Dollars, Debt and Demographics in Our Bipolar World
- Global macroeconomics should be just that: A framework for understanding the world through financial markets and geopolitics. However, many investors have a Western-centric outlook.
- The Dollar's Exorbitant Privilege: Uncover the challenges and complexities associated with the U.S. dollar's role in the global economy. Alf sheds light on the need for a deep and liquid market to recycle dollars, the potential implications of a transition away from dollar dominance, and the ongoing debt ceiling debate's impact on global markets.
- Alf joins Cem Karsan and me to chat about inflation, labor, the dollar and much more.
When we talk about global macroeconomics, most of us tend to think about American equities, interest rates and credit securities, as well as the foreign exchange market (FX) rate and the commodities market. We might consider European markets too. But the NATO alliance isn’t alone on this planet, even if the U.S. dollar is its currency.
“The world is becoming more bipolar,” says global macro investor Alfonso “Alf” Peccatiello. “Nobody can deny that.”
Alf is the founder and CEO of The Macro Compass, a disruptive investment strategy firm whose mission is to democratize professional macro analysis, interactive tools and portfolio strategy.
In spite of the bipolar geopolitics of recent years, “investors need to become more acquainted with looking at the world, and the world isn’t the U.S. and Europe only,” Alf says. “It’s everything else.”
Cem Karsan and I invited Alf to another Global Macro edition of Top Traders Unplugged for a wide-ranging, spirited discussion (well, perhaps an outright debate). We talk about inflation, interest rates, the U.S. dollar, China, commodities, and much more. Here are just a few highlights.
The Fed vs. Recessions
We kick off our conversation by asking Alf to share his big-picture macro views and what may have changed since his last visit (episode #18, June 2022). When we last spoke, he was quite bearish on everything from bonds via BTPs to stocks and credit spreads.
He begins with what he says might be his most controversial take: He thinks the Fed will cut interest rates to 1% or below — even all the way to 0% — in 2024.
“That will be the result of the massive tightening in monetary and fiscal policy we have gone through since 2022,” Alf says. He foresees a “much tighter fiscal policy” ahead of the November 2024 U.S. election, and that the Fed will maintain this contractionary stance “above equilibrium until something effectively breaks.”
When we see both a tight monetary and a tight fiscal policy for a while, we’re “basically waiting for an accident to happen,” Alf says.
“As in every recession, in every credit deleveraging episode, the Fed will need to cut way below neutral levels, which means 0% to 1% Fed funds.” (He notes that the Silicon Valley Bank and First Republic Bank bailouts are a completely separate issue — they’re “idiosyncratic, liquidity pool risk management banking issues.”)
Secular vs. Cyclical
Cem thinks Alf’s thought leadership work adds up to a “masterclass” on the cyclical effects of credit on economies.
“I think very highly of your work,” Cem says. “It doesn’t mean I agree with all of it. … I agree with a lot of the cyclical effects that you’re talking about, the lags that they operate under and what we’re seeing in real-time.”
Cem’s disagreements with Alf tend to focus on the fact that for the last 40 years or so, we’ve been living in “a very two-dimensional cyclical world,” he explains. “But it’s the secular effects I most worry about.”
He asks Alf to think back to the last time we saw high levels of inflation (1968 to 1982), talk about whether or not our current inflationary period is similar or different and discuss where we might be in a secular (preserving value even during a downturn) sense, not just a cyclical one.
“The economy of the ’70s was materially different than today,” Alf replies. “[It was] highly industrialized. Wage growth was a big driver of nominal spending. That was because the share of labor — let’s say, [labor’s] share of importance — as one of the factors for total economic growth was much larger than capital. So labor was beating capital … in terms of its effect on economic growth.”
What’s more, unions had much more power in the ’70s than they do now. (The Civil Rights Act of 1964 opened up the workforce to more women and people of color than ever before — who “powered a new wave of unionizing efforts,” according to labor historians Ellen Cassedy and Lane Windham.)
1970s vs. 2020s
Today, an American company needs “about one-tenth of the employees it needed in the ’70s to generate the same sales revenue,” Alf notes. “So employees were important. Wage growth was an important driver of nominal spending.”
The second big differentiator between now and the ’70s is changing demographics. The post-World War II baby boom came of age, “so labor force growth was pretty solid,” he explains. “Actually, we had labor force growth and productivity growth, which combined together were roughly in the 3.5% area.”
That meant the U.S. could grow structurally by 3.5% annually without the use of any leverage, so the total debt in the economy was much lower.
“There was no need to lever up and push economic growth … because structural growth was so strong,” he adds.
Inflationary episodes during that era were much harder to fight partially because they were “so easy to corroborate [with] structural factors,” Alf argues. When labor is such an important driver of nominal spending, it’s no surprise that inflation provokes workers to demand higher wages, which “can cause a wage-price spiral” if labor is suddenly scarce (as it was when three million workers went on strike in 1970 alone).
Capital vs. Labor
Fast-forward to today: The global economy is structurally different than it was when 200,000 postal workers went on strike (again, in 1970).
“It’s a much more capital-intensive economy [today],” says Alf. “Capital beats labor … demographics is what it is … the Chinese workforce and Asian workforce are expanding rapidly, providing cheap labor to a globalized economy.”
He notes that this will change over the next few decades — the Chinese workforce is projected to shrink by 30% over the next 30 years.
“That’s quite something,” he says. “We’re not going to have that cheap supply of labor back again.”
For the next three to five years, however, capital will still dwarf labor (and technology will continue to have a massive influence on the workforce, as well).
FX vs. Inflation
What happens to the U.S. dollar during a recession?
“It depends on which shape the recession takes,” Alf says.
Cem agrees. But he notes that “there are a lot of people outside the U.S. who would love to see the strength of the U.S. dollar fade. But the structural realities are … and this is not an egocentric American view … this is the biggest economy in the world (maybe not the strongest), [and we have] the biggest military in the world.”
Right or wrong, the prevailing wisdom among investors seems to be that their money is safer in the U.S. than in China, Europe or other places in the world.
“There’s a reason for those beliefs,” Cem adds. “We’ll see if they continue. It doesn’t mean we can’t get volatility along the way. Broadly, I believe we’re in a structurally inflationary place where if we continue to have the exorbitant privilege of the U.S. dollar — and it’s a big if — the odds are … [the status of the dollar] is not going to change overnight.”
And that exorbitant privilege comes with the ability to export inflation.
“The Fed has control, and ultimately it is in the Fed’s best interest to have a strong dollar during periods of inflation,” says Cem. “So I would be betting in that direction.”
Congress vs. the Rest of the World
Alf argues that the dollar itself (if we are to personify it) has a daunting task. It’s “the denominator of most global trades, most global invoices, most FX transactions in the world,” he explains. “Which means Saudi Arabia sells oil denominated in dollars and gets back … what? Dollars.”
He says we need to answer the following question: “Can you provide an outlet where I can recycle these dollars in a liquid, deep, repo-backed market that you continue to supply … and increase over time? Because [if] global trade grows, the economy grows. Saudi Arabia sells more oil. They get more dollars. So can you give me a big, liquid, deep and ever-increasing market [in which] to allocate back these dollars? It’s not easy.”
Europe can’t provide that kind of liquidity because its AAA market (of safe bonds, for example) is quite small. Japan can’t provide it either, because its central bank is about 60% of the market and doesn’t trade for several days in a row, says Alf.
China and Russia are out of the question: “You’re lucky if they don’t lock up your money, and the rule of law is not necessarily very strong. So [the dollar] is an exorbitant privilege, Cem, you’re right. But it is also difficult to fulfill the role; to be the dollar.”
Complicating matters, Alf notes that there are more than $12 trillion in dollar-denominated liabilities held in institutions outside the United States, according to the Bank for International Settlements. (This figure reached 13.4 trillion in 2022.)
To put this in context, Lyn Alden wrote that “these $12+ trillion in dollar-denominated debts mostly aren’t owed to lenders in the United States; institutions in various countries lend to others in dollars.”
That’s one of the big reasons why the dollar endures.
“Transitioning away from such a leveraged system, where leverage sits outside the United States, is not an orderly process,” says Alf. “It’s a very messy one. So when people tell me, We’re going to de-dollarize … Well, good luck with that.”
Debt Ceiling Rollercoaster vs. Our Collective Nerves
Thanks to the U.S. Congress, those who trade in dollars will need all the luck they can get. Although the market is optimistic about a resolution to the ongoing debt ceiling debacle (DXY is at a seven-week high as of May 19), the threat of default still looms. With more than half of the world’s foreign currency reserves held in U.S. dollars, Congressional brinkmanship could send shockwaves through global markets.
Brace yourselves: Whatever happens in Washington, it’s almost certainly going to be unnerving.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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