February 1, 2023 • 47 mins
It was looking bad there for awhile for Team Transitory. Anyone who had previously even uttered the word "transitory" in regards to inflation was regretting having used it. But lately the term is creeping back in, particularly as inflation decelerates while the unemployment rate remains low. So was the transitory perspective right all along? And is the fabled "soft landing" actually here? Macquarie Capital strategist Viktor Shvets believes it is. On this episode, the return Odd Lots guest gives his view of the economy and why he never gave up on his transitory stance. He talks about why inflation is falling and how many sources of anxiety — from geopolitical risk to deglobalization — won't materialize in the manner that many people are expecting.
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Episode Transcript
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Speaker 1 (00:10):
Hello, and welcome to another episode of the All Thoughts Podcast.
I'm Tracy Alloway and I'm Joe. Wisn't Joe? Uh? Soft
landing seems to have sort of it's in the air.
It's almost consensus at this point. I mean, markets are rallying,
shrugging off a lot of the survey data which looks
a little bit more pessimistic, which is all kind of
(00:32):
strange because you still have big segments of the market,
like bond yields, for instance, pointing towards recession. Yes, that's
the really weird part to me, So risk asset stock market,
really nice start to the year, much different tenor than
in head in two. We are recording this January. As
of right now, the NAS deck is up seven pc.
(00:53):
Of course you got clever last year, but you know,
you look at something like the short end of the
curve three month two year markets are pricing in rate
cuts really soon. Into my mind, I'm like, they're only
going to happen if there's like a recession or some
hard landing. Like it's hard for me to reconcile what
we're seeing in different parts of the market right now. Absolutely,
and it is. It does seem to have happened very quickly.
(01:15):
The shift to you know, everyone's focused on China reopening,
that unfolded pretty fast. Lots of the soft landing talk
seems to have sort of come out of nowhere. You know,
two or three months ago, everyone was talking about entrenched inflation,
the possibility of a wage price spiral. But given the
shift in sentiment, I think we need to speak with
(01:36):
someone who has been consistent in their view that the
world could avoid a high inflationary regime absolutely, because you
have a lot of people going back and forth. I
even saw something in the Wall Street Journal that's like
maybe it was transitory all along, and we hadn't heard
that word, and no one dared uttered it for like
six months, and everyone was ashamed at ever even having
(01:58):
used that term transit worry, and that was suddenly it's
creeping back that maybe that a lot of the inflation
really was due to these like massive shocks we experienced,
the pandemic in the war, and that as these things
at least normalized to some extent, that the residual inflation,
the entrenched noess would not be as high as some
people were concerned about. Right, So today we're going to
(02:19):
be speaking with someone who was always on Team Transitory,
who never left and defected like a lot of other people.
I'm not going to name any names, but someone who
has been I use that word consistent, someone who has
been sort of banging the drum of this idea that
actually a lot of the pandemic related disruptions might go
away and we might return to more of what we
(02:41):
saw over the past few years or so, you know,
low interest rates, lower growth, that sort of environment. So,
without further ado, today we're going to be speaking with
Victor Schwetz. He is, of course global strategist over at
McQuary Capital repeat a lots guest, one of our favorites. Victor,
thank you so much for coming on our parts. Thank you,
thank you for having me. So what was it like
(03:04):
being on Team Transitory for the past year or so.
I loved it um But for very simple reason. Whenever
everybody agrees you know something is wrong, you know you
need to get away from that. With inflation, I never
felt I needed to get away. And the primary reason
for me was that inflation that we have witnessed really
(03:25):
have nothing to do with demand. If you think of
the global economy, we are still below the trajectory pre COVID.
In other words, global demand is less than what it
would have been if there was no COVID. The only
country that it's slightly different is the US. But even
in the US, the aggregate demand is only about ninety
(03:46):
bits higher than it would have been if there was
no COVID. So it's not so much aggregate demand. Rather
it is a disruption, unprecedented disruption of the goods market,
services market, labor market that was responsible for that. So
if you think of the goods market, for example, if
we go back eighteen months ago, goods demand in the
(04:06):
US and in Europe we're about ten to fifteen percent
higher then it would have been pre COVID. So even
if there was no disruption in ports, there was no
disruption in supply, there was no way supplies could have
expected demand to be fifteen percent higher than what it
was today. If you think of Europe, goods demand is
(04:27):
already below the pre COVID trajectory. If you think of
the United States, it's right back to where it should
have been if there was no COVID. But then before
we normalized goods, we started destabilized services. So you find
if you go back eighteen months ago, services would have
been in the US about fift lower then it would
(04:48):
have been pre COVID. Today they are within two percent
of COVID. So in other words, services pretty much recovered.
So even before we normalize goods, we started to destabilize serve.
But theoretically, just like the goods market eventually normalizes, services
market will eventually normalize. And the only problem, and that's
(05:10):
your transitory part. The only problem if inflation become embedded
in a goods market, in the labor market, in the
wages market, as well as in the financial markets. And
my argument for the last twelve months was that I
don't see any evidence at all of embedding. Now, if
you don't have the evidence of embedding, then inflation should
(05:30):
come off pretty quickly, very similar what happened in nineteen
forty six nine, and central banks then will adjust their
policies accordingly. So the reason I was not in favor
of a global recession is that I never felt that
we need to destroy demand in order to lower the inflation.
It's interesting, so it's almost like the issue is not
(05:52):
aggregate demand. It's almost like the issue is disaggregated demand.
It was this shift, and we have an infrastructure there
was sort of designed for one sort of pattern of
consumption and a certain amount of good, certain amount of services,
and it was this shift. You know, there still is
this fear of embeddedness and that you know, and people
who are against team traditors like, yes, we know all
(06:14):
the shocks or nother thing, but it doesn't matter because
if inflation is elevated for too long, it can risk
becoming embedded. What is that process? What does that mean
in your view for how could inflation become embedded? Well,
you're absolutely right, the longest lost, the more likely it
is to become embedded. But we live in a very
(06:34):
different and unusual world in a sense that unlike nineteen
sixties and nineteen seventies, where we had pretty much, certainly
from late sixties into early eighties pretty much inflationary prescious,
was not any disinflationary off sets or ES two thousand,
when we had pretty much dec inflationary prescious with no
(06:55):
inflationary off sets. Today we have boats we have very
strong disinflationary pressures. That's your circular stagnation. In other words, demographics,
inability to add labor inputs, things like wealth, extreme wealth inequalities,
things like technology, things like financialization and indebtedness. They're incredibly
strong and they create a disinflationary backdrop. Now, against that,
(07:21):
you need to look at frequent black swans and fat tales.
That's what we keep discussing is that normal distribution of
events no longer exist. We're getting a lot of disruptions
coming in now whenever black swants arrived, and they could
be health scare driven, they could be geopolitically driven. What
we have we have inflationary spikes that occur. But as
(07:43):
soon as those pressures received either from a health scare
or your political perspective, disinflation comes in very quickly. And
so because of this disinflationary backdrop, it's incredibly hard to
embed expectation because you're not on a one way street,
either as if I ancial markets or the labor market
or the corporates sink of corporates. Corporates these days they
(08:05):
regain pricing powerful la a quarta too, and then they
lose it, and then they gain it again or somebody
else gains it. There is no consistency of corporate pricing power.
There is no consistency of the labor pricing power, in
which case it's very, very hard to embed those sorts
of expectation. I was about to ask you, what do
(08:40):
you say to critics who who maybe argue that it's
too early to declare a win for team Transitory, given
that CPI is still at six point five percent. But
it sounds like you're making the argument that we can
get these recurring spikes of disruption related inflation, but then
the deflation narrative will like rapidly reassert itself. So may
be a different way of asking that question. What would
(09:03):
change your mind when it comes to endemic inflation? Is
there something that you're looking out for for a sign
that the regime really has changed. Yes, a couple of areas.
One of them is deglobalization. One of the things that
I've been debating whether diglobalization, as it progresses over the
next ten ten years, whether it's inflationary, because the underlying
(09:27):
idea is that the essence of globalization is arbitrage of cost,
arbitrage of efficiencies opportunities. As you diglobalize, that arbitrage goes away,
and therefore its inflationary. One of the things I've been
arguing is that this time around, deglobalization will not be inflationary,
and there are a couple of reasons for that reason.
(09:47):
Number one is that labor is increasingly smaller percentage of
the arbitrage. So if you go back twenty thirty years ago,
labor in the let's say lab intensive industries like closing
and footwear, would have been sixty arbitrage. Today it's only
in some of the new industries labor is as little
as five percent, So, in other words, labor is no
(10:09):
longer as critical as it was twenty or thirty years ago. Secondly,
unit labor costs in emerging markets have gone up. In
other words, wages have increased faster than productivity, So in
other word, the opportunities for barbitrage is getting less. The
third area is services. This day's services is one third
of merchandise trade. You basically cannot do merchandise trade with art.
(10:33):
Services and services have very different dynamics to merchandise trade.
It can be located in various jurisdictions. It's much less inflationary.
The other thing to remember, of course, is technology. Think
of the United States. United States between nine two thousand
seven d industrialized. Basically, you had manufacturing output in the
(10:53):
US growing only one one and a half percent paranum.
Global growth was more like three and a half four percent.
In other words, US market share has rapidly declined. If
you look over the last decade, US has been matching
global numbers. Manufacturing output's been growing at three three and
a half percent every year. Now the reason for that
US is re industrializing, But US is re industrializing in
(11:17):
a very different form. This is not nineteen sixties nineteen seventies,
much less fixed assets, much less labor, more robotics, more automation,
and so you don't see it really in a labor force.
So as a percentage of labor force, manufacturing is down
relative to what it was ten years ago, down from
nine to eight point four percent. But US is reindustrializing.
(11:41):
Was a much more flexible core structure, and so the
result is on shoring that people expect probably won't be
as inflationary as what people anticipate. So to me, there
is a debate whether you look at the impact of technology,
whether you look at the impact of services, whether you
look at the impact of labor. I just and see
it's going to be inflationary at all. As we gradually diglobalize,
(12:05):
or to put it the other way, globalization is dying
and natural deaths, and it will die over the next
ten fifteen years. A new form of globalization will emerge
which will not be dependent on relative costs or relative efficiencies.
And so that's one area. If I'm wrong on that,
then you find inflation become much more embedded. The other
(12:26):
area is easy, particularly the e pot of e G.
And so if you look at s G again, my
view is that I'm I worry about the s G
more then I worry about a gglobalization. But if you
sing of the number one, we're going to take decades
to do what we want to do. Nobody is going
to touch the sacred goals of reduction of whatever it
(12:48):
is we want to reduce, but we will be meandering
towards that goal, will be trying to reconcile those subjectives
with the realities on the ground that we're facing. And
so number one is going to take a long time.
It's going to be a lot of meandering. Number two,
we're going to cut costs, not just put on new
costs the way a lot of people are expecting. And
(13:09):
the third area is that technology is reducing the cost
of new technology as you apply it. So even if
I look at E my argument basically it might not
be as inflationary as what people expect. Now, there will
be pockets of commodities that will be inflationary. So for example, oil,
we've got plenty of world, we just don't deliver it appropriately.
(13:29):
But we've got plenty of world we call we've got
plenty of coal, which is again not using it the
way we could have used it. But there are some
commodities in the real shortage copper, nickel, cobbalt, lithium, rare earth,
so there will be some increases and substantial increases in
the value of that. But overall, as I said, I'm
not totally convinced that E. S G actually will be inflationary.
(13:52):
And the third area is geopolitics. As you know my view,
and that's why part of my portfolio is what I
called bullets and prey. Sasons for the last ten years
is that I believed in the geopolitical and social dislocation
for a decade now, and I can believe that the
next ten years could be even worse than a ten
years we've experienced so far. But geopolitics is a process,
(14:14):
it's not an event. In other words, I usually say
it took Hitler fifteen years to come to power, so
it doesn't happen overnight. And so the critical area to
me is judging the periods where geo political pressures might
be less acute and identifying periods where your political pressures
will be more acute, recognizing that over ten fifteen years
(14:36):
period it's going to be worse, but there will be
windows of two or three years when those pressures actually
will be less prevalent. And I think twenty twenty three
and twenty twenty four will be a period of lower pressures,
not higher pressures. There are so many different threads there.
That was such a fascinating answer. I want to talk
(14:56):
more about geopolitics, but before I want to actually go
back to what you're are saying about the reindustrialization of
the U. S economy, because I think that's really fascinating, particularly,
you know, thinking about the impact of some of the
big legislation that was recently passed in the United States,
the Chips Act, which attempts to onshore recreate a domestic
semiconductor capacity, and of course the Inflation and Reduction Act,
(15:19):
which has incentives for domestic battery manufacturing other things like that.
Can you talk a little bit more about what this
new vision of a sort of re industrialized United States
economy looks like and how you see the pretty big,
substantial sort of industrial policy spending plans sort of moving
the dial. I usually like to compare us to China,
(15:41):
and I basically say sink of China as the equivalent
of the United States of nineteen seventies. China today responsible
for about global manufacturing. China today is very heavy in
fixed assets, very heavy in manufacturing, very low on cash flow,
relatively low and intellectual inputs. This is exactly what United
(16:03):
States look like in nineteen seventies. So China is in
the very earlier stages of conventional d industrialization, whereas US
on the opposite side. And that is why people in
Michigan and are higher voting the way they do. It's
already had the body blow of the industrialization and all
the social consequences, and now they're approaching it from a
(16:26):
different direction. How do we re industrialize in a different form.
And by the way US re and re industrialization started
a decade ago, this is pre dates Biden, It predates
any of the plans, because there are obvious ways of
on shoring now at a very different cost structure and
a very different positioning. That's why for a decade now,
(16:47):
manufacturing output in the US was broadly matching the global
manufacturing output, and US market share can no longer decline.
So the interesting thing to me is that if I
think of the US, twelve thirteen million people are so
in manufacturing, they are generating manufacturing out but half of China's. Now,
if you think of China, nobody really knows the numbers
(17:09):
in the sense that we only measure urban employment, but
there's also a lot of rural employment which actually directly
or indirectly feeds into manufacturing. So there's all sorts of estimates,
but the numbers are anywhere from eighty two hundred and
fifty million people involved directly or indirectly in manufacturing. So
think of it this way, twelve million in the US
(17:30):
generating half the output of what million China labors and
and workers are manufacturing. That tells you how much more
productive it is and what sort of malowa unit labor
costs you're gradually getting in the US. So the way
I look at chip ACT and everything else is it.
US finally recognized that instead of just staying ahead of China,
(17:55):
they do need to slow down China. In a sense,
they do need you put China at least couple of
generations behind. And the problem is, in my view, there
is not much China can do about it, because at
the end of the day, it's not about billions of
dollars you want to spend. It's about science. And the
(18:15):
reason Trump administration first stuff and then Biden administration were
so successful at kneecapping the high tech industries in China
is because China completely depends on the Western intellectual contribution.
If you cut it off, then the ability of China
to maintain its position and improve its position is very
(18:37):
significantly retarded. So the way I look whether you look
at batteries where they look at rare ars, and materials
where they look at by attack, where they look at chips,
the idea is to try to put you as even
further ahead and strategically, to me, that is the right approach. Ultimately,
ultimately nobody can hold anybody back or any length of time.
(19:00):
But given the predominance of the US in intellectual sphere,
given that almost everybody realies in some form on the
intellectual contribution of the United States, they can actually widen
the gap against China. So that's the way I look
at that. Not so much there is a plan for
re industrialization as such, that's been happening for a while,
(19:22):
but shift the United States even more towards the frontier. China,
on the other hand, is facing a period of conventional
de industrialization over the next decade or two, which they
need to they need to challenge how to do that.
They also face agricultural revolution. China had many revolutions, but
agriculture was not one of them. So China has a
(19:45):
much lower output in agriculture, even though they deploy two
million people in this area you asked as a fraction
of that, and a much larger agricultural output. So China
is facing conventional the industrial sization, it's facing agricultural revolution
or improvements and yields in agriculture that they need to do,
(20:06):
and many other aspects compared to US. Was just focusing
on reindustrializing in a different form. Just on the topic
of China. You know, we mentioned in the intro that
the reopening has become a big theme in markets. The
prospect of China really trying to restimulate economic growth, and
it does seem like to some extent they are opening
(20:27):
these bigots of credit once again. They're rolling back some
of the previous policy crackdowns on sectors like real estate,
some aspects of consumer tech. Two questions here. One is
the China reopening going to export inflation to the rest
of the world because it stimulates higher demand or is
it going to export deflation because industrial capacity is getting
(20:49):
boosted at the same time. And then secondly, is it
possible for China to return to the period of high growth,
you know, above five percent? And you know Joe mentioned
that we're recording this on January eighteenth. I think we
had China's GDP figures just a day or two ago
coming in at sub three something like that. Yeah, Well,
(21:09):
answering sort of the second question. First, if you think
of beyond the recovery from COVID so, in other words,
beyond second half of twenty three and the first half
of twenty four, if we start looking into twenty and beyond,
I don't believe China can return back to anything like
five six percent GDP growth rates. And the reason, but
(21:31):
it is simple contribution of labor is now zero. In fact,
even if you include quality adjustments. In other words, labor
force becomes more educated over time. Even if you include that,
there is virtually no labor contribution. Secondly, capital contribution has
been very high. Look at the last year, it was
all investment that draw the China's China's performance. So the
(21:53):
result is efficiency of capital utilization is declining, Incremental capital
output ratious and eight ten times. So in other ways,
you need eight ten dollars of investment for every dollar
of GDP that you generate. That explains why China it
is reluctant to stimulate conventionally, it's reluctant to unleash infrastructure
(22:15):
and real estate the same way as they did on
the previous three occasions over the last ten years, because
they don't want efficiency of capital utilization continue to declining
or the opposite side of a debt increasing. That's why
China is caring sixty trillion dollars of debt right now.
And that leaves you only was one area of growth,
and that's multi factor productivity. So if you don't contribute labor,
(22:36):
if you constrain capital, you only have multi factor productivity. Now,
the problem is multi factor. Productivity in China has been
declining consistently for the last ten years, even on official numbers.
On unofficial numbers, it actually even bordering negative numbers. In
other words, productivity detracts from GDP growth rates. So how
do you restart productivity? Well, to me, there is only
(22:58):
two ways. Whither you go back to the polls is
from nine eighties until GFC, and that is shrinking of
the state, shrinking of the role of state on enterprises,
opening up private sector. You either do that chances of
reversal of policy that they had since two thousand eight
for the last fifteen years, and that is the opposite
(23:19):
of it, growing state on enterprises, growing the role of
the state. Chances of that reversal occurring is near zero.
So what else do you have, Well, the only other
way to grow productivity is through technology. This is your robotics, automation,
fusion of infotech, bi attack, this is the alternative energy
transport platforms. But this takes a very long time to
(23:40):
come to pass. It's a right approach, it's totally right approach,
but it takes a very very long time. So the
only other way to try to grow productivity is to
mix and match all of that as much as you can,
and embark on domestic services agriculture. We just talked about
agricultural revolution improving domestic productivity now, so to me, when
I combine those numbers, I can't really see how they're
(24:03):
going to come back to five six groce rates. And
if they do, they're either committing even more capital, which
means efficiency capital utilization declines, or somehow they find a
way of growing productivity at a faster than I expect
to at our pace. So that's that second question. The
first question is harder because if you say, of the
(24:23):
first question, the opening up was so chaotic and so
rapid that it creates most positives and negatives. First of all,
you have a spread of COVID, you have meltdown of
some of the production and capacity. But on the other hand,
you have a promise of much more rapid recovery. Because
there has been massive accumulation of cash, just like in
the United States, just like in the UK, that cash
(24:46):
will be drawn down as we go into the second
half of twenty three and the first half of twenty four,
so there will potentially massive increase in consumption occurring at
the same time China is trying to control capital. In
other words, you want to grow infrastructure but not too much.
You try to allow real estate to stabilize, but you
don't really want to have a major real estate cycle.
(25:09):
So depending how China balances investment versus consumption, and depending
how much it recovers, it could be the case that
suddenly China might demand another one million or two million
barrels of oil. For example, our in house forecast right
now is six hundred thousand barrels, which means it's more
or less offsets weakness elsewhere. At the same time, more capacity,
(25:32):
as you correctly says, comes in and therefore more deflation
is coming into the system. So my view right now
is that the positives and negatives in the short term
balance and therefore China is not going to be an
inflationary agent. But longer term, as I said earlier, I
really can't see how they consistently can return to five six.
(25:53):
It is interesting if you look at the price action
in the market. We've seen a big surge in copper,
which you would associate with infrastructure investment, and not that
big an increase in oil prices, which is what you
would associate with greater demand. Maybe maybe in the second
half speaking of China, and I wanted to go back
to your point about geopolitics and these are a long
(26:16):
term process, but you think maybe the next two years
might be a little more mild on the headlines. I
feel like that's always a risky car. But what what
makes you think that, How do you even begin to
analyze a question, Oh, is this going to be like
a sort of hot year, volatile year versus a less
violatile I wanted a couple of ways to look at it.
In my view. First of all, nobody pushes the envelope
(26:38):
all the time, because if you push people for too long,
people become tired, they become irritated, whether it is domestic policies,
whether it's international policies. And that's why even during wars,
you don't have consistent wars. You have flare ups, and
then you have relative quiet. In other words, to put
it the other way, we don't kill each other every day.
(27:00):
And so the key from an investment point of view,
in my from my perspective is to say, first of all, Russia, Ukraine,
have you seen already the peak of economic commodity and
political disruption out of Russia Ukraine. The answer to me categorical, Yes,
we can debate in three. Inevitably, Ukraine's will attack, Russians
(27:21):
will counter attack. Russians will attack, Ukrainians will counter attack.
But it appears to me more likely that neither side
will be able to overwhelm the other, which implies that
sometimes to twenty three or into early twenty four, there
has to be a process whereby they will draw the
dotted line on the map. Nobody will agree on the conclusion,
(27:41):
because what Russia offering Ukraine will never Ukraine will never accept.
What Ukraine is offering to Russia, Russia will never accept.
But drawing a dotted line like North sas Vietnam and
North sas Korea, himalayas Kashmir, that is a very likely proposition.
Then you go onto other areas in a okay, China
(28:01):
was over the last four or five years or almost
ten years, on a civilizational mission. In other words, how
do you reshape society? How do you reshape politics? Higher
reshaped gear politics, whether it's a trading rules, internet rules,
information rules. I think over the next year or two
there is no doubt that China shifted much more to
(28:23):
prioritizing economic stability and growth rather than anything else, and
overcoming COVID. So I think it will be I think
China will be focusing on different things. Now. It doesn't
mean the China will not react to whatever happens in
Taiwan Straits. It would, but the degree to which China
will go out of the way in order to aggravate
(28:45):
the tension will be much more limited. And if you
look at the Middle East, for example, you could argue
that one of the underrated things clearly of Trump administration
was Abrahama courts, because they're basically what they've done, that
through the line who is the enemy and who is
a friend, And as soon as you draw the line,
it actually usually leads to a stell mate. In other words,
(29:07):
nobody reconciled with anybody, nobody trust anybody. But on the
other hand, you don't have a chaos that usually prevails
in the Middle East. So when I look at it,
the key areas where tektonic plates collide and where earthquakes
are likely to happen, which is Ukraine, Belarus, which is
Balkan's Middle East, the Himalayas, and Nata wants trades. I
(29:30):
actually think the next couple of years is not going
to be Now. Am I confident? Of course not nobody
can be. But I think it's a bit unlikely that
we're going to have a spike anything equivalent to what
we have experienced with Russia Ukraine. Speaking of tectonic plates
and the possibility of antagonistic battles, maybe we should talk
about central banks and markets because there does seem to
(29:52):
be an element of tension here where the FED is
talking about it wants to go hard on inflation. It
cares about financial conditions tightening, and yet we've seen risk
assets rallying recently, financial conditions loosening. Um. Meanwhile, we're again
we're recording this on January eighteenth. We just had the
Bank of Japan decision. A bond market in Japan certainly
(30:15):
seems to be pushing up against the central bank there.
How long can this tension go on for? Is there
going to be a time or an event that maybe
pushes markets and central banks into direct opposition. It all
comes down to inflation, coming back to the starting point,
(30:36):
what is inflation, how embedded it is, how much disinflation
is going to come through? Because central banks have to
be hawkish and the reason they have to be hawkish.
As you correctly said, the market is a forward looking machine,
and the market anticipating either or recession or greater disinflation
coming through. So if you are easing off on your policy,
(31:00):
what you find is that financial condition index will ease
very rapidly and before the time when you, as a
central bank are comfortable that you know in a position
where you want to be. Not to me, the markets
are absolutely correct. What you're going to get, You're going
to get longer term less gross, longer term less inflation,
(31:21):
circular stagnation, the old Larry Summer's words are well here.
He basically re enacted the old theory back from But
circular stagnation is back at the heart of the system
that we run, and so central banks need to get
around to that point. Now. My view, certainly for the
last twelve months, was that sometime in twenty three, also
(31:43):
I should say late twenty two, central banks will start
changing the rhetoric. Well, if you think of November December
twenty two, they already started doing it. They're already talking
of dual mandates. We don't just have inflation, we need
to balance inflation and grows if you're seeing AVCB, they're
still talking now more they're talking more about dual duality
or what they deal with. I think all of that
(32:04):
will become more pronounced as we go through the said
first and the second quarter of three, sometimes in twenty three.
I think we'll get on the same page. Now, I
to some extent depends on China, as we discussed earlier,
and how much it boosts the global economy and inflation.
But in my books, as Federal Reserve, who will start
cutting rates? QT will end sometimes to twenty three. I
(32:28):
always point up the middle of twenty three, but it
could be later, but QT will end as we go
into twenty twenty four. I think not only the rates
will be cut, but some version of keys also will
come back, and that will push you up in terms
of growth, up in terms of interest rates down. Now,
if you think of equities, what is equities? Equities is
(32:48):
earnings per share risk free rate and equity risk premiums
now earnings, but share will be more constrained because as
I said, we are in twenties three, we're probably going
to have two percent global GDP growth rates. Remember, even
the US equities as days have close EPs relationship to
global GDP than they do to US GDP, So you're
going to get more restricted EPs even in twenty four.
(33:10):
You're not going to return back to ten twelve percent
EPs growth rates, but there is no need for massive
cuts to negative ten NEGATIVEPS. So from an investor point
of view, you basically know, yes, you'ly scanning close to zero,
but you're not going to collapse in EPs. Not the
second part of each, which is risk free rate and
equity risk prem um. What we've just discussed this environment
(33:31):
where risk free rates will be lower, and at the
same time equity ris prem ums also could be lower
because we've avoided the worst outcomes. We've avoided bankruptcies, were
avoided the worst possible outcomes. So to me, it's almost
like a goldilock that is likely to occur. And that's
why in Avember last when when I previewed twenty three,
(33:52):
I basically argued that twenty three is likely to have
a much better risk reward balance than two, perhaps lower
or two. Then twenty two doesn't mean equities as an
asset class will appreciate significantly, but it doesn't mean that
you need to cut another out of the current equity value.
It's almost like mini gold Dellow emerging. Just on the
(34:31):
topic of financial conditions. I have a slightly weird question,
but I feel like you're a good person to ask
weird questions. If most of the inflation is about, you know,
we can call them transitory or transient or narrow disruptions,
then do financial conditions actually matter when it comes to
(34:52):
bringing down inflation. It's a good question because if you
think about the same applies to the yield curves and
extend to which the yield curves convey the right information
to you. When a lot of people and a lot
of businesses no longer depend on the banks and the
bank's lending, you have the bond markets, you have a
wholesale you have a shadow banking. Yet that there's so
(35:13):
many other things in there. For financial condition index is
basically amalgamation of various spreads. Which is a high yield market,
which is triple see debt, which is volatility of the
bond market, volatility of equity markets. So it's got a
variety of those elements in one number. As any given number,
it's not perfect because there's just too many elements together,
(35:34):
but directionally they are correct, so you find when you
do have an easy or financial condition index. On balance,
you would argue that it is easier to transact, It
is easier to do stuff than it was before, which
means it does support more economic activity. But this idea
that you as soon as you go into you know,
(35:57):
inverse yield curves for a period of nine months, you
always have recession. I think this is very much industrial
age idea, going back the fifties and sixties and seventies,
eighties and nineties. So I don't necessarily buy that that
is the and by the way, it can be reversed overnight,
because you remember, not only we have ample capital, because
(36:18):
we have more capital than we need, which is very
unusual in the human history. We always had shortage of capital,
but we have more capital than we need. But at
the same time, we did fully digitized, which means investors
can react in a split second. It means central banks
can react in a split second. That also means communication
policy is a single most important tool that central banks have.
(36:42):
And so and so to me, the inversion of the
ILK curve could disappear in the afternoon. It really could
take just a couple of hours, and there is no
inversion occurring. I want to talk about that further. I mean,
you anticipate in my next question, and I mentioned in
the very introduction, you know, the short end of the
curve is interesting because it implies, right that cuts are
(37:02):
coming soon. If you take it literally, the three month
two year portion of the U S y old curve
negative fifty eight, it's like basically the lowest since the
Great Financial Crisis? Is the Fed going to be cutting soon?
What would it take? Would it take recession, would it
merely take disinflation? Like what would it take in your
view for the Fed to go into rate cut mode? Well,
(37:24):
and the other question is doesn't really matter that the
l you've just mentioned and if that number persist for
a period of time, does it really matter to what
you do and what the economy does? Now? My view,
my view is that what we're going to see, it's
sort of describe it as a pendulum. If you remember
last time we talked that what we have is a
(37:45):
rapid pendulum shifts from one direction to another. And that's
why my view was that inflation is going to fall
much faster then what Federal Reserve or central banks believe,
and in fact, the spectrum disinflation could become much more
pronounced as we go towards the end of twenties three
into twenty four. As I said earlier on, China could
make a very significant difference to what will happen, But
(38:08):
that still remains my my base case. So it comes
back to inflation, disinflation and growth, extent to which Federal
Reserve and other central banks feel comfortable that inflation is
not a persistent problem, that it's not embedding itself, that
a lot of elements were truly transient rather than necessarily
embedding themselves into wages market, labor market, or protocol or
(38:31):
goods markets, in extent to which the second part of
the mandate, which is to do with maintaining certain level
of economic growth rates, becomes much more important. So if inflation,
if we if the pendulum theory or the pendulum framework
is correct, and if inflation comes down much more rapidly
than they expect, it's plausible that we could get cuts
(38:54):
even in the absence of recession, just because they want
to maintain their unemployment exactly okay, exactly right, And that's
where the balancing. So what you find you have more
and more governors because the way fair federal reserve communicates.
It basically gets those governors to talk publicly, and so
more and more those governors will be coming out and saying, well,
I think we've done a heavy lifting. They'll be saying
(39:15):
things like, you know, monetary policies work with a variable
and long lacks. They will start talking about, we need
to think about maintaining our employment and growth at an
acceptable level. So you get a lot more of that
communication coming out out of all of the center, and
as soon as federal reserve changes, other central banks will
(39:36):
follow suit. Now there are a couple of unusual players.
One of them is clearly China, which because of the
close nature of the economy and because it's state capitalism economy,
it doesn't really conform to those cycles that we've just discussed.
And the other one is is Japan and the extent
to which Japan is on a different tension compared to
(39:58):
everybody else. But if you think of a federal reserve,
if you think of ECP, if you sink a bank
up Canada, if you think of b o E, all
of them I think will be pretty much on the
same on the same page. And the only question is
and that's legitimate debate where the central banks will overtighten
h and whether in fact central banks will perpetuate policy
(40:21):
errors without reversing them. My view is no, even if
they overtighten, they can reverse it in split second. That
comes back to my argument that we have surplus of capital,
not shortage of capital. Remember u S liquidity system. If
you think of US liquidity system, UH banks currently maintain
(40:41):
two point two trillion dollars in reverse reapers. Remember reverse
repers is just net balance of the system. So there
is a surplus of two point two trillion that banks
cannot deploy, or at least they don't see way of
deploying that capital other than depositing it with with Federal
Reserve on an overnight basis. So so, so the way
the way I look at it is that we have
(41:03):
plenty of capital, we are fully digitized, we're dependent entirely
on the communications strategy. We can reverse a bear market
in the ball market in two hours, maybe minutes, maybe minutes.
And and Joe's you correctly said, just remember two thousand
and eighteen. Remember two thousand nineteen, Remember Federal Reserve restarted
que and was scudding raids about five months Before COVID,
(41:26):
COVID wasn't even there. Nobody knew that there was such
thing as COVID, So you can see how that will
happen now. A lot of clients saying that COVID it
is such a dramatic event that we are permanently repricing capital,
permanently repricing risk. We are now in a completely different environment.
I disagree with that. COVID, in my view, accelerated some
(41:50):
of the pre existing trends. For example, these days we're
relying more on fiscal levers than what we did in
the previous twenty or thirty years. It accelerated pre existing
trends like geopolitics, for example in the Black Swans. But
otherwise I don't think it changed the nature of what
we do think of sectoral balances. Now in the US,
(42:11):
we're already drawn down private sector savings, so so you
find net savings by the private sector as of December,
as of September for two thousand and twenty two was
almost zero. Now government is not cutting savings as much,
you know, the government actually deceaving. And so the result
is what's happening is that the rest of the world
(42:33):
balance for US is growing, it's back to four. So
if you think of the U s UK, your traditional
supplies of real demand in the economy, they're already back
to pre COVID. They are already they are already generating
deficits that they require other countries to finance. That means
the opposite is also true, because it's it's an accounting,
accounting identity, it has to be true that the rest
(42:56):
of the world is going back to supplying capital. So
and so, whether I look at impact of technology, impact
of demographics, whether you look at the impact of financialization,
where they look at sexual balances, everything tells me that
we are reverting to pre COVID times and therefore this
idea that we're permanently repricing culpital cheap money is gone forever.
(43:17):
To me, that's just nonsense, Victor. I think that's a
great place to leave it. We could easily talk for
absolutely others here, But yeah, thank you so much for
for coming back on our thoughts. Really appreciate it. Thank you,
thanks so much. That was great. That really, Joe, It's
(43:46):
always wonderful to talk to Victor. But there's so much
to pull out of that conversation. I'm actually having trouble
picking just one or two highlights. I did think the
comments about globalization were incredibly interesting. And we tend to
think of globalization as this like monolithic process that can
only go in one direction. But this notion that actually
(44:06):
you can have different types of globalization with different results, right,
And so this idea is like, Okay, the world like
Davos is happening right now, and I'm sure there are
a lot of people globalization. Yeah, I wonder if we'll
ever do like a Davo anyway, Like, you know, people
are anxious about that. But this idea that it's like, well,
(44:27):
maybe it's something different, and that actually the sort of
disinflationary impulses that we associated with globalization for forty years
or thirty years, or twenty years, however long you want
to identify, maybe that hasn't been the story in a
long time anyway. And as such, the idea that COVID
was going to mark some huge trend break from that
(44:49):
is just the wrong way to think about it from
the first place. Absolutely, also, the idea that maybe the
yield curve isn't that well suited to providing information in
the sort of post industrial age. I thought that was
interesting as well, and something that I think we've written
about at various points of time, the idea that there
are so many factors that go into bond yields now
(45:10):
not all of them related to the actual real economy,
that maybe it doesn't make sense to be looking at
the old curve for that sort of information about what
the market expects. You know what a headline I'm looking
at on the terminals right now that came from earlier.
Oh god, what is it? Larry Summers now more optimistic
on the US outlook the three months ago. Everyone coming around,
everyone coming around. You know what else I thought was
(45:33):
really interesting was the comments on geopolitics that maybe we
get because geopolitics always seems like one of those things
where it's like the idea of like forecasting, or it
seems like very difficult, and it feels like the risks
are always sort of in one direction, there's some black swan.
But this idea that maybe like we're in a position
where if you look at the major pressure points, whereas
(45:55):
Victor identified the tectonic plates or the intersection points, maybe
this is a pure of some like de pressurization. I'm hopeful.
I wanted to be true. I don't know if it
will be. If it will be, but I thought that
was an interesting comment. Shall we leave it there? Let's
leave it there? Okay, this has been another episode of
the ad Thoughts podcast. I'm Tracy Alloway. You can follow
me on Twitter at Tracy Alloway and I'm Joe wi
(46:17):
Isn't Though. You can follow me on Twitter at the Stalwart.
Follow our producers on Twitter Carmen Rodriguez She's at Carmen
armand Dash Bennett He's at dashbot. And check out all
of our podcasts at Bloomberg under the handle at podcasts
and for more Odd Lots content, go to Bloomberg dot
com slash odd Lots, we posh the transcripts, we blogged.
(46:39):
We have a weekly newsletter comes out every Friday. Go
there sign up. Thanks for listening to
Hello, and welcome to another episode of the All Thoughts Podcast.
I'm Tracy Alloway and I'm Joe. Wisn't Joe? Uh? Soft
landing seems to have sort of it's in the air.
It's almost consensus at this point. I mean, markets are rallying,
shrugging off a lot of the survey data which looks
a little bit more pessimistic, which is all kind of
(00:32):
strange because you still have big segments of the market,
like bond yields, for instance, pointing towards recession. Yes, that's
the really weird part to me, So risk asset stock market,
really nice start to the year, much different tenor than
in head in two. We are recording this January. As
of right now, the NAS deck is up seven pc.
(00:53):
Of course you got clever last year, but you know,
you look at something like the short end of the
curve three month two year markets are pricing in rate
cuts really soon. Into my mind, I'm like, they're only
going to happen if there's like a recession or some
hard landing. Like it's hard for me to reconcile what
we're seeing in different parts of the market right now. Absolutely,
and it is. It does seem to have happened very quickly.
(01:15):
The shift to you know, everyone's focused on China reopening,
that unfolded pretty fast. Lots of the soft landing talk
seems to have sort of come out of nowhere. You know,
two or three months ago, everyone was talking about entrenched inflation,
the possibility of a wage price spiral. But given the
shift in sentiment, I think we need to speak with
(01:36):
someone who has been consistent in their view that the
world could avoid a high inflationary regime absolutely, because you
have a lot of people going back and forth. I
even saw something in the Wall Street Journal that's like
maybe it was transitory all along, and we hadn't heard
that word, and no one dared uttered it for like
six months, and everyone was ashamed at ever even having
(01:58):
used that term transit worry, and that was suddenly it's
creeping back that maybe that a lot of the inflation
really was due to these like massive shocks we experienced,
the pandemic in the war, and that as these things
at least normalized to some extent, that the residual inflation,
the entrenched noess would not be as high as some
people were concerned about. Right, So today we're going to
(02:19):
be speaking with someone who was always on Team Transitory,
who never left and defected like a lot of other people.
I'm not going to name any names, but someone who
has been I use that word consistent, someone who has
been sort of banging the drum of this idea that
actually a lot of the pandemic related disruptions might go
away and we might return to more of what we
(02:41):
saw over the past few years or so, you know,
low interest rates, lower growth, that sort of environment. So,
without further ado, today we're going to be speaking with
Victor Schwetz. He is, of course global strategist over at
McQuary Capital repeat a lots guest, one of our favorites. Victor,
thank you so much for coming on our parts. Thank you,
thank you for having me. So what was it like
(03:04):
being on Team Transitory for the past year or so.
I loved it um But for very simple reason. Whenever
everybody agrees you know something is wrong, you know you
need to get away from that. With inflation, I never
felt I needed to get away. And the primary reason
for me was that inflation that we have witnessed really
(03:25):
have nothing to do with demand. If you think of
the global economy, we are still below the trajectory pre COVID.
In other words, global demand is less than what it
would have been if there was no COVID. The only
country that it's slightly different is the US. But even
in the US, the aggregate demand is only about ninety
(03:46):
bits higher than it would have been if there was
no COVID. So it's not so much aggregate demand. Rather
it is a disruption, unprecedented disruption of the goods market,
services market, labor market that was responsible for that. So
if you think of the goods market, for example, if
we go back eighteen months ago, goods demand in the
(04:06):
US and in Europe we're about ten to fifteen percent
higher then it would have been pre COVID. So even
if there was no disruption in ports, there was no
disruption in supply, there was no way supplies could have
expected demand to be fifteen percent higher than what it
was today. If you think of Europe, goods demand is
(04:27):
already below the pre COVID trajectory. If you think of
the United States, it's right back to where it should
have been if there was no COVID. But then before
we normalized goods, we started destabilized services. So you find
if you go back eighteen months ago, services would have
been in the US about fift lower then it would
(04:48):
have been pre COVID. Today they are within two percent
of COVID. So in other words, services pretty much recovered.
So even before we normalize goods, we started to destabilize serve.
But theoretically, just like the goods market eventually normalizes, services
market will eventually normalize. And the only problem, and that's
(05:10):
your transitory part. The only problem if inflation become embedded
in a goods market, in the labor market, in the
wages market, as well as in the financial markets. And
my argument for the last twelve months was that I
don't see any evidence at all of embedding. Now, if
you don't have the evidence of embedding, then inflation should
(05:30):
come off pretty quickly, very similar what happened in nineteen
forty six nine, and central banks then will adjust their
policies accordingly. So the reason I was not in favor
of a global recession is that I never felt that
we need to destroy demand in order to lower the inflation.
It's interesting, so it's almost like the issue is not
(05:52):
aggregate demand. It's almost like the issue is disaggregated demand.
It was this shift, and we have an infrastructure there
was sort of designed for one sort of pattern of
consumption and a certain amount of good, certain amount of services,
and it was this shift. You know, there still is
this fear of embeddedness and that you know, and people
who are against team traditors like, yes, we know all
(06:14):
the shocks or nother thing, but it doesn't matter because
if inflation is elevated for too long, it can risk
becoming embedded. What is that process? What does that mean
in your view for how could inflation become embedded? Well,
you're absolutely right, the longest lost, the more likely it
is to become embedded. But we live in a very
(06:34):
different and unusual world in a sense that unlike nineteen
sixties and nineteen seventies, where we had pretty much, certainly
from late sixties into early eighties pretty much inflationary prescious,
was not any disinflationary off sets or ES two thousand,
when we had pretty much dec inflationary prescious with no
(06:55):
inflationary off sets. Today we have boats we have very
strong disinflationary pressures. That's your circular stagnation. In other words, demographics,
inability to add labor inputs, things like wealth, extreme wealth inequalities,
things like technology, things like financialization and indebtedness. They're incredibly
strong and they create a disinflationary backdrop. Now, against that,
(07:21):
you need to look at frequent black swans and fat tales.
That's what we keep discussing is that normal distribution of
events no longer exist. We're getting a lot of disruptions
coming in now whenever black swants arrived, and they could
be health scare driven, they could be geopolitically driven. What
we have we have inflationary spikes that occur. But as
(07:43):
soon as those pressures received either from a health scare
or your political perspective, disinflation comes in very quickly. And
so because of this disinflationary backdrop, it's incredibly hard to
embed expectation because you're not on a one way street,
either as if I ancial markets or the labor market
or the corporates sink of corporates. Corporates these days they
(08:05):
regain pricing powerful la a quarta too, and then they
lose it, and then they gain it again or somebody
else gains it. There is no consistency of corporate pricing power.
There is no consistency of the labor pricing power, in
which case it's very, very hard to embed those sorts
of expectation. I was about to ask you, what do
(08:40):
you say to critics who who maybe argue that it's
too early to declare a win for team Transitory, given
that CPI is still at six point five percent. But
it sounds like you're making the argument that we can
get these recurring spikes of disruption related inflation, but then
the deflation narrative will like rapidly reassert itself. So may
be a different way of asking that question. What would
(09:03):
change your mind when it comes to endemic inflation? Is
there something that you're looking out for for a sign
that the regime really has changed. Yes, a couple of areas.
One of them is deglobalization. One of the things that
I've been debating whether diglobalization, as it progresses over the
next ten ten years, whether it's inflationary, because the underlying
(09:27):
idea is that the essence of globalization is arbitrage of cost,
arbitrage of efficiencies opportunities. As you diglobalize, that arbitrage goes away,
and therefore its inflationary. One of the things I've been
arguing is that this time around, deglobalization will not be inflationary,
and there are a couple of reasons for that reason.
(09:47):
Number one is that labor is increasingly smaller percentage of
the arbitrage. So if you go back twenty thirty years ago,
labor in the let's say lab intensive industries like closing
and footwear, would have been sixty arbitrage. Today it's only
in some of the new industries labor is as little
as five percent, So, in other words, labor is no
(10:09):
longer as critical as it was twenty or thirty years ago. Secondly,
unit labor costs in emerging markets have gone up. In
other words, wages have increased faster than productivity, So in
other word, the opportunities for barbitrage is getting less. The
third area is services. This day's services is one third
of merchandise trade. You basically cannot do merchandise trade with art.
(10:33):
Services and services have very different dynamics to merchandise trade.
It can be located in various jurisdictions. It's much less inflationary.
The other thing to remember, of course, is technology. Think
of the United States. United States between nine two thousand
seven d industrialized. Basically, you had manufacturing output in the
(10:53):
US growing only one one and a half percent paranum.
Global growth was more like three and a half four percent.
In other words, US market share has rapidly declined. If
you look over the last decade, US has been matching
global numbers. Manufacturing output's been growing at three three and
a half percent every year. Now the reason for that
US is re industrializing, But US is re industrializing in
(11:17):
a very different form. This is not nineteen sixties nineteen seventies,
much less fixed assets, much less labor, more robotics, more automation,
and so you don't see it really in a labor force.
So as a percentage of labor force, manufacturing is down
relative to what it was ten years ago, down from
nine to eight point four percent. But US is reindustrializing.
(11:41):
Was a much more flexible core structure, and so the
result is on shoring that people expect probably won't be
as inflationary as what people anticipate. So to me, there
is a debate whether you look at the impact of technology,
whether you look at the impact of services, whether you
look at the impact of labor. I just and see
it's going to be inflationary at all. As we gradually diglobalize,
(12:05):
or to put it the other way, globalization is dying
and natural deaths, and it will die over the next
ten fifteen years. A new form of globalization will emerge
which will not be dependent on relative costs or relative efficiencies.
And so that's one area. If I'm wrong on that,
then you find inflation become much more embedded. The other
(12:26):
area is easy, particularly the e pot of e G.
And so if you look at s G again, my
view is that I'm I worry about the s G
more then I worry about a gglobalization. But if you
sing of the number one, we're going to take decades
to do what we want to do. Nobody is going
to touch the sacred goals of reduction of whatever it
(12:48):
is we want to reduce, but we will be meandering
towards that goal, will be trying to reconcile those subjectives
with the realities on the ground that we're facing. And
so number one is going to take a long time.
It's going to be a lot of meandering. Number two,
we're going to cut costs, not just put on new
costs the way a lot of people are expecting. And
(13:09):
the third area is that technology is reducing the cost
of new technology as you apply it. So even if
I look at E my argument basically it might not
be as inflationary as what people expect. Now, there will
be pockets of commodities that will be inflationary. So for example, oil,
we've got plenty of world, we just don't deliver it appropriately.
(13:29):
But we've got plenty of world we call we've got
plenty of coal, which is again not using it the
way we could have used it. But there are some
commodities in the real shortage copper, nickel, cobbalt, lithium, rare earth,
so there will be some increases and substantial increases in
the value of that. But overall, as I said, I'm
not totally convinced that E. S G actually will be inflationary.
(13:52):
And the third area is geopolitics. As you know my view,
and that's why part of my portfolio is what I
called bullets and prey. Sasons for the last ten years
is that I believed in the geopolitical and social dislocation
for a decade now, and I can believe that the
next ten years could be even worse than a ten
years we've experienced so far. But geopolitics is a process,
(14:14):
it's not an event. In other words, I usually say
it took Hitler fifteen years to come to power, so
it doesn't happen overnight. And so the critical area to
me is judging the periods where geo political pressures might
be less acute and identifying periods where your political pressures
will be more acute, recognizing that over ten fifteen years
(14:36):
period it's going to be worse, but there will be
windows of two or three years when those pressures actually
will be less prevalent. And I think twenty twenty three
and twenty twenty four will be a period of lower pressures,
not higher pressures. There are so many different threads there.
That was such a fascinating answer. I want to talk
(14:56):
more about geopolitics, but before I want to actually go
back to what you're are saying about the reindustrialization of
the U. S economy, because I think that's really fascinating, particularly,
you know, thinking about the impact of some of the
big legislation that was recently passed in the United States,
the Chips Act, which attempts to onshore recreate a domestic
semiconductor capacity, and of course the Inflation and Reduction Act,
(15:19):
which has incentives for domestic battery manufacturing other things like that.
Can you talk a little bit more about what this
new vision of a sort of re industrialized United States
economy looks like and how you see the pretty big,
substantial sort of industrial policy spending plans sort of moving
the dial. I usually like to compare us to China,
(15:41):
and I basically say sink of China as the equivalent
of the United States of nineteen seventies. China today responsible
for about global manufacturing. China today is very heavy in
fixed assets, very heavy in manufacturing, very low on cash flow,
relatively low and intellectual inputs. This is exactly what United
(16:03):
States look like in nineteen seventies. So China is in
the very earlier stages of conventional d industrialization, whereas US
on the opposite side. And that is why people in
Michigan and are higher voting the way they do. It's
already had the body blow of the industrialization and all
the social consequences, and now they're approaching it from a
(16:26):
different direction. How do we re industrialize in a different form.
And by the way US re and re industrialization started
a decade ago, this is pre dates Biden, It predates
any of the plans, because there are obvious ways of
on shoring now at a very different cost structure and
a very different positioning. That's why for a decade now,
(16:47):
manufacturing output in the US was broadly matching the global
manufacturing output, and US market share can no longer decline.
So the interesting thing to me is that if I
think of the US, twelve thirteen million people are so
in manufacturing, they are generating manufacturing out but half of China's. Now,
if you think of China, nobody really knows the numbers
(17:09):
in the sense that we only measure urban employment, but
there's also a lot of rural employment which actually directly
or indirectly feeds into manufacturing. So there's all sorts of estimates,
but the numbers are anywhere from eighty two hundred and
fifty million people involved directly or indirectly in manufacturing. So
think of it this way, twelve million in the US
(17:30):
generating half the output of what million China labors and
and workers are manufacturing. That tells you how much more
productive it is and what sort of malowa unit labor
costs you're gradually getting in the US. So the way
I look at chip ACT and everything else is it.
US finally recognized that instead of just staying ahead of China,
(17:55):
they do need to slow down China. In a sense,
they do need you put China at least couple of
generations behind. And the problem is, in my view, there
is not much China can do about it, because at
the end of the day, it's not about billions of
dollars you want to spend. It's about science. And the
(18:15):
reason Trump administration first stuff and then Biden administration were
so successful at kneecapping the high tech industries in China
is because China completely depends on the Western intellectual contribution.
If you cut it off, then the ability of China
to maintain its position and improve its position is very
(18:37):
significantly retarded. So the way I look whether you look
at batteries where they look at rare ars, and materials
where they look at by attack, where they look at chips,
the idea is to try to put you as even
further ahead and strategically, to me, that is the right approach. Ultimately,
ultimately nobody can hold anybody back or any length of time.
(19:00):
But given the predominance of the US in intellectual sphere,
given that almost everybody realies in some form on the
intellectual contribution of the United States, they can actually widen
the gap against China. So that's the way I look
at that. Not so much there is a plan for
re industrialization as such, that's been happening for a while,
(19:22):
but shift the United States even more towards the frontier. China,
on the other hand, is facing a period of conventional
de industrialization over the next decade or two, which they
need to they need to challenge how to do that.
They also face agricultural revolution. China had many revolutions, but
agriculture was not one of them. So China has a
(19:45):
much lower output in agriculture, even though they deploy two
million people in this area you asked as a fraction
of that, and a much larger agricultural output. So China
is facing conventional the industrial sization, it's facing agricultural revolution
or improvements and yields in agriculture that they need to do,
(20:06):
and many other aspects compared to US. Was just focusing
on reindustrializing in a different form. Just on the topic
of China. You know, we mentioned in the intro that
the reopening has become a big theme in markets. The
prospect of China really trying to restimulate economic growth, and
it does seem like to some extent they are opening
(20:27):
these bigots of credit once again. They're rolling back some
of the previous policy crackdowns on sectors like real estate,
some aspects of consumer tech. Two questions here. One is
the China reopening going to export inflation to the rest
of the world because it stimulates higher demand or is
it going to export deflation because industrial capacity is getting
(20:49):
boosted at the same time. And then secondly, is it
possible for China to return to the period of high growth,
you know, above five percent? And you know Joe mentioned
that we're recording this on January eighteenth. I think we
had China's GDP figures just a day or two ago
coming in at sub three something like that. Yeah, Well,
(21:09):
answering sort of the second question. First, if you think
of beyond the recovery from COVID so, in other words,
beyond second half of twenty three and the first half
of twenty four, if we start looking into twenty and beyond,
I don't believe China can return back to anything like
five six percent GDP growth rates. And the reason, but
(21:31):
it is simple contribution of labor is now zero. In fact,
even if you include quality adjustments. In other words, labor
force becomes more educated over time. Even if you include that,
there is virtually no labor contribution. Secondly, capital contribution has
been very high. Look at the last year, it was
all investment that draw the China's China's performance. So the
(21:53):
result is efficiency of capital utilization is declining, Incremental capital
output ratious and eight ten times. So in other ways,
you need eight ten dollars of investment for every dollar
of GDP that you generate. That explains why China it
is reluctant to stimulate conventionally, it's reluctant to unleash infrastructure
(22:15):
and real estate the same way as they did on
the previous three occasions over the last ten years, because
they don't want efficiency of capital utilization continue to declining
or the opposite side of a debt increasing. That's why
China is caring sixty trillion dollars of debt right now.
And that leaves you only was one area of growth,
and that's multi factor productivity. So if you don't contribute labor,
(22:36):
if you constrain capital, you only have multi factor productivity. Now,
the problem is multi factor. Productivity in China has been
declining consistently for the last ten years, even on official numbers.
On unofficial numbers, it actually even bordering negative numbers. In
other words, productivity detracts from GDP growth rates. So how
do you restart productivity? Well, to me, there is only
(22:58):
two ways. Whither you go back to the polls is
from nine eighties until GFC, and that is shrinking of
the state, shrinking of the role of state on enterprises,
opening up private sector. You either do that chances of
reversal of policy that they had since two thousand eight
for the last fifteen years, and that is the opposite
(23:19):
of it, growing state on enterprises, growing the role of
the state. Chances of that reversal occurring is near zero.
So what else do you have, Well, the only other
way to grow productivity is through technology. This is your robotics, automation,
fusion of infotech, bi attack, this is the alternative energy
transport platforms. But this takes a very long time to
(23:40):
come to pass. It's a right approach, it's totally right approach,
but it takes a very very long time. So the
only other way to try to grow productivity is to
mix and match all of that as much as you can,
and embark on domestic services agriculture. We just talked about
agricultural revolution improving domestic productivity now, so to me, when
I combine those numbers, I can't really see how they're
(24:03):
going to come back to five six groce rates. And
if they do, they're either committing even more capital, which
means efficiency capital utilization declines, or somehow they find a
way of growing productivity at a faster than I expect
to at our pace. So that's that second question. The
first question is harder because if you say, of the
(24:23):
first question, the opening up was so chaotic and so
rapid that it creates most positives and negatives. First of all,
you have a spread of COVID, you have meltdown of
some of the production and capacity. But on the other hand,
you have a promise of much more rapid recovery. Because
there has been massive accumulation of cash, just like in
the United States, just like in the UK, that cash
(24:46):
will be drawn down as we go into the second
half of twenty three and the first half of twenty four,
so there will potentially massive increase in consumption occurring at
the same time China is trying to control capital. In
other words, you want to grow infrastructure but not too much.
You try to allow real estate to stabilize, but you
don't really want to have a major real estate cycle.
(25:09):
So depending how China balances investment versus consumption, and depending
how much it recovers, it could be the case that
suddenly China might demand another one million or two million
barrels of oil. For example, our in house forecast right
now is six hundred thousand barrels, which means it's more
or less offsets weakness elsewhere. At the same time, more capacity,
(25:32):
as you correctly says, comes in and therefore more deflation
is coming into the system. So my view right now
is that the positives and negatives in the short term
balance and therefore China is not going to be an
inflationary agent. But longer term, as I said earlier, I
really can't see how they consistently can return to five six.
(25:53):
It is interesting if you look at the price action
in the market. We've seen a big surge in copper,
which you would associate with infrastructure investment, and not that
big an increase in oil prices, which is what you
would associate with greater demand. Maybe maybe in the second
half speaking of China, and I wanted to go back
to your point about geopolitics and these are a long
(26:16):
term process, but you think maybe the next two years
might be a little more mild on the headlines. I
feel like that's always a risky car. But what what
makes you think that, How do you even begin to
analyze a question, Oh, is this going to be like
a sort of hot year, volatile year versus a less
violatile I wanted a couple of ways to look at it.
In my view. First of all, nobody pushes the envelope
(26:38):
all the time, because if you push people for too long,
people become tired, they become irritated, whether it is domestic policies,
whether it's international policies. And that's why even during wars,
you don't have consistent wars. You have flare ups, and
then you have relative quiet. In other words, to put
it the other way, we don't kill each other every day.
(27:00):
And so the key from an investment point of view,
in my from my perspective is to say, first of all, Russia, Ukraine,
have you seen already the peak of economic commodity and
political disruption out of Russia Ukraine. The answer to me categorical, Yes,
we can debate in three. Inevitably, Ukraine's will attack, Russians
(27:21):
will counter attack. Russians will attack, Ukrainians will counter attack.
But it appears to me more likely that neither side
will be able to overwhelm the other, which implies that
sometimes to twenty three or into early twenty four, there
has to be a process whereby they will draw the
dotted line on the map. Nobody will agree on the conclusion,
(27:41):
because what Russia offering Ukraine will never Ukraine will never accept.
What Ukraine is offering to Russia, Russia will never accept.
But drawing a dotted line like North sas Vietnam and
North sas Korea, himalayas Kashmir, that is a very likely proposition.
Then you go onto other areas in a okay, China
(28:01):
was over the last four or five years or almost
ten years, on a civilizational mission. In other words, how
do you reshape society? How do you reshape politics? Higher
reshaped gear politics, whether it's a trading rules, internet rules,
information rules. I think over the next year or two
there is no doubt that China shifted much more to
(28:23):
prioritizing economic stability and growth rather than anything else, and
overcoming COVID. So I think it will be I think
China will be focusing on different things. Now. It doesn't
mean the China will not react to whatever happens in
Taiwan Straits. It would, but the degree to which China
will go out of the way in order to aggravate
(28:45):
the tension will be much more limited. And if you
look at the Middle East, for example, you could argue
that one of the underrated things clearly of Trump administration
was Abrahama courts, because they're basically what they've done, that
through the line who is the enemy and who is
a friend, And as soon as you draw the line,
it actually usually leads to a stell mate. In other words,
(29:07):
nobody reconciled with anybody, nobody trust anybody. But on the
other hand, you don't have a chaos that usually prevails
in the Middle East. So when I look at it,
the key areas where tektonic plates collide and where earthquakes
are likely to happen, which is Ukraine, Belarus, which is
Balkan's Middle East, the Himalayas, and Nata wants trades. I
(29:30):
actually think the next couple of years is not going
to be Now. Am I confident? Of course not nobody
can be. But I think it's a bit unlikely that
we're going to have a spike anything equivalent to what
we have experienced with Russia Ukraine. Speaking of tectonic plates
and the possibility of antagonistic battles, maybe we should talk
about central banks and markets because there does seem to
(29:52):
be an element of tension here where the FED is
talking about it wants to go hard on inflation. It
cares about financial conditions tightening, and yet we've seen risk
assets rallying recently, financial conditions loosening. Um. Meanwhile, we're again
we're recording this on January eighteenth. We just had the
Bank of Japan decision. A bond market in Japan certainly
(30:15):
seems to be pushing up against the central bank there.
How long can this tension go on for? Is there
going to be a time or an event that maybe
pushes markets and central banks into direct opposition. It all
comes down to inflation, coming back to the starting point,
(30:36):
what is inflation, how embedded it is, how much disinflation
is going to come through? Because central banks have to
be hawkish and the reason they have to be hawkish.
As you correctly said, the market is a forward looking machine,
and the market anticipating either or recession or greater disinflation
coming through. So if you are easing off on your policy,
(31:00):
what you find is that financial condition index will ease
very rapidly and before the time when you, as a
central bank are comfortable that you know in a position
where you want to be. Not to me, the markets
are absolutely correct. What you're going to get, You're going
to get longer term less gross, longer term less inflation,
(31:21):
circular stagnation, the old Larry Summer's words are well here.
He basically re enacted the old theory back from But
circular stagnation is back at the heart of the system
that we run, and so central banks need to get
around to that point. Now. My view, certainly for the
last twelve months, was that sometime in twenty three, also
(31:43):
I should say late twenty two, central banks will start
changing the rhetoric. Well, if you think of November December
twenty two, they already started doing it. They're already talking
of dual mandates. We don't just have inflation, we need
to balance inflation and grows if you're seeing AVCB, they're
still talking now more they're talking more about dual duality
or what they deal with. I think all of that
(32:04):
will become more pronounced as we go through the said
first and the second quarter of three, sometimes in twenty three.
I think we'll get on the same page. Now, I
to some extent depends on China, as we discussed earlier,
and how much it boosts the global economy and inflation.
But in my books, as Federal Reserve, who will start
cutting rates? QT will end sometimes to twenty three. I
(32:28):
always point up the middle of twenty three, but it
could be later, but QT will end as we go
into twenty twenty four. I think not only the rates
will be cut, but some version of keys also will
come back, and that will push you up in terms
of growth, up in terms of interest rates down. Now,
if you think of equities, what is equities? Equities is
(32:48):
earnings per share risk free rate and equity risk premiums
now earnings, but share will be more constrained because as
I said, we are in twenties three, we're probably going
to have two percent global GDP growth rates. Remember, even
the US equities as days have close EPs relationship to
global GDP than they do to US GDP, So you're
going to get more restricted EPs even in twenty four.
(33:10):
You're not going to return back to ten twelve percent
EPs growth rates, but there is no need for massive
cuts to negative ten NEGATIVEPS. So from an investor point
of view, you basically know, yes, you'ly scanning close to zero,
but you're not going to collapse in EPs. Not the
second part of each, which is risk free rate and
equity risk prem um. What we've just discussed this environment
(33:31):
where risk free rates will be lower, and at the
same time equity ris prem ums also could be lower
because we've avoided the worst outcomes. We've avoided bankruptcies, were
avoided the worst possible outcomes. So to me, it's almost
like a goldilock that is likely to occur. And that's
why in Avember last when when I previewed twenty three,
(33:52):
I basically argued that twenty three is likely to have
a much better risk reward balance than two, perhaps lower
or two. Then twenty two doesn't mean equities as an
asset class will appreciate significantly, but it doesn't mean that
you need to cut another out of the current equity value.
It's almost like mini gold Dellow emerging. Just on the
(34:31):
topic of financial conditions. I have a slightly weird question,
but I feel like you're a good person to ask
weird questions. If most of the inflation is about, you know,
we can call them transitory or transient or narrow disruptions,
then do financial conditions actually matter when it comes to
(34:52):
bringing down inflation. It's a good question because if you
think about the same applies to the yield curves and
extend to which the yield curves convey the right information
to you. When a lot of people and a lot
of businesses no longer depend on the banks and the
bank's lending, you have the bond markets, you have a
wholesale you have a shadow banking. Yet that there's so
(35:13):
many other things in there. For financial condition index is
basically amalgamation of various spreads. Which is a high yield market,
which is triple see debt, which is volatility of the
bond market, volatility of equity markets. So it's got a
variety of those elements in one number. As any given number,
it's not perfect because there's just too many elements together,
(35:34):
but directionally they are correct, so you find when you
do have an easy or financial condition index. On balance,
you would argue that it is easier to transact, It
is easier to do stuff than it was before, which
means it does support more economic activity. But this idea
that you as soon as you go into you know,
(35:57):
inverse yield curves for a period of nine months, you
always have recession. I think this is very much industrial
age idea, going back the fifties and sixties and seventies,
eighties and nineties. So I don't necessarily buy that that
is the and by the way, it can be reversed overnight,
because you remember, not only we have ample capital, because
(36:18):
we have more capital than we need, which is very
unusual in the human history. We always had shortage of capital,
but we have more capital than we need. But at
the same time, we did fully digitized, which means investors
can react in a split second. It means central banks
can react in a split second. That also means communication
policy is a single most important tool that central banks have.
(36:42):
And so and so to me, the inversion of the
ILK curve could disappear in the afternoon. It really could
take just a couple of hours, and there is no
inversion occurring. I want to talk about that further. I mean,
you anticipate in my next question, and I mentioned in
the very introduction, you know, the short end of the
curve is interesting because it implies, right that cuts are
(37:02):
coming soon. If you take it literally, the three month
two year portion of the U S y old curve
negative fifty eight, it's like basically the lowest since the
Great Financial Crisis? Is the Fed going to be cutting soon?
What would it take? Would it take recession, would it
merely take disinflation? Like what would it take in your
view for the Fed to go into rate cut mode? Well,
(37:24):
and the other question is doesn't really matter that the
l you've just mentioned and if that number persist for
a period of time, does it really matter to what
you do and what the economy does? Now? My view,
my view is that what we're going to see, it's
sort of describe it as a pendulum. If you remember
last time we talked that what we have is a
(37:45):
rapid pendulum shifts from one direction to another. And that's
why my view was that inflation is going to fall
much faster then what Federal Reserve or central banks believe,
and in fact, the spectrum disinflation could become much more
pronounced as we go towards the end of twenties three
into twenty four. As I said earlier on, China could
make a very significant difference to what will happen, But
(38:08):
that still remains my my base case. So it comes
back to inflation, disinflation and growth, extent to which Federal
Reserve and other central banks feel comfortable that inflation is
not a persistent problem, that it's not embedding itself, that
a lot of elements were truly transient rather than necessarily
embedding themselves into wages market, labor market, or protocol or
(38:31):
goods markets, in extent to which the second part of
the mandate, which is to do with maintaining certain level
of economic growth rates, becomes much more important. So if inflation,
if we if the pendulum theory or the pendulum framework
is correct, and if inflation comes down much more rapidly
than they expect, it's plausible that we could get cuts
(38:54):
even in the absence of recession, just because they want
to maintain their unemployment exactly okay, exactly right, And that's
where the balancing. So what you find you have more
and more governors because the way fair federal reserve communicates.
It basically gets those governors to talk publicly, and so
more and more those governors will be coming out and saying, well,
I think we've done a heavy lifting. They'll be saying
(39:15):
things like, you know, monetary policies work with a variable
and long lacks. They will start talking about, we need
to think about maintaining our employment and growth at an
acceptable level. So you get a lot more of that
communication coming out out of all of the center, and
as soon as federal reserve changes, other central banks will
(39:36):
follow suit. Now there are a couple of unusual players.
One of them is clearly China, which because of the
close nature of the economy and because it's state capitalism economy,
it doesn't really conform to those cycles that we've just discussed.
And the other one is is Japan and the extent
to which Japan is on a different tension compared to
(39:58):
everybody else. But if you think of a federal reserve,
if you think of ECP, if you sink a bank
up Canada, if you think of b o E, all
of them I think will be pretty much on the
same on the same page. And the only question is
and that's legitimate debate where the central banks will overtighten
h and whether in fact central banks will perpetuate policy
(40:21):
errors without reversing them. My view is no, even if
they overtighten, they can reverse it in split second. That
comes back to my argument that we have surplus of capital,
not shortage of capital. Remember u S liquidity system. If
you think of US liquidity system, UH banks currently maintain
(40:41):
two point two trillion dollars in reverse reapers. Remember reverse
repers is just net balance of the system. So there
is a surplus of two point two trillion that banks
cannot deploy, or at least they don't see way of
deploying that capital other than depositing it with with Federal
Reserve on an overnight basis. So so, so the way
the way I look at it is that we have
(41:03):
plenty of capital, we are fully digitized, we're dependent entirely
on the communications strategy. We can reverse a bear market
in the ball market in two hours, maybe minutes, maybe minutes.
And and Joe's you correctly said, just remember two thousand
and eighteen. Remember two thousand nineteen, Remember Federal Reserve restarted
que and was scudding raids about five months Before COVID,
(41:26):
COVID wasn't even there. Nobody knew that there was such
thing as COVID, So you can see how that will
happen now. A lot of clients saying that COVID it
is such a dramatic event that we are permanently repricing capital,
permanently repricing risk. We are now in a completely different environment.
I disagree with that. COVID, in my view, accelerated some
(41:50):
of the pre existing trends. For example, these days we're
relying more on fiscal levers than what we did in
the previous twenty or thirty years. It accelerated pre existing
trends like geopolitics, for example in the Black Swans. But
otherwise I don't think it changed the nature of what
we do think of sectoral balances. Now in the US,
(42:11):
we're already drawn down private sector savings, so so you
find net savings by the private sector as of December,
as of September for two thousand and twenty two was
almost zero. Now government is not cutting savings as much,
you know, the government actually deceaving. And so the result
is what's happening is that the rest of the world
(42:33):
balance for US is growing, it's back to four. So
if you think of the U s UK, your traditional
supplies of real demand in the economy, they're already back
to pre COVID. They are already they are already generating
deficits that they require other countries to finance. That means
the opposite is also true, because it's it's an accounting,
accounting identity, it has to be true that the rest
(42:56):
of the world is going back to supplying capital. So
and so, whether I look at impact of technology, impact
of demographics, whether you look at the impact of financialization,
where they look at sexual balances, everything tells me that
we are reverting to pre COVID times and therefore this
idea that we're permanently repricing culpital cheap money is gone forever.
(43:17):
To me, that's just nonsense, Victor. I think that's a
great place to leave it. We could easily talk for
absolutely others here, But yeah, thank you so much for
for coming back on our thoughts. Really appreciate it. Thank you,
thanks so much. That was great. That really, Joe, It's
(43:46):
always wonderful to talk to Victor. But there's so much
to pull out of that conversation. I'm actually having trouble
picking just one or two highlights. I did think the
comments about globalization were incredibly interesting. And we tend to
think of globalization as this like monolithic process that can
only go in one direction. But this notion that actually
(44:06):
you can have different types of globalization with different results, right,
And so this idea is like, Okay, the world like
Davos is happening right now, and I'm sure there are
a lot of people globalization. Yeah, I wonder if we'll
ever do like a Davo anyway, Like, you know, people
are anxious about that. But this idea that it's like, well,
(44:27):
maybe it's something different, and that actually the sort of
disinflationary impulses that we associated with globalization for forty years
or thirty years, or twenty years, however long you want
to identify, maybe that hasn't been the story in a
long time anyway. And as such, the idea that COVID
was going to mark some huge trend break from that
(44:49):
is just the wrong way to think about it from
the first place. Absolutely, also, the idea that maybe the
yield curve isn't that well suited to providing information in
the sort of post industrial age. I thought that was
interesting as well, and something that I think we've written
about at various points of time, the idea that there
are so many factors that go into bond yields now
(45:10):
not all of them related to the actual real economy,
that maybe it doesn't make sense to be looking at
the old curve for that sort of information about what
the market expects. You know what a headline I'm looking
at on the terminals right now that came from earlier.
Oh god, what is it? Larry Summers now more optimistic
on the US outlook the three months ago. Everyone coming around,
everyone coming around. You know what else I thought was
(45:33):
really interesting was the comments on geopolitics that maybe we
get because geopolitics always seems like one of those things
where it's like the idea of like forecasting, or it
seems like very difficult, and it feels like the risks
are always sort of in one direction, there's some black swan.
But this idea that maybe like we're in a position
where if you look at the major pressure points, whereas
(45:55):
Victor identified the tectonic plates or the intersection points, maybe
this is a pure of some like de pressurization. I'm hopeful.
I wanted to be true. I don't know if it
will be. If it will be, but I thought that
was an interesting comment. Shall we leave it there? Let's
leave it there? Okay, this has been another episode of
the ad Thoughts podcast. I'm Tracy Alloway. You can follow
me on Twitter at Tracy Alloway and I'm Joe wi
(46:17):
Isn't Though. You can follow me on Twitter at the Stalwart.
Follow our producers on Twitter Carmen Rodriguez She's at Carmen
armand Dash Bennett He's at dashbot. And check out all
of our podcasts at Bloomberg under the handle at podcasts
and for more Odd Lots content, go to Bloomberg dot
com slash odd Lots, we posh the transcripts, we blogged.
(46:39):
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Therapy Gecko
An unlicensed lizard psychologist travels the universe talking to strangers about absolutely nothing. TO CALL THE GECKO: follow me on https://www.twitch.tv/lyleforever to get a notification for when I am taking calls. I am usually live Mondays, Wednesdays, and Fridays but lately a lot of other times too. I am a gecko.
The Joe Rogan Experience
The official podcast of comedian Joe Rogan.