Everyone’s Watching the Fed. The Real Story’s Somewhere Else ft. Louis Vincent-Gave

[00:00:06] Louis

It’s like tequila shots. You’ve never known when you’ve had enough until you’ve had too much. And government debt tends to be the same story.

You feel good, you feel good, you feel good, and then at some point you’re throwing up in the bathroom. So yeah, your point is, when do we start throwing up in the bathroom? And the answer is I’m not quite sure.

But I know it’s not a great asset class to own because at this pace, you know, it’s like you’re seeing the guy at the bar just pounding the tequila shots and you know there’s nothing good coming out of that. You’re not quite sure when he’s going to hit the wall, but you know that wall is there.

[00:00:43] 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’ll 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 products before you make investment decisions. Here’s your host veteran hedge fund manager Niels Kaastrup-Larsen.

[00:01:39] 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 a 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.

[00:02:23] Alan

Thanks for the introduction, Niels. Today I’m delighted to be joined by Louis Gave. Louis has been on the podcast a couple of times before, so he needs no introduction. But for those who haven’t heard from Louis before, he’s the founding partner and Chief Executive Officer at Gavekal. He’s been in the markets many years and is the author of several books.

Louis, great to have you on how is home on your side?

[00:02:45] Louis

Things are good. I’m delighted to be back. Thanks for inviting me.

[00:02:50] Alan

Not at all. And as I said, you were on, I think it was October last year and the summer the previous year. So, if people want to since check how your views have evolved or hear your full backstory, they can listen to those episodes.

[00:03:02] Louis

I hope I didn’t say anything too embarrassing back then. I can’t remember what I said. Hopefully it stood the test of time.

[00:03:11] Alan

I had a quick look back. It is funny how you kind of forget what was topical at the time. But you did. I mean, to your credit, you had a couple of very good calls. You were pretty confident. You were confident that Trump would win. And was it the French guy that you had the big bet on the betting markets?

[00:03:29] Louis

Yeah, that’s right, the French whale. A lot of people asked me if that was me and it wasn’t. Just to be very clear, that was not me. But yeah, I had quite a number of clients ping me and saying, hey dude, what are you doing putting such big numbers on the US Presidential election?

[00:03:47] Alan

Well, you seemed equally confident, at the time, and you were right on that. And the other point, the last couple of times you’ve been on, you’ve been definitely in the ‘no recession camp’ on the view that such large deficits in the US are not normally associated with recessions. And obviously, the deficits have not gotten any smaller in the last couple of years, so they’ve been getting bigger.

But we have had some weak data out recently which have kind of reignited goals for maybe a, a possible imminent downturn. So maybe that’s a good starting point. How, how are you reading the data? Do you see increased concerns on that front?

[00:04:22] Louis

Yeah, look, I am increasingly concerned. I became a lot more concerned with the tariffs, back in April when these were announced. And both Anatole, my business partner, Anatole Kaletsky at Gavekal, and myself wrote a number of pieces. Now, usually I start off with the premise that what matters the most is the cost of capital and the cost of energy.

The cost of capital is low enough, and when capital is plentiful, and when energy prices are low enough, and energy is plentiful, usually the economy just moves forward because, you know, every entrepreneur wakes up every morning trying to figure out how to make more money, how to produce more with less, etc. And that’s what drives our capitalist system forward. Which again, unless you have the brakes of too high a cost of Capital, too high a cost of energy, that usually works.

And that was part of the reason I was sort of dubious on the whole, oh, we’re heading into recession. Because in my career, most of the recessions have been preceded by either a big increase in the cost of capital, especially the cost of capital, I would say, for the private sector more for the government, i.e. widening corporate spreads. And we didn’t have that. And we also had a cheap price of energy. So, I don’t know, I felt pretty confident.

But inherent in that belief is also kind of the hope that entrepreneurs wake up in the morning feeling good about the future, wanting to invest, wanting to move the ball forward. And this is where the tariff throws an interesting wrench because they add a lot of uncertainty.

Now the reality is most entrepreneurs just want certainty in their lives. They want to know what the tax rates are going to be, they want to know what the regulations are going to be, and then they get on with it. Now, of course, every entrepreneur wants a lower tax rate, every entrepreneur wants lower regulation.

But by and large, you know, you’re told the rules of the game, and then you go out and play it, or not, or you decide, you know what, I don’t want to play this game. I’m taking my ball and going home.

My big fear, when the tariffs hit, and I wrote it at the time, was that when you look at the construction sector in the United States, you’re dealing with a bunch of entrepreneurs there who are still carrying the scars of 2020 and ‘21. You know, in 2020 and’ 21, you had massive supply chain dislocations, you had bare shelves at Home Depot, lumber prices spiking, etc. And so, a lot of projects got delayed. A lot of project delays, in the construction industry, means all of a sudden margins disappearing.

And so my fear was that, given these scars from the 2020, 2021 experience, a lot of the people in the construction industry (and I was seeing this talking to people) would react to the tariffs by saying, look, I don’t know if in three months time I’ll get the pipes, because the pipes are made in China. I don’t know if I’ll get electric wire, that’s made in China.

And the problem is if you don’t get the electric wire, then it postpones everything, right? It’s like, if I can’t get the electrician in today, then I can’t get the plumber in the next day. And if I can’t get the plumber then I’m not going to get the drywall guy in. And so everywhere around me, following the tariffs, I was hearing of projects being put on hold.

Now, the reason this matters… now, you could say, well, you know, construction, it’s only like 3%, 4% of US GDP, etc., but it’s a huge employer. It’s a massive, massive employer.

Which, by the way, that’s another uncertainty is, you know, there are a lot of illegal workers in the construction industry, especially in the whole southern belt of the United States, and Florida, and elsewhere where construction has been absolutely booming for the past decade or so. Whether you look at your Arizonas, your Nevadas, your Texas, your, your Florida, this is where most of the construction was happening.

So you’re dealing with, all of a sudden, if you’re an entrepreneur, uncertainty of am I going to get the parts I need when I need them, at what price, and am I going to get the workers and at what price? Maybe it’s just easier if I hold back and not do anything.

And I think what’s interesting in the recent weak data that has come out is the extent to which it does seem to point towards weak construction. And again, the PMI surveys that just came out yesterday, it disappointed, and it was all basically construction.

So, do I think we’re going to have a US recession? It’s a tough one because, you know, if you look at typical models, cost of capital, budget deficits, cost of oil, you would say no. So, you almost have to make the argument that it’s different this time.

But if ever there’s a time to make the argument that it’s different this time, it probably is today, where policymaking in the US Is very different than you and I have experienced through our careers. So, it’s hard to have a strong level of conviction either way. But I am fearful that the odds of recession are going up. Yes.

I’m not banging my fist on the desk saying, oh my God (to your listeners), watch out, US is recession coming, etc. I’m not doing this, but I think we have to acknowledge that the odds are probably higher than we’ve seen since the post Covid era.

[00:09:48] Alan

Okay. And you’re seeing that very much being driven by the construction side. Obviously, you know, consumer spending has slowed as well. I mean, are there other dynamics at play? Obviously, with tariffs coming through, it’s going to be a hit to disposable income in real terms. Any other channels you see are they kind of confirming the weakening economy scenario?

[00:10:10] Louis

Yeah, look, I think all of these make sense, but again, for me, construction is a huge employer. Construction is also, you know, there’s a huge multiplier effect across communities everywhere. So, I do worry about that.

Yes, indeed, I think there is a squeeze on US disposable incomes and both from, you know, inflation that is still there. I can’t remember the exact number, but I think inflation has been above the 2% mark of the Fed for something like 46 months in a row. Don’t quote me on that exact number, but it’s in that ballpark. It’s essentially 4 years.

The bottom line is, yeah, you look at the consumer being squeezed, you look at construction being highly uncertain. And frankly, even capital spending in general, if you look at the boom we’ve had in the US, it rested on many things.

One of them, of the recent years, was capital spending in AI. Now, this might continue. However, what we’re increasingly seeing is that the hoped for returns to the likes of Google and Microsoft and Apple, and Facebook, and others, you know, the hopeful returns on that are great. So, at some point does the AI sort of rush ahead and continue?

We’ve had very, very strong consumer spending which was partly linked to, I think, the wealth effect on houses, on equities, on crypto. Now granted, you could say, well, equities are all time highs, crypto is essentially at all time highs. So, maybe that continues, but maybe the lower end guy, does get squeezed. And then you had construction that was like booming. And I think that part is slowing really hard.

[00:11:54] Alan

Yeah, I mean, obviously when tariffs came along there was a huge uncertainty. And that was the theme of Q1, Q2. I mean, it was reasonable to say, well, businesses will postpone spending decisions or investment decisions. We don’t know what it’s going to play out like. But now I suppose you could say it is increasingly apparent what is playing out. It’s kind of 15% or 20% in most cases. Okay, we haven’t got a deal with China yet. But the noises are positive. I mean, do you think, as we get into Q3, Q4, we’ll get to a point where there is certainty on the tariffs, albeit that they are now here at kind of elevated levels?

[00:12:32] Louis

Yeah, look, I think, really, the three countries that matter the most for the US, and who the US trades the most with are Canada, Mexico and China. Now, when it comes to Canada and Mexico, you know, to your point, just like Europe, just like pretty much everybody out there, you’re going to be in the 15% to 20% range. And I don’t think that’s inconsequential. You know, that’s a pretty high number. Somebody’s going to have to pay for that.

Now I think that the premise of the Trump administration is that either foreigners will pay, or corporates will take the hit on their profit margins. Maybe they turn out to be right, but if the lower end consumer is made to carry some of that bag, then that bag’s already pretty loaded.

The lower end consumer is pretty stretched in the US. So yeah, so you’ve got that, and then you, indeed, have the elephant in the room, which is China, which is right now at 50%. Now 50% essentially kills the trade. Now, you know, China (unlike other countries) hasn’t come groveling.

They’ve quite the contrary, they said, okay, you want to go down this path, we can raise tariffs on you. We can block the export of rare earth. We can block the export of magnets. We can bring your entire auto, and armaments, and aerospace industry to its knees in about three months. So, you know, fine, you want to play, let’s play. Bring it on.

And you know, I think the perception in China is that, of course, this will hurt the Chinese economy, but that China’s ability to withstand pain is much greater than the US’s ability to withstand pain. That essentially, you know, if the GM factories are shut for two weeks, then Trump will be seen as a failure. You know, the whole ‘make America great again’, American industrial renaissance, etc., doesn’t work if Ford and GM can’t get rare earths and, and magnets to make cars.

So, China has played that card. It’s played it quite aggressively, which does probably open the door for a deal, at some point. But it really seems like China’s not rushing to get a deal.

[00:14:58] Alan

So, I mean, what is a likely deal, would you say, given all of that?

[00:15:03] Louis

So, if you look, right now China’s at 50%, 20% of which is the penalties for fentanyl. Now, already the US is now going around saying oh, you know, there’s been huge progress on fentanyl. It’s now much, much better. So, they can move pretty quickly from 50% down to 30%.

I mean, the US can decide that unilaterally and just say, okay, fentanyl, China’s done tremendous work there, well done. So, we’ll bring it back down. So, they’ve given themselves this leeway with the fentanyl tariffs. By the way, tariffs were also imposed on Mexico and Canada, and the US said okay, you know, they’re making progress, so we’re taking that off.

And I suspect that’s what will eventually happen. Now, you know, once you get down to the 30%, after that, it’s like, hmmm, it’s not obvious that it goes lower from here.

[00:15:58] Alan

Yeah. So, you think that it could settle somewhere around that kind of baseline, which would obviously still be significant.

[00:16:07] Louis

Yeah, 15% to 20% on everyone and probably 30% on China is, I think, where we basically end up, with the occasional other country that may also be at 30% or 35%.

[00:16:16] Alan

To the question on impact on inflation, obviously it pushes up the price level. We’ve seen a little bit of that in the most recent inflation data, on the good side. That being offset by weakness, I think, in the services side. Do you think we’ll see more, and then where do you stand on, like, will it be more persistent over time?

Chris Waller seems very intent on the view that it’s a one-off price impact and it’s not going to lead to sustained inflation. Would you be as confident on that view?

[00:16:49] Louis

I hate to make like a Jesuit priest and answer your question with another question, but I think the answer to your question depends a lot on what your outlook on energy is and what your outlook for the US labor force is. Because the reality is that goods within the US, goods inflation, is only a fraction. What probably really matters is whether we start to see wages push higher. Now, historically a huge catalyst for wages pushing higher is higher energy prices.

Somehow there’s a psychological element to energy prices. Perhaps this is because, you know, when we drive to work we see the gas price on the side of the road, perhaps because it’s the one thing we buy consistently, and it’s always the same thing. I fill up my car every week and I know I pay X to fill up my car.

And so, right now energy prices are low. Gasoline prices are low. And so, you know, wages are still not really rising all that fast, even with the immigration crackdown. Even with the immigration crackdown, wages haven’t been shooting up.

Now fast forward 6 or 12 months from now, if energy prices have moved up, and at the same time you’ve got a tight labor market because you’ve kicked off all the illegal immigrants, then you really have the recipe for, I think, an inflationary spiral where wages go up at the same time good prices are going up and gasoline prices are going up. And then the narrative, the popular mood really starts to swing to, oh my God, there’s so much inflation.

So, energy prices, at this juncture, are really, really critical. And I would say that if energy prices start to rise, then probably President Trump’s presidency starts to become very challenging. As long as energy prices stay low, basically the show more or less may manage to stay on the road.

Now, I happen to be a bull on energy, so I happen to be an inflationista. But I willingly acknowledge that energy prices today are low and that we’re going through an interesting time in energy because, on the one hand, I think we’ve underinvested in carbon for 10 years now, and the scope for oil and natural gas, et cetera, to go up is there.

But at the same time, you have the biggest energy importer in the world, namely China, that has invested like absolute crazy in its ability to deliver electricity and to essentially fund its own transition. A transition from carbon-based energy to electricity. Whether that electricity is produced by nuclear, by solar, by LNG plants, by hydro, by coal-based fire plants. But China now produces twice the amount of living electricity than the United States does.

Which is funny because the US is still supposed to be at least a third bigger as an economy. But when you look at electricity production, and if you think that’s probably a decent proxy for the size of an economy, China is now twice the size of the United States.

So, all this to say we’re at an interesting point where the energy of the future is electricity. It’s not gasoline, it’s not diesel, the energy of the future is electricity. China is moving very rapidly in that direction, the rest of the world, not as much. But meanwhile, we’ve also massively underinvested in carbon.

So, depending on where you fall on the energy question, I think, will dictate how you fall on the inflation question. So, I’m a bull on energy. I think energy prices move higher, I think inflation thus moves higher.

[00:20:45] Alan

And what’s the bullishness? I mean, I get the underinvestment case in energy. Obviously, oil prices have been stuck here in a range for quite a while now. And obviously we’ve had geopolitical events, we’ve had Iran strikes, etc., and the view always seems to be, get a spike, it’s a good opportunity to sell because the market is quite well supplied at the moment. So, what changes on that front or what are the risk factors, do you think?

[00:21:11] Louis

Yeah, look, I think the main thing is big energy bull markets are driven more often than not by demand. And so, I think what changes, what people underestimate is you could look at energy as, essentially, you’ve got different billion people markets. So, China’s a 1 billion person market (I’m rounding, of course), it’s like 1.3, but let’s just call it 1 billion. India is 1 billion, Africa will very soon be 1 billion, and then the developed markets are essentially 1 billion, and then everybody else is 1 billion (if I’m going to make it like very simplistic).

So, Africa has been a huge net energy exporter. That probably changes in about three or four years, between their population growth and their standard of living growth. So, they switch from being an exporter to an importer.

You know, India continues to import more and more. So, I think people focus on China because it’s been the big story of the past three decades in energy. And then they say, well, look, China’s energy needs are plateauing. They’re importing less or they’re not importing as much. They’re no longer growing. But it’s missing the story that’s occurring elsewhere in emerging markets.

So, when you look at total oil demand, it’s still growing by 1 million to 1 and a half million barrels per day every year, you know, ballpark. So, for that, given the fact that wells lose capacity over time, to make that extra million and a half barrels, you need to continuously invest. Now, today you could say, yeah, but you know what? OPEC probably has 2 million surplus. Yeah, and that probably covers you for the next year. And then what? So, then what you could say is, well, you know, you got some coming out in Suriname and some coming out in…

But here’s a fun fact on the other side. From nowhere – five years ago, China is now the biggest car exporter in the world. Something that nobody expected. China is now the biggest car exporter in the world. And 85% of the cars that China exports on any given month, 80% to 85%, are ICE cars. The electric cars stay at home and the ICE cars go abroad. Why? Because the cars go to emerging markets.

And when you live in Colombia, when you live in Indonesia, your electricity grid isn’t going to support electric cars. Also, electric cars depreciate too fast for emerging market investors. Good thing about ICE cars is they last 20 years, if you take care of them.

So now, all of a sudden, what you have in Indonesia, in Vietnam, in Colombia, in Brazil, you have people who buy cars who never bought cars before because they’re buying Chinese cars for less than 10,000 US dollar a car. So, you have, all of a sudden, people driving ICE cars all across the global south that were not consuming gasoline up until five minutes ago.

And I think that’s the part that perhaps people are missing today is yes, on the one hand OPEX has this extra 2 million etc., but at the pace at which China is exporting cars, you’re going to need gasoline, you’re going to need more refineries. Nobody’s building refineries, you’re going to need more refineries, etc. And so yeah, I do tend to think that the risk is to the upside.

[00:24:40] Alan

That sounds like maybe a story for next year or thereafter and not necessarily for the next six months.

[00:24:46] Louis

These things are always so hard to tell. What I do know is that today’s equilibrium is unstable. Now, you’re absolutely right that it could be stable for the next six months, 12 months, 18 months, absolutely. But I think that if there is a risk to our system today, if there is a risk to global economic growth, we’re now set on an easing stage for central banks everywhere around the world. Whether you know, the Fed, that’s going to be easing, the ECB, that’s easing, EM, central banks everywhere, easing, etc.

If there’s a risk to this whole environment, it is that oil prices spike. Now granted, I take your point. It’s like yeah, but that’s not going to happen in next six months.

Probably there’s like a 90% chance it doesn’t happen in the next six months. But what if it does? What if in that 10% chance it does? Then it’s going to obliterate your portfolio. So, at the very least you don’t invest on the premise that this is going to happen, but you buy protection for your portfolio in case it does.

[00:25:53] Alan

You mentioned easing is likely for the Fed. I mean, do you think, now, the Fed’s going to come under so much pressure that it will cut in September, and how much between now and the end of the year?

[00:26:06] Louis

Yeah, I think it cuts in September, I think it cuts in September unless (again, I’m sounding like a Jesuit priest, like hedging everywhere)… There are two CPI prints between now and September, unless you get two bad CPI prints. (And by bad, I mean the CPI that surprises on the upside, that turns out to be much stronger than expected), unless you get that, I think those job numbers we just had almost guaranteed that you’re getting cuts in September.

Now, you know, beyond that, is it going to be 25%, is it going to be 50%? I think a lot of that will be driven by the data between now and then. But, you know, recent PMI, recent ISM, have looked softer. If all these things continue, then, yeah, probably 50%.

[00:26:51] Alan

Okay.

[00:26:52] Louis

And then that allows the Fed to sort of at least get Donald Trump off their backs a little bit.

[00:27:00] Alan

Speaking of which, the big topic, in respect to the Fed, is what happens next. So obviously it seems like Trump isn’t going to fire Powell just yet, but obviously the window for putting a replacement in is, is opening. Obviously, there’s a spot for a new governor, which may or may not be the person who becomes the chair. What’s your thinking on this?

Obviously it’s kind of two Kevins and Chris Waller are probably the three names. I know there’s a fourth. I’m not sure if that’s Bessent, he now seems to be ruled out, or if there is somebody else. But back to the betting markets, they’re the top three contenders.

00:27:38 Louis

I thought Trump wanted to appoint himself.

00:27:38 Alan

That was also mooted at one point. Yeah, not impossible, but yeah.

[00:27:45] Louis

So first, I don’t think he fires Powell. I don’t think he fires Powell because Powell at this stage, he set him up as the perfect scapegoat. He’s done these big tariffs which may or may not work. It’s a big gamble. If it pushes the US into recession, he can turn around and say it’s the Fed’s fault, it’s Powell’s fault. “I’ve told you all along, this guy’s an incompetent, etc., etc.” So, he set up Powell as the scapegoat. So why would he want to get rid of him?

As soon as he gets rid of him and puts in the other guy, then he owns the economic situation (either guy or girl), he then owns the economic situation. So, I think Powell essentially serves out his term because he serves a purpose now, which is being a scapegoat.

Beyond that, who he picks, I think at this stage, what really matters more is that it’s been signaled, it’s been telegraphed, that the Fed from here on out will be easier, will be following easier monetary policies, and will be essentially pushing the US towards a weaker dollar. And I would say, who cares about the personalities at the top?

What matters for us as investors is the highest odds are that we’re going to have a set of policies that almost guarantee steeper yield curves and a weaker dollar. So, that’s what matters to us. And a steeper yield curve, a weaker dollar, that usually means outperformance of financials. Which is what you’re seeing in markets everywhere. It usually means outperformance of emerging markets, which is what you’re increasingly seeing. Usually, it means the outperformance of value against growth, which we’re not really seeing yet, but I think we’ll see probably further down the road.

[00:29:37] Alan

Plausible.

The one thing I would say is the likes of Kevin Warsh has very distinct views on balance sheet normalization and has been very critical of the Fed’s approach around QE. So, I mean, if we saw him come in, obviously he’s in favor of rate cuts at the moment, but he does seem to be a bit more independently minded than maybe say, Kevin Hassett.

[00:30:01] Louis

That’s a very fair point. I’m a big believer and a big proponent. I always say that, look, as money managers, we’re paid to adapt, not to forecast. So, I’ll be dead honest with you. I’m not actually spending that much time thinking through all the various scenarios of, you know, once who gets it, and what they do once they get it, etc. Because once we know who it is, then I’ll start thinking, okay, so, if it’s this guy, so it probably means this, this, and that.

Having said that, people change their minds, people evolve as well. So, I fear that trying to anticipate the various guys moves is maybe too many chess moves ahead. I played a fair amount of chess in my youth, and I was never very good because I could never do more than sort of three moves ahead. You know, the really good guys have got like six moves ahead. I could do about three moves ahead, in my head, and then I’d sort of lose it. And as an investor, I try to do the same. I try not to be too many moves ahead because the complications just get too big.

[00:31:14] Alan

Fair enough. You did mention a weaker dollar. And this has been a theme this year. Obviously, the dollars had, I think, the worst start measured on a calendar year basis. At least it did going back a few weeks. And the narrative was all about kind of outflows.

The end of US exceptionalism, obviously, was one narrative which has kind of diminished a little bit as the equity market has come back, and then outflows from the US market, and obviously some hedging pressures as well, undermining the dollar. So, putting all of that together, and obviously in the background chatter about US reserve status under pressure as well. I suppose that’s the consensus view. It’s hard to disagree with it. What do you think?

[00:31:57] Louis

Yeah, I think it’s hard to disagree with it. I think we are seeing a paradigm shift in the US dollar. And look, perhaps the most important shift in the US dollar… You know, if you were a French pension fund or a Korean insurance company, for years you bought US equities and you were long the US dollar. And if ever there was a market accident and equities went down 10%, typically your own currency went down 5%. So, net/net, on your US equity position, you would be down 5%. So it was, yeah, nobody likes being down 5%, but it’s not the end of the world.

So, the fact that for years and years the US dollar was this port in the storm, this shelter in rough seas made US assets very attractive. It made the US dollar very attractive and sort of a very reflexive move for foreign investors. And I think this was shattered this year.

We saw it very well in April when the Liberation Day tariffs were announced. Instead of going up, the US dollar went down. In fact, for a period of about eight days, you had the bond market in the US, the equities and the currency all falling at once. And if you’ve ever been down in emerging markets, you recognize that pattern immediately.

You recognize that pattern. You’re like, okay, I’ve seen this movie before. This is an EM crisis, I’m out of here. When you see those three things fall together, it’s a big warning bell. And that’s why I think Bessent and Lutnick had to intervene, and they talked the tariffs back and stabilized the markets. But the message was nonetheless sent that from now on, when US equities fall, so does the dollar. And therefore, this makes US assets, just this shift in correlations makes US assets a lot less attractive to most institutional investors everywhere.

So, I think you got that. Of course, you’ve got the greater uncertainty around politics and policies in the US. And politically it’s now no longer good to be seen being overweight the US if you’re running a public pension fund in Holland, or you’re running a sovereign wealth fund in Singapore. Being massively overweight the US may not be the smart trade. So, bottom line, I think the default mode amongst large institutional investors is now to bring money home.

You know, for the default mode for 15 years was, I’ invest in the US’. Now the default mode is, is bringing money home. But the problem when you talk to pension funds in Germany, or pension funds in Canada, they always tell you the same story, I want to bring money home, but I don’t have any assets to buy at home.

Now this is where it gets interesting. If you look at the new chancellor in Germany, at the new Prime Minister in Canada, the new prime minister in Canada comes out of Goldman. I tend to believe that you can get the guy out of Goldman, you’re not going to get Goldman out of the guy. So, if you now have pension funds that come to CM and say, hey Prime Minister Carney, give US assets to buy, he’s going to say all right, I know how to do this. Let’s build some infrastructure bonds. Let’s IPO the airports. Let’s build pipelines into British Columbia to sell the oil to Asia, and give all these Canadian pension funds, that have hundreds of billions invested in the US, opportunities to bring money home.

And I don’t want to pick on Mark Carney because you take the German chancellor, he used to be the CEO of BlackRock for Europe for six years. So, how hard is it for him to structure infrastructure bonds and call the head of every pension fund in Europe that he knows on a first name basis? Probably not very challenging.

So, I do think this trend is starting where the marginal dollar, instead of being invested back into the US, is now increasingly going to be invested domestically.

[00:35:44] Alan

It makes sense, I guess. I mean, the one thing that it ignores is the AI theme, and the Mag 7 have come back and haven’t been under pressure for a while. So, if investors want to play that theme, obviously the US still remains the obvious place to go to.

I mean, you mentioned there maybe some questions around the return on investment but at the same time recent results from Meta were encouraging, and I think some Microsoft, and a number of them were announcing upgrades to their CapEx spend. So, I mean for the moment it still seems to be raging on. Is that not part of the picture or you’re understanding?

[00:36:27] Louis

That’s a massive part of the picture. That’s a massive part of the picture because you’re absolutely right to highlight it in that you’ve had an epic capital spending boom in the US. I actually, recently, wrote a piece on this, where CapEx in the US, over the past few years, has gone from 9% of GDP to 11% of GDP. And this 2% of GDP increase in CapEx, by the way, historically it tops out at around 11.50%. Like, in 2000 it topped out at 11.50%.

That extra 2% has really gone to a handful of companies because that increase in Capex, some of it has been in data centers, some of it has been in building out new power plants (although nowhere near enough). And most of it has been in AI.

You know, it’s that 2%. It’s gone basically straight into Nvidia’s bottom line. Exaggerating of course, but don’t send me data saying, no, it didn’t all go into that. But it’s gone into Nvidia and, yes, to Microsoft. And so, the question now becomes, you know, you’ve had this huge increase in CapEx, what do we get on the other side of it?

Now, do we get the productivity gains and do we get the profits that flow to these businesses that have essentially turned themselves? you take a Facebook, it’s essentially turned itself from an extremely asset light business into an increasingly asset heavy business. Now again, if the money flows in, then happy days, then the show stays on the road. And yes, people want to keep buying Facebook and they’ll want to keep Nvidia, etc.

If the returns don’t come through, if AI turns out to be very commoditized, and if the profits on there or the productivity gains aren’t what was hoped and expected, then the US really hits the wall really, really, really hard. Because right now what is keeping the show on the road, to your point, is this excitement around AI. Take that away and all of a sudden things start to look pretty dire.

[00:38:28] Alan

And what’s your thoughts on in the next downturn? I mean there is a view that, because now of increased usage of AI, LLM, etc., that a lot of those entry level positions are not being filled and that in the next downturn we could see even more adoption and corporates trying to squeeze as much out of AI as they can and much higher unemployment. Is that too early to expect that or is that a risk factor on your radar?

[00:38:55] Louis

No, I think you have to worry about that. I mean look, that’s the very lynchpin of the AI hope is the idea that we’re going to get productivity gain.

[00:39:01] Alan

That’s the productivity gain, isn’t it?

[00:39:04] Louis

Yeah, it is. So, you have to worry about it because either, A this is… So, there are two options, A, this is going to be real and where all this (to your point) the entry level jobs in insurance companies and in banks and in a lot of places are going to disappear. And so, then you have to wonder, okay, so, what does that mean for our societies? What does that mean for jobs in general, etc. So, that’s your one path.

And the other path is, like I said, I think it turns out to be a dud. It’s nowhere near as productive as we’d hoped and we have a hell of a stock market correction. It almost reminds me of that Woody Allen quote about how we’ve reached a fork in the road, on one side lies despair and on the other lies misery, and that I hope we choose wisely. So, I don’t want to sound depressing for your listeners.

I tend to believe, and I may be wrong, but from my own playing with it, I tend to believe that the level of hype on AI is off the charts, and that there will be some productivity gains, sure, but it’ll be nowhere near what we’re being told, and it won’t be near enough to justify either the levels of CapEx that have been put into this thing, or the levels of the valuations on a lot of assets.

I mean look, I’ll give you just two examples. If you go back to 2008, in 2008 the whole world, from peak to trough, lost $18 trillion in equity market cap. So, you had essentially $500 billion of losses on mortgage bonds that triggered $18 trillion of market cap equity losses. It was a bloodbath – $18 trillion.

Now, okay, keep that number in mind for just a second. Today, if you look at Nvidia plus crypto, just those two assets – Nvidia and crypto, there, today, together it’s more than an $8 trillion market cap. Now, crypto and Nvidia just two years ago, crypto and Nvidia just two years ago were $2 trillion market cap. So, they’ve gained $6 trillion in market cap in two years. Now, $6 trillion is a lot of money.

I think there are only two economies in the world that have more than a $6 trillion GDP, China and the U.S. So, $6 trillion is a huge amount of money. And that’s what’s been gained in just two years by those two asset classes.

Now when you look at Nvidia and when you look at crypto, these are asset classes that every three to four years lose 75% of their assets. That’s just what they do. It doesn’t mean they’re bad. I’m not putting a value judgment on it. I’m just saying, like, look, these are asset classes that, through history, have had massive volatility, and massive upside and downside volatility.

Now, you could say, well this has changed now, that’s over. But let’s imagine that it hasn’t changed, that at some time in the near future we got a 75% wipeout on these guys. That will be $6 trillion that will pop away like this. That’s a third of the equity loss of 2008 in just two asset classes.

Now imagine the impact this will have, then, on capital spending; the impact this will have on consumption. You know, there’ll be a lot less boats being sold and a lot less sports cars and whatever else. So, for me, this is now the big risk in the market, to be honest. We’ve reached a point where the hype on AI the results really have to be pretty outstanding to match the level of hype that that was put in.

[00:43:05] Alan

You mentioned earlier about the period in April with the dollar bonds and equity selling off at the same time. And you know, it brought into, I suppose, focus the kind of maybe structural concerns about the long end of the curve in the US that you mentioned, the likelihood of steepening.

But we’ve had the Big Beautiful Bill. Deficits are not getting any smaller, they’re getting larger. And on a trend basis, year on year, we’ve just got used to kind of 6%, 7%, 8% of GDP. But we’re not seeing a huge reaction from the bond market. Obviously yields went up to maybe 4%, 5%, 4.6%, and are back to 4.25% now. There was a view in the markets of, do deficits matter? At what point do they matter?

[00:43:48] Louis

It’s the old story, right? It’s like tequila shots. You’ve never known when you’ve had enough until you’ve had too much. And government debt tends to be the same story.

You feel good, you feel good, you feel good, and then at some point you’re throwing up in the bathroom. So, yeah, your point is, when do we start throwing up in the bathroom? And the answer is I’m not quite sure.

But I know it’s not a great asset class to own because at this pace, you know, it’s like you’re seeing the guy at the bar just pounding the tequila shots and you know, there’s nothing good coming out of that. You’re not quite sure when he’s going to hit the wall, but you know that wall is there.

So, I do look at the fiscal situation across most of the OECD, and the reality is you could say, oh, it’s bad everywhere, etc. But there’s really three countries that have really bad fiscal situations today. One of them is my own of France, the other is the UK, and the third is the United States. These are really the three countries where, when you look at the increase in debt, you can start getting worried.

Now, the UK and the US still control their central banks, so they have the option to monetize the debt, to essentially take the pain through currency devaluation, through currency devaluations and a weaker currency. It’s harder for France to do this because we’re obviously part of the euro.

And so, if you want to look for a debt crisis, perhaps the more obvious candidates, at this juncture, has to be France, where you have a very tenuous political situation. You have a government that can’t pass a budget, that’s coming back in September from holiday, doesn’t control parliament because parliament is divided a third, a third, a third. And every one of those three groups hate the other two, where, basically, building coalitions is impossible.

And then you could say, well, if France hits the wall, then maybe that gives another boost to US treasuries, where foreign investors say, ah, Europe, it’s screwed. These guys can’t fight their way out of a wet paper bag. I thought they had it together, but they don’t.

By the way, I’m not saying this is going to happen, but I think that the risk of that is not zero. And then money comes back into US treasuries. So, you can actually make a bull case for US treasuries. Personally, I don’t own any US treasuries. I think the US dollar is a structurally weak currency from here on out. I personally have no Interest in owning bonds and currencies that depreciate.

I like to own bonds and currencies that appreciate – currencies are bound to be strong. I have no interest in owning US treasuries. But you could see an argument where, okay, actually, out of the three weak links in the system, France is the weakest link and when it breaks, it’ll boost the US.

[00:46:36] Alan

And what’s the scenario for a French problem? Obviously, in Europe we’ve had easing from the ECB. So, they’ve been much, much more ahead of the curve, I guess, than the Fed has been. Obviously, as you say, in Germany we’ve had a debt break being loosened.

[00:46:52] Louis

Maybe it doesn’t, which is why I said I’m not sure we go this way.

[00:46:57] Alan

Shifting gears. I mean, last time you were on was, I think, October last year. It was not long after the big kind of China announcement, still stimulus at that point. It was a kind of a big spike in the equity market. It’s been kind of up and down since then, but probably a little bit higher. So, you know, hasn’t reversed. But you mentioned the kind of the China Nettie exporter, the largest exporter of cars in the world.

And that’s been the Chinese strategy, isn’t it? Flood the world with its excess manufacturing capacity. To date, I guess countries like Indonesia, as you say, Brazil, have been happy to absorb that excess capacity. I mean, where do you see China now in its process of coming out of that big deleveraging that it’s been going through for the last number of years?

[00:47:44] Louis

Yeah, so I’m not sure that it’s been China’s strategy to flood these other countries. I think China’s strategy is actually a bit different. The way I conceptualize China is that China was humming along and in 2018, the US embargo on semiconductors was a massive shock to the system. When the US said no more high-end semiconductors to China, essentially the Chinese leaders panicked.

They thought, okay, if they’re blocking us from semiconductors today, tomorrow it could be auto parts, it could be tires, it could be chemical products, it could be anything. The US is trying to trip us up economically. We thus have to become self-sufficient and independent, resilient on every single supply chain.

And so, in 2018, essentially the government tells the banks, guys, no more loans to real estate, no more loans to the consumer, all the money has to go to industry. And so, we go through seven years of all the loans… If you were an auto manufacturer, you’d get a loan. If you were a battery manufacturer, a chemical producer, like whatever, you were getting a loan if you wanted it. But real estate, forget about it. And so, you see, real estate loans absolutely collapse, and you get a, epic real estate bust, unsurprisingly.

Imagine if tomorrow the Irish government told the banks, you’re not allowed to lend to real estate anymore, what that would do to the real estate market. It would probably be nothing good, especially if valuations were stretched to begin with.

And then you also had fairly little consumption. You lived through it, in Ireland, when people’s real estate goes down, you tighten the belt. And it’s not like you go out to the movies or the restaurant.

So that was the story, really, of the past six, seven years. And while this happened, it did create all this excess capacity that you talk about. And so, now, today, China turns around and produces all these cars, all these tractors, these telecom switches, these railroads. And then indeed, the question becomes, okay, where are we going to sell all this stuff?

Now, the obvious market would be, obviously the developed markets, but there’s this protectionism against China. And frankly, the Russia invasion of Ukraine, and the fact that China has sided with Russia, has made all that part even more complicated. And the Western world is even less likely to do business with China.

So, then the only market becomes this global south, for lack of a better word. It becomes Latin America, Middle East, Southeast Asia, Central Asia.

But all these countries are poor countries, so China’s got to provide funding. And this is where we are today is like, okay, China is now starting to export these cars, these train systems, etc. In what currency are we going to fund this?

And this is where it gets interesting is if you go back to 10 years ago, five years ago, all China talked about was funding its trade in its own currency, in the renminbi. And it talked about the offshore renminbi. And what China was saying was essentially, look, Indonesia, we’ll buy your coal for renminbi.

And if you don’t want to keep the renminbi for, you know, whatever reasons that are yours, you can come to Shanghai and exchange your renminbi for gold. And now what they’ve realized is that the more they trade and the more they push out the renminbi, the more people buy gold on the other side.

And so gold starts to go, not yet, but starts to move parabolic. It starts to move up. The risk, now, if you’re Chinese, if you’re the Chinese central bank, if you’re the PBOC, the risk is that gold really, really starts to shoot up because Chinese investors themselves first love gold, secondly love a momentum trade. They’re the biggest momentum investors. So, if gold starts shooting up, then they all start buying gold.

And the risk, then, is that gold goes absolutely bananas, and then it crashes, and you’ve wiped out an entire generation worth of savings, and you’ve made people very angry in the process, and you’ve destabilized social peace.

So, you will have witnessed, perhaps, that in the past sort of year there’s been a big change of rhetoric from the PBOC, and I’ve written a number of pieces on this. But the rhetoric is, essentially, the PBOC now comes out and says, you know what? China’s unique because we have two currencies. We have the renminbi and we have the Hong Kong dollar. Now, we can use the renminbi to fund our internal trade, and we can use the Hong Kong dollar to fund the external trade.

But of course, if we’re going to fund all this trade in Hong Kong dollar, then we’re going to end up with a lot of excess liquidity in Hong Kong dollars. All these Hong Kong dollars that get created, pushed out into the system, eventually come back into Hong Kong, into Hong Kong banks, buy Hong Kong assets.

So, I think we’ve started this cycle. Last year, the Chinese equity markets were actually the one market that outperformed the US equity market. This year, again, Hong Kong is massively outperforming, and nobody cares. Nobody cares. I look at China..

When I look at any market, I look at it through five prisms. First, I start with fundamentals. Does it make sense? And I would say China today, they put down more patents than any other country. They’ve gone from graduating a million university students a year to 13 million university students a year.

They’ve spent the past 20 or 30 years dramatically improving their infrastructure to the point where they now have the cheapest electricity costs in the world. They have the cheapest transportation costs in the world. So, the fundamentals actually make sense.

Then I look at valuations. They’re still very attractive. The momentum is now very solid. Then you look at investor positioning, and nobody owns China because, remember, they’re always about to invade Taiwan and all sorts of crazy stuff.

And then finally you look at policy support, and this is where you’ve had the biggest shift in China is that up until a year and a half ago, the rhetoric from the Chinese government was put all the money in building industry. And now the rhetoric is we want asset prices to go up and we want to create a positive balance sheet effect partly to boost domestic consumption. So yeah, I think, look, we’ve started an equity bull market in China and frankly nobody’s involved.

[00:54:12] Alan

So, the transmission mechanism and the Hong Kong dollars are lent to kind of emerging markets who then sell those back into the system in Hong Kong. So, you’ve got more liquidity in the system there that flows into the equity market.

[00:54:27] Louis

You see this excess liquidity, but one of the things that’s been a head scratcher for many investors is the extent of Hong Kong interest rates. So, Hong Kong is pegged to the US dollar, for your listeners who don’t know this, the Hong Kong dollar is pegged to the US dollar. So, historically the interest rates are roughly the same because otherwise there’s always an arbitrage opportunity. If I can borrow Hong Kong dollars that’s pegged to the US dollar.

Now, if there’s a crisis, what would usually happen, people worry, oh my God, the peg’s going to break or whatever else. So, in periods of crises, Hong Kong dollar interest rates would move far above US interest rates to essentially attract people back into the Hong Kong dollar. This is how the peg works.

All year long you would have seen that highball rates are way, way below US interest rates, not by a little, but by 200 basis points, which is frankly unprecedented and is a testimony to all the success liquidity that is now sort of flowing into the Hong Kong dollar in sort of a broader world.

[00:55:34] Alan

Do the Hong Kong banks, not just buy the dollars, and is there an arbitrage there that somebody has got on a huge scale?

[00:55:41] Louis

No, I think the Hong Kong banks do it, but they’ve have so many deposits in Hong Kong dollars coming in they don’t know what to do with the Hong Kong dollars.

[00:55:50] Alan

Okay. Just conscious of time, outside of Hong Kong. Well, which is not really emerging, I guess, but emerging markets more broadly. I mean, you painted a positive picture from the perspective of an environment of a weaker dollar, which would generally be positive for global liquidity and for EM. I mean, from a more kind of structural growth perspective how has EM been playing out? Obviously, the tariffs, I guess, are a headwind for certain countries or not. Or how do you see that?

[00:56:22] Louis

Yeah, I think, to the extent that everybody’s getting them, it sort of evens out.

[00:56:27] Alan

It evens out.

[00:56:27] Louis

Now, you’ve had some that have been punished more than others. Brazil’s the obvious one now. I happen to have been and remain a bull on Brazil. I look, and for that matter the whole broader Latin America spectrum today, especially if you’re a fixed income investor, it’s the one part of the world where you can easily anticipate 150, 250, 350 basis points of interest rates drop over the next 18 months. And today you can go out and buy a Brazilian TIPS giving you 7.5%, 8% real returns. You can go out and buy Brazilian bonds that are going to give you 14% nominal at a time when inflation is roughly 5%, 5.50%.

So, you know, nowhere in the world has that level of real rates. And you know, in a weaker dollar world the local central banks will have their hands free to cut interest rates much more aggressively. So, I think there’s tremendous trades to be had in Latin America.

There’s, yeah, I think the Chinese equity market has started a bull market that few people are even noticing. So, yeah, there’s things to do out there.

[00:57:46] Alan

So, is that your top tip for the coming year or months? I mean, is that what your most high conviction view on bullish EM or what would you say?

[00:57:54] Louis

Oh yeah, look my highest conviction move, I believe by far, is we’re starting a new bull market in emerging markets. A bull market that won’t be derailed until we either get a new Fed tightening cycle, which seems highly unlikely right now (we’re going quite the opposite), or until we get much higher energy prices. And again, as you pointed out, right now things are stable. It doesn’t seem like a spike is the most likely scenario for the next six to nine months.

So, now I want to buy hedges against that spike because I’m super long emerging markets and I do worry that they would get squeezed if energy prices shot up. So, I want to buy hedges against energy prices shooting up to protect my EM positions. But EM is where you want to be.

[00:58:44] Alan

Good. Great to have you back on again. I’m sure we’ll do it again, maybe next year at some point, and reassess all of those calls.

But yeah, for all of our listeners obviously keep tuned and make sure to follow Louis work at Gavekal l to get his insights over time. But from all of us here, thanks for tuning in and we’ll be back soon with more content.

[00:59:06] Louis

Thanks so much, Alan.

00:59:08 Ending

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