Campbell Harvey - Global Macro Series - 19th August 2020

[00:00:06] Campbell

I see the possibility that technology is going to enable a massive surge of human capital and this surge is so large that there is no historical comparison. What I mean by that is that we’ve got 1.7 billion people in the world that are unbanked. They have no access to the world of the internet, in terms of eCommerce and things like that, that’s going to change.

[00:00:41] Niels

For me, the best part of my podcasting journey has been a chance to refine my own investment framework through a series of conversations with extraordinary investors in every corner of the world. In this series, I along with my co-hosts, Robert Carver and Moritz Seibert, want to continue our education by digging deeper into the minds of some of the thought leaders when it comes to how the world economy and global markets really work to try and learn how they think.

We want to understand the experiences that have shaped them, the processes they follow, and the historical events that have influenced them. We also want to ask questions outside our normal rules-based playground. We’re not looking for trade ideas or random guesses about an unknown future but rather knowledge accumulated over the course of decades in the markets to try to make us better-informed investors and we want to share those conversations with you.

Our Guest today is a distinguished professor of finance at Duke University who has an eight for eight track record in forecasting recessions in the U.S. using his own invention known as the yield curve indicator, but who is also involved in crypto and blockchain technology. So, you are really in for a treat today. Please enjoy our conversation with Professor Campbell Harvey.

Cam, thanks so much for joining us today for a conversation as part of our miniseries into the world of Global Macro where we relax our usual systematic, and rules-based framework, to provide you, with a broader context as to where we are in the global and historical framework and, perhaps, discover some of the trends that may occur in the global markets in the next few months or even years and, ultimately, how this will impact all of us as investors and how we should best prepare our portfolios.

So, we’re super excited to dive into many different topics in the next hour or so, not least because you are the inventor of the yield curve indicator which has a tremendous track record of identifying upcoming recessions. Let me kick it off with kind of 30,000-foot question and that is, where do you think we are in the bigger global macro picture?

At least to me, it feels like it’s a blend of things that we have seen before. Whether it be the 1920s; Japanese Bubble; or the late ‘80s Tech Bubble; Great Financial Crisis, there is a little bit of everything at the moment. On top of that, of course, we have a global pandemic which makes it an even more unique timeframe. So, how do you see it right now?

[00:03:21] Campbell

So, I like your characterization of ‘a bit of everything’, however, it’s compressed. So, all of this bad news is compressed. I call it the ‘Great Compression’ where you see these numbers that are just off the charts. I just can’t imagine econometricians, in the future, having to deal with these observations that are just extreme outliers compared to the past.

So, obviously, every single recession is different and this one has got a lot of characteristics that are unusual compared to previous recessions. So, for example, we knew exactly when it began and that was February 2020. It was obvious to everybody.

It’s often the case, with a recession, that you don’t know when it actually begins, and you certainly don’t know when it ends. It could be years after the end of a recession that it’s finally dated by The National Bureau of Economic Research.

We know the exact start because we know the cause. The cause is a biological cause. So, that makes this recession different in that it’s not, for example, our financial institutions taking extreme leverage, doing a poor job at risk management, being off-sides in so many different ways, and, essentially, putting us into the global financial crisis. No, we can’t point fingers at any particular firm, any particular industry, this pandemic, when it hit, is more akin to a natural disaster and we fell off a cliff – a very sharp cliff.

So, compression means that we go into a deep recession but we also come out of it and the numbers that we will see coming out of this recession will also be noteworthy, and new records for positive increases. So, it’s also interesting that in the global financial crisis we didn’t really know when it would end. Indeed, in the U.S., the official end was in 2009, but unemployment continued to go up and it peaked in 2010. Indeed, we didn’t get back to the rate of unemployment before the Great Recession started. It took, actually, nine years, so an incredibly long time.

Whereas this time, we actually have a good idea of what the end game actually looks like and it’s a combination of things but the main item is a vaccine. When we have a vaccine deployed that’s the all-clear signal, effectively, and we can go back to how we were operating before. So, given that the cause is biological and the solution is biological, it’s compressed into a short period of time, it does make this recession very unique.

[00:06:36] Rob

What’s crazy if the cause is biological and Niels has already alluded to your famous yield curve model which, for those who don’t know, is that, I believe, you look at the difference between the ten year and the three month of the U.S. risk free rate effectively did actually predict this recession even though the cause is biological. So, I’ve got a couple of related questions about the model, Cam, if I may. The first is, I think someone famous once said something like, “Every price the financial markets is a combination of an expectation or a forecast and a risk premium.” So, I’d like to understand how your model disentangles those two effects.

The second is, given that the curve indicator did seem to forecast this recession, do you think that’s because there perhaps would have been a recession anyway, albeit probably a mild one because we’re kind of “overdue for one.” Or is there something about the shape of the yield curve that actually is almost causal and makes it more likely that there’ll be a recession or that it will be more severe than it, perhaps, otherwise would have been? I’m just thinking off the top of my head, here. For example, it makes it harder for banks to make profits if the yield curve is very flat. So, there you go, two pretty big questions there, but I know it’s a subject that you know a lot about. So, I’d love to hear your answers.

[00:07:53] Campbell

Sure, and there are a lot of questions that you just asked. Let me tackle them. So, it is true that, actually, June 30th of 2019 I went on the record that the yield curve had inverted. So, the ten-year rate was lower than the three-month rate for a full quarter. At that point, I said, “code red.” This indicator has got a very good track record, so, it’s based on my dissertation at the University of Chicago and, at the time, I was using data from the 1960s and the indicator was four for four. My dissertation committee was, rightfully, skeptical saying, “Well, you’ve got four observations, maybe you’re lucky.” But they were persuaded, I guess a few things persuaded them.

Number one, almost nobody got that double-dip recession in the early ‘80s and my model actually got it quite nicely. Number two, it wasn’t just a statistical model. It was based upon economic theory and fairly widely accepted economic theory. So, that really helped.

So, they signed off and then we go out of sample. So, I graduated in 1986 and the model was challenged a number of times. The first challenge was October 1987, the stock market crashed, economists believed there would be a recession in 1988 and there wasn’t.

It went to forecast correctly the next three recessions including the Global Financial Crisis. So, I’m sitting in my office at Duke in June of 2019 declaring ‘code red’, saying, “Well, this indicator is seven out of seven; it’s got a long out of sample record of accuracy.” So, it’s not that I just backtest overfit something. No, no, no, this has been out of sample validated since 1986.

It not only got the seven recessions but it hasn’t had a false signal yet. Of course, it’s a simple model and it could be wrong, but never the less, given that you’ve got something with a seven out of seven: it inverts, that means there is a lot of risk and you need to take it seriously. That’s exactly what happened.

I think what’s different, in 2019, and it’s linked to your idea of causality, was that there was a causal channel. So, in the past people had ignored my indicator. So, the yield curve inverted before the Global Financial Crisis, and the Fed did nothing. They did nothing for a year, looking at an inversion for a full year. They had to act, eventually, when the economy started to fall apart.

So, this time was different in that, all of a sudden, I was being featured in the media as somebody who had an indicator that was seven out of seven and I think that it actually had an effect. So, Duke University does a survey of CFOs in the U.S. and around the world. At that time, shortly after the inversion, over 50% believed that there would be a recession in 2020. If you added in the first quarter of ’21 it was like 80%. And you’re correct.

This business cycle was long: it was over ten years, the longest time from a trough since the NBER started collecting data in the 1850s. So, the business cycle was long and you’ve got an inversion. The causal channel is interesting in that when you’re faced with an indicator like this if you’re a corporation, are you going to pull the trigger on a major capital investment, go to the bank, increase your leverage, in the face of a yield curve inversion with increased probability of a recession? The answer is no. In the Global Financial Crisis, the CEO steps in front of the shareholders and credibly says, “We were just totally surprised.” And so was everybody, so there was safety in terms of the crowd.

If it was the case that we went into recession after the yield curve inversion this time, and a CEO got up for the shareholders and apologized saying, “Well, I was just surprised by this.” They would be laughed out of the room.

So, this was well covered and I do think that sort of conservatism or frugality started the decrease capital investment; and with consumers, it was the same thing – why max out my credit card when there’s a possibility of a recession and I could easily be laid off. All of this tends to reduce economic growth.

This is really important, we’ll never know if the yield curve forecasted a recession accurately because we just don’t know the counterfactual without the Covid. So, I believe that the expectations were widespread that we were going to have a mild recession. So, the yield curve inverted for a couple of quarters, which is a relatively short inversion. It wasn’t a deep inversion, so it kind of made sense that it would be a slowdown or a brief recession. But then something external happened.

Look, there’s often a trigger that isn’t in the model. So, the Opec Oil Embargo in the early 1970s is another example of something that was unexpected. So, I guess, no matter how you look at it, the model is now eight out of eight. You’re correct that the yield curve inversion obviously did not forecast a pandemic.

The mechanism is super straightforward and you can look at it in so many different ways. For example, this inversion was largely the result of the long-term rates going down. We all know that the U.S. ten-year bond is the bell-weather flight to safety bond. So, when people get nervous, risk increases, people pile into the bond, the rate goes down, and that was the mechanism that kind of led to the inversion.

But more generally, interest rates, you think about interest rates, they are basically an expected inflation component. There’s an expected real component that’s linked to growth and there is also risk premium, as you mentioned. So, there are many different ways for this to actually happen and my dissertation looked at the real component. So, if you expect lower real growth, then that real rate is lower. That’s standard in these models. That is the mechanism that I pursued.

So, the final thing I’ll say is that I haven’t done research on that model since 1991, though I always get asked about it and I have to update it every year, at least, or even more frequently in 2019. But it’s just a model. We know these models are just simplifications of the world. I’m not saying that this model will never have a false signal. That would be unscientific. It will certainly have a false signal, and indeed it’s probably more likely if we continue on this trajectory where the Treasury and the Fed are effectively merged and we talk about things like yield curve control.

[00:16:10] Moritz

You know these recessions, they are a tricky beast, a tricky research object in my opinion, because there is not a single recession that is exactly like the one that we’ve observed before. Everyone seems to be caused, or every recession is caused by a different trigger. This one is special because it’s caused by the pandemic.

There are economies, such as Australia, that didn’t have a recession in thirty years. In other developed markets, we tend to think that every four, five, six, seven years (whatever the case may be) there is a recession and the recession is necessary because it has a healing effect on the economy. It’s kind of like you inhale, you exhale and you need to exhale with that recession and then start afresh.

But my… And this may be a completely disqualified observation, but ever since Bretton Woods there seem to be more severe recessions, crises, financial crises, and they occur with greater regularity. Every crisis that comes after the one that happened before is a level worse. My concern is, then, maybe the question to you is, are we going to be able to be healing with the current recession because the amounts of money that central banks and governments are throwing at the problem, I’m at a loss of even counting the digits in that figure. It’s just some staggeringly large number. I’m not sure what the end game of that is going to be and whether we’ll really get out of this in good shape.

[00:17:37] Campbell

Those are excellent points. First, if you actually were talking to the macroeconomists in the mid-2000s, they would actually have a different take. So, they were advocating this idea of ‘The Great Moderation’. Looking back at the business cycle from that perspective, the 2001 recession was trivial. I don’t think that there was a negative year-over-year real GDP growth in that recession.

Going back further, in 1991, 1990-1991, again, it was like a trivial recession. At that point, they were thinking, “Well, maybe we should be patting ourselves on the back that our great macroeconomic engineering has reduced the volatility of the business cycle.” There are a lot of models that kind of showed that, using the data of, let’s say, up to 2005.

But then the Great Recession hit, and the Global Financial Crisis, and that was a real puzzle. These economists had a hard time explaining. They just didn’t know what the answer was and it certainly didn’t fall under their models. But, even the Great Recession, if you look at the drawdown in GDP, the drawdown was only five percent. So, I know that people were comparing it to the Great Depression at the time, but we’re talking about a relatively minor drawdown in GDP even though it is kind of the example number one of business cycle volatility.

So, we get to today and today, again, we’ve seen all of this bad news compressed where we’ll see a very substantial drawdown in the second quarter of GDP. I guess the issue is, well, we do have some insurance mechanisms. So, traditionally governments have provided some insurance to kind of smooth things over. However, the amount of insurance is much different than previous recessions. So, I guess, what is the implication of that? What sorts of risk does that pose for, what I call, the economic path forward? The risks are substantial.

So, on the positive side, think about the difference between this recession and the Global Financial Crisis where it was pretty repugnant that we had to bail out the banks that, essentially, caused the crisis, with taxpayer money. So, they were off-side and we had to basically bail them out and we all know that that creates a pretty big moral hazard problem. So, you reward the banks for doing a bad job, they’ll do a bad job in the future and expect to be bailed out again.

Whereas, this time, there is nobody you can point to as being off-side. So, the threat was to a lot of businesses that were actually high-quality businesses. They weren’t over-levered, but they got hit with something like a natural disaster. In a natural disaster, whether it’s a flood or hurricane, there is some relief that government gives and the idea is to provide bridge financing so that high-quality companies don’t go out of business.

I have no problem with low-quality companies going out of business, but you don’t want high-quality companies going out of business because then you compromise growth in the future. So, that’s really important. So, if a lot of high-quality companies went out of business in the U.S. or any part of the world, that takes away from growth in the future and it’s a structural problem.

So, the logic of the policymakers was, “Let’s provide that bridge. We know that this is a short crisis because we’ve got high confidence that a vaccine will be deployed. Even though we know only 15% of vaccines succeed. There are over a hundred in the research stage and over ten in the testing stage, so something is going to work.

So, we can provide that bridge of financing, in the short term and try to avoid this structural downside. However, when you do that… So, when you provide money for unemployment, it might be forgivable loans to corporations, you increase debt. When you increase debt you are simply shifting income from the future to the present. On top of that, it’s not just the fiscal side. There’s also the monetary side. The amount of quantitative easing, this time around, is effectively unlimited. The Federal Reserve Chair basically said, “He will do what it takes.”

So, you’ve got a situation. In the Global Financial Crisis, there was QE, but it was limited. I think that a number of people are looking at the experience of the Global Financial Crisis and saying, “Oh, well, we spent a lot fiscally. We did this quantitative easing which is money creation, and oh, there was no inflation so let’s do it again.” The problems… There are many problems.

One problem is that, after the Global Financial Crisis, we had the opportunity to pay back some of that fiscal debt. But no, ten years in a row the U.S. is running very substantial deficits and increasing the amount of debt to about two hundred thousand dollars per taxpayer in the U.S. That’s an issue. Also, the amount of monetary stimulus that actually happened in terms of the QE, the balance sheet of the Fed only began to decrease in 2018 and the rate of decrease was very small.

So, people look at that and say, “Well, it worked in the Global Financial Crisis therefore it will work in this particular crisis.” I’m not one to extrapolate from a single observation. I think it’s incredibly dangerous. So, the amount of debt is far different than it was in the Global Financial crisis. The amount of QE is far different than it was in the Global Financial Crisis, and I do believe that one of the risks, in terms of the path forward, is inflation. Yes, we didn’t see it after the Global Financial Crisis, and no, we don’t see it right now. No, it isn’t reflected in break-even inflation rates.

I believe that policymakers really will avoid tax increases. To raise taxes is toxic in terms of your electability. So, it’s easier to have some sort of inflation and blame it on the pandemic or something like that. That is going to be a complicating factor. Inflation, obviously, is bad in terms of economic growth, and it’s especially bad in terms of income inequality because the people paying the inflation tax are the people that can least afford it.

[00:25:53] Moritz

It creates a bunch of problems, inflation does. Probably nobody knows what the inflation rate, going forward, is going be. Is it going to be at target’s 2%? Is it going to be 4%? I guess those levels will probably be levels that one could live with for a period of time even though, mind you, if you had 4% inflation for ten years in a row, you compound that, that is a lot of purchasing power lost there already. What if it starts to get out of control and inflation becomes way, way higher? The end of this is devaluation of currency – disruption of whatever currency you’re looking at, be it the Euro, be it the Dollar, be it the Yen. We’ve had that before. We’re going back to that. So, this is a really, really scary picture.

[00:26:44] Campbell

So, we’ve been there before and it’s amazing how short policy maker’s memories are. It’s not just that the U.S. and the U.K. have been there before, but many other countries. You don’t need to go back to the 1980s. You can see this mechanism playing out in different parts of the world.

That being said, the U.S. is special. So, it’s special in a number of regards. Number one, the economy is the single most important economy in the world in terms of driving world economic growth. Number two, it has been the driver of innovation in the world. Number three, the currency is the defacto number one currency in the world. Number four, much of the U.S. debt is held by non-U.S. persons.

So, if you think about that, if the rates go up, obviously, the value of the debt goes down. So, you’re effectively expropriating. Then, as you say, if there is a currency devaluation that also works against the foreign holders. So, I think that the U.S. is different, but I do see this possibility of some unexpected inflation as a major risk to the future economic growth. It’s interesting but the expectations have almost completely discounted that possibility in terms of the marketplace, it’s definitely not the generally believed belief. But, as you full well know, that’s where people that are doing investment management really shine. They have a different view.

[00:28:45] Niels

I’m completely in agreement with you in terms of the inflation. Actually, I also think that, personally, it’s going to show up much quicker than anyone can actually imagine.

I want to go back to one thing that you said earlier and I want to also ask you another question. So, I know you said that this crisis, that nobody could have seen it, it’s a pandemic and so it’s no one’s fault and therefore the moral hazard, maybe, is not as big as it could have been. But, on the other hand, I would say that we’ve seen all these companies buying back their own stocks, not being prepared financially for the unforeseen and isn’t it the responsibilities of these well-paid CEOs of always expecting the unexpected?

That’s how we do our investment strategies because we’re rules-based. We live by the rule of knowing what you don’t know. That’s how you should look at things. So, I don’t know if we can say that these actions are not, once again, benefiting the 1%. I think they are even though there is some broader help.

The other thing I wanted to ask you is about, obviously, the Fed and certainly, in terms of your work with the yield curve, the Fed is an important player. I’m sure you know much more about this than we do, and that is that this is not the first time that we’ve seen… I think a lot of people believe that this is the first time that the Fed is being very active and powerful, but, as far as I recall, it’s also happened in the ‘60s and the ‘70s. I wonder if you can talk a little bit about how that occurred and how it, perhaps, is different from what they’re doing today?

[00:30:24] Campbell

Sure, so, I teach a course in risk management. In the very first lecture, we talk about systemic risk. It’s a wide-open lecture. There are no formal lecture notes for it. It’s mainly a brainstorming session about what systemic risk actually is.

Systemic risk is the sort of risk that is just very difficult to hedge. So, think about a thermal nuclear war between the U.S. and Russia. It doesn’t matter where you are, you’re going to be affected by it. You can be on some mountain in New Zealand and you’re going to be affected by it. So, that’s a systemic type of risk.

All of these risks are a little different. Obviously, a nuclear bomb happens very quickly and the effect is almost immediate. Some risks are slow-moving. So, there’s a risk that our planet degrades so much, because of climate change, that it turns into a desert. That is something that would happen over a very long period of time and, as we know, it’s difficult to get people energized about managing that type of risk.

Or we might have the science fiction asteroid heading to earth, but we might have a hundred years of warning and time to prepare for that. But, we always end up with pandemic and pandemic is a known, a systemic risk, and it is one of the easier ones to actually mitigate. It is true that we have a long history of pandemics and the most significant pandemic, in recent history, obviously, was the Spanish flu in 1918. It’s very interesting looking at the stock market around that time, you can’t really tell what the impact was on the stock market when you’ve got a pandemic that, in contrast to this pandemic, was largely killing younger people.

The size of the death rate was just enormous compared to what we have today. But we have had many other things that could have turned into pandemics. We’ve had a number of scares, whether it’s SARS, MERS, HIV, there are many sorts of warnings about this. Yet, and you’re correct, why wouldn’t this work into the risk management of these companies?

It’s only about 50% of the companies in the S&P 500 even mention the risk of pandemic in their risk disclosures, which is kind of extraordinary. So, this, unfortunately, is a very painful and costly wakeup call. So, I think that this is something, in the future, that more companies will be prepared for, and, on top of that, given the cost (and the cost is enormous), the cost in the U.S. is something like ten billion dollars a day.

So, I think there will also be some risk management coming, from the government side, to make sure, for example, that we fund initiatives to develop vaccines quickly. So, this fourteen to eighteen months is completely unsatisfactory if you’re burning ten billion dollars a day. So, I think that we will invest in new technologies that kind of speed up, dramatically, the process.

If we can map the DNA of Covid 19 in two weeks, then we should be able to develop a vaccine in two weeks. So, in the future, I think that we will be investing in those technologies. Testing technologies, also, are super important in terms of mitigating the spread of a virus. So, I think that you’ll see risk management coming from corporations that we haven’t seen before, but I think, in particular, we will see the risk management coming from our governments to be ready to go.

I call what’s happening today, in terms of the Covid 19, ‘The Fire Drill’. So, what I mean by that is that it’s very important to learn from this particular pandemic. You cannot assume that this is a once in a century event that you don’t need to worry about and your children don’t need to worry about it, maybe your grandchildren. No, this could happen again and it could happen sooner rather than later, and it could happen in an even more deadly way. So, I believe that we need to invest in that risk management to mitigate this happening again. The economic cost, the human cost is enormous and I think that would be worthy of investment.

[00:35:54] Rob

Yeah, I think it’s interesting, isn’t it? I think risk managers and also regulators tend to kind of fight the last battle. So, even myself. I think when things started to look unpleasant in early March, one of the first things that I did was to go back to my 2008 playbook. I went to the bank and took out quite a lot of physical cash, which now I cannot spend because everyone prefers you to use a credit card which is less likely to transmit any infection.

I want to sort of pivot away, slightly, from the risks that are very hard to hedge and go back to risks that maybe, potentially, are easier to hedge. But I’m not sure how you hedge it and that’s the risk you already alluded to, the risk of inflation which is what we can kind of expect from this huge quantity of money that is going into the system. So, the traditional playbook for hedging inflation risk, obviously you’ve got inflation risk bonds, linked bonds, they tend to be expensive. We can have a long academic debate about whether stocks are good inflation risk or not. The extra risk premium looks pretty miserable at the moment anyway, so, that’s not maybe so good.

So, then we’re into the world of potential real assets like real estate, but then, also, we talked to some other people on this podcast series and they will start banging on about things like gold and also something that I know you’ve been looking at over the last year which is bitcoin. So, someone who’s thinking about hedging inflation risks in the world today, where do those different assets fit into my portfolio, or is there something I’m missing?

[00:37:26] Campbell

So, what’s really important in actually addressing this issue is not just to look at inflation but to look at how unexpected inflation impacts different asset prices. So, what we’re talking about, what we need to hedge is unexpected inflation.

It’s easy to get expected inflation because that’s in… It should be in bond yields. So, what the danger is, is that something happens that is unexpected. So, if inflation, next year, went to 3%, that would be completely unexpected. So, the inflation rate now is about 1.5% in the U.S. and that would be a very substantial surprise.

So, the first thing that’s important to do, and this is actually linked to some current research that I’m working on because I believe that inflation, or unexpected inflation, is one of the major risks that we’re going to face in the next few years. What I’m doing is looking at different assets, different asset classes to look at their exposure to unexpected inflation.

It’s challenging to do because inflation is really complicated. So, sometimes it’s bad news. So, it would be bad news if inflation in 2021 was 3%, but in other stages of the business cycle it’s good news because it’s an indication that the economy is recovering, prices are going up, and it’s just a sign of vigor. So, it’s incredibly difficult and, on top of that, there’s the issue of what is inflation?

So, inflation is different for different people. We measure it in arbitrary baskets and often we don’t take certain things into account, like the quality of different goods has changed through times. There are crude adjustments for that but I’m not convinced that they are that accurate. So, number one, I think you figure out what the sensitivities are of different assets and that’s going to help you and you need to be very careful because what you see as sensitivity in the 1970s might not be the sensitivity going forward in 2020.

So, stocks are controversial. Again, you shouldn’t look at overall stocks, you need to look at sectors and figure out which ones are most immune to inflation. Commodities have traditionally been a purported hedge for unexpected inflation. My research on that suggests that it depends on the commodity. So, I would not buy a basket of commodities. I would probably fine-tune it to the commodities that are most relevant and exposed to unexpected inflation.

Regarding real assets, one issue is that the data is rather sparse. For the average investor, some of those assets are difficult to obtain. Gold (Rob, you know I’ve done a lot of research on gold) is a notoriously unreliable hedge for just about everything. Gold volatility is about 15%, the same volatility as the stock market. Sometimes it works and when it works people trump it (that’s the great hedging ability of gold), and then sometimes it doesn’t work and you don’t hear anything from the same people. So, gold is unreliable.

The last thing on your list is cryptocurrency. Yeah, you’re correct. I’ve been very much in that space for a number of years, since 2013. I’ve taught a blockchain course at Duke University called Innovation in Crypto Ventures. I also teach a second course now called Tech-Driven Transformation of Business. Both of those courses are linked to distributed ledger technology.

I don’t really talk about bitcoin investment. I talk about blockchain as a solution to many problems that exist today that could greatly transform our economy. The problem with the cryptocurrency is that there is no history. So, this is actually the first recession observation for cryptocurrency.

So, people were thinking, “Oh well, we’ll buy cryptocurrency, it’s algorithmic, so it will naturally be a hedge.” Then, if you look at the data, in March what was happening to these purported hedges? So, the stock market is tanking and so was the cryptocurrency. So, it proved, with at least that influential observation, to fail as a hedge. The reason is that the people that are the marginal investors in cryptocurrencies right now are speculators.

Those speculators are just basically buying it because it’s got 100% volatility, you’ve got effectively natural leverage and they’re betting on a big move. When you go to a risk-off situation you dump your risky assets and that’s exactly what we saw in March. People dumped equities and people dumped cryptocurrencies. They even dumped gold and then went into the safe-haven assets like the U.S. Treasuries.

So, I think, again, this is very challenging to design a hedge. Obviously, linkers or tips are set to the inflation, but you’re correct, they are expensive. I think for portfolio managers you need to be creative to take an approach where you look at multiple assets and fine-tune your portfolio to basically get that hedge to unexpected inflation.

[00:44:08] Moritz

You’ve said the U.S. is special because of the status of its currency being the world’s reserve currency. All the other countries seem to be drawing the shorter end of the stick always, especially if there is an inflationary environment which would hurt emerging markets, in particular. Do you think that maybe some of those economies, let’s say China, Russia, somebody else, they will develop their own cryptocurrency, not bitcoin, but their own central bank, whatever crypto bank-issued currency that is limited in supply; cannot be inflated; maybe it’s backed by something – I don’t know what that could be. Then they will go to the world and say, “Hey look at this. Here’s a really hard currency; a stable cryptocurrency that cannot be played around with. I think it’s time to get away from the U.S. Dollar, what do guys think? Should we be doing trade in that currency?” If they get a lot of acceptance for that then this may, then, be a problem for the U.S. Dollar.

[00:45:06] Campbell

So, let me make a couple of remarks. I said that the U.S. dollar is the defacto number one currency in the world, right now. It probably will be in the near term. But I think, just looking at history, it’s really naïve to think that the U.S. will be the dominant currency forever. So, things change. So, economic tides come in and go out.

While it is the dominant right now, it will be challenged. On this idea of, what we call, CBDCs, so, Central Bank Digital Currencies, every major central bank is working on some sort of crypto version of their own currency. So, it just makes sense. It doesn’t make any sense that, in the future, we will be carrying a wallet that has got physical cash in it, physical credit cards, physical driver’s license, passport, all this stuff will be a relic. It will be in museums. It’s obvious that that’s not the world of the future.

So, crypto is definitely the way to go. You can just think of it as a digital currency and the way that it will happen (we’ve already seen this happen) is with the rise of so-called stable coins. For example, JP Morgan has announced a stable coin. It’s very simple, it’s a crypto that is one hundred percent collateralized with the U.S. Dollar. They can move that around very quickly and cheaply and get around a number of problems with the traditional systems of transferring money.

Facebook announced their Libra Project. I know it’s not very popular for Facebook to do this in terms of the degree of trust, in terms of Facebook’s privacy issues and other issues, but their idea was basically the same thing, and the initial idea was to have a basket of currencies 100% collateralized.

There are dozens of stable coins that are out there, today, and they’re effectively are tokens that are collateralized with something. It could be U.S. Dollars; it could be gold; it could be diamonds. So, there are many possibilities out there.

As for a national government or central bank establishing a crypto, that is just going to happen. I’ve said in the past that that’s a major threat to the existing cryptos to have these central banks issuing their crypto. But, in contrast with the model that you are proposing where it would be algorithmic and out of the control of the central bank, that’s not the way it’s going to happen. It’s basically going to be a digital version of the Pound or the Dollar, or the Euro, or the Yen and the central banks will have the same control that they’ve had in the past in terms of increasing or decreasing the money supply.

Indeed, if you think about it, it is the dream of the macro monetary economist where, with a line of code, you can do a helicopter drop into everybody’s wallet, their digital wallet, a certain amount of the digital currency. It just happens instantly. There’s no mailing of stimulus checks or anything like that. It just shows up immediately. I think governments will embrace this technology for another reason and that is tax. So, right now with the value-added taxes, especially in Europe, there are just so many incentives to basically transact in cash to avoid the VAT. Then, the more people do that the higher you need to make the VAT, and then the higher the VAT the more people will transact in cash. So, if you take the cash away, then everything is done digitally and there is nowhere to hide. That value-added tax can tend to actually go down dramatically with that.

So, I believe that the model that will arise is a model where it will be the same old thing except the central banks will do this with distributed ledger technology, and, of course, there are some benefits here. Cash is anonymous and it is the number one mechanism to do criminal transactions where with a digital currency it is far more difficult.

So, this idea of a government establishing either a fully collateralized currency or an algorithmic currency, like bitcoin, I think is unlikely. The whole idea of decentralized finance is that there isn’t a central authority actually doing this. It happens in a peer to peer method with an algorithm. I just don’t think that governments will cede control of something that is so important to them, to their monetary policy.

[00:50:52] Niels

Yeah, I think that it seems very likely that that’s the way we’re going to go. Maybe in a few years, we don’t really need the banks because we’re all going to be clients of the central banks, in a sense.

I want to shift gears a little bit away from bitcoin and just ask you about another topic that I don’t know if it’s something that you have looked at, but, at the moment we’ve talked on the podcast, a few times, about Neil Howe’s and Bill Strauss’ work on the Fourth Turning. I don’t know if you’re familiar with that, but of course, it is about things repeating, cycles repeating and, in this case, generations and especially the Fourth Turning is kind of the worst one and that’s (according to their work) exactly where we are right now. How does demographics play into all of this and generations? Is that something that you’ve taken into some of your work as well?

[00:51:47] Campbell

So, my work is kind of widespread. What I mean by that is that there are many different topics that interest me. I guess I have learned, over my career, that the main job for me, as a teacher, is to give my students a vision of the future.

So, for example, I have never used a textbook. A textbook, for me, is material that was written many years ago, and just to get into the textbook takes years. So, I always push my students to the latest research papers that are not even published yet, to get them a vision of the future.

But, this is really important in terms of my students selecting a career. Again, I teach Tech-Driven Transformation of Business and a student comes to me and says, “Well, I’ve got a job offer from Visa and I’ve got a job offer from Apple, and the career management people want me to take the Visa job.” It’s really obvious that Apple would dominate in terms of the world of Fintech especially.

So, to look at the future is difficult and you can never accurately forecast the future but I do give some ideas to my students. We start with the decentralized finance and Fintech and what all of the problems that decentralized finance actually solve.

There’s no excuse for paying three hundred basis points when you swipe a credit card. There is no reason that it takes two days to settle a stock transaction. It doesn’t make any sense that we can’t do microtransactions on the internet. It doesn’t make any sense that it’s really difficult for me to actually sell something on the internet and be paid for it. So, there are all these problems that exist.

I did, for example, a wire transfer the other day, where I was quoted a rate that was three percent unfavorable to market rates. I might as well have been swiping a credit card. So, all of these problems can be substantially mitigated with decentralized finance. But if you think of the bigger picture here, the bigger picture is what will technology actually do? How will technology transform the world? We’re seeing a little bit of that.

I heard somebody at a conference say, “Well, my iPhone is the power of a supercomputer of the 1990s.” I actually did a little research on that and it turns out that compared to like a CrayX-MP Supercomputer which was like the fastest supercomputer for five years in a row at the beginning of my career, that iPhone is like 100X faster, 100,000X faster.

So, when you’ve got technology like that; when you’ve got machine learning; when you’ve got open source software, things can happen really quickly. You need to think about how that will reshape the world. This is where Neil’s writing comes in here. He’s a deep thinker and I admired that he thinks about these different cycles.

I don’t really see it as a cycle, I see it as an evolution and that evolution involves a number of different things. One thing, you mentioned demographics. That is really important and it’s kind of obvious if you think about it, but we’re going to live way longer in the future, yet, the actuarial calculations don’t take that into account.

So, we’re operating in a system where people retire at 65 and in Europe it could be far less than that. This is a system that maybe was appropriate 50 years ago but it’s not appropriate today, and certainly won’t be appropriate in the future. I worry a lot about this in terms of the funding of older generations because those pensions are just not going to be able to pay. They’re underfunded already and then, if you add on the demographic risk, that’s enormous.

On the positive side, and this is where I kind of depart from Neil’s analysis, I see the possibility that technology is going to enable a massive surge of human capital and this surge is so large that there’s no historical comparison. What I mean by that is that we’ve got 1.7 billion people in the world that are unbanked. They have no access to the world of the internet in terms of eCommerce and things like that. That’s going to change.

I think that these digital currencies are going to help with that but it’s going to be the case that everybody will have free access to the internet. Everybody will have a smartphone. Indeed, in many places in Africa, you can buy your smartphone along with a small solar panel that powers a light bulb and USB charger for your smartphone.

Everybody will be enabled and all of a sudden that kid in some village in Africa that has got a 190 IQ but there is no school for two hundred miles, that child will be enabled. They will be presented with a quality of opportunity on a scale we’ve never seen before. He will be able to unleash the value of his human capital.

We’re going to see many examples like that. That’s all good for economic growth. I’m particularly bullish about this positively impacting emerging markets, but the residual effect on developed markets is pretty substantial also. So, I actually don’t believe that we will be continuing on this vector of slower and slower growth. We’ve seen it and I think it’s naive
to extrapolate it.

So, I believe that technology will deliver a surge, in particular, to emerging markets; will spill over to the developed markets; the increased productivity will be striking. We will not be working 40 hour weeks in the future. There will be a lot more leisure time. There will be less income inequality as we’ve got equality of opportunity.

Technology is a great equalizer where you’ve got somebody in a poor country in Latin America using the same smartphone that Bill Gates is using. So, technology, I believe is really important. I think that, even though we see it in front of us, we see the advantages in technology people don’t do a very good job of exponential forecasting and that’s really what we’re looking at. So, I think that the future, while there will be bumps in the road, is a lot more positive than some of the other people looking at it.

00:59:59] Niels

Rob, Moritz, just to be mindful of Cam’s time, do you have some questions that are easier to answer in a short space of time? (Although we could go on for a long time.)

[01:00:11] Moritz

We could but there are no easy questions, I’m afraid, so Rob, how about you?

01:00:16] Rob

I think that such a brilliant and positive statement is a very good way to end this discussion, actually, personally. I think any question I could ask would only bring a more depressing answer, so, let’s keep things upbeat.

[01:00:30] Niels

Well, let me finish with one thing then, Cam, just trying to put everything… because I do agree with Rob. I don’t think we come across that many, at the moment who have a real positive outlook, at least not the circles that we follow, so I do agree with Rob on that. But, I wanted to still ask you, when you put everything together that you see in your work, in your interactions with peers, etc. etc., the next five, ten years, from a strategic investment point of view, what does that look like in your opinion? How do people prepare themselves for, in any event, you could say, a somewhat uncertain future right now?

01:01:16] Campbell

So, one thing that is kind of obvious is that the investment landscape has been distorted by government and central bank influences. So, to me, it doesn’t make a lot of sense in Denmark that you can have a mortgage where the bank actually pays you. That to me is just pure distortion. I think that we need to be very careful about the sort of structural damage that can do in the future.

It’s really difficult to think about buying a very long-term bond, whether it’s ten, twenty, or thirty years, at the rates that are being offered today knowing that just a minor jump in inflation would just hammer your fixed-income portfolio. We have seen a very confusing equity market where we’re at an all-time high in the U.S. in February; the market tanks as you would think it should but then it has come back very rapidly, effectively pricing a V-shaped recovery which I think is very naive.

So, one thing that’s really missing here (and it kind of links to my discussion of decentralized finance) is that the investment opportunities are very limited. One thing that is very exciting to me is the possibility of tokenizing other types of investments.

What I mean by that is that there are so many financial constraints out there that it is very difficult for a small business to get a loan. The bank just isn’t interested because the loan is too small and they’ll tell the small business, “Oh, just use your credit card.” And you know how that goes. The interest rate could be like 22%. So, you’re looking at a really good project and it might be returning twenty percent but no, you can’t do it, because your cost of funds is 22%.

So, this idea of raising capital in alternative ways, I think, will become more and more important and it will be less important to transact on either centralized exchanges or over-the-counter transactions with your broker. So, I see the possibility of tokenizing projects, equity, many different things, infrastructure projects, and essentially what this does is that it allows anybody to invest.

So, I already talked about tokenizing gold, so you could have, in your wallet, you want to invest twenty dollars in gold. Well, that’s really easy to do, you got it. So, think of completely different investments that are just in the mode of thinking; think about investments like stocks and bonds and maybe commodities or a few other things; think about new classes of investments. Think about somebody tokenizing a cell phone tower and you buy a piece of that tower then somebody drives by and uses ten cents worth of that towers time. If you own ten percent of that tower, then in real-time, money is transferred to you – one cent.

Or think about tokenizing a self-driving car where you actually are able to participate, and again, in real-time. These are different types of investments that we will see in the future.

The infrastructure of projects is limited to these giant pension plans that can actually have the scale to invest in them. Private equity has got a pecking order also where the biggest players are the first to the good projects. So, think about a different system where, again, everything is tokenized; there’s much more democracy and many more opportunities.

This works even with things like basic instruments. So, when my grandfather died I found that, in his estate, he held a mortgage. Basically, he had lent the money to somebody and that person was paying him every month. So, it wasn’t diversified but it was a peer to peer transaction. That’s exactly what we will see in the future. So, it will be a lot more cost-effective, in terms of a lower loan rate, for a small company to go to peers and to be funded.

For those peers, they get a much better rate of return than investing in a Treasury bond or a mortgage bond, or a certificate of deposit. So, my view of what is going to unravel in the next five years is a dramatic transformation of what’s available in terms of investment opportunities.

So, I think, again, this link to my vision of the future, we think about those investment opportunities, and say, “Well, how much should I put in stocks and how much should I put in bonds?” What I’m saying is that the landscape is going to be transformed, that there will be opportunities, many opportunities, that don’t exist today that will exist in the future.

So, people talk about the rate of return going down, the equity premium collapsing, the expected rate of return on bonds is really low, well, that’s fine but think about the possibility of the landscape changing dramatically and the opportunities for different types of diversification that we’ve never had the opportunity to participate in, in the past. So, I think that, strategically, there will be ways to invest in the near future that will be really pioneering and open the door for, not just the average investor, but any investor, whether retail or institutional. The opportunities really abound.

[01:07:47] Niels

Yeah, that is a fantastic way to end our conversation today. I’m sure the three of us will already start thinking about tokenized trend following, but that is to come. Cam, thank you so much for spending time with us today, we really appreciate this and I’m sure all our listeners do as well. By the way, make sure to check out Cam’s work on LinkedIn and at the Research Affiliates website. From Rob, Moritz, and me thanks so much for listening and we look forward to being back with you as we continue our Global Macro Miniseries. In the meantime be well.

[01:08:19] Ending

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