Asset Allocation a la carte ft. David Kelly

[00:00:06] David

One of the sad ironies today in America is that if you add up the unemployment and the inflation ratio, people used to call it the misery index, that misery index is lower today than it’s been 75% of the time over the last 50 years, but people feel more miserable about the state of the world than they have 93% of the time. The index of consumer sentiment is almost as low as it’s ever been in a 50-year period.

So whatever we’re doing in the economy, we may be achieving growth, we may be achieving low unemployment, we may be bringing inflation down, but it’s not making people happy. If it doesn’t make people happy, or contented, or fulfilled, then what’s the point?

[00:00:45] 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.

Before we begin today’s conversation, remember to keep two things in mind. All the discussion we will have about investment performance is about the past, and past performance does not guarantee or even infer anything about future performance. Also understand that there’s a significant risk of financial loss with all investment strategies, and you need to request and understand the specific risks from the investment manager about their product before you make investment decisions.

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

[00:01:39] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary investors from all around the world. In this series, I have invited one of them, namely, Alan Dunne to host a series of in-depth conversations on the topic of what it takes to be a world-class allocator. In today’s world, portfolio construction is fast moving to the top of the agenda of many investors as they tried to analyze and understand the riskiness of their portfolios.

With ever-increasing uncertainty around the globe, being well-diversified across many different strategies and themes in your portfolio can mean the difference between ruin and survival when the next crisis emerges. The aim of these conversations is to try and understand the experiences that have influenced these highly specialized allocators and the processes they follow to harness the best returns for their clients so that we can all become better-informed investors. With that, please welcome Alan Dunne.

[00:02:42] Alan

Thanks very much for that introduction, Niels. Today, I’m joined by David Kelly, Chief Global Strategist at JP Morgan Asset Management. David has been at JP Morgan Asset Management for a number of years. Prior to that, he was at Putnam and a number of other firms as an economist and a senior strategist. He is a frequent commentator in the media on CNBC and Bloomberg and other financial media outlets. David, it’s great to have you on the podcast. How are you?

[00:03:10] David

I’m very glad to be here, Alan. Doing very well.

[00:03:13] Alan

Good stuff. Well, I gave a very brief synopsis of your experience, but maybe it’d be good to hear from you how you ended up in economics and in financial markets. What’s the journey been for you?

[00:03:24] David

Well, it’s a long and winding journey. I started out in Dublin. I went to UCD. I studied economics there. My father was a politician in Ireland. The reason I did economics is that he was a lawyer and he was a very good public speaker and he was very convincing, but he knew and I certainly knew that to some extent, there was a little bit of waffle in his economics because he really hadn’t studied it.

So I felt that very unoriginally, I wanted to follow in his footsteps to start but I figured I needed to know something about economics because Ireland in the 1980s needed people to understand the economy. So I did an undergraduate degree in UCD and then I had nothing but questions. So I thought I’d do a PhD over in America to get some answers.

But along the way, I met a girl from Grand Rapids, Michigan and settled down in Massachusetts. I was an economist, a pure economist for some time, but then I discovered there was really more of a living to be made being a strategist. My first love is understanding the American economy and modeling it, forecasting it.

But I also realized that the reason this is valuable to people is if you can make predictions, then based on that make predictions on what’s going to happen in the bond markets, what’s going to happen in the stock market, what does it mean for investors, and that’s really what I focused on. Just before the financial crisis, I moved over to JP Morgan Asset Management and I’ve been with them ever since, so that’s 15 years now.

I run a team called Market Insights. We’re global strategists. We’ve got a group in New York, a group in London, a group in Hong Kong, strategists in different countries. What we focus on is trying to understand the economy as it impacts financial markets and the financial environment, but also very much trying to explain it clearly. I think there’s so much political bias in what people hear, which makes the information completely suspect and useless.

There are so many people who just try to loft the ball over people’s heads. They set off with the goal showing how smart they are rather than actually trying to communicate. We very much believe that none of this information is worth anything unless it can actually be communicated to average intelligent investors, so that’s what we focus on.

[00:05:44] Alan

Very good. Well, I guess one of the prevailing questions that people are trying to understand at the moment is where is this recession that everybody has been talking about that many economists have been forecasting. It’s been maybe the surprise of the year from an economics perspective. Obviously, we had very strong Q3 GDP out in the US. What’s your perspective on that? How do you explain that to clients?

[00:06:09] David

Well, I wasn’t quite as surprised as consensus. I never actually did call for a recession this year. I think it was a close call, particularly in the middle of the banking mini crisis that we had. But there are two things which really protected the United States from recession and still to some extent do. One of them is that there is no boom in any cyclical sector of the economy.

Usually, when you have a recession in America, it’s because people are buying too many houses or we’re doing way too much investment spending, like before Y2K, or we’ve got too much inventory or we’re buying too many cars. But if you look at the cyclical sectors in the economy, none of them are overextended right now. It’s very hard to get a bust without a boom. There’s a lot of the economy which normally just drives forward. So unless you have a sector that gets very high and then falls very sharply, it’s hard to get a recession.

The other thing is that we came out of the pandemic with a very weird labor market. We had 12 million job openings back in March of last year and we’ve been gradually whittling away at that. That’s about 4.5 million more job openings, the highest number we’ve ever seen before. Now, we’ve got that down to about 9.6 million job openings, so it’s down about 2.5 million from its peak. But we’re still about 2 million higher than its long-term peak.

What that means is that for every month, we’re creating hundreds of thousands of jobs so it’s really hard to actually say you’re in a recession or put yourself into a recession if you’re creating hundreds of thousands of jobs. So I think those two forces have really protected the US economy. If you look at some of the cyclical sectors, there are offsets in lots of areas where we thought we were about to see a drag.

So, the economy, it’s keeping going, but the other thing that I’d say about the economy is we’re at full employment. We’ve been under 4% unemployment since December of 2021. When you’re at full employment, the economy can only grow slowly. It’s kind of like you’re riding a bike uphill slowly. If you’re riding fast, you’re pretty stable. If you’re riding slowly, it doesn’t take much to knock you over. I think that that’s really where the American economy is today.

Sooner or later, the economy’s going to step on a big banana skin and end up with a recession. I can’t say that’s going to happen in the next year, but if you give me between now and the end of 2025, probably a recession will start.

[00:08:38] Alan

Okay. The simple forecast or observation maybe a lot of people made was that Fed tightening cycles often end in some kind of accident. Obviously, it’s either a capital markets event or a debt crisis or something. We had the banking sector wobble but that was managed. Have you been surprised that rates could go from 0% to 5.25%, 5.5% and not have that accident?

[00:09:07] David

Not really. There are two problems. There are two problems the Federal Reserve creates when it raises interest rates. One of them is the idea that higher interest rates will just naturally slowly drag on the economy and slow it down. The other problem is that it can cause financial instability because there are certain companies, businesses, banks, which are all geared to low rates. You suddenly spike the rates up and suddenly they find they’re insolvent.

That’s kind of what happened with the great financial crisis where you suddenly had a lot of institutions, they looked like they might be insolvent as things crashed around them. I think after the great financial crisis, the regulations put in place thereafter made the US banking system very safe. It didn’t exactly make it very innovative or dynamic or risk-taking, but it did make it very safe. So I think we were less vulnerable to a big shock or unexplained event from high rates.

Then there’s just the other question of the assumption that higher rates slow the economy down. That has not proven to be very much the case. It certainly is not the case that lower rates sped up the economy. Actually, that’s true in Europe also. Throughout the last decade, we had super low interest rates. It didn’t do a darned bit of good in speeding up the economy or creating inflation. I think that’s true in the United States also.

There are some really interesting reasons why. The economy is much more about services and much less about investment spending today. Therefore, it’s much less sensitive to interest rates. Also, a lot of people have money in cash accounts, and when interest rates go up, they all get a pay increase. That has been helping consumer spending grow here. So I don’t think this economy is particularly sensitive to interest rates anyway and I think that the potential for shock or disruption or dislocation has been reduced by reform since the great financial crisis.

[00:11:09] Alan

Okay, interesting. I saw you writing recently about the addicted US consumer, and it was interesting because it was around a time of the personal income and spending data which showed that the savings rate was down to about 3.4%, 3.5% or so, not as low as it has been. But certainly, it’s back down at a range kind of similar to what we saw maybe pre-financial crisis, which was deemed to be very low by historical standards.

What is it? Is it a cultural thing? What’s your observation on why the savings rate is so low in the US? Will it always be that way or is that a risk factor that you see for the economy where that could snap back at some point?

[00:11:55] David

When the savings rate falls… The saving rate itself is calculated as total disposable income minus total spending as a share of total disposable income. That’s how it’s measured. It’s actually a residual of two enormous numbers, rather badly calculated numbers. So I’m always a little suspicious of the actual rate itself. But when it trends down, as it did for most of the 1980s and ’90s and into this century, when it trends down, it just means that spending is growing faster than income, and that certainly was the case all the way up until the great financial crisis.

Then the savings rate started rising. I think it started rising because banks just didn’t want to take the risk anymore. Actually, before the pandemic started, household balance sheets were in very good shape. Over 90% of mortgages in the United States are fixed-rate mortgages, 30-year fixed-rate mortgages. So if interest rates go up, it doesn’t affect people at all, most people. People that used the pandemic to pay down credit card debt, that credit card debt has gone back up again.

But if you look at debt service as a percentage of disposable income, it’s really just back to where it was before the pandemic and it is way below where it was before the financial crisis. So I think that when you look at the savings rate and look back to before the financial crisis, it’s kind of missing the point. What we have is the impact of a year or two’s “bad behavior” right now. But back in the financial crisis, we had the cumulative effect of 25 years of bad behavior. So I don’t think consumer balance sheets are in nearly as bad shape as they were back then.

[00:13:30] Alan

You mentioned how maybe the US economy isn’t so rate-sensitive. But going back to the point about Fed tightening cycles ending in accidents, I think if you look back over 30, 40 years, there have been enough. It’s been one or two soft landings. Certainly the 1994, ’95 period was a soft landing. But generally, it’s been difficult to engineer a soft landing. Obviously, you’ve looked at many cycles. You’ve been in the markets for a number of decades. Is there any obvious parallel now when you look at the economy or do you think this cycle is very unusual relative to the past?

[00:14:05] David

They’re all unusual. The thing about a recession is it’s kind of like the start of the book Anna Karenina where they say all happy families are happy in the same way but all unhappy families are unhappy in a very unique way. Recessions are all uniquely bad, but they all have their own characteristics. So no, I don’t think there’s a parallel. I think it’s very dangerous to draw that parallel. I see people drawing parallels all the time.

For example, over the last two years, they said this is just like the 1970s, and it wasn’t just like the 1970s. It was so important the Federal Reserve understood that. They didn’t really. They haven’t managed to sink the economy yet. I think it’s very dangerous to try and find parallels in an economy that is constantly evolving and adapting over time.

[00:14:53] Alan

It sounds like you’re a bit skeptical as to whether the Fed needed to raise rates as much as they have done. Taking the perspective on the central banks going back over maybe the last decades, some people would have said, was the Fed part of the problem in the first place in being too eager to try and stimulate the economy to push up inflation to hit that 2% level whenever it was 1.5% or so. Do you think central bankers in general have too great a sense of their ability to influence the economy? Would that be fair to say?

[00:15:29] David

Yes, very fair to say. First of all, let me say, about the Federal Reserve (and I think I can say this about the European Central Bank and other central banks around the world), they do intend well. That puts them, probably, a little bit ahead of the game relative to other people in making policy in the government. I think they do want to do the right thing. But what we’ve seen in history is that central banks are very good at dealing with a financial crisis because they essentially have a money tree.

If you’ve got a money tree, you can buy up any number of bad assets and you can stabilize things. That’s a role that central banks have played and played very well over the years, and they did that after the great financial crisis. What they’re very bad at doing is directing the economy either with regard to economic growth or with regard to inflation. They can’t seem to get it to speed up, and then once it’s sped up for other reasons, they can’t seem to get it to slow down.

The way I think about it is that they make these solemn pronouncements about we’re moving rates up 25 basis points or down 25 basis points today as if this was going to move the whole economy. It’s like they’re in this rather unwieldy boat in a very turbulent river with heavy rapids and so forth. They’ve got this tiny little paddle, and so they’re paddling furiously on the right, and then when things don’t work out, they paddle furiously on the left.

But the truth is, the river is taking the boat wherever the river wants to take the boat, and all they do by pushing rates too high, and then too low, then too high again is to destabilize financial assets and encourage suboptimal asset allocation or resource allocation across the economy. So I wish that they would just stick to an appropriate monetary policy for the long run and then occasionally step in if there is a financial crisis.

[00:17:16] Alan

Not a counter-argument, but another perspective on this is that the bond market should migrate to the correct level of interest rates regardless, maybe, of the central bank. Obviously, what we’ve seen lately is a very pronounced rise in yields just since the summer, whereas maybe if we had spoken three or four months ago, I might have been asking you why have bond yields risen so much in response to the tightening cycle? What do you think happened in the summer to prompt that change in sentiment? What’s your perspective on debt sustainability, etc.? Is that a concern or not?

[00:17:49] David

Well, I think the first thing that happened is that people realized that the US economy wasn’t going to go into a recession. We published this 4.9% in GDP for the third quarter, and that was published I think on Halloween. But it was quite clear, for a month or two before that, that the economy wasn’t just not slowing down, it was actually speeding up. So that I think had an impact on the bond market.

I think a second thing that had an impact on the bond market is, as the smoke cleared, after some of the debt ceiling debates over the summer and the government shutdown stuff, as that smoke cleared it became apparent that the US government was running a bigger deficit than everybody thought. In fact, the deficit for the last fiscal year was $1.7 trillion, and even that is lower than it would have been without a certain accounting entry for student loan costs, which is not really part of the budget.

So in real terms, the budget deficit was about $2 trillion last year. It’s going to be about that this year. When you add on to that the fact that the Federal Reserve is reducing its own holdings of treasury bonds by about $720 billion per year, what it means is that global capital markets now have to find a way of coming up with $2.7 trillion this year to fund the US government, and that’s a pretty heavy lift.

So I think that there are two problems. One, it looked like economic recession was off the table. Two, this is a lot of debt to try to sell to the markets. I think we can sell it to the markets, but probably not at as low as the interest rates we were paying before the pandemic.

[00:19:31] Alan

Once the market starts moving in one direction and yields start to rise, it seems to influence sentiment. Obviously, it’s the nature of markets. You start seeing all the calls about debt crises. I think Ray Dalio was out saying the US will face a fiscal crisis. Barry Eichengreen presented a paper around this at Jackson Hole which was a pretty pessimistic perspective, I would say, saying high debt levels, high deficits are here to stay. Not suggesting that we’re in for a crisis anytime soon, but really suggesting that the conditions that would be needed for fiscal consolidation would not be in place.

Would you concur with that perspective that high debt, high deficits are going to be a feature of the landscape going forward?

[00:20:15] David

Yes. The US economy, unlike for example the Irish economy, is a slow-growing beast and there’s only a certain pace it can do going forward. Since the turn of the century, it has grown at an average annual rate of 2%, in real term,s per year, and that’s what it’s going to do going forward, maybe a little bit less than that. In that kind of economy, you can’t grow your way out of the debt and the deficit. The only way you can deal with the debt and the deficit is you have to make tough choices.

You have to cut defense spending, cut Medicare, cut Medicaid, cut Social Security, and increase taxes. But no politician in America will get elected if they say they’re going to cut defense, cut Social Security, cut Medicare, cut Medicaid and raise taxes. Because of that, I would agree that we are stuck in high deficits and growing debt for a long time to come.

The thing is that, as an investor, you probably want to bet against this causing a crisis anytime soon because people do need to save for retirement. There are billions of people around the world who are saving for retirement, and ultimately, the foundation of all of those savings, you need to have a secure asset. I sort of think of US Treasury bonds as being right at the bedrock of the global financial system. So there will be demand for that.

The government may not be able to borrow money as cheaply as in the past, but I don’t think it’s going to cause a crisis anytime soon.

[00:21:47] Alan

It does raise, I suppose, a question around, as you say, we’re into a period of maybe higher debt, high deficits, and you touched on the change in the landscape with respect to the Fed’s balance sheet, etc. In aggregate, do you think that’s all pointing to a very different macro backdrop and investing landscape in this decade versus the last?

Obviously, the last decade was very unusual, zero interest rates, QE, low inflation, stable growth. If you were to paint a picture of what the next 10 years, in broad terms, might look like, what do you think that is?

[00:22:26] David

Well, let’s say barring shocks for a moment before we talk about any of this (we will obviously come back to that), I don’t think that it’ll be quite as good as the last decade in terms of the environment. What I think we will do is we will get back to low inflation. I am convinced that inflation is coming back down to 2% by the fourth quarter of next year and will be below 2% in 2025. I think that’s the direction the US economy is simply going in. But I don’t think the Federal Reserve will cut rates down to zero again. So you will end up with positive real rates.

When the US has a recession, when inevitably that happens, then the Federal Reserve will normalize policy. So instead of looking at a federal funds rate of between 5.25% and 5.5%, you might end up with something in the 2.5% to 3% range. I think that’s quite possible. But I don’t expect us to get down to zero again. So to that extent, I don’t think there will be a raft of free money around going forward.

I think and I hope that the European Central Bank is not going to start dabbling in negative interest rates again, which I think is a terrible idea. So I don’t think it’s going to be quite that good for asset prices, but I think it will be good in terms of just the overall level of inflation.

[00:23:43] Alan

From a cyclical perspective, I take your point on inflation with the direction of travel at the moment. Out in the market, there’s still different views. There is the sticky inflation view and there’s a whole raft of structural factors people point to as potential factors that may elevate inflation over time such as higher investment in relation to the greening of the global economy and deglobalization.

I saw you writing about the rise of industrial policy lately, so about all of these structural factors which could influence inflation to differing degrees. Sounds like you’re fairly sanguine on the longer-term outlook. Any reason for that?

[00:24:24] David

I feel better about US inflation than I do about inflation for example in the United Kingdom or Europe, or even oddly enough in Japan. But in the US, the thing that really strikes me about the US is inflation didn’t show up when the Federal Reserve eased policy, inflation didn’t show up when the Federal Reserve had negative real rates. That’s because, as I said earlier, I don’t think that monetary policy is capable of actually stimulating the economy. You can bring the horse to water, but he won’t drink.

But when you do fiscal stimulus, it’s like you set up an intravenous drip on the horse. Particularly if you’re giving money to low and middle-income consumers, they will spend it. The problem is if they spend it on stuff that isn’t there, you end up with inflation. I think that’s really what happened. But I don’t think that the Fed caused inflation then.

But also, I think more importantly, when I look at inflation in the 1970s and when I look at inflation in the early 2020s, what really strikes me as a period between those; between 1983 or ’84 and 2019 where inflation basically went sideways or down for 40 years. A lot of times, people thought it was going to pick up and it never did. I think there are three reasons for that. One of them is that you’ve got much less union power in America than you had back then. Back in the 1970s, 25% of the private sector workforce was in a union. Today, it’s about 6%. Workers don’t have bargaining power and that stops a price wage spiral.

Second of all, you’ve got information technology which tends to help buyers more than sellers. Sellers always know more about the thing they’re selling the buyers do. But information technology has turned so many markets into competitive markets. It’s really helped push inflation down. The third thing is you’ve just got rising and huge inequality. Half the income in America is received by the top 10% of households. The way the top 10% of households, in terms of their economic behavior, the biggest difference between the top 10% of households and everybody else is the top 10% save. They save about 37% of their income. Everybody else doesn’t save anything at all.

If so much of income is going to people who save, what that does is creates a leakage in circular flow of income. The idea is you’re supposed to produce $100 worth of output and that generates $100 of income. The income is supposed to come around the economy by the output. But 37% of that is leaking out of the economy to go to investments. That’s why you can see stock prices go up, bond prices go up, house prices go up, but you don’t see enough demand for basic goods and services. That has tended to push down inflation.

I think it’s something of a global phenomenon, but it’s certainly very prevalent in the United States. I think there is more union power in Europe. There are more regulations which tend to lock in inflation increases. So I think inflation will be stickier in Europe and in the UK and probably in Japan because they’re pressing their luck here. They seem to love inflation for whatever reason. But in America, I think inflation is just heading down. In the long run, this is not an inflationary economy.

[00:27:29] Alan

Of those points that you mentioned, do you see any sign of a shift? Some of the points people will say are, union power has been low but are we starting to see a shift in that dynamic? Obviously, Biden out there on the picket lines with UAW workers recently just being a symbol of that maybe. Obviously, in 1983 to 2019, the integration of China into the global economy, the dividend from that, the peace dividend I guess as well from a stable global geopolitical situation, lots of people can point to possible changes at the margin and then draw an argument that maybe that whole period is different. It’s the end of neoliberalism, we’re seeing a shift back towards more active fiscal policy, more active industrial policy which could be part of a more inflation-prone economy.

[00:28:27] David

There may be parts of the global economy which are more inflation-prone because of it. But on the whole issue of deglobalization, I do recognize the integration of a very cheap labor force in China into the global economy did act as a deflationary influence for many years. But I don’t really think that globalization is exactly going to go in reverse here. I think it’s stalled out.

I think what you could end up with is a new equilibrium where you’ve got the trading bloc of the autocrats and the trading bloc of the democracies. A lot of people talk not about outsourcing or resourcing, but friendsourcing. So if stuff is made by cheap labor in Malaysia or Vietnam or Mexico as opposed to China, so be it. India is trying to grow very fast as a manufacturing hub that’s not going to be particularly high cost. So I think there are enough countries which have cheap a labor force to try to avoid that. That’s kind of how I see it.

On union power, well, I think we’ve got about 20 major strikes in the United States so far this year, including the UAW strikes, and those are 20 major strikes, strikes with more than 1000 workers. If you go back from 1965 to 1979, there were more than 200 major strikes in America every single year. In fact, back in 1974, there were 424 major strikes. So while strikes have gotten a certain amount of media play this year, it is a very, very tiny fraction of the labor force that is unionized. An even smaller fraction of that labor force that is unionized is actually out on strike for higher wages.

[00:30:14] Alan

Maybe talking about some of those structural themes that I mentioned a moment ago, these are all things that you pick up. The JP Morgan asset manager just released their long-term capital market assumptions. They talk about, I guess, the state of the world or what it might look like on a medium to long-term basis. So maybe to pick up on some of the points within that. We’ve kind of talked about some of that.

I think it’s a US real GDP, as you say, just below 2% going forward, which is kind of reflective of what we’ve seen, and inflation a little bit higher than what we’ve seen at about 2.5%. As you say, some of the areas where you’re seeing more notable changes are inflation in Europe and the Eurozone and Japan. The Eurozone in particular, is that just related to some of those factors you were talking about there from a unionization perspective or is it more a structural growth story that you are more optimistic on?

[00:31:06] David

No, it’s not so much structural growth, I have to say. I think Europe can grow faster. I think the Eurozone actually seemed to operate slightly better post Brexit than it did before Brexit. I don’t want to call it more than that I guess, but it does seem that way. It just takes a long time to get things going in Europe. There’s been all this talk about fiscal stimulus because of the green transition, but if you look at the actual purchasing manager data or GDP data coming out of Europe, the whole economy seems as flat as a pancake.

In fact, for all the talk about how the energy transition is going to fuel economic growth in Europe, one of the biggest problems seems to be that the cost of energy is so high for German manufacturers, they just can’t make money. That’s actually slowing down the European economy. So no, I don’t have a higher inflation outlook for Europe because of speedier economic growth. Part of it is a little bit more unionization, but also part of it is regulation. There are countries in Europe where everybody’s entitled to a wage increase to compensate themselves for prior inflation. America bosses a lot of the workers who say that. I think there are, embedded in the system in Europe, all the things which cause inflation to linger in a way that it doesn’t in the United States.

[00:32:32] Alan

Interesting. From a Japanese perspective, we’re also seeing a trend higher in inflation there. Do you see Japan now as being out of that deflationary phase that it was in for so long?

[00:32:46] David

Yes. Be careful what you wish for. What I worry about with Japan is just how much debt they have. Because if they ever had to pay true market interest rates on that debt, they’d go bankrupt. The Bank of Japan owns about half the outstanding JGB issuance, which is kind of amazing. So I don’t think there’s a problem there right now.

But right now, Japan is seeing above-trend growth and is seeing its inflation rate go up and they want to see their inflation rate go up as opposed to every other central bank in the world who’s trying to get their inflation rate to come down.

Ultimately, one of the assumptions we make in our forecast is that while we don’t think the monetary policy is particularly effective, we do think it’s a reasonable forecast, in the long run, that central banks will get more or less what they wish for in terms of inflation rate.

[00:33:34] Alan

Okay. Maybe moving into more of the asset perspective, asset allocation and investment returns part of the forecast, so you see, I think, US equities delivering around 7% going forward, which would obviously be reasonable returns but below very long-term averages in terms of nominal returns. In terms of cash rates, it looks like 2.9%, and then bond returns just under 4%. For a dollar-based global 60/40, it’s at 7%, but a specific US 60/40 would be more like 6%.

All in all, it seems to be a picture of a fairly okay kind of environment, not fantastic, not terrible. Obviously, fixed income has become more interesting and equities; presumably valuations are constraining future returns. Is that a fair synopsis?

[00:34:34] David

Yeah, I think that’s right. Last year, we were looking at a 7.9% return from US large cap stocks, and this year, we’re looking for a 7% return. The reason is we cut off our forecasts on September 30th, and the margin was a lot higher on September 30th, 2023 than it was September 30th, 2022. That’s why we have a lower outlook for US equities than we did a year ago. But it’s still very good.

I would emphasize that our outlook for cash is a lot weaker than current cash rates. Currently, you can get above 5% on cash. But we do think in the long run, a total return from cash is only going to be about 2.9%. So we do think that it’s going to be a lot lower. In any one year, it may not make that much difference to make 7% of your money on 2.9%. But over a 10, 15, 20-year period, it makes a huge difference. Long-term investors generally should not be putting long-term money in cash.

[00:35:37] Alan

Absolutely. One of the points you do that does get picked up within the report is around the role of bonds in a portfolio. Obviously, bonds are attractive again now, I guess, from an investment perspective as yields have backed up. The report does point out that they can still be diversifiers in the case of a disinflationary shock, but obviously not, I guess, in the case of stagflationary shocks like we saw last year.

That negative correlation between bonds and equities, which was so persistent for 15, 20 years, now has become less reliable. So when you’re talking to clients about that, is it that investors should now look beyond 60/40? I guess everybody naturally does look beyond 60/40, but it does strengthen the case for alternatives and that seems to be something that comes up in the report.

[00:36:31] David

Well, yes, we think there is a strategic reason for having alternatives in a portfolio. It does diversify. It is a diversified source of income and total return, which we think does need to be in a portfolio. I do think though that the long-term role of bonds as a diversifier will play out for almost all of the next 10 to 15 years.

We have this insect in America called the cicada. It’s this weird insect. It sleeps for 17 years, and then every 17 years, it pops out of the ground and starts squawking. The whole place is full of cicadas, and then they die off and they won’t come back for 17 years. They are a real nuisance when they’re there, but I sort of feel like you should celebrate them because they’re so rare.

I think to me, a year in which bonds are not doing their job in a healthy diversified portfolio, they’re not zigging when stocks zag, that is actually very rare. It does happen when inflation is a story. When inflation is going up a lot, then bonds or stocks will go down. If inflation is coming down a lot, then bonds or stocks will go up.

But if the story stops being about inflation and begins to be about real economic growth, a recession or no recession going forward, as is typically the story, if that’s the issue, then news that causes stocks to zag will cause bonds to zig and vice versa. So I don’t have any theories about the ability of bonds to mostly help diversify a portfolio. I also would say that starting today, you’re getting a pretty decent income on fixed income. So that’s kind of good too.

I don’t think you get the opportunity for capital gains that you had for many years. I think people got spoiled in the bond market thinking, well, okay, so yields are 5% but I’m going to make a bit of a capital gain, so maybe make 7%, 8% this year. I don’t think that’s going to be the case going forward, in the long run, because we’re starting with lower yields. I think you get one year where you get decent capital gains when rates come back down to more neutral levels, and then that’s kind of over.

As you say, one of the things we do focus on is alternatives. I think it’s something where, so long as you can do it in a tax-efficient manner and in a way that’s permitted under the regulations, I think having alternatives in the portfolio can provide you with income and growth and diversification.

[00:39:04] Alan

Just going back to the equity forecast, with US equity, large-cap equities at 7%, people talk about US equities or large-cap as a group of but it’s almost become two separate groups of The Magnificent Seven and rest. Taking your market observer hat as opposed to an economist, you’ve seen many cycles. I’m not sure if you were around for the NIFTY 50.

I was having this conversation with somebody yesterday. If you put a label like Magnificent Seven on a set of stocks, it’s almost asking for trouble because it does bring back memories of that kind of thing. How worried are you about a significant rerating of those stocks at some point? One might have expected it might have happened with higher yields, and it hasn’t.

[00:39:53] David

That’s a legitimate concern. It’s one of reasons why people may want to be a little bit more active in their asset allocation rather than just seizing indexes because the indexes will be overweight whatever hype. Because of capitalized weighting, they will automatically be overweight the most overpriced stocks. I think there is an issue there. But I still would defend that 7% long-term forecast.

It may be higher than that or lower than that for the top 7 stocks or top 10 stocks. They may get lower returns going forward, but the other 484 stocks in the S&P 500 should do better. So I do think it’s worth differentiating between them. Just because there are some stocks that are pretty overvalued, it also implies that there are plenty of stocks that are not overvalued by any means and actually look like rather good values if we’re right on inflation.

[00:40:50] Alan

There’s a couple of thematic pieces within the capital markets piece. One is on industrial policy which, I guess, assesses the rise of industrial policy from a couple of different lenses. One is from more of an economic perspective, which is,does it make sense; and then secondly, what is the market and economic and investment implications for it. It is quite striking how we have seen the shift towards subsidies and encouraging certain, I suppose as you said, nearshoring or encouraging firms back to the US in the case of Bidenomics.

Do you think this is going to be a feature of the landscape on a multi-year basis? Is that something to build portfolios around in terms of thematic plays?

[00:41:43] David

I think it’s very important to be aware of it because I think that there are a lot of governments who are going to very actively tip the scales in financial markets, and you should know which way they’re going to tip. As an economist, I’m somewhat skeptical of the ability of governments to find the right thing to do. Even on climate change, I absolutely fully believe that we need to do something about climate change. But unless I’m missing something in the science completely, the global climate is actually affected by global activity.

No matter what Europe does or even what the United States does, if China keeps on spewing out carbon, there is no way to prevent the temperature from keeping on rising. But also, some of the attempts to use government policy to try to reduce consumption, certainly here in the United States, some of the subsidies are very ill-conceived.

Let me give you an example. In the United States, they have a weird rule called the corporate average fuel efficiency standard for vehicles. They introduced this many, many years ago. They said that a car has to be, on average (the fleet that’s sold by an automaker), has to have a certain fuel efficiency, maybe 25 miles per gallon. And then light trucks have to, well, they’re bigger, but they have to have a fuel efficiency of 17 miles a gallon. They introduced this and over the years, they talk about it, hey, this is great, this is making our fleet more efficient. But did you ever notice that in America, 80% of the vehicles are now classified as light trucks?

People do nothing but buy SUVs and light trucks, and the auto companies have every incentive to do so because they’ve got a lower fuel efficiency standard that they have to meet. So in fact, America’s driving round in some of the least efficient vehicles in the world precisely because of the standard that was introduced to try to make the fleet more efficient. There are so many cases of that all over the world.

I am somewhat skeptical that a government that depends upon the votes of people easily led by populist leaders, that those governments will actually introduce policies which achieve the things they’re supposed to achieve.

[00:43:59] Alan

So you’re pessimistic on climate change transition then or is that just particularly with respect to the US?

[00:44:05] David

I think there are plenty of trends to take advantage of. I think electric vehicles are absolutely for real. I think AI is absolutely for real too. There are lots of alternative energy sources, wind farms, solar. There are plenty of things that will benefit from government subsidies and the public’s desire to do something about global warming. There are investment themes there.

I am skeptical that it will make not a whit of difference in terms of global carbon emissions because it’s essentially a global problem and we won’t do the most obvious thing, which is a global carbon tax. If you have a global carbon tax, you can deal with the problem. Everything else is kind of just window dressing.

[00:44:51] Alan

You touched on AI there, and that was a big driver of the markets, at least for a number of months during the summer. McKinsey had a report out at that time which as well talked about the potential benefits. It came out around the time that everybody was looking at Chat GPT, so it seemed to capture people’s imagination.

It was striking that if you looked at the McKinsey report, I think they were saying the boost to productivity could be anywhere from 0.1% to 0.7% annually and the gains might accrue largely from 2030 onwards. So pretty wide bands in terms of when this might practically start to impact the economy. What’s your sense on those questions?

[00:45:35] David

It’s very hard to define the magnitudes here, but I do think it’s a big deal. In our long-term capital market assumptions, we added just one-tenth of a percent to global economic growth, in every year, for the next 10 to 15 years just because of AI. We realize that may be a lowball estimate, but we also think that the gains will be more important in the out years.

I was doing a podcast with somebody who is much more of an expert on AI than I am. One of the things that he said to me that I thought was really profound is that English is going to be the programming language of the future. The thing about generative AI which is so cool is not only can it provide you with output that is basically simple English, but it could also interpret simple English in a way to provide you with coding. That could be tremendously important.

If you are the manager of a local McDonalds, and you can tell the robot operating near the hamburger flippers at the back to please flip them twice rather than once and then package them up in a certain way and bring them back to the front counter. If you can do all that by saying it and that is all converted to code so it actually does it, the robot does it, then it has tremendous implications.

Similarly, I think that the combination of AI and robotics can have profound implications for transportation. There are millions and millions of people around the world driving Ubers and taxis and planes and ships and trains who are doing, essentially, a simple job which AI is quite capable of doing. The more you have a labor shortage, the more of these jobs there are. You can see that over time, if you can find a way of programming a type of lawnmower which you can sell to anybody which will happen to know exactly how to mow the lawn of grass, map the whole thing out, goes out itself every second Saturday morning, knows how to work with rain and just does the job.Iit’s not very difficult programming and it can have a profound impact.

So I think over time, as this technology is exploited particularly in the world where there’s a shortage of labor, I think it will have a profound impact on productivity.

[00:47:56] Alan

You say that’s in a world of labor shortages. Even with that, presumably, there will be dislocations, then, as some workers are displaced. How do you see that being managed politically? Is that a source of a second wave of globalization in terms of not just blue collar, I guess white collar workers being displaced. Any thoughts on how that might evolve?

[00:48:25] David

Well, I think, first of all, there’s no reason why it needs to push up the unemployment rate. Every revolution in technology, that we’ve seen since the start of the Industrial Revolution, people have said this is going to cost jobs and there’d be no jobs for people. Yet, the economy has always created jobs. People, humans have an almost unlimited demand for stuff and services. There’s no end to stuff that we want.

What’s just going to happen is the stuff that we want is going to evolve over time. So long as there are some artificial constraints on supply, there’s no reason why that shouldn’t fully employ everybody who wants to work. There’ll be business cycles and so forth, but I don’t think it’s going to cause higher unemployment. It could cause greater inequality and it’s something I’m very much worry about because inequality is really severe already.

I think there are a lot of people who feel isolated in the economy. They feel like they are just servants of the machine, so to speak. They might quite literally become servants of the machine in the AI world. You almost have two classes of people, those who are programming and running the machines and those who are being run by the machines. I do think it could make inequality worse. I think it could make social discontent worse.

I don’t expect that it’s going to cause thousands to riot on the streets, at least not in the United States it won’t. But I think there are profound social challenges to all of this technology, the technology we’ve introduced so far this century which I think erodes society in a lot of ways. I think we have to think very carefully about that. If you’re using the metrics of an economist, real economic growth, unemployment, productivity, it’s mostly good.

[00:50:12] Alan

It’s all good. So it’s higher economic growth and higher productivity. Presumably, that would be good for stocks and would be associated with higher interest rates over time as well. Is that fair to say, or a higher neutral rate?

[00:50:25] David

Good for stocks, because generally speaking, companies are quite good at taking advantage of productivity gains and scooping them up for themselves. Not necessarily higher inflation. Higher productivity tends to reduce inflation, not increase it. I don’t see there’s any reason why this causes excess demand relative to supply. It’s basically a way of providing supply more cheaply. So I don’t think it means higher inflation.

But I do want to emphasize that as an economist, I always feel guilty about this constant focus on what’s going to push up the price of stocks or price bonds or GDP. One of the sad ironies today in America is that if you add up the unemployment and inflation ratio, people used to call it the misery index, that misery index is lower today than it’s been 75% of the time over the last 50 years.

People feel more miserable about the state of the world than they have 93% of the time. The index of consumer sentiment is almost as low as it’s ever been over a 50-year period. So whatever we’re doing in the economy, we may be achieving growth, we may be achieving low unemployment, we may be bringing inflation down, but it’s not making people happy. If it doesn’t make people happy, or contented, or fulfilled, then what’s the point?

[00:51:36] Alan

Well, that seems to be a global phenomenon. We have it here in Ireland as well. Obviously, unemployment is very low, but everybody’s pointing to the housing crisis, the health crisis, etc. Is it the same in the US? As you say, ostensibly, this is a great period based on those economic measures but Biden’s popularity is low. Even across Europe, there’s a shift to the right in Germany. Obviously, Germany has their own economic problems.

But yeah, there seems to be this discontent with economic performance even though that’s something you should see based on the data, as you say.

[00:52:15] David

Well, I think that’s true. I don’t think it’s just that we’re missing something here necessarily. I think it has a lot to do with how people get information. We talk all the time, I’m sure you do too, about the damage caused to young people by social media because of the phones and whatever, getting likes on Instagram and so forth. But equally, the feed of information you get, the feed I get on my Facebook page, it just reflects whatever I clicked last.

The only way they can get me to read something is it’s got to make me very scared or very angry. So we’ve got an entire industry devoted to making people scared and angry, and that is having an eroding effect on people’s wellbeing. So I genuinely don’t think things are as bad as people think. You can see this with survey data. People are asked, “Well, how are things in your family?” “Oh, pretty good.” “How’s your living status? You’re doing okay?” “Yeah.” “How’s the country doing?” “It’s terrible. It’s just dreadful.”

How can everybody individually think they’re doing okay, their neighborhood is doing all right, but the country is going to pot? That’s the effect of drinking in all this biased information. I personally think that the best solution for a lot of the woes of the American economy and the EU, indeed, probably the harsh economy of the European economy too, is you need a good jug of water in which you can put your cell (phone) and a good baseball bat with which you can beat up you television. If you can do those two things, you’re going to feel a lot better about life.

[00:53:49] Alan

Absolutely. Without getting into a whole political discussion, I’m conscious that we’re a year out from the presidential election in the US. Obviously, we’ve had a very important shift in policy with Biden economics in the last number of years, but it was an unusual period, at least at the start when Democrats had control of the full policymaking agenda. How do you see that playing out over the next four years? Is it too hard to say?

Obviously, despite all of the legal battles, Trump looks to be the front-runner, based on the betting markets at the moment, very marginally. If we were to go back to that type of scenario, would that be a concern from the protectionist agenda or not from an investment strategy perspective?

[00:54:39] David

I don’t think that you could say that Donald Trump is a conviction politician. It’s not that he actually believes in the right to life or believes in restricting trade or believes actually even in restricting immigration. His whole career, up until he got into politics, would suggest that he A, believes in the right to choose, B, is quite happy to benefit from international trade and C, is quite happy to employ immigrants. So I think he’s a conviction politician. Because of that, policy will be whatever suits the times. But it’s concerning. I think just the whole US election system is concerning.

I try to walk the narrow line between the parties. It’s not my job to tell people how to vote. I don’t try to do that. But I am concerned about the fact that the majority of the population in America do not want what they’re going to get, which is a runoff between Biden and Trump at the moment. Now, they’re both very old men. So it’s quite possible that one of them is going to run into some sort of roadblock. It may not be Trump / Biden at this time next year. But if it is, it’s pretty hard to predict exactly the outcome of that.

I just would say that in the long run, generally speaking, people overestimate the impact of Washington on the market. A lot of Republicans wouldn’t invest while Obama was president, a lot of Democrats wouldn’t invest while Trump was president. The stock market went up in both cases.

[00:55:35] Alan

One topic I just wanted to get to before we wrap up is around the demographic situation. Many baby boomers are now retiring in the US. Are you seeing any interesting impacts of that? For example, I was reading a comment today around the expectation of accelerated house sales from baby boomers as being one possible dynamic. Obviously, baby boomers have accumulated a lot of wealth already.

Is their disposal of financial assets going to be an important theme in markets in the next decade? Would that be a headwind for financial assets? Have you done any work or have any particular thoughts around that?

[00:56:56] David

I don’t think it should be too much of a headwind for financial assets because I think people will take systematic withdrawals from portfolios. Maybe they take 4% out per year or something like that, but it’ll be a relatively slow process. Even when it comes to selling the family home, one of the problems right now is it’s almost impossible to sell a family home because you have to buy something else.

If it’s just a cash transaction, I guess that can work out. But if it involves taking out a mortgage on something else, it’s very difficult. I know prices are very high. So we’re not seeing a lot of inventory on the market. The first baby boomer retired in 2012, so that’s 11 years ago. We haven’t seen a lot of inventory come on the market. I think it will be slow to come on the market. So I don’t think that’s going to push down asset prices in a big way.

I think for asset prices, the key is inflation. If we get back to low inflation, low inflation justifies low interest rates which justifies higher multiples. I think that’s really the key.

[00:57:57] Alan

From an economic perspective, do you see, as people retire, are they tending to spend less? That’s kind of the textbook answer, I guess, that the aging population is disinflationary, but are you say you’re seeing that in the data?

[00:58:13] David

Yeah. What we find is that people occasionally do a splurge just after they retire. So they do the trip they intended to do, they want to make sure they visit all the grandchildren and so forth. But then, over time, the spending comes down, and then it picks up right at the end because of course you have medical care expenses. It follows a fairly predictable pattern.

I do think that, despite the impact of the pandemic for health reasons, we will see a resumption of the labor force participation of older Americans. I think people get awfully bored not working. So I think there are people who won’t pull the trigger of retiring quite as soon as their parents would have done.

I think we’re going to get back to that because there’s a huge demand for labor and people are scared about what their life is going to be like if they’ve got nothing to do.

[00:59:05] Alan

Absolutely. Well, maybe that’s a good place to pause. Before we wrap up, we do like to ask guests for, maybe, advice for people coming into the markets and people who are interested in maybe global macro and economics. Are there any particular things you read or did, during your career, that were particularly influential that you would share and pass on to people as good as advice as things read or do?

[00:59:34] David

Well, first of all, for people who are investing, don’t look for the hot stock. Looking for the hot stock is like sitting down and playing at a casino. The whole point is to own the casino, then you’re going to make money all the time. You can just invest broadly on assets that depend on the long-term growth of the global economy, which is a pretty good bet, and you could do just fine.

So I think that investing should be a way to supplement your income and to allow your savings to grow faster over time, but it shouldn’t be a way of making a quick killing. That’s a good way to get burned. In terms of how to develop an understanding of global financial markets, I think everybody owes it to themselves to do that. Sometimes people pretend they’re not good at math or whatever and so they don’t understand. Look, it’s very important.

If people understand things about their own health, they need to understand things about the financial markets. Stocks and bonds and investment alternatives are not that confusing. There are a lot of people who try to make them confusing, but they’re not that confusing. Even if you’re using a financial advisor, you need to have a sense of it yourself.

When I visit a doctor, yes, I’m going to ask the doctor for his expert advice, but I’m also going to check out, as much as I can, what’s wrong with me before I go in there so I understand what language he’s talking. Equally, investors really just take the time to think a little bit about what you’re trying to do here, how much money you are going to have to save, what’s the rate of return you need to get.

Don’t expect markets to do what they are not going to do. Don’t stretch for return. Don’t look for things where you say, this can only work if I can find something that makes me 10% per year. Do not do that. What you say is I think I can make, as I said, 7% per year from the 60/40 portfolio, what you think it can do in the long run. Okay, you can make that.

Now, if that’s not enough, then how are you spending money and how are you earning money? You’ve got to make those two things work in a way that allows markets to help you out. Don’t expect markets to do what they can’t do for you.

[01:01:34] Alan

Very fair and sound and wise advice, I think. Well, David, thanks very much for joining us today. This has been a great conversation. Make sure to follow David’s work because as you can tell from today’s conversation, it’s a very interesting and turbulent global macro environment we’re living in so it’s as important as ever, as David says, to be well-informed on global macro developments and everything contributing to an investment landscape. From all of us here at Top Traders Unplugged, thanks for tuning in and we’ll be back soon.

[01:02:04] Ending

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