HYH Interview: Invictus Research's Mike Singleton

Hey everyone,

We’re kicking this newsletter off with my 3rd investing interview for y’all - Mike Singleton of Invictus Research is going to talk Macro with us. Previously, I ran two interviews on Deflationary Pressures and the Media Industry with two leading Anon FinTwit Analysts.

Mike and I connected back in late 2021 as he was branching out on his own to start Invictus. I’ve been following him on Twitter for a while and always appreciated his caution as the change in the business cycle started to impact the market. Secondly, as a visual learner, it’s been helpful for me to go through the videos and charts that Mike puts out. How Mike doesn’t have more Twitter followers is beyond me. His Twitter is here.

Mike’s mission statement is simple: Invictus provides macroeconomic and market strategy research to institutional and retail clients, with the goal of making hedge fund quality research available for everyone.

Here’s my interview with Mike below.

Disclaimer – This is not legal or financial advice of any kind. Nothing contained within the newsletter should be understood as investment or financial advice.

1) Okay Mike, what's your background, who are you and what's Invictus?

Funny enough, my background is in bottom-up stock-picking. My first job was at a concentrated, long-term, long-only, investment firm with a few billion under management. It was a great experience, but I realized a couple things: 1) Most of the price action for individual stocks has nothing to do with their underlying businesses. 2) Risk managing a portfolio (even a concentrated portfolio) of single names based on fundamentals alone is incredibly hard.

After a few years at this firm, I met a mentor (from a different firm), who took a more top-down approach to markets. I noticed that he was getting more calls right than I was. And moreover, he was making calls on assets I had no idea how to forecast (gold, rates, sectors, etc.). After watching him crush the market for a while, I figured it was time to put aside my pride and learn about the business cycle.

Over the coming months and years, I spent a lot of time learning about the economy, the markets, and how they interact – and that process dramatically improved my stock-picking skills. Eventually, I figured I could create more value by starting a new firm, and that’s how Invictus was conceived.

2) Why is zoning into the business cycle the first part of your process and how has learning about the business cycle shaped your investing process?

Earlier I mentioned that the majority of price action for individual stocks has nothing to do with the underlying business. So, what’s going on? The truth is, most stocks are highly correlated with both their sectors and the market-at-large. And sector performance and the market-at-large are driven by the business cycle.

At Invictus, we define the business cycle as having three constituent sub-cycles: the real growth cycle, the inflation cycle, and the monetary policy cycle. It’s that simple. These three variables drive the vast majority of price action for tradeable assets.

Scott Bessent, former CIO of Soros Fund Management, once said “People always forget that 50% of a stock’s move is the overall market, 30% is the industry, and then maybe 20% is the extra alpha from stock picking”. That breakdown is roughly consistent with our work at Invictus.

3) A lot of Bears have been ready to call a recession for the past year, but the broader market has recovered well - what's your Base Case over the next 18 months?

Unfortunately, our outlook over the next few quarters is quite bearish. In 2022, we saw a considerable interest rate shock. The Fed hiked 425 basis points in 12 months (1/1/2022-12/31/2022), and currently, the FOMC dot plot is penciling in a terminal rate of 5.00-5.25%. Consequently, the entire US interest rate complex rapidly moved higher.

As Milton Friedman famously said, interest rate policy affects economic conditions on “long and variable lags”. The big question is: how long? At Invictus, we’ve done quite a bit of work on this, and our models suggest a lead time of 16-18 months. That implies a nonlinear decline in growth (employment, production, incomes, consumption) in late 2023 or early 2024.

Ahead of that, we want to be positioned defensively. Within equities, that means overweighting large-cap, low-beta, defensive sector exposures. And we want to be opportunistically shorting (or underweight), small-cap, low-beta, cyclical exposures. Within credit, that means more investment-grade and less junk.

But, every dark cloud has a silver lining. Our models suggest that growth (and therefore equities) is likely to bottom toward the middle of 2024. Of course, making forecasts 15 months out is hardly an exact science, but that’s our base case right now.

A quick note on sentiment before I move on (because you mentioned it!). A lot of investors twist themselves into pretzels worrying about whether consensus is too bullish or bearish. Here’s a rule of thumb: sentiment tracks price! And price tracks the fundamentals. If you focus on getting the fundamentals directionally right, you’ll usually be ahead of the crowd. 

4) What cracks have you been seeing so far in the markets? Any canaries in the coal mine?

The US economy has been slowing since Q1 of 2021. A lot of investors don’t realize that. However, it’s been slowing from a very high level (the post-COVID reopening). Consequently, until Thursday (4/6), the labor market has appeared largely “resilient”. In other words, headline measures of labor market health have remained strong (the U-3 unemployment rate initial claims, etc.).

However, as of Thursday (4/6), we are starting to see signs of preliminary weakness. First, initial jobless claims (a proxy for layoffs) for most of 2023 were just restated higher. They’re still low in absolute terms, but they’re now moving in the wrong direction. Second, layoff announcements (courtesy of Challenger, Gray, & Christmas) have been trending higher. Finally, the ADP payrolls report on Wednesday was weaker than expected. And if you look at the labor market internals, some of the most significant weakness was in manufacturing (30,000 net layoffs). Historically, manufacturing layoffs are the “canary in the coal mine”. When manufacturing employment starts to give out, that’s when you know monetary policy is starting to significantly influence mainstream economic conditions.

5) A lot of investors got caught pretty flatfooted when markets shifted 16 months ago - what did they get wrong that should've been obvious in hindsight?

It sounds silly to say, but virtually every market participant (even the "seasoned pro") was caught off-guard by how seriously the Fed took its price stability mandate. It was relatively easy to forecast a directionally more-hawkish Fed with headline CPI comping 7%+ annualized by late 2021. But, very few investors expected the most aggressive monetary tightening since Paul Volcker (four decades ago!). The result was a blood-bath for anyone exposed to "duration" as a risk exposure. One of the lessons here is: "listen to what the Fed is communicating to markets!" Chair Powell was very clear from the start about how seriously he took inflation. For most of 2022, the consensus refused to listen.

6) In what ways could your Base Case be proven wrong? If things go differently from what you expect - why would that have been the case?

There are, of course, many risks to our outlook. However, there’s one that we find especially credible.

It’s possible that Fed is unable to induce widespread manufacturing layoffs as quickly as historical business cycles suggest. Why might that happen? US manufacturing companies may have “whiplash” from firing workers through COVID, quickly re-hiring them afterward, and now being induced to fire them again. Such rapid back-and-forth has both logistical risks and reputational risks. It’s possible that manufacturing companies are willing to watch margins decline for longer than they would through a “normal” business cycle before significant layoffs. This would elongate the Fed’s tightening schedule. It’s not our base case, but it is possible. 

7) Inflation and Rates: Are we finally entering a time where inflation proves transitory or is there stickiness at play that will keep Inflation above the 2% target? The Market thinks the Fed is cutting rates by June - do you believe this?

Forecasting inflation past the current business cycle is a tricky exercise… and generally beyond our investable time horizon at Invictus. That said, we expect a return to 2% inflation over the long-run. To understand why, let’s think about what’s caused the current inflation.

1. Immense monetary and fiscal stimulus pushing out the aggregate demand curve.

2. Global supply chain bottlenecks (due to COVID and attendant lockdowns) pushing in the aggregate supply curve.

Higher demand against reduced supply is a textbook recipe for high inflation. The long-term question is: will those drivers be persist past this current business cycle? At Invictus, the house view is no.

This past cycle will likely leave a very sour taste in the mouths of policy makers – and we expect them to be gun-shy about implementing the same “tools” next cycle.

Where could we be wrong? We find the lack of investment in fossil fuel production to be a credible case for structurally higher inflation. No matter how you measure it, energy investment is down considerably over the last 8 years; and as it happens, the price of oil and inflation has a very close correlation. The higher oil goes, the higher inflation goes. If we see structural oil shortages through the next decade, higher inflation is a foregone conclusion. That said, we think higher oil prices probably induce a supply response sooner than most “oil bulls” expect.

8) How about the High Yield market - what's your view on credit spreads?

Credit spreads trade with a leading ~75% inverse correlation to economic growth (for example, the ISM Manufacturing PMI). Given that we expect growth to continue slowing in the coming months and quarters, our expectation is that spreads widen. Generally speaking though, we don’t see spreads “blow out” unless there’s a nonlinear break in the labor market. And that may take several quarters to materialize. As a result, we don’t love shorting credit, especially since the cost of carry tends to be very high. There are better options if you’re looking to short.

9) Thank you Mike, this has been incredibly helpful - What's the closing message you'd like to convey to readers?

Thanks for having me. My closing message is: watch the business cycle! Unless you’re running a factor/sector/beta-neutral book, you’re always making a “macro” bet… whether you know it or not! Understanding the business cycle can enhance virtually any investment process and it will save you massive headaches.

At Invictus, we specialize in making macro simple. We deliver hedge fund quality investment research over video at a retail friendly price point. Use the discount code HARRY for a one-month free trial!

That concludes the interview. I hope everyone found it insightful!

Coming up on the newsletter over the near-term, I’ve been working away at an incredibly comprehensive credit recruiting guide. It is quite extensive and is an unfiltered look into my perspective and advice on recruiting for seats coming out of college and at a junior level.

Thanks again to Mike, be sure to check out Invictus!

That’s all for now, speak soon.

Best,

HYH