Dario Perkins - Global Macro Series - November 22nd, 2023

[00:00:07] Dario

When people imagine the word recession, they imagine this precipitous collapse in everything, asset prices collapsing, employment collapsing, and that’s because we’ve been used to these deep financial-based recessions. We had dot-com, we had the global financial crisis, we had Sweden in the early ’90s, we had Japan in the early 1990s. Well, we just don’t have that today.

I think we could have a mild recession. It may not even feel like a recession to a lot of people. We had a boom and a recovery that never really felt like a boom. Maybe we end up with a recession that never really feels like a recession.

[00:00:48] Intro

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

[00:01:44] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is the series that I not only find incredibly interesting, as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle.

We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game-changing issues and hopefully dig out nuances in their work through meaningful conversations. Please enjoy today’s episode hosted by Alan Dunne.

[00:02:29] Alan

Thanks very much for that introduction, Niels. Today, I’m delighted to be joined by Dario Perkins. Dario is Managing Director of Global Macro at TS Lombard. Dario has been in the markets as an economist for many years. He started off in the UK Treasury where he put together Gordon Brown’s global macro forecasts. He also worked as a senior European economist at ABN AMRO before going back to the Treasury and then joined TS Lombard over a decade ago.

Dario, great to have you with us. How is all on your side?

[00:03:01] Dario

Yeah. All good. It’s good to be on the show and good to talk to you. I’ve got a slight case of man flu as my wife describes it, but apart from that, everything’s good.

[00:03:11] Alan

Hopefully, that won’t detract from the overall experience. I’m sure it won’t. As we like to do, we always like to ask our guests to give us a little sense on their backgrounds, give a brief overview of your experience. How did you end up in economics in the first place?

[00:03:27] Dario

Well, when I was a teenager, I wasn’t exactly dreaming of being an economist. I’d watched the Top Gun movie and wanted to be a fighter pilot. Given the way the world’s going, it’s probably a good thing I wasn’t. I think I went on a school visit to the Bank of England Museum and weirdly fell in love with economics, studied it at university and then went as a summer student to the Treasury.

I really enjoyed it there, so I went back after my degree. It was a good place to be in the late ’90s because that era of “Yes, Minister”, of bureaucracy and seniority was breaking down with Ed Balls and Gordon Brown coming in. They gave young economists a lot more freedom; sent you over the world talking to the likes of Ben Bernanke and Mervyn King. So it was a good place to be, and I learned a lot. By 2014, I was doing Gordon Brown’s global forecast.

But over time, the fact that your wage isn’t really growing, that a lot of people you went to university with are suddenly driving fancy cars and earning many multiples of what you’re earning at the Treasury, and the fact that you can’t get any acknowledgement for anything you do because you’re just a civil servant with no name and no way of publishing your studies and stuff, you become frustrated. So in 2014, I moved to investment banking. I was working at ABN AMRO. That all went extremely well until the takeover from RBS and then obviously the nationalization. I left RBS at the height of the financial crisis, decided to go back to the Treasury just on a three-year fixed role.

It was an interesting role because it was reviewing internally the Bank of England’s inflationary map and looking at the lessons from the financial crisis and whether something needed to change at the Bank of England. I was looking at creating this new financial policy committee at the Bank of England, so learning the lessons of systemic risk and thinking of ways that the bank might be able to deal with that in the future.

After three years there, I quickly remembered all of the reasons I left in the first place. I didn’t want to go back to investment banking because of the whole RBS fiasco and realized that a good compromise would be independent macro research. You get a lot of the benefits of working in investment banking without the drawbacks and the risks and is still a much more interesting role than being at the Treasury. So for me, this has worked pretty well. I get a lot of freedom. I can cover anything I want, and I think it’s a good place to be.

[00:06:22] Alan

Very good. Historically, it was Lombard Street and it became TS Lombard and Global Data TS Lombard. So you’re covering global macro and geopolitics and asset allocation, is that right?

[00:06:35] Dario

Yes. We have a strategy team that looks at asset allocation. We have a history of policy analysis and geopolitics that comes from the trusted sources side; that’s the TS in TS Lombard. Obviously, originally, Lombard Street was all about monetary analysis and financial markets, and so there’s a liquidity emphasis that comes from that. But my role is very much standard macro, thinking about how the global economy is evolving, looking at long-term trends and trying to translate that into simple language for asset allocators.

[00:07:18] Alan

Good stuff. That’s a good segue into the current question or dilemma in markets. A lot of people are wondering why has this cycle been different. Obviously, we’ve had a big shift up in interest rates and many economists have been forecasting a recession, but it hasn’t arrived. What’s your take on what’s happened and why has the consensus been so wrong?

[00:07:45] Dario

I think that people have just misunderstood this economy ever since the lockdown period. There’s been this continuous attempt to impose a business cycle framework. For three years, I’ve had investors saying, where are we in the cycle? And my response is always the same. This ain’t a cycle. It never was a cycle. There’s nothing organic about this business cycle.

We shut down the global economy. We reopened the global economy. We created enormous amounts of pent-up demand. We put in enormous one-off fiscal stimulus. We created massive disruption in global supply chains. None of this was a normal organic business cycle.

So this idea that everybody had at the start of the year that we had very high inflation, we had very low unemployment, so the Phillips Curve said you had to have a recession in order to get inflation down, that was all wrong. That was all much too deterministic. It was a complete misreading of the economy.

I think what we’ve discovered, through the course of this year is that a big part of that inflation was artificial. It would have come down anyway, and we’ve been on this path to a soft landing. Now, the path is still pretty precarious. I think it’s ironic that everyone has given up on their recession forecasts over the last two months because I would say the risk of a recession has probably increased over the past two months. But at the moment, we’re still on that path to a pretty softish landing.

[00:09:26] Alan

Very good. It’s interesting you say that. Obviously, there was a lot of expectation from very big names in the economics world around the pain coming from this and I guess team transitory were much maligned initially, but it sounds like you think they were ultimately right. Is that fair to say?

[00:09:48] Dario

I don’t think you could say they were ultimately right. I think a big part of the inflation was transitory for sure. I think that what they got wrong is that they downplayed, first, how much inflation could actually rise, and second, how long it would stay at those sorts of levels. But the big thing they got wrong was obviously the policy response, because the whole conclusion of team transitory was that central banks didn’t need to do anything; that they would just leave interest rates on hold and wait for the inflation to come down.

That was just a complete misreading of the way central banks were thinking about this because I think you had to think about it from a central banker perspective. This is one of the things I tried to highlight when talking to investors in 2022, when central banks were becoming very, very aggressive, is that if you’re a central banker and you’re seeing inflation at the highest levels in 40 years and you don’t do anything about it, there is a very good chance that you’re going to go down in history looking like a complete joker.

I think you had to look at it from their perspective. It would be even worse than the 1970s because we spent 40 years looking at the 1970s thinking, how did central banks make all these terrible mistakes? How did they let it happen? Well, this time, it would have been, how did they let it happen again with the 1970s as a template?

So I think central bankers were only ever going to respond the way they responded, which was to freak out and to raise interest rates very, very aggressively. As soon as they raised interest rates very aggressively, the whole debate about transitory inflation just became meaningless because you could never know for sure what would have happened without that massive policy response.

[00:11:35] Alan

Yeah. It’s an interesting thought experiment. We don’t know the answer.

[00:11:41] Dario

We know what central banks will be telling us. They’ll be telling us, we were the ones that delivered.

[00:11:46] Alan

They will, of course. Yeah, they’ll say that they originally got it wrong but they brought inflation down, which obviously is questionable.

[00:11:53] Dario

What I’ve been saying recently to investors is that if we do get a soft landing out of this, we will never hear the end of it because this will be independent central bankers’ finest moment. They will tell us that we were facing a rerun of the 1970s, that if it wasn’t for them, we would have had the 1970s. But it was their aggressive and timely response that prevented all of that. We know they’ll have a good counterfactual, and we know they like to take credit for everything.

[00:12:22] Alan

That’s the beauty of economics and global macro, isn’t it? You make a good point. It’s certainly not a conventional business cycle for sure. It’s been a very unusual setup. So with that as a backdrop, where are we now? Obviously, Q3 GDP, 4.5%, 4.9%, whatever it was in the US, is very unusual at any point.

Obviously, listening to the Fed last week, they presumably don’t think that kind of level of growth is going to be sustained. But obviously, the US consumer is spending at a fairly rapid rate. The economy is growing strongly. Unemployment has ticked up but remains close to multi-decade lows. Given that it’s been all artificially generated in response to COVID, how does it play out from here?

[00:13:18] Dario

Well, I think inflation is back down to where they need it to be. So all this stuff about wanting to get inflation back down to 2%, I think 3%, 3.5% inflation, which is what we have now pretty much all across the developed world, that’s perfectly tolerable. That’s perfectly acceptable. They will say it’s not, but if you’d offered this to them 12 months ago, they would have bitten your hand off. So I think from an inflation point of view, we’re where we need to be.

I think that they have been worried about what they describe as an underlying imbalance in the economy. This is the fact that we’ve had three years of very strong labor demand, but labor supply in many countries actually went down during the pandemic. So you’ve had this big imbalance in the labor market. I think that was the bit that made people think we had to have a hard landing because we needed to get employment down and that would inevitably mean that unemployment went up. But that’s not what’s happened because what’s happened is central banks have managed to destroy demand in the labor market, but a lot of that demand wasn’t being realized anyway because it was job openings and job vacancies. So this was the very acute labor shortages that we had after the pandemic. So I think we’ve seen these labor markets beginning to rebalance.

The labor demand has gone down, and because that’s gone through lower job vacancies rather than lower employment, they’ve managed to deliver that rebalancing without unemployment going up. So that’s, I’d say so far, so good. Inflation is where we want it to be. Labor market is rebalancing. I wouldn’t attach too much weight to the GDP growth numbers. I think they were radically strong in Q3 in the US. They’re coming down, inevitably coming down. But I think it’s all about the labor market at this point.

We have tight monetary policy everywhere. The question is, will we continue to get demand destruction in the labor market without unemployment going up? I think in Europe, it’s looking a little bit precarious right now. I think the labor market is looking quite dangerous. The one thing we have going for us is that European companies tend to hoard labor, so they’re not going to be quick to start firing people. That helps you if you’re looking for a soft landing.

But I think we have to remember that monetary policy is an incredibly blunt tool. What’s gone well, over the past 12 months, is that we’ve destroyed labor demand most in sectors that had the biggest labor shortages. We’ve taken out some of the heat in the labor market without causing unemployment to go up. The risk, I think, is that we start to lose jobs in sectors where there are not big labor shortages, and that would be the beginning of mismatch in labor markets that would see the labor market start to weaken more seriously. That would be your hard landing scenario.

I don’t think there’s anything inevitable about that, but I think that’s the thing that I’m watching. I think you have to watch credit markets because the credit cycle now is clearly turning. We’re seeing default rates going up. We’re seeing bankruptcies going up. We’re seeing delinquency rates and consumer debt beginning to go up. So far, I think that looks like a normalization.

Again, it comes back to the fake cycle. We had a two-year period where central banks and governments basically put the credit cycle into this complete hibernation, so you couldn’t default or go bankrupt in that period because governments wouldn’t allow you. They backstopped everything. That policy support has been removed, and so we’re beginning to see pent-up stress and strains in the credit system. I think so far, that’s the normalization. But again, this is something that we have to watch.

So I would say we’re still on that path to a soft landing, but I think over the last couple of months, it’s beginning to look quite treacherous. So the irony is that all of those people that were forecasting a recession at the start of the year and have since capitulated and given up on those recession calls because there’s only so long you can stay wrong in this industry, they may discover that the hard landing starts just at the point where they gave up.

[00:17:43] Alan

Obviously, a lot of people have been wrong, but when rates go from zero to 5.5% or whatever in a space of 18 months, you would normally expect some kind of reaction. Even a simple economic model suggests that you should have less investment and consumer demands, presumably. Has that surprised you or do you think it comes back to what you said at the outset about this being an unusual cycle?

I guess the flip side is, are we still to see to the full extent of that? Is the lag of monetary policy longer than people assumed or is it just are people impatient? How do you read all of that in terms of the transmission mechanism of monetary policy?

[00:18:27] Dario

Yeah, the long and variable lags is the cliche response. I think that the resilience of the economy this year isn’t that surprising. The big thing about the fake cycle is that it created this big deterioration in leading indicators that weren’t necessarily a sign that the economy was headed into recession. So the obvious thing is that if we’re all at home buying stuff off the internet, you’re going to get an enormous boom in global manufacturing, consumer goods, world trade.

Typically, we create leading indicators for the economy based on what’s happening in the manufacturing sector. But as we came out of lockdowns and the economy pivoted back into more normal spending patterns and you had pent-up demand for experiences rather than goods, you were always going to get a manufacturing and global trade recession. So if you were building leading indicators for the economy based on the manufacturing sector, you were getting this enormous head fake from those indicators.

Some of it was that the economy was never on the brink of that recession. The other part of it is the demand that came out of goods went into services. Services are naturally a source of demand for workers because that’s what a service is, it’s the services of labor, and so you had a lot of resilience in labor markets. Now, it doesn’t make sense to talk about a recession if employment is still growing, because a recession is not an event, it’s not two quarters of negative GDP growth. It is about a process that happens in labor markets.

People start to lose their jobs, confidence goes down, consumption goes down. As a result, corporate revenues go down and then this reflexivity kicks in because then you get more rounds of redundancies. That is the recessionary process. We’re just not seeing that anywhere this year. The other big part of it is that we’ve seen a lot of demand destruction in labor markets that’s happened, and it’s happened through vacancies and job openings, as I said, rather than employment. So all of this together gives you a very resilient outlook.

I think that the recession risk was always about monetary policy. We had a fake cycle, central banks freaked out, they raised interest rates very aggressively. The recession risk was always that they’d raised interest rates too much and would then be too slow to reverse course when the economy started to deteriorate. That risk is still there. I think that what we’re seeing in terms of the impact of monetary policy is basically playing out the way that we should have expected it.

I think there are two effects from monetary tightening. The first one is a flow effect. You basically cut off the availability of credit or you make credit too expensive. So anything that is very interest rates sensitive like construction activity, housing activity, demand for cars, all of that stuff has plunged pretty much everywhere all across the world. So we’re seeing the first impulse of monetary policy, and we’ve been saying that for the better part of 12 months now.

The second effect is a stock effect from monetary tightening, and that’s all about existing debt holders. So if you have lots of variable rate mortgages, if you have a lot of short-term floating rates corporate debt, then you get a big squeeze on existing debt holders. Now, that effect has started, but it’s quite uneven across different countries.

If you think about the US, you have everyone on a 30-year mortgage. You have this big terming out of corporate debt has happened over the last decade. So that stock effect from monetary tightening is pretty much absent. You’re not really seeing that in the US, but you are seeing it in Europe. So if you look at the interest rates that companies and households are paying on their existing debts, that’s gone up massively as the ECB and the Bank of England have raised interest rates.

In the Bank of England case, there’s still more of this to come because everybody’s on two-year fixed-rate mortgages. So I think we’re seeing an effect from monetary policy. It’s been all about that flow effect. The stock effect has started and it is much more powerful in Europe. So if you think about that recession risk coming from monetary policy over-tightening, I would say that Europe is much closer to a situation where central banks have overtightened already compared to the US where I don’t think the Fed has over-tightened yet.

[00:23:18] Alan

Obviously, Europe is grappling with a number of challenges. You’ve got Germany with what you might say are structural challenges in relation to the higher energy costs, and some of their industrial and chemical industries may be no longer viable given the climate change energy price landscape.

But also, I did see in some of the research you’ve written recently that some of the countries, I think France, has had much higher debt service costs or higher debt levels. Within Europe, which countries would you see as being most vulnerable to the extreme tightening from the ECB?

[00:24:00] Dario

In terms of just the tightening from the ECB, I think you’re looking at where you see that sensitivity for debt. Any of the periphery countries, they’ve pivoted into fixed rate mortgages, but the stock of mortgages still has a very big floating rate. So Portugal, Spain, those are the obvious countries that get squeezed very quickly by mortgage rates going up. On the corporate side, it’s not just a question of the type of debt that you have, but also the amount of debt.

So if you look at somewhere like France, you have massive sensitivity to interest rates just because French companies have taken on so much debt over the past 15 years. Then you look at Germany, it has long-term fixed rate mortgages. That’s a good thing. But it also has massive sensitivity to the commercial real estate sector. So I worry a little bit about that.

In aggregate, I don’t think we’re looking at anything like what happened after the subprime crisis because if you think about the last decade, you basically had deleveraging across all of the developed world. Private sector debt levels, particularly on the household side, are down substantially since 2008. So it’s not like we’re looking at this ticking time bomb of something going to go terribly wrong as it did after the global financial crisis, but I think there are vulnerabilities there.

If it is just a question of the ECB having raised interest rates too far, all of this is solvable as long as they then reverse course quite quickly. My worry is that just as we had that perverse reverse currency war last year where all of these central banks tried to match the Fed policy tightening one-for-one because they were worried about their currencies going down, I don’t think we want to be in a situation where the ECB or the Bank of England are worried about cutting interest rates just because the Fed is on hold because they’re worried about the currency, because that would be bizarre.

In one sense, you’ve lost that currency war whatever you do because if you cut interest rates while the Fed is in hold, your currency is going to go down. If you just ignore the fact that your economy is deteriorating, your currency is still going to go down because allowing your economy to implode is a pretty bad way to defend your currency. You would hope that these central banks realize the mistake that they’ve made and pivot quite quickly regardless of what the Fed does.

[00:26:38] Alan

Inflation has been a little bit stickier in Europe, is that not fair to say? It hasn’t come down as much. Would that not be the ECB’s defense? Are there any unique factors in Europe that might make inflation stay a little bit stickier that could contribute to that scenario that you’re mapping out?

[00:26:58] Dario

I’d say I’d have more sympathy for the Bank of England than the ECB. I think that the UK has been this nasty mix of the euro area and the US. So it’s had the European energy crisis, but it’s also had the US labor market crisis, and a lot of that was self-imposed. So after a decade of austerity and Brexit, we’ve seen a lot of supply destruction in the UK economy.

So I think that the Bank of England is in a much more difficult situation. The supply side has deteriorated. They’ve got a nastier trade-off between growth and inflation. They will probably have to tolerate higher inflation than they did in the past, and that’s probably the least nasty way to get through that.

But the ECB, I just think they’ve overreacted. They saw this weird 1970s dynamic that was largely in their minds, this idea that inflation was becoming unanchored, that the inflation expectations were rising, that they were losing some central bank confidence. I think it was mainly a figment of their imagination. I think euro area inflation has basically just lagged the US, but it’s had an extra component coming from food and energy prices because of what happened in Ukraine.

To me, I think you’re going to get quite rapid disinflation now in the euro area. We just have to hope that it’s quick enough for the ECB to be able to pivot before their policies create too much unnecessary damage.

[00:28:35] Alan

Going back a few minutes, we were talking about this hypothetical scenario if the central banks hadn’t tightened and it was all just transitory. But there has been a real change in the markets of late. Obviously, we’ve had a significant rise in bond yields. You could say, well, is that just driven in response to the market just pricing future monetary policy as well?

But we’ve had a big shift in real bond yields as well. Economists would typically say real bond yields are driven by real factors and the relationship between savings and investment. So when you look at the big jump in real bond yields in the US, how do you read that?

[00:29:17] Dario

I think that a big part of it is about economic resilience. I think at the start of the tightening cycle, there was a view that these economies were very, very sensitive to interest rates, and as soon as interest rates went up, the economy would just implode. So every central bank hike just caused the yield curve to invert more on this view that the more they hike now, the more they have to cut in the future.

A big part of it is about economic resilience. The global economy has proved much more resilient than people expected, and so that I think has lifted bond yields.

[00:29:55] Alan

Why do you think that was or why were people wrong? Because as you say, if we went back to the start of the tightening cycle, there was this sense that the Fed Funds wouldn’t go above 2.5% because of all the debt in the system. Did people just forget about the fact that most of that debt was refinanced at low rates? What was it?

[00:30:14] Dario

Some of it is the fact that it had been termed out. So that’s the best part of it. Another part of it is that we’re so used to this idea that global debt has gone up over the past decade that we forget the sources of that debt. So part of it was government debt, it wasn’t private sector debt. A big part of it was China. China is the one part of the world that has had a massive private sector debt puddle. But for most developed economies, the amount of private debt, particularly on the household side, has gone down.

So that naturally made us less sensitive to interest rates. Then we had this rotation into fixed rate and longer-term debt, which has also helped from that perspective. So I think that’s probably the big story there, shifts in the nature of the debts that we’ve had. The simple story here is that we had a credit cycle that never really cycled. We had a decade of very subdued credit growth or creditless expansion, and so that naturally made us less sensitive.

People have a partial way of thinking about this. They think, well, if the interest rate goes up 500 basis points, that must mean that debt is no longer sustainable. But what they’re forgetting is that nominal incomes went up a lot too. So nominal earnings for corporates went up massively during the pandemic. Nominal wages have been growing more quickly pretty much everywhere, and that speeded up this year.

So the way to really think about debt sustainability is not just by shocking the level of interest rates and thinking about what that does. It’s about thinking in terms of r minus g, the difference between interest rates and income growth. We’re used to doing that for government. People always think about government debt in terms of r minus g, but for some weird reason, nobody does it with private sector debt.

The analysis I’ve been doing over the past 18 months, plugging in terminal interest rates into debt servicing ratios for companies and households, suggested that we should have been all right even with interest rates going up, that there wasn’t some big tipping point there was waiting to happen. But obviously, this is a dynamic that is still playing out and some mortgages will reset, some companies will need to refinance.

So there is still an additional squeeze that is coming. That’s why I wouldn’t completely dismiss the idea that we could get tipped over into something nastier.

[00:32:52] Alan

Okay. I want to talk about r minus g, but as you mentioned, something nastier. You did mention commercial real estate in Germany, but obviously, commercial real estate around the world has been challenged, particularly in the office sector. I have seen some research around this in terms of the amount of commercial real estate that was refinanced around that 2019 time suggesting that we may move into a period, 2024 or 2025, where a lot of that debt has a refinancing feature after about five years. Is that something that is on your radar as a risk or do you think that’s significant enough to be concerned about?

[00:33:40] Dario

I think a lot of rich people are going to lose money in commercial real estate. I think that from a macro perspective, people draw this comparison with subprime, but it’s just totally different. Commercial real estate is not systemic in the way residential property markets work. So if you look at the early 2000s, you had massive credit growth, household credit growth as a result of that long housing bubble.

But you also had economies everywhere channeling more and more resources into the residential property market. So you had big increases in employment, big increases in investment. You don’t see any of that with commercial real estate. So you could get something quite nasty in the commercial real estate sector and a lot of people could lose money, but you’re not going to see systemic macro consequences in the way that we had after the subprime crisis.

[00:34:36] Alan

That’s fair enough. As you say, we’ve had the growth of private credit as well and private markets. So a lot of that disintermediation or intermediation has been done by the private sector as opposed to the banking sector. The US regional banks is one sector where people are pointing out a high sensitivity to commercial real estate, but obviously, they’ve had a big rally in the last couple of weeks or last week I guess, so less concern there, but as you say, not systemic.

[00:35:05] Dario

I think there’s a slow-burn banking crisis in that sense. There are a lot of similarities with the savings and loan crisis in the US in the late ’80s and early ’90s. We had a recession in 1990, but it wasn’t a deep recession. It wasn’t anything like what we had after the global financial crisis. So even though you had central banks over-tightening and you had these problems in the banking sector, you didn’t end up with some big systemic credit event or some horrendous balance sheet recession. So I take some comfort from that.

I think that that is a source of optimism, particularly compared to the past. I think that’s a broader question here about recession because when people imagine the word recession, they imagine this precipitous collapse in everything, asset prices collapsing, employment collapsing. That’s because we’ve been used to these deep financial-based recessions. We had dot-com, we had the global financial crisis, we had Sweden in the early ’90s, we had Japan in the early 1990s.

The reason for that is that there was always some deep underlying macro-financial imbalance in the economy. Well, we just don’t have that today. People have spent the last 15 years looking for The Big Short 2, the big Lehman moment in the global economy, and it’s not there. Not through lack of analysis trying to find it, it isn’t there. So we could have a recession, but it will be a pretty standard recession which would just be central banks over-tighten, economy starts to weaken.

As soon as people start to lose their jobs, central banks will pivot very aggressively because there is no way. They can talk this game about how they might have to endure some pain and they want to be just like Paul Volcker in the 1980s, but there is no political tolerance for a big rise in unemployment. So as soon as the labor market genuinely starts to break, all of these central banks will capitulate.

So I think you could have a mild recession, but it may not even feel like a recession to a lot of people. We had a boom and a recovery that never really felt like a boom. Maybe we end up with a recession that never really feels like a recession. I don’t know.

[00:37:25] Alan

In fairness, in the 1990s, you mentioned the savings and loan recession. When you got to recovery, it was a jobless recovery in the early ’90s, so there was some pain there that was felt economically for a number of years. But I take your point that not every recession is the global financial crisis, so we shouldn’t always be looking for that.

[00:37:44] Dario

I think 1990 would be a worst case for me. I could see a technical recession, particularly in Europe, but I don’t think we’re going to get a big rise in unemployment because there’s just still massive labor shortages. So it’s hard to see a big rise in unemployment in that sort of environment.

[00:38:03] Alan

Okay, fair enough. We touched a little bit about debt sustainability and r minus g, and obviously, there’s the r side and the g side. A lot of this question I think comes around to, what’s the next decade going to look like? We had an economic picture of the 2010s that was low variability in inflation, low economic growth, low variability in economic growth.

Jerome Powell, if you listen to him, he always talks about 2019 and when they almost had this perfect labor market and he’d loved to get back there. All of the various subcategories were coming down, youth unemployment, black unemployment, all of these things. Can we go back there or because of COVID and the policy experiment, has that knocked everything out of equilibrium? What does this next decade look like in your opinion?

[00:38:58] Dario

Well, the only way we go back there is a gut-wrenching, head-clutching Old Testament-style recession. If we have a early 1980s-style recession, that would reset the clock. We’d be back to zero interest rates. We’d be back to negative interest rates in Europe. We’d be back to perma QE. I don’t think that’s going to happen. I think the world has changed, but I think it’s changing in quite a subtle way.

If I was to distill that into a very simple idea, it would be that 2% inflation, which used to be a ceiling on inflation, so we were always trying to get inflation up to 2% and that was the macro challenge of the 2010s. That 2% becomes a floor on inflation. So from now on, the whole bias in monetary policy shifts. It’s not about persistent 4% or 5% or 6% inflation, but it is about a world where the prevailing tendency of inflation changes.

So your basic role, as a central banker, is no longer about getting inflation up at all costs. It’s occasionally and more frequently than in the past having to actually restrain. In terms of what that means, let’s think about why that is. Firstly, what has actually changed since the beginning of this pandemic? Number one, we have structural labor shortages everywhere.

Now, only a gut-wrenching recession eliminates those labor shortages, and as I said, I think central banks probably panic soon as the labor market starts to deteriorate. So those are not going away. The other lesson from the pandemic is that we’ve seen how demographics can interact with labor shortages, because as older people drop out of the labor market, which they did en masse during the pandemic, those labor shortages become much worse.

So I think we’ve discovered that demographics is not just going to be this continuous deflationary force. It actually has this inflationary element to it that happens in labor markets. The second big thing is supply chains. Even before all of this geopolitical jiggery-pokery that we’ve had over the past few years, I think private companies were discovering that supply chains had to change. Just in time, they needed a sort of element of just in case. They needed to build resilience into those supply chains. So there’s a private incentive to do that.

Then you have the Ukraine war and you have these increasing geopolitical tensions in the Middle East and the increasing geopolitical tensions between China and the US. Suddenly, you’ve got a public sector incentive to shift supply chains as well. So this is the whole de-risking of supply chains.

So deglobalization, as far as I can see, is now gaining traction much more fiercely than people expected. Actually, all of those protectionist policies that people like Trump put in place before the pandemic, they’ve all remained in place and they’re all beginning to distort global trade patterns.

The other big thing that’s changed is the role of governments. In the 2010s, we had the perfect neoliberal environment of austerity, governments trying to reduce the size of their balance sheet, and that’s gone. We now have this bailout culture where any problem in the world can be solved with fiscal policy. So you have an energy crisis or cost of living crisis as the politicians call it, an inflation crisis, what do we do? We throw fiscal spending at it.

We now have a mortgage crisis, which is ironic because it was central banks raising interest rates in order to deal with the previous energy crisis, the previous inflation crisis. We now have governments looking at ways to help people pay their mortgage. Now, because the political system is so polarized, there is no hope that we’ll ever target any of these fiscal measures to where they’re actually needed. So you just get economy-wide everybody bailouts.

So the fiscal regime has completely shifted, and the best signal here is our strategic industrial policy. When I joined the Treasury in the late 1990s, if I’d said there was a role for governments in targeting investment and supporting various parts of the economy, they would kick me out. That was not the world that we were living in. That was not the neoliberal regime.

Well, now we have this reconsideration of all of the evidence around industrial policy and economists beginning to say, well, actually, maybe strategic industrial policy can be a good thing, particularly if we’re in this more difficult geopolitical environment where we can’t trust China or we can’t trust other parts of the world. So governments now are beginning to play a bigger role in the economy. Bidenomics in the US is a good example of this.

But look at China. China is basically decimating Europe’s car industry over the past 18 months. So strategic industrial policy is working in China, it’s working in the US. So what are the Europeans going to do? Well, they’re going to have to do the same thing. So the austerity era is gone, fiscal policy is back, strategic industrial policy is back as well. What does this mean?

Well, I always think about this in terms of what I call the supercycle, and the supercycle is in interest rates and inflation and it’s all about politics. People think that inflation is all about monetary policy, inflation is always and everywhere a monetary phenomenon, but it’s not. It’s about politics and it’s about the balance of power in the economy. What happened in the early 1980s is that we tilted the balance of power massively towards capital.

So we opened up labor markets to immigration, we opened up product markets with globalization, we destroyed the trade unions, we gave independent central banks their role, gave them very explicit inflation targets. That was the neoliberal dream. Well, that’s the bit that’s ending because neoliberalism is now firmly in retreat. It started in the mid-2010s with Trump and Brexit and euro skepticism and all of that stuff, but it’s really accelerated over the last three years.

I think that gets you to a world where you have a secular bear market in bonds, so bond yields are rising. I think about that in terms of higher lows and higher highs rather than just continuous increases in yields. Maybe we’ve gone too far over the past few months and so now we get a period where yields go down a little bit. But I think the prevailing tendency is going to be higher.

I think we have a 2% floor on inflation rather than a ceiling, and I think that changes everything for investors, but it’s quite subtle. This isn’t about, well, we’re now going into the 1970s and the whole world is going to look different. This is subtle changes in the economy and subtle changes in what this means for financial markets compared to what we had before.

[00:46:21] Alan

A lot to unpack there, as they say. But just on the inflation target piece, which makes absolute sense in terms of how they came up with 2% in the first place I think was a bit random. Obviously, the Kiwis I think came up first and then there was…

[00:46:38] Dario

Some guy made off-the-cuff remarks in a press conference and then they had to find a way to explain it.

[00:46:44] Alan

Exactly. It’s been long touted. Even going back to 2010, I think Olivier Blanchard was saying maybe 4%. But then you listened to Jerome Powell and he is very much talking about getting back to 2% and they will absolutely do it. But I suppose the question I had for you, given your experience, you’ve been in the midst of policy discussions at the Treasury and spoken to central bankers. I’ve asked Bill White this question before. Do central bankers actually say, well, let’s just let inflation slide a little bit higher over time that we’d be very happy with too? Obviously, they’re not going to publish that in the minutes, but do you think that is where their mind is at now?

[00:47:25] Dario

I think that if 12 months ago, you’d offered them 3% inflation, they would have jumped at that. They were worried, not that inflation was going to be stuck at 3%, 3.5%. They were worried that they were slipping into the 1970s and that they were going to go down in history as complete jokers and charlatans. That hasn’t happened. So I think they take a lot of reassurance from that.

I get frustrated with journalists continuously asking central bankers if they want inflation at 2%. Because what do you expect them to say? They’re always going to say that they’re absolutely committed to 2%. In reality, it doesn’t matter whether the target is 2% or 3%, you just have to have a target. The problem that they have is that they can’t change an inflation target when they’re missing the existing one.

If you’ve got inflation at 3.5 and you say, well, okay, 3.5 is all right, well, what happens if you can’t then hit 3.5? You’ve got this drift. So from their perspective, you start to lose that nominal anchor. Again, that’s a word that they like, not that I like, this idea of inflation expectations and nominal anchors and all the nonsense that central bankers usually talk about. But they believe all of that stuff, so they have to deny it.

What you need is plausible deniability. You have to be in a world where inflation seems to be moving in the right direction, is within tolerable levels close to 2%. If it’s at 5 and increasing, then you can’t possibly sustain this sort of bluff. But what you end up with is not that central banks come out and say, well, that’s it, 3% is fine. What we discover is that they will have a reveal preference for higher inflation.

What I mean by that is that if inflation is at 3 and the economy is growing, they are not going to come in and engineer a massive recession in order to get inflation down that extra 100 basis points. So what we will discover looking back is that actually, 3% inflation was fine and they were okay with it.

[00:49:32] Alan

Okay. So where we’re at at the moment, then presumably, you expect that the Fed has done tightening given where inflation is now and would be happy to start cutting rates if unemployment was up another half percentage point or how much. How do you think about that?

[00:49:50] Dario

I think that if they start to see monthly payrolls turning negative, that would be a very clear recession marker. Typically, payrolls don’t contract outside of recessionary periods. So if they see that, I think they cut rates immediately. If the labor market remains resilient and they’ve got even more of this growth in payrolls, I think that the hurdle for actually raising interest rates is very, very high.

Even if you had a sort of energy price shock coming from the situation in the Middle East, I don’t think that triggers more rate hikes. It’s going to look very different to how it looked in 2022. In 2022 when they all started to freak out, it was because they were seeing this broadening of inflation pressures. The whole distribution of the CPI had shifted higher. If this was just an energy price shock coming from the Middle East, I don’t think it would look like that. It would look quite different and they would probably ignore it.

It would be a bigger problem for the ECB and the Bank of England because they seem to be a bit more sensitive to energy prices. It would make it much more difficult for those central banks to actually cut interest rates. But I think for all intents and purposes, the tightening cycle is basically finished at this point.

[00:51:16] Alan

Just going back to the changed environment for fiscal policy as you were talking about and the end of neoliberalism, so a few different things. Obviously, the reemergence of industrial policy is one thing, and then as you say as well, solving every crisis with fiscal support. I think the IMF were out this week or last week saying, okay, they can’t keep doing this or something to that effect.

Whereas going back three years, you had modern monetary theorists saying, yes, you can do this as long as you want. There is a suggestion that we had that one-off window where debt levels weren’t that high, interest rates were zero, so of course, you could be very aggressive fiscally. But I guess your point is that has got embedded in the system so we’ve got used to that and we’re not going to be able to get away from that.

It’s ironic, nobody is saying the Rogoff and Reinhart argument anymore about once you get above 90% GDP, we all have to go into austerity, as you say. But I suppose my question is, will there be limits to fiscal policy? Is that part of your thinking around bonds if we see this ongoing fiscal bias for action, that you get that old, what we were taught in school about crowding out of the private sector via higher yields? Is that it? Will the rating agencies come in and say, no, you’ve got to be more constrained on fiscal policy?

[00:52:53] Dario

I’m always off about rating agencies because it reminds me of 2010 at the UK treasury. The government was absolutely obsessed with the idea that they could get downgraded at any point. The rating agencies always used to come in for these meetings. In my first stint at the Treasury in the early 2000s, you basically sent this summer intern to meet the raising agencies because you didn’t care less.

By 2010, it was Gordon Brown that was meeting them in person and they were bringing in these lavish, by Treasury standards, Marks and Spencer’s sandwiches to try and keep the ratings agencies on site. So I always think back to that.

[00:53:35] Alan

Even on that point, if you look at the UK experience last year, obviously an unusual set of circumstances with the Truss experiment and obviously the pension side of things was an accelerator. But I suppose it is the highlight of disrespect for the external perspective on an aggressive fiscal package and what could happen.

[00:53:57] Dario

My point about fiscal policy is that the debate is all in terms of, are we going back to austerity, are we going to a world of fiscal dominance where central banks are forced to support the public finances and they just let inflation go.

Actually, I think the likeliest scenario here is a muddle through scenario where central banks probably have to tolerate a bit more inflation than they did in the past, but they’ll be happy to do that, and governments are going to be putting more money into the economy than they did before but not to the extent that they have to worry about the bond vigilantes and all of that stuff.

I think that we have a weird way of looking at the 2010s because economists look at that period and they say, well, interest rates were really low and so debt was sustainable because interest rates were so low. But they were forgetting that austerity and that horrible policy mix that we had, very tight fiscal policy and very loose monetary policy, was the thing that was giving us very weak nominal GDP growth. So we had this toxic policy mix, and yes, it kept debt sustainable, but it was horrible from a real economy perspective.

What I think is changing here is that the policy mix is changing. So we’re going to be in a world where fiscal policy is more expansionary more of the time, not to silly Trussonomics degrees, but it’s going to be more expansionary than it was before, and monetary policy is going to be tighter than it was before. Yes, that means interest rates are going to go up, but I also think it means that growth is going to be stronger than it was in the past.

So if you’re thinking in terms of r minus g, your r is going up but your g is going up as well. There are lots of reasons for that. One of them I think is that policy mix contributed to this perma lukewarm economy that we had before. That was an economy where productivity just deteriorated. Look at the UK 2010s, we had the weakest productivity in 150 years since the Industrial Revolution.

The reason for that is that we just weren’t pushing the economy hard enough. Companies could just be reliant on cheap workers and cheap debt. You had a few superstar companies that were doing investment, were generating huge increases in productivity and good returns, but technological diffusion basically just ground to a halt. I think if we’re in a world where that policy mix is actually forcing the economy to work harder, so you don’t get crowding out but you do get more pressure on resources and you get secular labor shortages, you’re going to force companies to invest.

So I think you’ll get a lot more investment, a lot more productivity growth than we had before. In that sense, the policy mix is actually better than it was before. Even strategic industrial policy I think could have some benefits for the economy. Now, as I said, if you’d said this 30 years ago, you would have got kicked out of the economics magic circle.

But actually, if you look at the actual data, there’s lots of evidence where governments have invested in industries that have actually helped. The World War Two experience where we are big public sector investment led to big increases in R&D, big increases in productivity across the economy. You can look at the space race in the 1960s. Government took over a lot of investment in new technologies related to the space industry. Those filtered through into the rest of the economy.

You can even go back to the 1800s where you had a Napoleonic blockade of UK transport with France. At the start of that blockade, which I think was 1803, France didn’t have any textile industry because they didn’t have the mechanized spinning industry that the UK had. So the UK had a massive advantage. But actually, blockading trade led to the development of this infant industry that then persisted for decades after that.

So it isn’t true that fiscal policy is necessarily bad for the economy. It can have advantages. I think you have to bear in mind that we’ve just lived in a 15-year period in Europe where there’s been no net public investment. Now, that is just not sustainable. Because we had governments that were so fixated on meeting these really silly fiscal rules, they cut the things that we actually wanted them to invest in.

They cut public infrastructure, they cut green energy, they allowed themselves to become dependent on Russian energy. A lot of really horrendous policy mistakes were made in that era of austerity. Hopefully now, all of that stuff is gone.

[00:55:24] Alan

Interesting. Obviously, what you’re painting there is a very different macro backdrop which presumably will contribute to change, market backdrop in the sense that QE zero rates obviously was a contributing factor to supporting certain types of stocks as well and in this environment, whether it’s the return of the old economy presumably, but it certainly sounds like that listening to you.

If you were to paint out a few big asset allocation calls, conscious of time, over the next decade, as you say, a secular bear market in bonds, presumably stocks do okay if it’s a higher growth environment and if productivity is doing well. But what are your thoughts on that? Also, any thoughts on currencies?

[00:59:58] Dario

Okay, with a secular bear market in bonds, I think the big change here, we talked about the resilience part that had lifted yields, but there’s a term premium element to this. Because for the last 30 years, we’ve been in a world where inflation has always been pro-cyclical. So inflation and GDP growth have always moved together. The reason for that is that we never had to worry about supply shocks, we only had demand shocks.

So we just had central banks moving interest rates up and down and getting asset price bubbles. I think if we’re looking at a world where inflation is going to be much more volatile than it was in the past, all of the reasons that we’ve gone through, but also things like climate change, which will naturally make inflation more volatile, you’re going to get more periods like 2022 where you had stagflation.

Now, in those periods, what happens is that both bonds and equities sell off at the same time. So where this shows itself in financial markets is that the correlation between bonds and equities which was always perfectly negative, bonds always had that beautiful hedging property, that begins to weaken, not because it turns positive like it was throughout the 1970s. It’s not going to be positive all the time, but there’ll be periods where it’s positive, whereas before there weren’t. So on average, that correlation becomes weaker, and that means that bonds start to lose some of their equity hedge.

Now, think about what the term premium is. The term premium was negative because investors wanted to use bonds as this perfect insurance hedge. If they start to lose that insurance hedge, the term premium has to go up. I think that’s what it comes down to. It’s not about fiscal policy. It’s about these deep underlying shifts in the macroeconomy. So that gets you the secular bear market in bonds.

But on bonds, we’ve gone a long way in a very short period of time. So I don’t think we’re just on this linear extrapolation of continuously higher yields. I think there is this pendulum between inflation and recession. We’re shifting back towards recession risks. That takes some of the heat out of yields. But I think the trend is there.

In terms of the equity market, I don’t think this is net bad for equities. People look at this environment and they think, oh, my God, this is going to be horrendous for asset prices for the next 10, 15 years. It isn’t. It’s about the nature of equity markets. The way I think about it is in terms of growth versus value.

The 2010s, perma lukewarm economy, constant disinflation, zero interest rates, negative interest rates, QE, all of that was the perfect environment for long duration, US tech companies, growth sectors. If you look at growth versus value, you can get data on this all the way back to the 1930s, the 2010s is really weird. There is no other period where growth just completely kills value continuously for a decade.

So that I think is the big change here. You get this big rotation into value away from growth, you get this change in the way that people are insuring the bond part of their portfolio. So I think you have more commodities, you have a more thematic approach to this.

So instead of just putting money into US tech, you think, well, what are the sectors that actually benefit from deglobalization, from climate change, from decarbonomics, from fiscal policy, from industrial policy, all of these big shifts. How do you identify the bits of the equity market that do well in that environment, and those are the bits that you invest in. So you have to be a bit more discerning as opposed to just pumping the money into the mag seven stocks.

[01:03:41] Alan

Exactly. Great stuff. We could go on for a lot longer but time is against us. Dario, this has been a fantastic conversation. Thanks very much for doing this today.

Make sure you follow Dario’s work because as you can tell from today’s conversation, we’re living in a truly global macro driven world and it’s more important than ever to stay well-informed. From all of us here are at Top Traders Unplugged, thanks for tuning in and we’ll be back soon with more exciting content.

[01:04:11] Ending

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