquencies and charge-offs was muted due to the range of consumer-supporting policies implemented to mute the effect of lost incomes. The effect can however be observed in 2001 and the GFC where fiscal stimulus was slower to come and support the economy. We currently observe the rate of chargeoffs accelerating relative to delinquencies but unemployment was rapidly accelerating during the three prior recessions; something we are not observing currently.

The ISM PMI’s also help get a sense of economic growth and we note that services are still in an upwards trajectory for the year. Manufacturing however is in contraction but we can expect to see an uplift there from loosening monetary conditions.

Given manufacturing currently composes 30% of economic activity, overall growth continues supported by services.

Now that we have some confidence in the economic trajectory for growth in the U.S. we can start thinking about which equity sectors we are interested in allocating to. Sticking to the macro synthesis nature of this note, I want to quickly look at the defensive equities before doing sector-by-sector fundamental analysis in the next one.

A quick look at the flows between defensive (utilities and staples) and cyclical (energy , materials, industrials) equities shows an interesting picture of capital guided by uncertainty.

Now, we agree with the market that uncertainty is well and thriving. However, we diverge on the efficacy of defensive equities in protecting against uncertainty, given our views on inflation. In line with our framework detailed above, equities had virtually no movement from the hot CPI print. We should continue expecting a muted impact of inflation readings relative to growth for the time being. This lack of volatility pick-up coincides with the increased positioning in defensives, which have some characteristics of long-duration bonds. Given our shorts on 20+ year bonds, we also believe that defensives will underperform relative to other equity risk profiles. The increased allocation to defensives presents an opportunity to enter or increase allocation into some equities that can benefit from inflation at attractive valuations despite all-time highs for equity indices.

The rates market justified the view laid out on Sep 29th after the CPI report, with the 30y gradually selling off while the 5y quickly rallied and retraced but remained bid on Friday’s close compared to the 30y, which keeps selling off, in part an effect of inflation volatility remaining heightened. This continues to provide justification to be long below the 5 year and short above the 20 year.

I wanted to put together this synthesis on U.S. growth and inflation in one place as a reference before exploring the equity sectors of interest. In the following research piece, I will promptly tackle these equities without macro-deviations.

In our prior research note, we established that China is experiencing a consumer-driven residential property balance sheet recession.

Fed and China go big or go home

What problem does China have, and what will be the impact of its stimulus efforts?

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Here is the conclusion we reached: