Any Happy Returns...the Next Super Cycle? ft. Peter Oppenheimer

[00:00:00] Peter

We’re gradually moving away from a period of hyper-monetization and QE. I think that’s a positive thing. But we’re also perhaps shifting to an era where there’s more fiscal policy for the reasons we’ve been discussing and governments taking on more debt. That probably also means higher costs of funding the debt, higher long-term interest rates for governments over time.

[00:00:35] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes and their failures. Imagine no more. Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level.

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:30] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely, Kevin Coldiron, to host a series of in-depth conversations to help uncover and explain new ideas to make you a better investor. In the series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it so that we can all successfully navigate the challenges within it. With that, please welcome Kevin Coldiron.

[00:02:07] Kevin

Thanks, Niels and welcome, everyone. Today’s guest is Peter Oppenheimer. He’s Chief Global Strategist and Head of Macro Research in Europe for Goldman Sachs. Peter is here to talk about his new book “Any Happy Returns: Structural Changes and Super Cycles in Markets”.

This matters for investors because these super cycles tend to be the primary driver of returns. No two cycles are the same. They differ in length, they differ in intensity, but they do share similar phases that describe the interaction between investor psychology, corporate profits, and structural changes in the global economy. All three of those things are front and center right now, so this is an excellent time to talk about Peter’s framework and hopefully use it as a lens to understand what’s going on now, what we might expect in the future.

It’s a personal treat for me to have Peter on the show. I’ve been reading his work for many, many years when I was a Goldman client and even before that when he was at HSBC. So this is a treat for me and hopefully for everyone as well. So, Peter Oppenheimer, thanks for joining us and welcome to the show.

[00:03:17] Peter

Thank you so much, Kevin. It’s really good to be here.

[00:03:20] Kevin

I’m curious, were you always a believer in cycles or is this a perspective that you developed over time in your career?

[00:03:33] Peter

I have been interested in cycles really going back quite a long time. I started my career in the mid-1980s and it was a time of great change both cyclically and also structurally. Cyclically because this was really the beginnings of the great disinflation following the very high levels of inflation and interest rates in the 1970s. But structurally, of course, it was the beginnings of great changes and deregulation of financial services, but also big changes in economies when you saw supply-side reforms coming through which really brought in a whole new way of thinking about economic policy and the prospects for growth.

So I’ve been really interested in this topic for quite a long time. Actually, just about three years ago, I wrote a book called “The Long Good Buy”, and this was really looking at cycles in markets and how they interact with cycles in economies. These were really looking at the shorter-term cycles that you tend to get around expansions and contractions of economies. And this new book “Any Happy Returns” I hope is complementary to that first book. But as you say, it’s looking much more at the long-term structural changes.

[00:05:00] Kevin

You start the book with an overview of cycles more broadly; societal cycles, political cycles, business cycles. We had Neil Howe on the show last year talking about the fourth turning where his thesis is that generational cycles are the big core fundamental cycle that drives things. I guess my question is, do you see financial cycles as derivative of these more fundamental cycles, foundational cycles in human society, or do they exist on their own separately?

[00:05:36] Peter

Yes, I think they’re very much a part of those big structural shifts that you mention. And perhaps to be a bit clearer and indeed differentiate between the kind of cycles I was talking about in the book “The Long Good Buy” and the structural super cycles that I’m talking about in “Any Happy Returns”, the shorter cycles are a little bit more simple because what you tend to have is financial markets reacting to, responding or anticipating turning points in economies.

For example, if you go back to the 1850s, there have been about 35 recessions in the US economy and roughly the same number of bear markets in equities. If you go back to the Second World War, there have been roughly 13 recessions in the US economy and about the same number of bear markets. So you can see straight away there’s some kind of connectivity between expansions and contractions in the economy and movements up and down in equity markets and indeed bond credit markets and other financial instruments.

But to your point, the structural changes, often within which these cycles unfold, can be much more long-lasting and really a function of so many other factors: geopolitics, how fashions in society change, how priorities shift, and impacts of technology, demographics, all of these other kinds of things. They come into play. They shape, affect financial markets as well.

[00:07:20] Kevin

Let’s roll up our sleeves and dig into the cycles a little bit. You talk about the equity cycles and their drivers and you say they can be broken down into four phases: despair, hope, growth and optimism. You use some fascinating (to me, fascinating anyway) phrasing to say what distinguishes them is different forward-looking return requirements.

Now, that’s a little geeky, but to me, I thought that was so interesting because it seemed to be what you’re saying is, it’s really about what investors want at different phases in the cycle, their psychology of how they interpret the fundamentals. Is that right?

[00:08:09] Peter

It is right. For example, what we call the despair phase is in effect a bear market. It’s a period where risk assets like equities are falling in price, and that’s usually because investors are anticipating a fall in profits, which is normally of course a function of recession. To incentivize investors to take risk when conditions are deteriorating, they require a much higher return. That’s really why the risk premium in that period tends to be very high.

What it’s really telling us is that the bar for investment to put money into risk assets is much higher when economic conditions are poor, when uncertainty is very high. And of course, in a boom time, when everybody sees very low risks, the required return actually starts to come down because people feel that the risks around their central assumptions are very low and they’re prepared to get a return certainly above a risk-free rate or cash, but it doesn’t need to be that big.

So in a sense, you’re right. I think it is a bit of a function of shifts in human psychology and the required return that drives these different phases.

[00:09:34] Kevin

By the way, there’s a lot of great graphs in this book. They really pop when you read it in say Kindle format or on the computer where you can see the colors. Anyways, there’s the graph here where in each of the phases, you show the returns to investors, you show the change in multiples, the PE ratio, and then also earnings per share growth. It’s a nice graph because what it shows is that those things are not synchronized.

You say that the actual earnings growth and price returns are different, that in the despair phase, EPS growth isn’t that horrible but because of this risk premium rising, the returns are actually quite poor. Is that an idea that you find investors have a difficult time accepting this desynchronization?

[00:10:35] Peter

Yes. It seems a little a bit counterintuitive but it’s very much clear when you look at the data. Of course, I should say that cycles do repeat themselves through history under very different circumstances. Of course, they’re not all the same in terms of length or depth, but they do tend to have these repeated patterns within them. And often, the best times for investment, for example, are when uncertainty is very high, when economic data is very weak, when companies are posting poor earnings.

That’s the time when investors start to see prices rising in anticipation of a future recovery. And that’s exactly why during that phase, what we call the first phase of the recovering prices, what we call the hope phase, we call it that because it’s exactly what it is. It’s about hopes of recovery rather than actual proof of that recovery. That’s a phase when valuations tend to rise very quickly and really dominate the returns.

It’s not until the next part of the cycle, what we call the growth phase, when companies actually are posting profits and paying dividends and economies are growing that most of the actual growth comes through. But of course, investors have already paid up for some of that in anticipation, and that’s when returns and valuations tend to be positive but more moderate.

[00:12:15] Kevin

So that’s the third phase, and then there’s a fourth phase called optimism where the improved valuation that we saw in the growth phase starts to attract people back in the market, earnings growth fades but returns are strong, and those returns are enough and almost kind of like a self-reinforcing thing to bring more people into the market. That’s the optimism phase.

I have to say, I kind of struggled to place us in one of these phases right now just looking at those returns and earnings growth ideas. So where do you think of us as being right now?

[00:12:55] Peter

Well, look, I have to confess, as with most things, when it comes down to data, it’s so much easier to see these things with the benefit of hindsight than in real time. Because in real time, you can misinterpret these signals very easily. If I had to guess I would say we probably are entering an optimism phase of an extended cycle.

I think you could place the despair phase really in the pandemic in 2020 when you got this big fall in stock prices as people really feared deep recession and profits declining. As you got the introduction of vaccines and furlough schemes and other interventions from governments and things didn’t seem to be quite as bad as feared, you got the first hope phase, a very explosive recovery from those bear market lows.

And then really, we’ve been in a period of expansion of economic activity over the last few years. Yes, we’ve seen some inflation pressures pick up. It’s not that unusual actually with rising rates. But now what we’re seeing really is risk assets rising again in price and in valuation as investors are getting more confident in soft landing and the ability of the economic cycle to just extend and also optimism that interest rates will start to come down.

I think this optimism phase could last a while. I certainly don’t think we’re in a bubble, but I think we’re probably in the later stages of one of these cycles.

[00:14:39] Kevin

In that section, you talk about, I wouldn’t call them models necessarily, but frameworks for saying hey, we could combine valuation with some notion of where we are in the economic cycle. You had this little matrix where you showed is valuation very expensive relative to history or very cheap relative to history in one of those five buckets, and then at the same time, where are we in the economic cycle?

You show that, hey, when we’ve got cheap valuations and we’re near the trough of the economic cycle, those are when forward-looking returns become really good. Can we do something similar on the other side? Can we say when economic activity is very strong relative to history and valuations are very expensive relative to history, that combination, does that give us some kind of forward looking indicator of poor future returns?

[00:15:40] Peter

Yeah, I think, Kevin, that’s a very good question. And, yes, you can take a signal from that. Interestingly, the signals are more powerful when you’re at the bottom of the cycle. When people are very depressed and valuations are very low, the hit rate of then becoming more positive is very, very good, but it’s very difficult to do psychologically because when things are bad, there’s always the sense, well, they could get a lot worse before they turn.

When you are in the real optimism phase of the cycle, it is true that when valuations are high, forward-looking returns or future returns tend to be lower, but that often doesn’t play out in the immediate future. It’s usually over a 5 or 10-year forward type of perspective. And of course, just because you’re in an optimism phase where valuations are high, it doesn’t necessarily mean that you’re about to see a collapse in the markets.

You could see an extended period of rising returns but at a lower pace for still some time. I think that’s probably what I would describe the environment we’re in right now. Generally, valuations have gone to quite high levels, particularly in the US equity market. That’s giving you a reasonably good sense that forward aggregate returns are going to be lower, but we could well be in a period where equities are still in a fairly benign environment for some time where absolute returns are rising but not at a very, very high pace.

I think in that part of the cycle, diversification and also focusing a little bit more on alpha rather than beta, trying to look at differences within and across the markets rather than just buying the market, usually makes some sense.

[00:17:39] Kevin

Yeah, that makes a lot of sense. Toward the end of your book, you talk about what’s going to be different about this cycle compared to the past, and that leads on to some potential ideas for alpha or maybe different sectoral allocations. So I want to talk about that toward the end. But I thought if we could spend a little bit of time going through some of the post-war super cycles in equities.

I don’t want to walk through them necessarily chronologically, but if I could just pick up on certain themes that I noticed when reading about them and just ask you questions, hopefully, those themes are relevant to investors today. You talk about the fat and flat cycle from 1968 to 1982. So fat and flat I guess is fat meaning relatively long and then flat meaning that the aggregate returns aren’t that strong.

You had a graph in that where you plotted out real interest rates over quite a long horizon. What struck me there is that we’ve seen real interest rates (so basically, that’s the difference between bond yields and expected inflation) come up a lot. But we’re still at a level that relative to that 100, 150-year history puts us toward the bottom end of the range.

So I’m curious, do you see room for real interest rates to rise? How do you actually interpret real interest rates? Do you see them as reflecting the long term potential growth in the economy?

[00:19:27] Peter

Yes, I think that’s right. There are different pressures on real interest rates. In part, they should reflect long-term real trend economic growth or expectations of, so the stronger growth, the higher real rates should be. They can also reflect other factors related to risk and uncertainty as well. Particularly when you’re looking at bond markets, what are you really looking at? You’re looking at lending money to governments. So the scale of debt that governments have can lead you to require a higher return, in other words, a high risk premium.

Also, if you’re very uncertain about future inflation, you may want a higher return to compensate for that risk as well. Bear in mind, bond markets are what we call nominal in the sense that you’re lending money for a fixed coupon, a fixed nominal yield. And so while you may know what that yield is each year for, for example, the next 10 years if it’s a 10-year bond, you don’t know what your return is going to be in real terms taking into account inflation.

Now, over the last couple of decades when inflation was very, very, very low, people didn’t really worry about inflation eroding the value of those loans, and so that risk premium reached very low levels. In a world where inflation pressures may be picking up, the compensation you require for that uncertainty should go up as well. So I think real interest rates are a function of a number of different things.

They did reach extraordinarily low levels particularly in the decade after the financial crisis, and I don’t think they’ll be going back to those significant lows. Now, some of that reflects good news, that we’re coming out of an era dominated by deflationary fears and very troubled economic cycles. And if longer-term growth is expected to be higher, so should real interest rates.

On the other hand, high real interest rates mean that the cost of capital should be higher as well, and that just makes it harder to fund investment and businesses. So there’s a balance between these two things I think.

[00:22:01] Kevin

One of the things, another structural thing that’s characterized the economy, particularly over the last 15 years, is the relatively high share of profits, corporate profits and GDP. I was curious to see how you view that. Profits to GDP tend to fluctuate over time, but in the last 15 years, it has really broken or seems so potentially broken it’s longer-term trend.

Where do you see the drivers there? Is that a balance of power between labor and capital or there are other kinds of structural forces? And that’s important, right? Because if you had profits coming back down to the levels that we would have seen as normal pre say 2010, that would represent a big drop in profitability and potentially equity returns as well.

[00:23:00] Peter

Yeah. Well, it’s interesting because earlier in our conversation, you mentioned that fast and flat period between 1968 and 1982. That was a period of course very much characterized by high inflation, by the oil shocks firstly in 1973 and then in 1979 of declining world trade growth and two deep recessions, but it was also a period where profit shares of GDP or profit margins came down.

So it was a very bad time to invest really. It was very bad in the economy. In fact, it was just a very, very poor time in general, other than perhaps for music, which was really great in that decade. But generally speaking, it was a difficult time for investors. Now, actually, the phase that followed that, the super cycle that followed it that started in 1982 really went through to the end of the century when the technology bubble burst.

That very long period was characterized by inflation and interest rates continuing to fall to ever lower levels. That brought down the cost of capital and it meant that investment became cheaper. And that was one of the factors that helped profit shares or profit margins, profit shares of GDP to rise, and they did so really for three decades. There were other factors that contributed to that.

One important other factor was globalization because that helped to reduce input costs, keep labor costs low or the labor share of GDP at very low levels, because as the world integrated, so did the labor markets around the world. Many Western companies outsourced their production of labor-intensive products into cheaper labor cost in other parts of the world. Obviously, technology innovation has had some part to play in this as well.

But I think what’s interesting about the more recent past is that as we inflect into a world where there’s less expansion of globalization and more focus on regionalization, and for the first time in many decades, we’ve actually got very tight labor markets and energy markets which is meaning that these input costs are going up, it is beginning to put downward pressure on margins, or if you like, profit shares in GDP.

You can think of this really as a kind of cake. If you think of the economy as being a cake, who gets the biggest slice? Is it the corporate sector, is it the labor sector, or is it the government? In the last 20 or 30 years, generally, the corporate sector has got a bigger share while labor has got a smaller share, and governments have generally been getting smaller. And that is now shifting as we move into an era that I call the post-modern cycle where governments are expected to get more involved in economies.

Partly, this reflects geopolitical realities. With more tensions in the world, and sadly, more wars, governments are having to spend more on defense, for example. They are having to spend more on subsidies and tax breaks to encourage decarbonization. And as populations age, there are more liabilities.

So government shares of GDP will probably rise, tight labor markets are pushing up wages, and that’s at least preventing profit margins in aggregate from rising and, in some cases, they’re actually beginning to come down.

[00:26:56] Kevin

When I saw in that fat and flat period that profit shares have fallen quite dramatically, and then you start going through all the drivers of why profits had been strong that you just talked about, it seems like all of those trends are reversing. So it’s hard not to escape the conclusion that a bit of the cake going to companies is going to get smaller.

[00:27:23] Peter

Yes. That’s part of the reason why companies that are managing to maintain very, very high margins for example in the technology industry but not exclusively in that industry, high margin businesses are tending to see better performance in the stock market and higher valuations.

So in this more recent period, as you’ve began to see some downward pressure on aggregate margins, investors are rewarding strong balance sheet, higher margin, higher return on capital businesses, relative to the rest of the market than they’ve typically done in the past. Of course, there are some offsetting drivers that could potentially prevent margins from coming down. One of them is compositional changes.

So as you get bigger representation in stock markets of areas like technology, which have managed to generate higher margins at least for a period of time, that can prevent broader index margins from coming down. Of course, other factors like AI could be quite margin-enhancing as well because ultimately it may well stimulate improvements in things like productivity.

The magic about productivity, which has been quite absent from economies in the last 10 or 15 years, is that this is the thing that at least theoretically could just expand the size of the cake. The overall pie just gets bigger, and that means that the labor market and the corporate sector can both prosper at the same time. That’s why governments are so keen on trying to find ways of boosting productivity.

[00:29:18] Kevin

Yeah. You talk about that toward the end of the book when you say what areas investors might want to focus on. We had Mark Mills on the show last year. I don’t know if you’re familiar with his work, but he has got this thesis that we’re at this very unique moment in history where there’s innovations in information technology, materials technology, and machine technology all coming together at the same time. We really haven’t seen that, maybe once in the late 1800s.

That has the potential, he’s very optimistic that it has the potential to unleash a productivity boom. What I thought was fascinating when you dig a little deeper into his idea is that he charts out productivity by sector in the economy, and healthcare, a very large sector in the US, education, also important, and very little to basically no productivity growth in those sectors for a long time.

But AI and the combination of machine technology gives you the now the potential actually to see improvement in healthcare productivity. If you could get that, then that translates into the potential for productivity growth in the economy given how large that sector is. That was kind of the idea. Anyway, I don’t know what you think about that.

[00:30:46] Peter

I think he’s absolutely right. In one sense, AI is coming at a very opportune time because it happens to be coming at a time when at least in many rich, developed countries, populations are aging quite quickly and we find ourselves in an environment where labor markets are very tight. Often, industries, companies can’t get hold of the labor they need. Therefore, if you could get technology which can off the place of people in some of these cases, that could be very helpful.

But to your point also, there are many large industries which have stalled in terms of productivity for a long time where AI offers a potential step change to really accelerate innovation and application of products and services. Just using massive datasets, for example, in healthcare to accelerate drug innovation and discovery and approval could really change things for the better both in terms of returns and prosperity but also of course of healthcare outcomes.

[00:31:56] Kevin

One thing that he mentioned at the time, and I hadn’t started hearing about it until very, very recently, was the energy intensity of AI. He made it very clear that you can’t just apply it across all these sectors with with the flip of a switch. They’re very energy-intensive. You need a lot more data centers. You need data centers located close to where people are using it, and they require a lot of energy.

We’re starting to see just in the last I think month or so people talking more about the increase in energy electricity consumption in the US due to AI. Do you see that as a potential break on the ability of AI to increase productivity? How much of a break do you see? If so, how much?

[00:32:47] Peter

I’m really pleased you mentioned that point because the last third of my book which is really trying to think about the future in what I call the post-modern super cycle which undoubtedly will have some greater headwinds, less globalization, more regionalization, perhaps more protectionism, for example, higher cost of capital, and we can talk more about those.

But it’s also likely to be defined by two really dramatic shocks, one of them around AI, which is very much unfolding if you like in the virtual world. And the other is decarbonization, which is very physical in the sense that we need to work out a way of physically restructuring our economies and the infrastructure around them to generate, deliver, store and distribute energy.

But there is an interesting symmetry here because while AI offers lots of potential in terms of boosting productivity and accelerating virtual access to data, it is as you say very, very energy intensive, so it can’t be done without vast amounts of electricity. And of course, decarbonization is all about electrifying our economies using new renewable sources.

So there’s an interesting symmetry between these two challenges and shocks to our economy. Of course, both of them offer risks and opportunities like many big changes do. I guess with AI, while it does offer great prospects in terms of productivity, it is also likely to disrupt labor markets and displace many jobs as technology innovations have done historically.

And in the case of decarbonization, the cost is just simply the complexity and the monetary cost of delivering these net-zero goals. The UN, as an example, talks about the aggregate costs being perhaps something like $100 trillion over the next couple of decades. The scale of this is just huge. But if we do achieve it, then we end up potentially with a world in which the marginal cost of energy is close to zero, something which would be hugely advantageous in terms of economic growth.

So I think these two things together are actually really interesting and are going to be quite disruptive but offer a lot of opportunities. And really to fulfill the potential of something like AI, we do need to get it right when we talk about energy production as well, because as you say, these large language models for example require huge amounts of compute power, which is very, very energy consumptive.

[00:35:49] Kevin

Do you think the financing of this $100 trillion or whatever the number ends up being has to come from the public sector? Do you think that at least that it can be initiated with the public sector, de-risk it to some extent, and then you have the private sector chip in? The private sector is not necessarily great at financing projects that have ultra-long-term returns.

[00:36:20] Peter

Yes. And that’s where regulation and clarity is so important, because if you keep changing the regulation or the goalposts, it’s very difficult to encourage private sector investors to really put in the scale of investment required over a very, very long term period to benefit from the potential long-term gains.

I think there is a desire to do that because there are lots of investor types, pension funds, insurance companies, for example, that have very long-term liabilities, which means they theoretically would like to invest in very long-term investments which have a very persistent, clear, repeatable payout in terms of returns and income.

So I think there is the possibility of doing this, but as we’re finding more often, to really jumpstart it, you need some public sector involvement as well, and that could take the form of subsidies and tax breaks. And indeed, that is increasingly what’s happening.

When you think of something like the Inflation Reduction Act in the US for example, although it’s not all about decarbonization, certainly one of the drivers is to provide an attractive investment environment to get the private sector into the US to find solutions and accelerate the decarbonization process, and it is involving public or taxpayers money to do that. But I think the returns ultimately will be worthwhile.

[00:38:07] Kevin

I hadn’t realized that the European Union has a competing legislation as well. Has that been enacted? Is that on a similar scale to the Inflation Reduction Act here?

[00:38:21] Peter

It’s taken a different form. So there are monies available, but they’re not upfront tax breaks and subsidies in quite the same way. Of course, it does raise another very important issue, which is that in a world where you get more protectionist policies and where you have a fashion for things like industrial policy, governments picking and choosing sectors and industries that they want to support and foster, which is increasingly true when you look at things like battery production, semiconductors, defense, energy, food supply, and so on.

This sort of industrial policy which was not particularly fashionable in the ’90s and 2000s but was in the 1960s and ’70s is coming back. And if one country is doing it, particularly a country of the importance and size and scale of the US, then it really requires other countries to do something rather similar or they just fall behind. So the European Union is embarking on some similar types of projects.

Again, it’s a reflection of the slightly changed global, economic and geopolitical environment that we’re living in. It’s less integrated with more intervention by governments in regulation in the fiscal space as well, that means tax breaks, subsidies and so on, and that’s causing competition really between different regions.

[00:40:01] Kevin

It’s kind of funny because when we started this conversation, you said you started your career in the mid-1980s, kind of like the end of that cycle of government, and so now you’ve kind of…

[00:40:16] Peter

Gone full cycle, or super cycle. Again, it does demonstrate that lots of things really are about changing priorities and changing fashions. So a lot of the things that we’re seeing at the moment, in terms of policy priorities, are not unique. We just haven’t seen them for a long time. Defense spending is a very good example. Of course, during the Cold War period of the 1950s, ’60s, ’70s, there were big rises in defense spending that took up a large chunk of government budgets.

When the Berlin fell in 1989, and within about a year the Soviet Union had dissolved and the US period of military and political hegemony really started, there was what was called a peace dividend. It meant that governments could spend much less on defense and could start to trust and integrate much more their economies with other parts of the world, which really characterized the thrust of development that took place through the ’90s and 2000s. In a sense, we’re just moving back into a period where those priorities are coming back again in some form.

[00:41:36] Kevin

So from an investment point of view, does it become more important for investors to understand public sector priorities? Are the winners in the equity market going to be the companies that are able to or are best positioned to profit from where big governments think the investment should be in the long term?

[00:42:11] Peter

I think that will be a part of it. Of course, governments are interested in innovation and technology because this is what’s going to power their growth and productivity over the next decade or so. And so having reliable supply chains that are dependable is becoming more important.

That’s why you’re seeing a slightly less globalized world and one that is more regionalized with more government support for those critical strategic inputs, which are not just now labor and oil, but things like semiconductors and batteries and defense and many other things like that too. So being in areas which are being encouraged by government strategic drivers are very important.

To give you an example, we have a basket of defense companies in Europe and that’s up about 40% year to date, the value of that basket or the price of that basket. So these companies are doing very well and did extremely well in fact last year and the year before, because just quite simply, there’s more procurement and more spending on defense companies now. So it does, of course, to some degree reflect the changing realities of the world about us and where are the real engines of growth.

[00:43:46] Kevin

We’ve been talking a lot about the importance of the public sector, and of course, a big part of the public sector is central banks. I wanted to get your read on what you think the importance and role of central banks in the markets is going to be going forward. In the section on what you call the modern cycle, 1982 to 2000, what struck me there was you have this chart where you show volatility falling, so that’s kind of the Great Moderation, volatility and GDP falling.

At the same time, you list out all the different crises that happened over that period. We had the stock market crash, Latin American debt, we had the Savings and Loan, we had LTCM. There’s a lot of stuff that happened. So, basically, my question was, is it the fact that the Fed and global central banks provided liquidity, lowered interest rates in response to those crises that allowed or that prevented that volatility from reaching the markets?

So, normally, you would think of that liquidity provision would be inflationary, but then you layer on to that the offsetting globalization and demographic deflationary aspects and the Fed sort of quote-unquote “gets away with it” because you have these structural deflationary offsets to its liquidity provision.

I know there’s a lot in there, but I’m curious to I guess maybe go back to the first question. The central bank response, is that what helped or stopped the volatility from falling and finding its way into the markets?

[00:45:47] Peter

I think very much so. Of course, we don’t know the counterfactual. We don’t really know what would have happened in the absence of those policy interventions, but I think they were critical. To go back to your point, in the era between really 1982 through 2000, particularly under the chairmanship of Chairman Greenspan at the Federal Reserve, there were a lot of shocks that hit financial sectors.

He generally cut interest rates when these shocks looked to be particularly severe, and that increasingly began to be known as the Fed put, that actually, you could take more risk because in the event that there was a shock or something went wrong, your downside risk would be limited by the near certainty that the Federal Reserve and other central banks would step in and cut interest rates and provide liquidity.

So you did have this curious combination of quite a lot of shocks over that decade or so but quite low realized volatility because you did get a lot of liquidity provision to stabilize financial markets when these shocks emerged. But there are other important things that were happening as well.

Of course, central banks increasingly became independent of political influence through the 1990s around the world, and that gave more confidence in financial markets that central banks would move in a way that really constrained inflation and stabilized growth.

It was a period of lots of innovation technologically which helped to prevent inflation from picking up. And as we were discussing earlier, it was a period, post the dissolution of the Soviet Union and the growth of US economic hegemony, that there was much more integration of the global economy. We really saw the modern age of globalization. This helped to stabilize growth and reduce volatility as well. But all of those things together I think were part explanations.

[00:48:16] Kevin

So do you anticipate that the Fed will continue to play this kind of, I don’t know if activist is the right word, but this important role, stabilization role in markets that future crises are also going to lead to a response?

[00:48:38] Peter

Look, I think central banks play an absolutely critical and unique role in financial markets, and ultimately and most importantly, economic stability. And I think they’ve been doing an extremely good job. Bear in mind, look, just in the last few years, we’ve been faced with a series of extraordinary shocks.

The global financial crisis in 2007 and ’08 and the seizing up and the failure of the banking system in many countries, the Greek crisis and then the sovereign debt crisis in Europe, the pandemic, the war in Ukraine, all of these things have been huge shocks and central banks have managed to move swiftly in concert with governments and fiscal policymakers as well to intervene when they needed to really try and stabilize the system and prevent worse outcomes. And I think they’ve done that very effectively.

But, of course, in the aftermath of the financial crisis when interest rates were already very low when that hit, they had to get interest rates down to record low levels, zero, and in some cases across Europe negative. This was prior to that really quite a sort of theoretical concept. But interest rates went negative and stayed negative for about a decade in Europe. And of course, we entered this period of so-called unorthodox policy easing through the adoption of quantitative easing, printing money.

These things were required to get the cost of capital down sufficiently to support demand and investment, but it did get quite extreme. Bear in mind, only about three years ago, the yield on government debt, on government bonds, fell to all-time record lows. About 30% of all government debt around the world had a negative yield. Investors were effectively paying for the privilege of lending money to governments with the certainty that they’ll get back less than they were lending because there was so much uncertainty at that time.

Of course, we’ve moved away from that now. Interest rates have gone up. They’re not likely to go back to those lows. We’re gradually moving away from a period of hyper-monetization and QE. I think that’s a positive thing. But we’re also perhaps shifting to an era where there’s more fiscal policy for the reasons we’ve been discussing and governments taking on more debt, and that probably also means higher costs of funding the debt, higher long-term interest rates for governments over time.

[00:51:25] Kevin

On that point, a lot of people would do the math, look at some of your structural drivers saying that government debt is going to have to increase because of pension promises, demographics, also the investment needed in decarbonization, all the things that you mentioned, and the only way that that can be done at a reasonable cost, in other words, the only way that can be done without interest rates going really high is for central banks to buy the debt. Maybe not all of it, but some of it, and that becomes inflationary. What’s your view on that?

[00:52:05] Peter

There are various possible solutions and it may be a combination of them. The best way of getting out of a period of higher debt is through increased economic growth. We’ve talked a little bit about this today. A productivity boost would be the best way of achieving that. Maybe AI and related technologies are one of the things that may achieve that, at least in part.

Because if you’re growing your way into prosperity, the value of that debt on a relative basis will come down. And perhaps with higher growth, you’ll have a little bit of more inflation as well, at least relative to what we’ve seen in last 20 years, and that will also help to erode the value of that debt. Other things that governments will consider or may need to consider are higher taxes, at least in part, which are difficult to administer and of course unpopular, or lower spending in certain areas, which of course also are very unpopular.

So there’s no easy way out of this. The most successful way out of it is stronger economic activity. And that’s why some of the things we’ve been talking about, more technological innovation, decarbonization which will drive growth as well, are really quite critical I think to the successful outcomes that we’d hope to see over the next few years.

[00:53:34] Kevin

Yeah, I think that’s absolutely right that there’s this kind of tension between the funding pressure and when these productivity-enhancing technologies start to have an effect. Because even as you say, if you could get the marginal cost of energy down to zero, that’s transformative for the economy, because in some sense, the economy is all about energy. People have argued that the fundamental currency of economic activity is energy, and if that becomes costless or close to costless, then that’s…

[00:54:14] Peter

A huge boost to the sustainability of the planet, to our health outcomes, but also to economic outcomes. Yeah, absolutely.

[00:54:22] Kevin

So it’s I guess a question of, when do we start? When does that investment start translating into a lower cost of energy? We don’t know. So yeah, it’s a fascinating time. There’s lots of different competing tensions and I think your book does a great job of setting those tensions in historical context and then helping people think about how they might evolve in the future.

So I think that’s a good place to end. Peter, I appreciate you taking the time and chatting with us. Again, the book is called “Any Happy Returns”.

Peter, thanks for joining us and we wish you all the best.

[00:55:05] Peter

I appreciate it. Thanks so much for having me.

[00:55:07] Kevin

Okay. with that, I’m going to pass it back over to Niels.

[00:55:11] Niels

Thank you so much, Peter and Kevin, for an absolutely fascinating look into the complex factors that impact structural changes in financial markets and investor opportunities that are changing as we speak. I thought it was a great conversation that gave us a good historical perspective on many of the things we discuss on the podcast in general and how they fit into the bigger picture and where we stand right now, which may well be at the beginning of a new super cycle.

If we specifically look at the post-modern super cycle that Peter expects will include higher cost of capital, bigger governments, more proactive industrial policies, greater regulation, and of course, less globalization, it is very enlightening to me to hear Peter talk about how the two opposing forces of AI and decarbonization, which also represents by the way the virtual world versus the real world, how they will impact the overall energy consumption on the planet as well as the future opportunity or finding lower costs of energy.

I also liked his view on central bank actions in the era of 1982 and 2000, and the introduction of the Fed put was quite interesting in terms of how it artificially impacted the volatility of the markets, and to some extent, still does. Make sure you go and follow Peter’s and Kevin’s work, as well as getting a copy of both of their books, because as you can tell from today’s conversation, some of these ideas and topics may not be discussed enough on mainstream media.

From Kevin and me, thanks ever so much for listening. We look forward to being back with you on the next episode. In the meantime, take care of yourself and take care of each other.

[00:57:02] Ending

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