David Rosenberg - Global Macro Series - May 24th, 2023

[00:00:07] David

The future is going to be one of fiscal restraint and I think it will be global and it will be out of necessity. Because coming out of this interest rate shock, you’re seeing debt service costs rise inexorably. If that cuts into program spending, it’s going to have brutal implications for fiscal finances in the future at a time when interest rates aren’t so low anymore. Now, I think they’ll come back down. But this has been a significant shock to the fiscal side at a time when you have more and more people dropping out of the labor market.

These are high-income people. You’re getting low-income people coming in; not low-income, but younger people. They’re not paying as much taxes. So I think we’re building up to something on the fiscal side and this is one of the risks. One of the risks is that we’re going to have a fiscal crisis. I know it’s the boy who cried wolf. But just remember this: in that story, the wolf shows up.

[00:01:01] Intro

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

[00:01:57] 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.

[00:02:41] Alan

Thanks very much for the introduction, Niels. Today, it’s a great pleasure to be joined by David Rosenberg. David is Founder and President of Rosenberg Research, an economic and financial market consulting firm he established in 2020. Prior to creating his own company, David was Chief Economist and Strategist at Gluskin Sheff and Associates. Prior to that, he spent many years at Merrill Lynch where he was Chief North American Economist.

David is a frequent contributor to major financial newspapers and publications around the world and makes regular TV appearances. Dave, great to have you with us today. How is all on your side?

[00:03:16] David

Everything is good here. Doing better than the US regional banks. So I’ll set the bar low.

[00:03:24] Alan

Very good. Well, great to have you on. As is always the case with our guests on our podcast, we want to get a sense on their journey in the financial industry. Obviously, you’ve had an interesting journey from Wall Street to founding your own firm. Can you give us a sense of how you ended up doing that and what’s been your path through the financial markets?

[00:03:46] David

Well, it was a dream of mine to ultimately set up my own research consulting company. When I came back to Toronto from New York, when I left Merrill Lynch, I had a lot of people coming up to me and saying, you should just hang up your own shingle and do your own thing because the sales force at Merrill told me that the research that I was pumping out, and especially my daily, was the most widely read piece of research coming out of the macro strategy team at Merrill at the time. This was back in 2009.

But although I was pushing the ripe young age of 50 years old at the time, I thought that you can still teach this old dog new tricks and when I had the opportunity to go to Gluskin Sheff, which was this boutique mutual fund in Toronto, I thought that I wanted to round out my career as an at-will employee on the buy side because that’s the one area that I hadn’t been involved with.

I was an advisor to the buy-side all those years as a sell-side economist, whether it was the Bank of Nova Scotia or the Bank of Montreal or Merrill Lynch. The 12 years I had at Gluskin was invaluable because when you’re there and you’re sitting down next to portfolio managers and the CIO every single day, you get a much keener sense than you do as a classic Wall Street economist or strategist. You get a real sense as to how the decisions, in terms of wealth management, really take place.

I would never have known, starting my business, how to jump into the brain of a portfolio manager and understand what makes them think; what it is that helps them make decisions. So I delayed my eventual startup of Rosenberg Research until early 2020, and at such a point as I was comfortable and knowing how I can best help the investment community. Those 12 years at Gluskin Sheff, I’ve got to say, were more valuable than the previous 30 years I’ve had in this business combined. So that explains that.

In terms of just the financial markets, it’s interesting because when I got hired, at Merrill Lynch, Canada, back in late 1999 and I was picked off from the Bank of Montreal’s economics department where I was the number two to the economists back then, Sherry Cooper. They wanted to put me on the institutional investor list, both for economics and strategy. This is back in the beginning of 2020 when I really started rolling my material out for Merrill Lynch, Canada. This is two years before I went to the US.

I told my employers at Merrill Lynch, Canada, I said, “Well, I’m an economist. So put me on the rankings for economics not strategy.” They said to me, they said, “We’ve read your stuff for years and although you’re an economist, you talk like a strategist and we noticed that every single time you write a piece on the economy, you never fail to attach a market call to it. So we’re going to put you on both surveys.” For years, I got ranked on both surveys.

So I think at a young age, I realized that if you’re going to be a relevant economist on B Street or Wall Street or Boylston Street or Montgomery Street or any street, it’s incumbent on the economist to take your analysis to a new level that’s going to connect the dots, from the macro to the markets, and formulate as best you can a cogent and coherent and cohesive investment strategy out of it. So that’s why the financial markets, as an economist, have always been, to me, intertwined so importantly.

[00:08:00] Alan

Very good. Obviously, you’re a macro analyst. There’s a huge amount of information to shift into. So maybe before we get into current views on the economy and where markets are heading, it would be good to get a sense on your process, I guess, your research process. How do you determine what to focus on, what’s the most relevant? Do you have more of a US focus or is it global? What would you see as your edge? Where do you differentiate yourself in terms of your macro analysis?

[00:08:35] David

Right. Well, being from Canada and Canada being a small open economy, you could never call the Canadian economy without having a strong sense of what’s happening around the world. I guess I can say the same thing about an Australian economist. I tended to find, historically actually, and to this day that the folks that call Canada know the global economy and the US economy as well as Americans or true global economists. So you have to have that world hat.

Rosenberg Research, we have almost 3000 clients across 40 countries, and 70% of them are in the States and the other 30% are dispersed between Canada, Europe, Asia, and some of Latin America. So we cover the entire world and we cover all the asset classes and all the economies and all the markets. So we’re broadly based. I guess you could say that we probably, given the composition of our clients, have more of a US focus than probably any other region, but we cover everything.

We have a monthly asset allocation model and investment strategy model that we publish every month and it covers all the asset classes across all the different countries around the world. So we are truly global. What the thought process is, we are top-down. It comes down to what are the things that influence interest rates, what are the things that influence valuations, what are the things that influence where we are in the business cycle? So we’re very model-driven, but I have to say, I do have 40 years of experience so there’s a lot of intuition.

At my heart, I have a strong knowledge of economic and financial history. The old Mark Twain refrain that patterns, they might not repeat, but they certainly rhyme. If you don’t have a sense of history, the chances that you will end up working at Rosenberg Research are very low because I want quant but I want a knowledge of history. As Warren Buffett famously said, the one thing that we learned from history is that people don’t learn from history. So it’s always important to know, in that perspective, what’s similar and what’s different.

So the bottom line is I put an historical perspective on our quantitative analysis and I’m able to isolate what makes sense and what doesn’t make sense. But we’re very much a top-down macro shop that attaches our macro views to where we think the markets are going. More often than not, if you get the call right on inflation, and you get the call right on interest rates, and you get the call right on growth, well then, as they say, Bob’s your uncle, then you solve a lot of other questions for your client base no matter what asset class they’re managing.

[00:11:58] Alan

Fair enough. You mentioned having that perspective on history as being important. I guess you always get, maybe in the media or elsewhere, people drawing parallels. After the pandemic, everybody said maybe we’re going into the roaring ’20s. Obviously, we’ve had a lot of parallels with the ’70s and then parallels between Jay Powell and Volker. You could draw parallels between now and 2000 at the end of a tech boom and possible bust.

I think I heard you speaking somewhere else where maybe the parallel at the moment is with now and the savings and loans challenge in the late ’80s, early ’90s. So how do you go through that process of not so much fitting the current economy, but trying to say, well, this is most like or these parallels are relevant but that’s a bit superficial? Is it just experience? How do you think about that? Where do you see the parallels now with history?

[00:13:00] David

Well, I said that this was eerily similar to the late 1980s because of the leveraged boom we had in commercial real estate and how that infected the savings and loan industry, which went through several years of rapid consolidation. We had a credit crunch. We had a three-quarter recession. The Fed took the funds rate from 9 7/8 down to 3. Even after the recession, we had two to three years of a very subdued disinflationary recovery on our hands.

So in the context of commercial real estate, once again, being the problem child, it’s not about residential mortgages this time around, that was the last war, and that we are seeing the problems where most of the CRE are situated is on the regional banks finding out the small banks aren’t so small anymore. So it had that sort of a flavor. Because the one thing that you always know is whether or not we have a recession or not, Fed tightening cycles always end in tears. Whether we have a recession or not, it usually pops whatever bubble or whatever excesses there were from the previous period of excessive accommodation.

So it bears a lot of resemblance to the late 1980s in that regard. You mentioned before about the roaring 1920s. That was, of course, a whole theme from Ed Yardeni, who actually debated yesterday at the John Mauldin event, and he’s moved from the roaring ’20s to rolling recessions, to which I say I like Rolling Rock because at least you can drink that. The roaring ’20s, I thought you can draw that comparison because of course we had a war shock, World War One and we had a health shock. We had the Spanish flu.

So now we have the war in Ukraine. We had the COVID. So then we came out of that. The 1920s was a radically different time period. A much younger population, a much more vibrant population than we have today. When you look at the median age, the population and the dependency ratio, it’s vastly different. We came out of that period, came into the 1920s, with very low levels of public and private debts, believe it or not, even after fighting the war.

Look at how strained the balance sheets are right now especially in the public sector, but also in other parts of the private economy. So we had a different quality of the balance sheet and we had a different demographic. Tax rates through the 1920s; because of the better fiscal position, tax rates were coming down. Does anybody believe that tax rates are going to be coming down? The one thing we know is that the levels of debts are unsustainable and fiscal restraint is going to be the order of the day going forward.

That wasn’t the case because the government balance sheet was in such better shape back then. There are just too many differences to draw this comparison. The two most important is the state of fiscal policy and of course the fact that we had a much more vibrant, youthful demographic base back in the 1920s. So I sort of dismissed that out of hand.

The 1970s, people talk about the 1970s. Of course, that’s been reinforced by the fact that Jay Powell, at every opportunity, has compared himself to Paul Volcker. But Volcker inherited a 12-year institutionalized inflationary situation. The economy was much more sclerotic, much more regulated. Technology back then was not AI. It was a transistor radio. Microsoft didn’t go public until 1986.

So to talk about stagflation-inflation, look, we know where this inflation came from. It came from the pandemic. It came from the policy response to the pandemic. I guess I would be willing, as an economic historian, to say that inflation was transitory. It lasted 18 months. I don’t think anybody predicted, including me, it was going to go to 9% last June, but we’ve almost cut that in half right now and we’re making progress. Inflation is this exciting race, for an economist, between watching paint dry and grass grow. It’s a process.

Inflation, everybody says it’s not falling fast enough. But inflation was falling just as fast, in the past nine months, as it did in the comparable period in the early 1980s under Paul Volcker. So I would say that the makeup of the economy, and this comes down to what’s the same and what’s different. The 1970s, again, had a much different demographic backdrop. The first of the Boomers were in their 20s. They are heading into their 70s. So we had a much different savings and spending dynamic.

The spending dynamic with the household formation, which was going nuts in the 1970, that was demand inflation. OPEC raised oil prices 7 of those 10 years in the 1970s. So look, you take the oil price up tenfold, from $3.50, at the time of the embargo in ’73, and then you go with the $39 in 1979, yeah, you’re going to get a massive inflation bulge no matter what. But I mean, is oil going up tenfold? Is oil going to $800 a barrel? Is that what people think it’s going to go to? So we had an inflation shock.

We had supply constraints and they were coming from all circles, China shutting down port cities of over 20 million people because of a handful of COVID cases, but that’s over now. The war in the Ukraine, that’s ongoing but the effects on the commodity markets have leveled off. The era of all the monetary fiscal stimulus is in the rearview mirror, and that was your inflationary episode. You have contraction of the money supply right now. The Fed did not contract the money supply in the 1970s.

This Fed, this Jay Powell Fed, the new Paul Volcker Fed modern day is contracting the money supply. That’s very important because what it means is that any inflation you have right now is going to be a relative price game. Company X might raise its prices, but Company Y will be forced to cut their prices. I think people will be surprised in the next year how quickly inflation comes down. Of course, it’s a funny thing talking about the CPI when 30% of the index is rents or imputed rents and they’re inherently lagging in both directions.

One of the reasons why it took inflation so long to go up, everybody was saying but prices are going up is because of the lagged impact of the low rents we had. Then all of a sudden, rents go skyrocketing with a lag. It has an outsized influence on CPI inflation. So this is all to say that it’s not the 1970s, it’s not the 1920s. I think at the margin you could argue that COVID had an impact on lifestyles, maybe produced more of a narcissistic I’m going to get my bucket list. But at some point, you do have to get back to work.

Maybe this had more of a reinforcing trend on work from home. Work from home, you could say, well, that leads to lower productivity, which you could say is inflationary. At the same time, it’s led to commercial real estate vacancies being way higher than they otherwise would be. So that’s created a deflationary development in the office. You can see in the retail space in commercial real estate, so they’re more or less offsetting. So there have been changes coming out of COVID but it wasn’t like a five-year war.

It wasn’t like the repeated OPEC shocks we had in the 1970s. OPEC was raising prices almost every year. So I think that every cycle we come out of with some changes. We came out of the dot-com bust with some changes, came out of the whole new financial nomenclature. Everybody said things will never be the same after the great financial crisis and now people are saying it’s not going to be the same. But I think that the way I see it, is that the overall factors that determine the economy, which is policy and demographics, interest rates; how is that going to change? That hasn’t changed.

I think a lot of the distortions, outside of work from home, a lot of the distortions from the COVID are behind us. What’s most striking to me that tells me that we’ve actually normalized, to large extent, is if you’re taking a look at most global supply chain measures. The bottlenecks globally, today, are actually lower than they were pre-COVID. Look at the Baltic Dry Index. It’s collapsed 70%. It’s back where it was two decades ago. So a lot of things have normalized.

I think that the last thing that I’m looking at is the participation rate for (and this is in the US) 25 to 54-year-olds. The prime working age participation rate has gone up to its highest level in 15 years and I think that’s a very important result. It does mean that women, for example, who were finding it frustrating, in terms of childcare costs or were fearful to come back into their work setting because of contracting COVID, that’s over.

For males, this great retirement theme you see, that was one of the things people talked about that there was something new happening that people over the age of 50 or even 40 can just sit there and trade GameStop and buy bitcoin and play the S&P 500 and all the growth stocks and all the meme stocks and they don’t have to go back to work. Of course, for a while, they didn’t have to go back to work because the government was paying them so much money and you had an unemployment insurance situation, maybe out of guilt by our policymakers where people were getting paid more not to work than they were in the previous job, which is absolutely crazy.

That’s all in the rearview mirror. Nobody talks about the great resignation theme anymore. The great retirement theme has been retired. So I think that what’s interesting is that here you had World War One was called the Great War. I’m not so sure we’re calling the Ukraine war a great war. Then we had the Spanish flu, which was devastating for young males. It was a devastating global blow to the world population on a much grander scale. The two events coincided, but you’re talking about five or six years.

By 1925, F. Scott Fitzgerald is writing The Great Gatsby. Who would have guessed that there’s not one word about the Spanish flu or the great inflation. Inflation from 1915 to 1920 averaged 15% per year. I would say the big danger would have been to extrapolate that into the future. Of course, the one thing about the Roaring 20s was that we had 10 years of either disinflation or deflation and I actually think we’re going back into that period.

If there’s one thing I could agree with on the roaring ’20s is that we’re going to revert, we’re going to revert. There is no new era here of higher inflation, and the Fed is looking after that.

[00:25:00] Alan

Obviously, the market narrative has shifted to I guess more mixed views. But if you went back to maybe Jackson Hole last year and listened to some of the speakers at that, the guy from the BIS or even Isabel Schnabel, it was all about the challenges on the supply side of the economy. Were they wrong do you think? Do you think that’s all normalized? I guess the view might be, going forward, you’ve got a huge transition of the economy coming in terms of the greening of the global economy going to require much higher levels of investment demand.

Will that not push up overall growth and be a challenge in terms of being more of an inflationary force? That’s typically highlighted as one of the factors that could be associated with higher real rates and higher inflation over time. Would you agree with that or not?

[00:26:00] David

Well, I think that you hear that a lot that the greening of the world is going to be somehow inflationary. I don’t see how that’s going to be the case if the central banks are going to be keeping the rate of growth of money supply below the rate of growth of nominal GDP growth. It’s a very myopic view to come out and say… There are thousands of variables that go into predicting inflation, and to then say, “Oh, well, deglobalization, that’s going to be inflationary.” It’s ridiculous. At the margin, it could be a very modest effect.

There’s other things happening at the same time. Oh, the greening of the world. Yes. Okay, so maybe the prices of copper and cobalt and lithium will be higher than they otherwise would be. But how does that weigh against one of the most powerful disinflationary forces in the world which is declining populations in critical parts of the world like China and like Japan?

If you’re taking a look, for example, in Canada, the only way Canada’s population is not declining, when you look at the fertility and birth rates is because of the aggressive immigration policy, but immigration is just stealing people away from another country. Look at US labor force growth. Look, here’s the reality. People were saying this for years. There’s nothing new. The greening of the world was starting to happen anyway. Did we just discover Elon Musk during COVID? I don’t think so.

The ageing of the population, people say, “Oh, this is going to be tremendously inflationary because of what it means for the labor force and shortages of labor.” Ridiculous, because you can’t forecast inflation with just a supply curve. What you tend to find is that when people break the age of 50 and 55, their spending on cyclical goods and services goes down significantly because their incomes go down.

Actually the demand shock, the demand shock from an aging population, much greater than the supply impact on the labor side, and this is what the inflationistas don’t tell you because of demographics. War is inflationary. If aging populations were inflationary, then why is it that the two countries with the most aged and aging populations, China and Japan, also have the lowest inflation rates? The first of the retiring boom didn’t start with COVID.

It actually started over 20 years ago when the first boomers started to retire and that is actually when the participation rate peaked. So the participation rate peaking in the year 2000, 2002, you’d be saying we got to be going through an inflationary future because of participation rate. Bad call. So there are so many things that go into it: productivity, obviously monetary and fiscal policy. Where?

The most important thing, and this is what you asked me at the beginning, where is it that we have our edge with our research? We are constantly drawing and redrawing what aggregate supply and aggregate demand curves are looking like because those are the most powerful curves. We’re trying to come up with a price and we’ve tried to come up with a price for everything. Now, when you’re talking about inflation, you’re talking about aggregate prices. Well, you have to have a framework where you have an understanding of what the shape of the aggregate supply curve and aggregate demand curve look like, and then how are they moving.

Therefore, you can get to a bonafide inflation forecast. That’s really, when you think about inflation, drives interest rates. Interest rates drive the economy. For investors, if you don’t have a view on interest rates, how can you drop a dividend discount model? How can you tell an investor, “Based on this interest rate that I think we’re going into, this is actually the discounted present value of the future earnings stream?” You can therefore identify are you overpaying or underpaying for this particular security or asset class. So this is why it’s a very important call to make.

But yeah, I would say that if that view is correct, both the greening of the world, we all know about it, then why is virtually every commodity, every commodity is either in a correction or a bear market over the course of the past year. Things have changed. What’s changed is not the inelastic supply curve of these commodities, it’s the demand side. It’s the demand side. Interest rates are working their magic. It just takes a while. There’s lags involved. That’s what’s happening.

What has shifted more quickly, because we are in a bear market in most commodities, by the way, including food, and that’s because the demand curve is moving much quicker right now. This is the opposite of what happened 18 months ago when it was about the supply curve and it was about the demand curve, but the demand curve now is shifting in the other direction.

[00:31:16] Alan

You touched on a good point. Obviously, as you say, Fed tightening always ends in tears. We’ve gone from zero to 5% so you would expect there to be a reaction. What do you use from a timing perspective to get a sense of okay, it’s starting to bite now? Obviously, if we went back a year, people might have thought… If you go back to the start of the tightening cycle, people didn’t think rates could go above 2.5% percent, whether it’s something breaking.

Now we’re up to 5. Okay, we’ve had a wobble in the banking sector but unemployment is still at 3.5% or 3.4%. What are the key indicators you watch to say, okay, now it’s actually happening where policy is starting to bite? You mentioned the money supply so I guess that must be one key metric. What else are you seeing at the moment that suggests yes, policy is restrictive and impacting the economy enough that we’re heading towards this significant downturn?

[00:32:14] David

Yeah, look, it’s always very difficult to time. When the Fed started tightening policy in March 2022, the title of my slideshow was “Soft Now, Hard Later”. Now, I didn’t have that because I’m the Pfizer analyst and I was talking about soft landings and hard landings. But I was saying, we were making the transition; we were making the transition from expansion to recession. We know that the lags between Fed policy and the economy, in both directions, those lags are long. They work in both directions. Take a look.

The Fed started cutting interest rates in the summer of 2007. Recession didn’t end until June of ’09 and the bear market didn’t end until March of ’09. So even then, it took a couple of years for the Feds magic to work its way towards economic recovery, and of course, other things had to happen along the way like TARP, which was not insignificant. It’s interesting because I saw my friend Sara Eisen, on CNBC, this morning saying the Fed has been tightening for a year and there’s no recession. It’s some sort of miracle.

But the Fed doesn’t start tightening in March and you get the recession in April. It’s not like it starts tightening March, you get the recession in May. If you look once again at the historical record, by the time that we get the recession after the first rate hike, it’s 15 months which sort of says that by June, this economy has got a bull’s eye on its forehead. So we have to understand the nature of interest rates. Now, we’ve had 14 Fed rate hiking cycles since 1950. Not all of them land the economy in a recession.

There were 11 recessions that surprise surprise happened in the aftermath of a Fed tightening cycle. There were three soft landings when the economy cools off enough to cause inflation to go down and enough to cause the Fed to back off. So three soft landings. There’s a big difference for the markets between a soft landing and a recession. A recession is actually the country takes a pay cut.

It’s one thing to have your bonus cut, another thing to have your salary cut, and that’s the difference between a soft landing and a recession. In recession, you have a national wage cut. It happened in the mid ’60s, a soft landing, the mid ’80s and the mid ’90s. Each one had their own peculiarities, but you see the Fed did not tighten into an inverted yield curve. The Fed tightened this time into an inverted yield curve.

If I was on a desert island (and there’s a lot of people that wish I was), and I had just one tool in my kit, it would be the yield curve. It’s got 100% track record when the Fed inverts it. There was one head fake when we rallied into an inversion, the bond market rallied into an inversion around long-term capital in the last leg of the Asian crisis in 1998. You see, the history is coming out right now. You don’t want to throw something out. Of course, it always gets dismissed.

It’s funny to me that when the Fed is cutting rates and the yield curve moves to a positive slope, all the economist, strategists are all over the yield curve. But when the Fed is tightening and inverts the yield curve, everybody dreams up ways to ignore it. Ignore it at your peril. It’s got a perfect track record. So this time around, and this is why I thought last summer, we’re in trouble, because the Fed continued to raise rates in their quest to kill inflation. Of course, around the same time, Powell was consistently comparing himself to Paul Volcker.

So it’s pretty consistent. You mentioned we’ve gone from zero to 5% on the funds rate. Last time the funds rate went up this much in such a short time period (this was a real big interest rate shock) was back in 1981. Sample size of 1. Well, 1981 was followed by 1982, a six-quarter recession. So the chances we get out of a recession are so remote. So what do I look at? I look at real M2. Real M2 growth is a leading indicator. I look at the yield curve. It’s a leading indicator. I look at a range of ratios. I look at copper to gold, I look at DOW transports to utilities.

So I always take a look because the macro and the markets, they’re joined at the hip. There’s a symbiotic relationship. I look towards the markets to give me the signal, and of course, all the yield curve is the yield curve is another ratio, just a ratio between long-term rates and short-term rates. But we have to understand when we get to a one or two standard deviation event, we’re only in an inverted yield curve historically 15% of the time. It doesn’t make sense otherwise, the time value of money.

Normally, the yield curve is positively sloped. It’s the bond market’s signal to the Fed, “Uncle, you’ve gone too far.” Now, the reason why the Fed didn’t have to go too far in the mid ’60s, the mid ’80s, or ‘mid 90s, is that inflation was not seen as a big problem. Look, you’ve got to put yourself in poor Jay Powell’s shoes. When you start getting compared to Arthur Burns and you’re in your second term, you’re not going to let that happen. You want to be compared to Paul Volcker.

We know Paul Volcker created the conditions for a demand destruction to kill inflation and I think that we’re on that road. I think that people that say, oh, well, unemployment is always at a low when you’re making this transition from one cycle to the next, that doesn’t impress me. It’s a lagging indicator. Employment is always at a peak. In fact, it’s not rare to have employment continue to go up into the early stages of recession. So I would spend my time really looking at coincident or lagging indicators, although I think that the Fed has been doing that.

I look at leading indicators. So real M2, the yield curve, I look at various ratios in the commodity markets and in the stock market for a sense as to what the markets are telling me, but I also look at the contours in the business cycle. One of my favorite indicators, by the way, that I’ve always used, back when I was a young pup in the mid ’80s at the Bank of Nova Scotia, is what’s called the cyclical share of GDP, and it’s a great confirmation.

That’s basically business spending on CapEx, it’s commercial construction, it’s housing. It’s inventory investment and it’s consumer spending on durable goods and cyclical services. That actually was fractionally negative in the first quarter. That was fractionally negative in the first quarter. So that is a red flag for me. That’s telling me that the recession is actually going to be starting imminently.

[00:39:15] Alan

Was it the consumer side or the business investment side that drove that?

[00:39:18] David

Well, actually, what’s interesting is that non-resident construction, and this is where maybe you’re getting some of the infrastructure was actually positive. But CapEx was negative, consumer spending on the stuff I’m talking about durables, everybody talks about the 3.7% consumer spending growth. But on the cyclical stuff, it was actually not nearly as strong. Then of course, inventory investment was negative and it looks like it’s going to be weak again in the second quarter looking at the survey data.

Look, GDP is a slow-moving animal. So much of GDP is spending on education. You want to look at that to call a recession? I don’t think so. So much of the spending in the GDP is on healthcare. Is that going to help you call a recession? No, there’s so much spending on utilities and on rent, for example, and on shelter. So you want to look at the more, I wouldn’t say volatile, but the components of GDP that tend to have more amplitude that actually give you a signal.

Now, look, sometimes it could be a head fake. I’m not saying it can’t, but all the stars are lining up right now. Like I say, have you heard anybody say don’t fight the Fed in the past several months? Back when they were cutting rates in early 2020, don’t fight the Fed. Through all 2008 and ’09, don’t fight the Fed. Once again, you see, I’ve been in this business too long and the bulls love to say don’t fight the Fed, don’t fight the Fed, don’t fight the Fed when the Fed is cutting rates and breathing liquidity into the marketplace and steepening the yield curve all the while.

Look what’s happened here. They’ve already raised rates twice into a banking crisis. We’ve lost three banks, and the last central banker, the last Fed official to raise rates into a bank failure was guess who? It was Paul Volcker in May in 1984 around Continental Illinois. They didn’t really have a full understanding of it, but I got news for you. They raised rates, and then once they realized the extent, we didn’t go back in recession. But Volcker kept rates 150 basis points pretty quickly once they recognized the significance of the event.

Here we have the Fed raising rates. It goes to show you how freaked out they are over inflation. They’re buying into this view that it’s not falling fast enough. It’s such a slow-moving animal. They’re not taking credit. I guess they’re so embarrassed by having the inflation get to 9% on their watch and now we’re down to 5%. Instead of taking credit that we’re making strides, no, no, no, no it’s not enough. You see, these are the things you’ve got to factor in.

Are they going to wait? Are they really going to wait? Are they going to wait for inflation to get to 2% before they start cutting, because that is my definition of insanity? Volker didn’t get the 2% inflation till 1986. It took him 7 years. It took Greenspan 10 years to get to the 2% holy grail. So under both those other gentlemen, interest rates came down and rather significantly.

People tend to forget that the greatest inflation dragon slayer of all time, who Powell compares himself to, Paul Volcker, was also the biggest interest rate dragon slayer of all time. Volcker cut rates 1200 basis points. Guess what? Inflation didn’t get to 2%. Of course, back then they weren’t talking about this being the holy grail, which is I think ridiculous in its own right because theoretically it should be zero. It should it be a pure price stability, but it’s such an impure… Forty percent of the CPI is imputed by the BLS. Forty percent is just pure guesswork on the service side.

But I’ll tell you, what is not guesswork is what’s happening on the commodity side. You swung from commodity inflation to commodity deflation. Tell me at $124 a barrel on oil, we’ll talk about inflation. Down towards $70, I don’t think so. It’s true across every single gamut. There’s only three commodities that are still at or near their highs. I think it’s sugar, cocoa, and cattle, and that’s it. So I’ll tell you what, move from the steak to the pork chop because hogs have been in freefall.

[00:43:56] Alan

It’s a really compelling case you make for a downturn, and obviously, signs as well as you say in terms of some of those cyclical indicators that maybe it’s starting to play out now. We touched on a little bit with the deglobalization and demographics debate and all of that. A lot of the analysis you read about from a macro perspective is what’s going to happen over the next six months or so, are we going to have reception or whatever.

But from a lot of asset allocators’ perspectives, it’s how’s the world going to look like for the next 3, 5, 10 years? So if somebody was to say, will the world be more like what we saw between 2010 and 2020 or more like what we saw in 2022? Obviously, this is really important from a financial market perspective. You would have negative correlation between bonds and equities historically, but last year, we had this positive correlation linked to inflation.

Do you think we’re going back to the previous world? It’s back to the same strategies that worked in that period? Looking ahead, what would you say to people from an asset allocation perspective in terms of what’s the longer-term trajectory for those key variables you’re talking about: inflation, interest rates and growth?

[00:45:14] David

Well, my answer will be different probably a year from now when we get into the recession and we have much lower multiples and probably much lower bond yields. So when we move the equity risk premium on the S&P 500 from call it 200 basis points to over 400, which happens in recession bear markets, I’m going to tilt very heavily towards the stock market, but it’s not my view right now. Like your question, I tend to take things a year at a time. The further you go out, the fuzzier it becomes.

So I’d say that I never abandoned this, whatever the classic 60/40 is. In fact, 60/40 is just an accident of history. We actually found, depending on the timeframe you look at, that 50/50, a perfect split between stocks and bonds actually delivered the most superior call it Sharpe ratio, risk-adjusted returns on a balanced fund. But everybody went towards 60/40 because I think everybody just finds the stock market to be generally speaking more sexy than bonds, so just own more stocks than bonds.

But you’re right, both bonds and stocks got slaughtered last year but it was mostly because of the starting point. You had no yield protection in the treasury market so it didn’t take much of a move up in yields to cause negative returns across the Treasury curve. Then of course, we started the year with the price earnings multiple in the S&P at something like 22 times. It was the second most expensive stock market at a peak on record only surpassed by the dot-coms in late 1999.

So it was a bit of a funny year, starting a calendar year with such an egregiously low coupon protection for bonds and at such a high multiple for stocks. So there was a setup there for both asset classes to be correlated towards a negative return. I don’t know why anybody would superimpose that into the future. So far this year, look, I’m not impressed that much with the stock market. The breadth has not been that good. It really comes down to eight stocks in the S&P, but so be it. All those are eight great companies. The stocks are probably overdone.

Apple just continues to surprise everybody to the upside. But as Warren Buffett said, you reach a situation where you’d rather own an iPhone than a car. Apple has moved from a cyclical consumer gadget company to something that’s almost like a food product company. You just have to own it. It’s a staple. A lot of these growth companies have become staples and they’re mega caps. But the stock market’s up this year and bond market returns are positive this year so nobody talks about end of 60/40 anymore. That was last year’s story because so far this year, it’s working out okay.

I am a believer in diversification and not just in terms of stocks and bonds but across all asset classes. I still believe diversification is important as a risk management tool. You’re asking me about going beyond the recession and what’s going to happen in the near term. Yeah, in the next 3, 5, 10 years, you could see some tectonic shifts that are happening. It’s becoming geopolitically a much different world than we’ve had in the past.

This is where you start to put your hat on that there are things that are fundamentally changing: China, Russia, you could argue with Brazil. You’re seeing that this economic war between China and the US is likely to intensify, that we’re going to have a world where Russia will be a pariah and outside the traditional global economic system for some time, but this forms other allegiances. Now you’re seeing other allegiances between Brazil, Saudi Arabia, Russia, China. What they’re doing, of course, is now trading and renminbi. So you’re going to continue to see the share of US dollar activity in world trade and in world reserves going down.

Now the central banks, of course, are bolstering their gold reserves. So things are happening here. I’m not going to say that the US dollar is going to be threatened in our lifetime as the world’s reserve currency, but its status is going to be undergoing a profound change. This will have an impact on the cost of capital in the United States, it will have an impact on real interest rates, it could have an impact obviously on the US dollar. So I would say that it leaves me more bullish on gold than I was before.

Looking around the world, looking for visibility, you’ve got military budgets going up in previous pacifist countries like Japan or like German. Military budgets are going up everywhere and that has visibility. Really, the best aerospace defense companies are in the United States. I would just buy that ETF. I think that that is one area that transcends the business cycle that has growth.

You mentioned before, of course, the greening of the world. One of the things we did at Rosenberg Research is we created a green commodity index. I think that’s going to be ongoingly an area of focus. I think agriculture farmland is going to be a theme because of coming out of the COVID. But it’s been the case for some time, and of course, climate change is playing a role here as well, but security of supply when it comes to foodstuffs, including food technology. So those are the areas. Cybersecurity, that’s not going to go away. That is going to intensify.

So there are things that you can invest around. I fully agree with you on the commodity side, especially on the metals and on fossil fuels, undercapitalized, underinvested. It’ll take at least five years to bring any new mine up on board to add to the supply. So, I said before the commodity prices are going down, but only because of the demand pressures from the global rise and interest rates.

If we come out of this recession, I think that commodity prices will bottom at higher prices than they have in the past and then we will be in a secular bull market once we get past the recession, which is a natural part of the business cycle. We won’t be talking about it after 2024 even though I see it coming over the next three months. So if you have a 5 to 10-year view, those are the areas I think that you can point to.

I would say that regionally, India is where China was 25 years ago. China 25 years ago had a very dynamic, youthful population. India’s got amongst the best population profiles in the world. Modi, notwithstanding how divisive he is on the political side, is making great strides on infrastructure, which is what India has been lacking, an educated workforce and it’s a liquid investable market. So that’s one area. If you’re asking me in the next 5 to 10 years, what market I’d be looking to be adding to, it would be the Sensex.

[00:52:58] Alan

One other theme you hear when people think about the next number of years is how will debt, high debt levels get resolved and get brought back into line. From that perspective, your argument is around financial repression. I guess linked to that, from the perspective of monetary policy over the next number of years, you mentioned inflation may not come back down to 2%. So is that the scenario that you see?

It may not settle out. It sounds like we may see deflation in the short term. But do you think when it does settle, will the longer-term level of inflation be a bit higher? Periodically, you hear this debate that, as you say, 2% was kind of plucked out of the air. Maybe it could be 3%. Do you think that’s going to be a theme that we hear going forward as well?

[00:53:46] David

It could be. It’s hard to say. You really want to fade a lot of this rhetoric. It’s the same rhetoric that said that the wave of retirees, which isn’t new, it started 20 years ago. It’s ongoing but we’re going to get inflation out of aging demographics. We’ve done a ton of work on demographics and the coefficient on inflation, the aging demography works in a disinflation manner. So that’s going to be a weight on the inflation view. Debt is a pervasive constraint on aggregate demand.

So I think that the necessity, and look, maybe it comes out of the debt ceiling fiasco, we’ll see what happens. But I think that it’s a natural inclination to view fiscal policy in the future as being one of restraint, not stimulus. I think we just unfortunately blew our wad. Trump unnecessarily provided a trillion-dollar tax cut in 2018 at a time of full employment. How crazy is that? Then we have stimulus checks for all, stimulus checks for all when we already reopened the economy.

But I think that era of fiscal recklessness is over and I think we’re going to go through a prolonged period where we’re going to have fiscal austerity. That’s going to be a weight, a negative weight on aggregate demand growth relative to supply. So everything we’re talking about, dealing with the debt situation, well, how are we going to deal with it? People always said to me for years and years and years, we’ll deal with the debt by inflating our way out of it, we’ll inflate our way out of it.

How well did that work out? Did the Fed sit there and say in June of 2000 and 2022, did Powell say, “Hey, we love 9% inflation. We’re going to inflate our way out of these debts.” No, he went nuts raising rates because they don’t want the inflation because they view the inflation rightly as a tax. It’s actually a social disease. It’s a tax on the poor and it’s a tax on the elderly. So no, we were not there to inflate our way out of the debts.

Well, what else you’re going to do? Default? Really? We’re going to default on the debt. Oh, really? Most of the pension funds that pay the retirees, they own these treasuries. So you’re going to default on them? Sure. Then you get this craziness about debt monetization or MMT. Those days have passed. I think it’s going to be old fashion. Here’s where you want to be a historian. Look up other countries have done it; New Zealand, Australia. Canada were the “poster child” for fiscal austerity back in the 1990s and put Canada on a much more stable fiscal footing.

I would say Canada actually at the federal level is on a much more stable fiscal footing than the United States is principally because of the changes that were made. One of them by the way, God forbid, God forbid, we should ever do this in the United States, but means testing for entitlements. What do you know? In quasi-socialist Canada, entitlements are means tested. Oh, no, no, no, but not in the capitalist United States.

You see, a lot of things are going to be changing that can be changed at the margin to get the US fiscal footing, but it’s going to come at the expense of aggregate demand. That’s way all the stuff we’re talking about winds up more like disinflation than inflation.

[00:57:12] Alan

I suppose a lot of people in the camp of the inflationary side or financial repression, etc., would be of the view that because of the political landscape at the moment, even in Europe here, you’ve had higher rates from the ECB but a lot of countries have brought in measures to soften the blow basically, subsidies for energy costs, etc. Obviously, you’ve had the checks during COVID in the US and high levels of government spending.

So around the world, the bias has been for more active rather than less active fiscal policy, whereas back 10 years ago, austerity was in vogue. So what do you think prompts the political landscape to shift? Is it just the economic reality kicks in and it’s a necessity or do you see the pendulum shifting back towards more of an acceptance of austerity?

[00:58:07] David

Well, it’s when you start reaching a situation, like you have in the United States right now. Maybe Europe hasn’t got there where your fiscal finances get engulfed by debt service costs. Now you’re seeing debt services. So you reach a situation where if debt service charges start to rival or exceed program spending, you’ve got a big problem. When you get your interest payments so high that you’re running these deficits especially because of higher interest costs on the outstanding debt, at some point, and this is where the inflection point may be is when you get a failed auction.

Could that ever happen in the United States where you get a failed auction where all the bids aren’t filled? It’s hard to think that that could happen. But you know what? That’s your inflection point for a crisis. Guess what? Exactly what happened in Canada in 1995. Canada almost had a failed auction. The Canadian dollar plummeted, interest rates backed up, we had an exogenous shock, and the left-leaning Liberal government under Jean Chrétien and Paul Martin did an about-face. That was for the history books. Most people don’t know about that. It’s worth studying. So I guess we’ll have to wait.

It’s like sometimes you have to wait for the crisis to happen. The crisis of this sense would be what if you had a failed auction or a massive failed auction in one of these Treasury auctions. Then you start having people talk about the US losing its reserve currency status. Well, that would be a splash of freezing cold water. So I’m not going to say it’s going to happen, but it’s amazing. Why waste a good crisis? I think the future is going to be one of fiscal restraint and I think it will be global and it will be out of necessity.

Because coming out of this interest rate shock, you’re seeing debt service costs rise inexorably. What does that do? That cuts into program spending and then when you’re talking about Europe, Old Europe, or I can say old United States, the United States does not have the immigrants coming in like they do in Canada, you’re talking about a dependency ratio. That’s going to have brutal implications for fiscal finances in the future at a time when interest rates aren’t so low anymore.

Now, I think they’ll come back down. But this has been a significant shock to the fiscal side at a time when you have more and more people dropping out of the labor market. These are high-income people. You’re getting low-income people coming in, not low income, but younger people. They’re not paying as much taxes. So I think we’re building up to something on the fiscal side and this is one of the risks. One of the risks is that we’re going to have a fiscal crisis. I know it’s the boy who cried wolf. But just remember this: in that story, the wolf shows up.

[01:00:56] Alan

Very good. Well, we’ve been chatting now for just over an hour. One thing we do like to ask people before we wrap up is advice and suggestions. One thing I wanted to ask you about was that you referenced some of your former colleagues at Merrill Lynch and their wisdom a lot in your writing, particularly Bob Farrell. So why was Bob Farrell such an influence on you and any other influences? What advice would you have for people who want to learn more about global macro and financial market analysis?

[01:01:29] David

Right. Well, look, Bob Farrell, there was just so much depth, so much knowledge, and so much experience. That’s the one thing you can’t replace in this industry that we’re in is experience. But he had just a very unique lens on the markets and could distill a lot of information into a market call. He was very disciplined and very impartial. He just basically let the charts and let the numbers do their thing.

Just like a museum curator could look at a picture at the Museum of Modern Art and tell you what’s there that you can’t see, if I told you how many times I would sit down with Bob and he’d be able to look at a picture of a chart of anything and be able to tell you things that you actually couldn’t see, not evident to the naked eye. He was just in a class by himself. A lot of the people that worked for him actually went on to have stellar careers as well, Walter Murphy, Dick McCabe. So that’s the one thing you know is when someone’s disciples go on to have stellar careers of their own, you know that the leader was doing something right.

I would just say in terms of the last two questions, my market call is basically, in my personal portfolio I’m under 20% in the equity market right now. So I’m not zero. I don’t believe in zero or 100. It’s always shades of gray. But those shades, they change color too, but I’m at my lowest equity weightings personally since 2007. So I think rates are going to come down, I think inflation is going to come down. So I like long bonds. I also like gold.

One of our themes has been the bond-bullion barbell, which has worked out very well. A lot of the other themes that we’ve been talking about, most of my money is in actually alternatives. When I say alternatives, I mean market-neutral long-short strategies, things that are more right now and have a lot of cash. So right now, it’s about being in capital preservation mode. That’s the time of the cycle to be focused on capital preservation. We’ll move to green and cyclicality when we’re three-quarters of the way through the recession. It’s only about to start.

In terms of how people can find Rosenberg Research, you can either just google Rosenberg Research or go to information at rosenbergresearch.com. We have 12 different products. We have a webcast series. You have the ability to contact me. We have an information box where you can ask me questions. I spend a third of my day just answering questions to clients. But that’s a very effective low-cost way to stay in touch with me. So information@rosenbergresearch.com.

Everybody who wants to, we offer a one-month free trial, so you have the opportunity to kick our tires before you commit yourself to a one-year subscription. Very proud of the fact that I started this business with 1600 clients and we’re up to almost 3000 in 3 years. So I figure through thick and thin, I must be doing something right.

[01:05:02] Alan

Great stuff. Well, David, thanks very much. This has been a fantastic conversation. Thanks very much for coming on today. So make sure you follow David’s work because as you can tell from today’s conversation, we have a lot to think about from a global macro perspective and it’s more important than ever to stay well informed. So from all of us here at Top Traders Unplugged, thank you for tuning in. We’ll be back soon with some more exciting episodes, so stay tuned.

[01:05:29] Ending

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