Ed Yardeni - Global Macro Series - November 8th, 2023

[00:00:07] Ed

Certainly, as rates are going up, we should be getting more demand for bonds. But when the velocity of a move is so intense to the upside, nobody really wants to jump in there, they can really spike up to levels that cause a credit crunch and a recession. I’m hoping that the economy will slow some without outright recession and that inflation will continue to moderate and that will stabilize the situation. But we are seeing aspects of a debt crisis which are very unsettling.

[00:00:41] Intro

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

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

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

[00:01:37] 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.

[00:02:22] Alan

Thanks very much for the introduction, Niels. Today, I’m delighted to be joined by Ed Yardeni. Ed is the President and Chief Investment Strategist of Yardeni Research. Ed has been on Wall Street for over 25 years as a Chief Economist and Chief Investment Strategist in multiple houses. He’s also worked at the Federal Reserve and US Treasury. He’s also a frequent commentator on the financial media such as CNBC. Ed, great to have you with us today. How are you doing?

[00:02:49] Ed

Just fine, Alan.

[00:02:51] Alan

Good stuff. Well, before we get into the meat of the conversation, we always like to get our guests to give a sense of their background in markets. Obviously, you’ve been around analyzing the markets and the economy for many years. So if you could just give us a sense on how you got started in economics and as an economist and then transitioning into investment strategy.

[00:03:10] Ed

No, I’m sorry you want to do that because it’s going to sound like I can’t keep a job. I went to Cornell for undergraduate. I studied economics and government. Then I went to Yale and did first a master’s in international relations and then a PhD in economics. I studied under James Tobin. He’s a Nobel Prize winner.

I graduated six years after Janet Yellen graduated from Yale and I owe her a debt of thanks because she wrote these very copious notes from Tobin’s class and they were subsequently xeroxed and sort of became the unofficial textbook of Tobin’s class. So she got me through Yale. Of course, she’s a liberal where I tend to be more conservative at least on economic policy matters.

Graduated from Yale, I went on for a stint at the Federal Reserve Bank of New York for a year. I had an office with no windows. I think I had a polyester white shirt that I wore on a regular basis and kept some ties in the office. I wrote some memos on the savings and loan industry, which was in crisis back then. Well, actually, it wasn’t. It was pre-crisis, but I just monitored their deposit flows. Those memos I think are still somewhere in the basement of the Federal Reserve Bank of New York in some file I suspect.

Then I got a call from a headhunter on Wall Street who said there’s a job opening at EF Hutton. When EF Hutton talks, people listen was their motto. So I went to EF Hutton as a junior economist working for the senior economist. The senior economist was very kind. He moved on after a couple of years. So at the age of 28, I became the Chief Economist of EF Hutton.

From there, I moved to Prudential, which was called Prudential-Bache at the time. It was called Bache at that time, and then it became Prudential-Bache. Then from there, I got a job at CJ Lawrence where Ed Hyman was the Chief Economist, a renowned economist. So I took over that spot and stayed there for some time. It kind of morphed into Deutsche Bank Securities as Deutsche Bank bought a CJ Lawrence. Then after that, I went back to Prudential for a couple of years. Then that ended my career directly on Wall Street.

For a couple of years, I worked for Oak Associates in Akron, Ohio, managing money. I continued to do my research and we sold it to institutional accounts that I had contact with when I was on Wall Street. Then I decided just to go off on my own in 2007. We were virtual from the get-go. So I tell everybody since the pandemic, welcome to our world. We’ve all been working from home since 2007.

Here I am, President of Yardeni Research. We have over 4,000 individuals at major institutions around the world that get our research, and we have a product for individual investors. If I may give a quick commercial, it’s yardeniquicktakes@yardeni.com for individuals. I wish I could give you some cough drops.

[00:07:05] Alan

Hopefully, that won’t persist.

[00:07:06] Ed

No. Good.

[00:07:07] Alan

Well, great. That’s a great history of some of the big names on Wall Street, I guess. As you mentioned, you’ve worked as an economist both on the policy side and on the buy side. I guess one of the things that has been interesting about the current cycle is how wrong, again, the economics profession seems to have been about the economy this year. Starting the year, there was a lot of pessimism around and Jamie Dimon talking about whatever hurricane approaching that hasn’t.

[00:07:45] Ed

That was May of last year. Sure.

[00:07:48] Alan

Yeah. We obviously had a bit of a wobble with the banking issue in March. But what’s your take? Why has the economics profession got it wrong again? What’s interesting about this cycle that the economy is so resilient?

[00:08:02] Ed

Fortunately, I think I got it mostly right, not completely right. But I actually started arguing early last year, in early 2022, that the economy was in a recession. But I explained that I thought it was a rolling recession, otherwise known as midcycle, slow-down growth recession. The idea was that the Fed was raising interest rates, which is what got most economists to start forecasting a recession.

They figured that if the Fed was going to be aggressive in raising interest rates and if inflation was going to be persistent rather than transitory, then the result would be a credit crunch and a recession. I didn’t see it that way. I said that for starters, we have a housing recession, but we have to be exact about that. It was a single-family housing recession. Housing starts for single families took a dive.

Multi-families remained very strong because developers and landlords realized that there was a lot of demand for rental properties and for apartments, and so that’s been very strong just until recently. In August, we saw a big drop in that and that may be the rolling recession now rolling into multifamily housing because they might have overbuilt in that regard.

Then, here in the US, we were locked down during the pandemic in March and April and we all got cabin fever. I guess we avoided COVID, but we got cabin fever for sure, and when the lockdowns were lifted, we all needed to do something to make ourselves feel better. The wonderful thing about Americans, maybe lots of other people, is when we’re happy, we spend money, and when we’re depressed, we spend more money. So we ran out and started going on a shopping spree, a buying spree, couldn’t get really much in the way of services because there were still social distancing requirements.

So we bought a lot of goods, and basically, inventories were depleted by late 2020. Retailers ordered a bunch more merchandise from China and other places that all got jammed in the ports of LA and there weren’t enough trucks to bring it all. By the time it all arrived, the consumers basically said no más, we don’t really need any more goods, we have enough. They went on a buying binge for services. They went traveling, they went to restaurants, they stayed at hotels and motels. More recently, they went to Taylor Swift concerts or went to see Barbie and Oppenheimer at the movies.

So the retailer’s got stuck with a lot of merchandise and had to discount it, which brought inflation down quite sharply at least in the goods area. Now the rolling recession is rolling into commercial real estate. Look, I’m not saying that we couldn’t still have an economy-wide recession, but there’s been a lot of economic correcting in some important cyclical sectors.

[00:11:05] Alan

Very good. One of the things people have been (I suppose, focused on trying to grapple with is this), one of the lags for monetary policy and different views on this. For a while, Powell was suggesting maybe some research that the lags might have sped up, but as the expression is, they are long and variable, so hard to forecast. What’s your stance on when we should feel the maximum impact of the tightening we’ve experienced already?

[00:11:36] Ed

As I just indicated, I think we’ve already seen that the impact was quite immediate in the housing market. I’m seeing some signs that the single-family housing market may be bottoming. I don’t think it’s going to recover much with mortgage rates going from 7% to 8%. So we’ve had that happen pretty quickly. We’re actually seeing a rolling and recovery in goods. The latest manufacturing survey, the manufacturing purchasing managers survey suggests that we’re starting to see some pickup in manufacturing.

The so-called MPMI, the Manufacturing Purchasing Managers Index is still below 50. But it’s actually been rising towards that level. I think it got to 49 in September, so it’s been improving. But the long and variable lags is certainly going to be hitting commercial real estate for a long time and it won’t be that variable. I think it’s already started.

Look, a lot of commercial real estate was financed at near-zero interest rates, and some of that is variable, some of that has to be refinanced, and the math just isn’t going to work with interest rates now substantially higher. So we will see a lot of defaults. We’ll see some significant losses for the banks kind of reminiscent of what happened around 1990 when we had the savings and loan crisis.

Again, I pointed out that I had a head start on looking at the savings and loan industry when I was at the Fed, so I was on top of that situation. But it took a long time. We had a minor recession back then. It didn’t last very long and then it weighed down the economy for a while. So that may be what we have up ahead here. The consumer clearly is the key question and is the key reason that we haven’t had an economy-wide recession.

There are folks out there who still think that consumers piled up this excess savings, so-called, during the pandemic, and that they’re running out of that. As soon as they run out of that, they’ll have to retrench, they’ll have to cut back. Consumers have faced some other headwinds such as student loan payments have started once again. So that could potentially weigh on the consumer.

But meanwhile, the labor market remains really strong. It’s hard to get a recession when workers are getting jobs. We just had job openings data for August that showed that there’s plenty of jobs that are still available, and so employment still looks pretty good. By the way, wages, for the past several months, have been rising faster than prices. It didn’t happen in August because of energy prices, but the trend has been for an improving real wage environment.

[00:14:43] Alan

Very good. I guess another interesting part of the puzzle that we’ve been grappling at the moment has been the behavior of long-term bond yields. Obviously, for a long time, yields didn’t really respond that much, somewhat, but maybe not as much as expected in response to the Fed tightening. But more recently, we have started seeing bond yields starting to ratchet higher. So how do you see that? What’s driving that and how do you see that panning out?

[00:15:09] Ed

Well, funny that you should ask. We’re doing this podcast on October 4th, and I just happen to have an op-ed on that in today’s Financial Times. It’s called The Bond Vigilantes are Back. I coined the phrase bond vigilantes back in 1983. The idea is that if bond investors conclude that fiscal and monetary policy is reckless, it’s too stimulative, it’s too inflationary, that’s obviously not in their best interest. Then they basically send their friends to the bond vigilantes to take over the credit markets.

Now, for a while there, they really couldn’t do very much between the great financial crisis and the great virus crisis. Central bankers were buying bonds and they were lowering interest rates close to zero, at least to historical lows in the bond market. As a result of that, the central banks were desperately trying to get inflation to go back up to 2%. But beware what you wish for here. Inflation is much higher than that. So the central bankers have had to reverse course and raise interest rates.

As they’ve raised short-term rates, bond yields have kind of followed along. But then sometime last summer, summer of 2022 exactly, not 2023 but a while ago, the yield curve inverted meaning that bond yields still went up but not as rapidly as short-term interest rates because bond investors figured, you know, the Fed is doing it right. They’re aggressive. They’re laser focused on bringing inflation down. So if the Fed keeps going, something will break as it has in the past. In the financial markets, there’ll be a credit crunch, there’ll be recession. So it’s okay to buy a bond at 4% (10-year bond at 4%) when the 2-year note is at 5% because odds are the 2-year note is not going to stay there very long once the recession hits.

The inverted yield curve, of course, caused a lot of forecasters to anticipate a recession. Well, in fact, the yield curve got it partly right. We had a banking crisis in March of this year. It didn’t last very long. The Fed came in and squelched it, contained it with a banking liquidity facility and we didn’t have a credit crunch, we didn’t have a recession. But recently, this summer, we’ve seen that the bond investors have become increasingly concerned not about reckless monetary policy, but they’ve become concerned about reckless fiscal policy.

As we know, Fitch Ratings downgraded US government debt back on August 1st, and they really didn’t tell us anything new. It just reminded everybody that with all the spending programs that had been enacted by the Biden administration in 2022, that the outlook for outlays was daunting. Meanwhile, there was no political will to increase taxes. So the deficit suddenly in August on a 12-month basis was $2 trillion and the auctions for the treasuries and securities increased substantially.

The bond vigilantes came to the fore and said, okay, well, we’re not going to buy bonds at 4%, especially if there’s not going to be a recession, and we’re going to need a lot more in order to buy all this supply. So as of our podcast, we’re at 4.8%. It’s been a vertical ascent in the bond market. Basically, the bond vigilantes are saying if you folks in Washington don’t do something to narrow this deficit, we’re going to push bond yields up to whatever level it takes to get your attention. Of course, that would be by creating a debt crisis or at least a debt crunch and a recession. So that’s where we are right now.

[00:19:20] Alan

It was interesting. I think Barry Eichengreen had a paper that he presented at Jackson Hole about debt and debt sustainability. He’s been a guest on this podcast too, so we follow his work with interest. I guess it was interesting in itself that people at Jackson Hole were focused on debt dynamics in the first place.

I guess the conclusions from his paper were, well, okay, maybe not forecasting an imminent crisis, but certainly, the trajectory of travel didn’t look good in the sense of if you look at the conditions normally in place for reduction of debt levels and fiscal primary surpluses, that they’re not in place now.

The question is how you would get that down and his argument seems to be that we should just get used to living with high levels of debt. But he did focus a lot on this equation that I guess economists look at, the relationship between r and g, to infer whether debt is sustainable or not. How far away do you think we are from a negative spiral of higher rates pushing up more debt repayments and then piling on more debt and all of that, and reaching a crisis at some point in the future?

[00:20:35] Ed

Well, we’re actually there. We’ve been there for probably the past year, maybe past two years. We’ve accumulated a tremendous amount of debt before the pandemic, a lot more debt during the pandemic, and now the deficits remain wide and are widening, which is unsettling to see in an economy that’s still growing.

The bond market really never had a problem with widening deficits in the past because they widened during recessions when private credit demands were shrinking and when interest rates were coming down as the Fed was fighting a recession. This time around, the economy is hanging in there quite well and the deficit is widening because of fiscal excesses. That’s quite a change.

Where we’re having the problem, this is not all because of Biden’s spending programs which really haven’t even kicked in yet. A lot of this has been social security payments are ratcheted to inflation, so they’ve been ratcheted up, and then the big problem is the interest expense. All that debt is generating increasing interest outlays by the US government, and that’s something that’s non-discretionary as they say. The government has to make those payments.

We’ve seen, on a 12-month basis, those payments double since July of 2022 to about $650 billion or so, and they’re going straight up. A good part of the deficit here and now is in fact attributable to rapidly rising interest costs, and that I think got the bond vigilantes particularly riled up because they realized that there’s a spiraling debt problem with regards to the government, with no political will to even recognize that problem or do anything about it.

I’m an optimist at heart, believe it or not, so I tend to believe that it doesn’t necessarily have to end badly. You mentioned one economist, the hedge fund community is also convinced that we’re going to have a debt crisis. Ray Dalio has talked about a debt crisis. The idea is really quite simple. Bond yields are going to go up to whatever level it takes to make bonds attractive again, meaning certainly as rates are going up, that we should be getting more demand for bonds.

But when the velocity of a move is so intense to the upside, nobody really wants to jump in there, they can really spike up to levels that cause a credit crunch and a recession. I’m hoping that the economy will slow some without outright recession and that inflation will continue to moderate, and that will stabilize the situation. But we are seeing aspects of a debt crisis which are very unsettling.

[00:23:52] Alan

It’s a side question, but curious to get your perspective. Did the US Treasury miss a trick not issuing 100-year bonds like the likes of Austria and Argentina did back when rates were zero? Now the profile presumably of the debt is more near-term. Is that fair to say?

[00:23:53] Ed

Yeah, I was wondering why the Treasury didn’t take the opportunity of such low interest rates. The 10-year Treasury yield got down to 0.5% in 2020 I think it was. Why not just refinance everything at 10 years or 20 years, or, as you said, 100 years? I don’t know the answer to that. I think Wall Street told the Treasury that they need to have a range of maturities in order to keep their government bond desks going, but here we are with interest rates a lot higher, with a lot more debt.

We’ve calculated that currently, the Treasury is paying on average 2.5% on its debt as it’s had to refinance it. 2.5% is not where the 2-year note is right now, it’s at 5%. So as they have to continue to refinance their debt and accumulate more debt, they are going to have more and more outlays for net interest.

[00:25:22] Alan

You touched on no political appetite to address this and it’s interesting to think about some of the just the political headwinds. On the one hand, you touched on Bidenomics and this shift towards greater industrial policy fiscal activism in the US, which would suggest we would see ongoing deficits over time. Then obviously, we’re in the middle of the usual logjam in Congress at the moment, so very hard to see how this would play out positively. But what is the end game?

Maybe as you say, our economy goes into a recession and that brings yields down. But if this debt issue was to roll on for a number of years, is it the case that we have to see much higher levels to precipitate some kind of sense of crisis do you think to get policymakers to act on deficits?

[00:26:13] Ed

Yeah, I think that’s right. We’ve seen in the past that the policymakers don’t really respond to changing policy on the economic side unless there’s a crisis. We certainly saw that with the great financial crisis. But the bond vigilante’s heyday was actually back during the Clinton administration when James Carville, who was an adviser to Bill Clinton, made him very aware of the power of the bond market. In many ways, the bond market is more powerful now because it’s bigger.

There’s just a lot more debt and there’s a lot more leverage in the economy. It’s a clear and present danger that frankly, I didn’t see it coming because it’s always been my view that I’ll worry about debt when the bond market worries about too much debt. In the past, the bond market really didn’t focus much on supply and demand in the bond market, particularly not in the treasury market, because as I said, the deficits widened in recessions and that was not a big deal, and then they narrowed during expansions.

But the bond market now, I think really since August 1st, since Fitch Ratings downgraded government debt, the bond market now seems to be very much concerned about the imbalance between the supply of securities and the demand. The demand has been diminished because the Fed instead of buying treasuries is letting its portfolio decline. It’s letting the bonds mature, the portfolio mature.

Then, of course, the commercial banks have seen some weakness in their deposits. So they’re letting their bond portfolios mature to raise funds to offset some of that weakness. That leaves domestic, individual and institutional investors to buy treasuries with foreign investors. There’s a lot of questions about whether foreign investors have the appetite to buy our securities. So it all adds up to a situation where the elements of a debt crisis have suddenly appeared out of the blue, but they were actually hiding in plain sight all along.

[00:28:47] Alan

Yeah, interesting. There was an article from James Montier at GMO there I remember reading a few months back called Slow-Burning Minsky Moments. It was on that theme that the debt level preconditions for a Minsky moment were in place, if not the immediate dynamics, but obviously, the immediate dynamics are shifting. I guess going back to the Eichengreen paper, in terms of debt sustainability, there’s two sides of it.

One is interest rates and the other side is economic growth. I guess the optimists might say AI might save us and we could have a productivity boom, and economic growth could end up being very strong. There’s different views on this. What are your thoughts on that?

[00:29:32] Ed

Well, again, our conversation has clearly been on the pessimistic side with regards to the debt issue. But believe it or not, I’m in that camp that believes that growth will save us and the productivity will save us. I don’t know if I’d say AI. I think it’s a combination of technologies that will boost productivity. I’ve been arguing that we are in the early stages of a productivity growth boom.

We had a productivity growth boom in the ‘50s, in the ‘60s, another one in the ‘90s. This one has the potential for being much broader in scope because the technologies that are out there do lend themselves to solving a very significant problem we have in the economy here and around the world. There’s a shortage of labor, there’s shortage of skilled labor. So companies really desperately need to increase the productivity of the workers they have, they need to augment their skills with technology.

I think it’s artificial intelligence, it’s robotics automation and nanotechnology, 3D manufacturing. There’s just a host of technologies that are very user-friendly, they’re relatively inexpensive, and they do lend themselves to increasing productivity in just about every business. So from that perspective, almost every business now is a technology company. If they don’t make technology, they have to use technology. They have to spend a good part of their capital budgets at technology to increase their productivity. That being the case, we may very well have a productivity boom.

Productivity on a five-year trailing basis at an annual rate bottomed at 0.4% back in 2015. It got all the way up to 1.6% right before the pandemic. That doesn’t sound like a lot, but that’s a quadruple increase in productivity. It all goes straight into real GDP growth. In other words, if productivity was adding 0.4%, suddenly, it was adding 1.6%. Then the pandemic hit and everything got screwed up. People quit and hard to maintain productivity when people are quitting and you have to hire new people.

But I think things are normalizing now and I expect productivity, which was back to 1.6% on that trailing basis that I just mentioned, I think it’s going up to 3% to 4%, which sounds farfetched, but that’s the kind of productivity booms we’ve had in the past. If we get that, that’ll help a lot in boosting growth, because again, if productivity is growing 3%, labor force is growing 1%, that’s 4% real GDP.

[00:32:26] Alan

Everything in economics is difficult to forecast I guess, but productivity in particular, and it’s often treated as a residual. You’ve got the growth numbers and the population growth. It’s so hard to know. McKinsey had a report out on AI saying it was going to boost productivity I think anywhere between 0.2 and 0.6, might have been even higher, but it was pretty wide range. But there was then that the benefit might not come for another 10 years.

Even after the internet in 2000, there was probably, I don’t know, maybe 10 years before we saw the productivity numbers really pick up. What do you think about that? Are you just observing what you’re seeing in the real economy amongst different companies? How do you get confidence in that forecast?

[00:33:12] Ed

Yeah, you’re right. But there are data series that we can monitor that. There is quarterly data on productivity. It actually bounced very nicely to the upside in the second quarter, but it can be volatile from even quarter to quarter. But I’m monitoring that. As I said, I monitor the 20-quarter average growth rate at an annual rate to focus on the cycles. That looks like it at least has stopped going down. And I’m watching the quits. Obviously, if quits are coming down, that should help to stabilize the labor market. You’re not having to retrain new hires.

I’m watching real wages. There’s a very strong correlation not surprisingly. This is one thing I studied in economics, particularly macroeconomics, that actually I can see in a chart that makes sense, and that shows the productivity growth rate versus the growth rate in inflation-adjusted real compensation.

People get paid their productivity in a competitive marketplace. So if you have a relatively competitive marketplace, wages will go up faster than prices as long as that’s sustainable and supported by productivity. So I’m watching, on a monthly basis, average hourly earnings, which is wages, just the wages, not total compensation. But that’s what I have on a monthly basis divided by the consumption deflator, which is kind of like the CPI. That’s been recovering this year after stalling last year.

Then I’m watching quarterly and then I have weekly data indicators of corporate profit margins. Corporate profit margins were very weak last year and they seem to be recovering this year. You’re right. Productivity is a squishy topic and to say AI is going to increase productivity doesn’t really help you much. Personally, I’ve tried to use it for what I do and it’s been useless. It’s just got all these errors, so I’ve just gone back to just Google links and finding the original source and writing it myself rather than having Bard or Bing write it and then having to fact-check the AI.

[00:35:56] Alan

You don’t have Chat GPT writing the daily commentary quite yet.

[00:35:59] Ed

No. Not yet.

[00:36:01] Alan

You touched on the 1990s experience a moment ago when we were talking about the rate hikes and the commercial real estate challenges. You’ve seen cycles going back, I don’t know, I guess 30, 40 years. People always want to draw parallels and you’re talking about this productivity boom which is I guess reminiscent of the late ‘90s. But equally, there’s that parallel between the early ‘90s.

I saw you had a piece a couple of days ago comparing versus the ‘70s but highlighting maybe more differences versus similarities. How do you draw on that experience? There’s always parallels but always differences. When you look at everything together now from a capital markets, from an economic perspective, each cycle is different. What stands out in terms of parallels? Obviously, you touched on 1990. Anything else?

[00:36:57] Ed

Well, I wrote a book back in 2018. It turned out to be longer than it should have been. I think it was like 500 pages or so called Predicting the Markets: A Professional Autobiography. Basically, it was almost everything that I learned, learning by doing over the past 40 years of my professional career. In some ways, it’s a history lesson. I was sort of like Forrest Gump. I was there at the time that some very interesting economic history occurred.

I am very fortunate because I think the past 40, 45 years have been absolutely fascinating and radically different from anything we’ve seen in the past. So I think history is very important in assessing where we are now. Some things, history maybe doesn’t repeat itself, but it does rhyme as they say, and there are a lot of useful analogies. But it’s also important to recognize, as you said, what’s different this time.

Sometimes that’s viewed as a jinx when an economist says, well, it’s different this time. Then you know for sure, it’s just going to be the same old, same old and usually they’re saying, well, it’s not going to be bad and it turns out to be bad. I may be in that position because I’ve been arguing that it’s a rolling recession, we’re not going to have an economy-wide recession.

I’ve been arguing that inflation is turning out to be transitory after all, not persistent, and that productivity is making a comeback. Maybe I’m just going to be wrong about all of that. But I’ve acknowledged, I’m trying to be not just optimistic, but realistic. I’ve acknowledged that there are some significant risks and a debt crisis of the nature that people like Ray Dalio and some of the other hedge fund people have been talking about is a realistic scenario. It’s a plausible scenario. But it doesn’t have to end as badly as they think. Things change. Demography changes.

I’ve also become an amateur demographer over the years. I’m 73 years old, so I’m a card-carrying member of the baby boom generation here in the US. Many years ago, I had this egotistical view that I was very special and then I realized there was 75 million people that are just like me, other baby boomers who are more or less doing the same thing. We went on to college, we had this mindset that the next thing we did was get a job.

Hopefully, we’d work for that company forever, collect a pension. We’d move to the suburb after we got married, have children. That was the mindset. Obviously, that’s not the mindset of the younger generation now. But one of the insights based on looking at my life as something that’s not unique that I see is what’s different about me is I’m still working for a living, whereas a lot of my friends are actually retiring. That’s a radical change in one’s lifestyle.

It’s like you suddenly think to yourself, well, wait a second, I’m not getting a paycheck anymore, that’s why I saved all that money and now it’s time to start spending it. But what if I live a long time and what if I’m not healthy? How much do I want to leave the kids? So there’s a lot of questions that the baby boomers are facing now, but one of the things that’s clear is that they have a lot of excess saving, all this talk about excess saving their pandemic. How about all the retirement assets that have been saved by baby boomers?

There’s something called 401Ks in the US where people are actually once they turn into their 70s are required to take money out of there. Now, they could save it, I guess, in another instrument. But they may very well say, now that I got this check, I’m going to spend it. So the baby boomers, the retiring ones, my friends are going out to restaurants, they don’t cook at home anymore. They are traveling quite a bit. They’re using the healthcare system quite a bit.

This, by the way, explains why the economy has been so resiliently strong is we’ve got a lot of demand for workers in the healthcare industry, all-time record high, a lot of demand for workers in the hospitality industry, all-time record high and so on.

[00:41:40] Alan

I think that’s very interesting because people often talk about demographics and just say ageing of the population is deflationary when, as you say, there’s so many dynamics and dimensions to this in the sense of it depends when people- how they forecast, how long they expect to live. As you say, people will spend more, but equally, there is the dimension of there will be more demand for people to support older people, so healthcare workers, and that’s the Charles Goodhart argument.

Obviously, what we’re seeing as well, people are tending not to have heart attacks and those types of diseases, but more mental, Alzheimer challenges, etc., and that increases demand for care workers as well. It’s hard to say. Is the baby booming population, is that more of an inflationary or deflationary force? Hard to say. What would you say?

[00:42:42] Ed

It’s hard to say. Right now, it’s more of a reason why the economy has been resilient. I don’t see that it’s been a source of inflation. I think with the benefit of hindsight, we will discover that inflation was a fairly transitory phenomenon related to the pandemic. There was too much fiscal and monetary stimulus, but all of that fueled a goods buying boom that we discussed earlier in our discussion, and they got stuck in the ports and so on and so forth.

I think where the demographic factors are much more deflationary is in China. We haven’t really talked about the global dimension. But I’ve described China as the world’s largest nursing home. I don’t know if I’ll ever be able to go there because they might stop me for questioning why I said things like that about them. But it is. It’s the world’s largest nursing home. The demography has turned very geriatric, exacerbated by the one child policy.

Now we’re seeing that China is slowing down and their property bubble is bursting or at least it’s leaking lots of hair. So China has slowed down, which on the one hand is bad for global economic growth. On the other hand, it’s fundamentally deflationary, which helps to bring our inflation down, particularly in the goods market.

[00:44:06] Alan

Yeah, you’re right. I suppose a big theme is this potential Japanification of China. Would you go that far in terms of the outlook over the next couple of decades? Do you see that deflationary impulse becoming embedded?

[00:44:22] Ed

Well, the Chinese government, the Chinese Communist Party to be exact, is really the source of China’s problems. China’s prosperity really occurred when the Chinese Communist Party stood back and let capitalism work. But they’ve been squelching that of late and the Chinese Communist Party imposed the one-child policy that now is coming back to haunt them. Now they’ve tried to provide incentives for people to have children and it’s just not working. So I think that the demographic prospects for China are pretty grim.

In some ways, China is just a big version of Japan. Japan has also got a very geriatric demographic profile. Things aren’t terrible in Japan. They’ve got a pretty good standard of living. But they don’t have a young population that will stimulate growth in the future. China has that same problem.

[00:45:25] Alan

Outside of China, obviously, there tends to be as much optimism now maybe about the outlook in India versus pessimism in China and some of the other emerging markets benefiting from maybe deglobalization, people are looking at Mexico, Vietnam, areas like that. Do you think that’s an opportunity for investors?

[00:45:45] Ed

Well, interestingly, thanks to Zoom technology and all that, over the past several months, I’ve actually been doing a regular discussion with CNBC India. So as a resolve to make sure that if they ask me a question, I have some knowledge of what’s going on in India, I’ve been following that more. India has got the young population. They speak English, which is good for doing business with the United States, Australia and other English-speaking areas of the world. They are working on infrastructure. That’s where China has them beat.

China has great infrastructure. China has things organized remarkably sensibly when it comes to the way industries can get parts and so on. India has got long ways to do all that. But India, it is increasingly being viewed as an alternative to China, but so is the United States. We’ve seen in the United States, there’s data on construction of manufacturing facilities, and it’s gone straight up. We’re building more manufacturing here because of onshoring as the word goes.

Onshoring has been the reaction to the increasing tensions between the United States and China. It’s been a reaction to the pandemic, and it also shows that technology is now available to replace labor. Labor is not so cheap even in China anymore. It’s not available, maybe still relatively cheap in India. But all in all, technology is allowing American manufacturing to come back even if we don’t have the workforce that is necessary to run factories because now we’ve got robotics and automation.

I’m fascinated to see that Elon Musk is working on all these technologies. One of those adventures is robotics. These robots, I’ve seen a video of it, it looked like they’re being trained to build cars.

[00:47:51] Alan

Okay. Well, that’s interesting. You touched on a little bit earlier corporate profit margins, how they were. It came down a little bit last year. It seemed to be improving this year. In that context, just bring into the discussion maybe towards the outlook for equities, you were talking about the onshoring which you would have thought maybe might push up prices and costs for companies presumably if they went offshore for cheaper costs. By bringing it onshore, it’s more resilient chains but maybe at a higher cost. How do you see the valuation perspective and the outlook for equities?

[00:48:30] Ed

We started off with a relatively pessimistic discussion of a potential debt crisis. So with the proviso that I’m keeping an eye on the 10-year bond yield to see what my friends the bond vigilantes are going to do, I think there is an optimistic scenario here. I think it’s actually my base case for now. I’m assigning a 75% probability to a continuation of rolling recession with inflation coming down and things stabilizing here. So the bond yield doesn’t shoot up above 5% is a requirement of this relatively happy scenario.

Earnings have turned out to be better this year than others expected. We actually got it right because we didn’t have an economy-wide recession. We think that earnings are going to continue to improve next year. The earnings outlook I think suggests that we’re still in a bull market, that the bull market started on October 12th of last year. At the end of October last year, if I may toot my own horn, I said that I thought that was the low and that we were in a bull market and it looked pretty good until July 31st.

Then we’ve had I think a correction since then. I don’t think it’s the beginning of a new bear market, I don’t think it’s a resumption of the old bear market. But there’s that 25% that I’m subjectively assigning to the possibility of a hard landing recession. I’ve recently actually raised that from 15-25%, so I’m sensitive to the risks. With the rest of valuation, I think we just have to factor in that the, I call them the mega-cap eight, some people call them The Magnificent Seven, the big tech companies that account for 25% of the market capitalization in the S&P 500, they’re not going away. These are very profitable companies. They’re doing extremely well. So they’re going to continue to account for 25%, maybe 30% of the S&P 500 and they have high valuation multiples. They tried to bring those multiples down and they rebounded somewhat. I think you have to factor that in.

When you look at the market, then you really have to look at the mega-cap eight versus the rest of the market in terms of valuation. The valuation of the market, excluding the mega-cap eight right now is around 15, which isn’t dirt cheap. It’s fair value. But it does suggest that there are opportunities in the marketplace. We continue to like energy. I know financials hasn’t been doing well this year, but financials, the big-cap financials look quite good. In some ways, they are technology companies because they’re spending billions of dollars on technology.

Technology itself, IT is a place where we want to continue to have exposure. We’re aware of the doomsday scenarios. We’re aware of the debt crisis scenarios. If you wanted to spend a whole hour saying let’s depress everybody and just talk about how everything could go wrong, I know that story pretty well. I always point out that the pessimists don’t seem to know my story very well, which is a more optimistic one.

[00:52:16] Alan

You talk about the mega-caps versus the rest, and then if you were to look at outside the US versus the US, outside the US, the valuations look more attractive. But then the question is, will the earnings growth be as strong? What’s your perspective on that?

[00:52:33] Ed

Well, I’ve been in the stay home camp from the vantage point of American investors, and what that means for global investors is you want to overweight the US. I’ve been saying that for quite some time here. Maybe I’ll overstay my welcome. But I’m still in this stay home overweight the US. It doesn’t mean don’t invest overseas. It just means overweight the US. Europe has some real challenges. China has some real challenges.

Maybe there’s some opportunities in Japan, maybe some opportunities in India and Brazil, but in terms of liquidity, in terms of diversification, rule of law, transparency, the US has a lot going for it and it’s still the world’s largest economy with the world’s most dynamic technologies with a consumer that was born to shop. I would continue to overweight the US.

[00:53:34] Alan

Very good. Well, I think we’re just coming up in time. We always just wrap up by getting some perspective, advice maybe for people coming into the markets, younger people starting off as to things to do or read. Obviously, you’ve been through everything in the markets. What would your advice be to people?

[00:53:52] Ed

Well, if I was starting all over again, I would have saved more even if that meant reducing my standard of living and I would have put it in high-quality dividend-yielding stocks, companies that have been around for a long time, that have been growing their dividends, paying more year after year, and put them away and not get involved in the day-to-day battles that we have in the financial markets.

You can really get whipsawed around quite a bit in the stock market, even in the bond market. I think you have to buy quality, buy securities that are giving you a good return, and then just put them away and try to get some peace of mind because if you’re trying to trade these markets, it can be quite tough, very difficult on you for an individual investor.

[00:54:54] Alan

Very good. Good advice, I’m sure. Well, Ed, thanks very much. This has been a tremendous conversation. Thanks very much for doing this today. Make sure to follow Ed’s work because as you can tell from today’s conversation, we’re living in a fast-moving global macro world and it’s more important than ever to stay well-informed. From all of us here on Top Traders Unplugged, thank you and we’ll be back soon with more episodes.

[00:55:19] Ending

Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today’s episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you’ll be sure to get all the new episodes as they’re released.

We have some amazing guests lined up for you and to ensure our show continues to grow, please leave us an honest rating and review on iTunes. It only takes a minute and it’s the best way to show us you love the podcast. We’ll see you next time on Top Traders Unplugged.