Gregory Peters - Global Macro Series - December 27th, 2023

[00:00:00] Gregory

I think there’s more room to be less hawkish now with inflation closer to their target than where they were a year ago. So I do believe that they’re willing to have a little more inflation in the system to help the labor market from cratering. But that’s a real test. The question that we often get is will central banks explicitly change their target?

We don’t think so. We think that would be a really bad idea. You can’t change the rules of the game midway through. It doesn’t invoke confidence in the institution. But I think it’s one of those things where they’ll allow a little more tolerance than they have historically for protection of the labor market.

[00:01:02] Intro

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

[00:01:58] 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.

[00:02:42] Alan

Thanks very much for that introduction, Niels. Today, I am delighted to be joined by Greg Peters. Greg is Co-Chief Investment Officer of PGIM Fixed Income and is one of the co-heads of the Multi-Sector Team. Greg has been in the markets for a long time. Prior to joining PGIM, he was Morgan Stanley, Global Director of Fixed Income and Economic Research and Chief Global Cross Asset Strategist. Earlier in his career, he worked for Salomon Brothers and at the Department of the US Treasury. Greg, great to have you with us today. How are you?

[00:03:14] Gregory

I’m great. It’s a pleasure to be here, Alan.

[00:03:17] Alan

Well, thanks for joining us. We always get our guests just to kick off by giving a brief intro to their careers, how they ended up in markets and economics. So if you wouldn’t mind, can you give us a quick overview of your route to becoming PGIM’s Co-Head of Fixed Income?

[00:03:34] Gregory

Yeah, it’s a circuitous path, which I think oftentimes is the most interesting one. I started out with the federal government here in the US, the Treasury Department on the tail end of the savings and loan crisis. It was a fantastic experience, as a bank regulator, going through that time.

What was great about that is that I had a tremendous amount of responsibility, probably too much responsibility for a 22-year-old. But I really learned a tremendous amount and really used that as fuel to broaden my understanding of different parts of lending and markets and structuring. So it was really fantastic.

I moved there to basically Salomon Smith Barney, which was acquired by Citi. I was on the mortgage side, mortgage derivatives side, then moved into research. What’s funny about that is that I’ve moved out of trading into research and it that was something that I was really quite upset about. But the reality is, it was the best thing to happen to me. It fit my personality. I learned so much.

It allowed me to delve deeply into issues and to use my broad-based knowledge. It was fantastic. So I grew up on the research side and then about 10 years ago, I moved to PGIM to manage portfolios and it’s been a great, harmonious type of career in that respect.

[00:05:15] Alan

Good stuff. Obviously, you’re a head of your team at PGM Fixed Income and one of the co-heads on the Multi-Sector Team. So in terms of the types of portfolios you’re running, can you give us a sense of those?

[00:05:28] Gregory

Yeah, so it’s broad global fixed income, there is a whiff of equities here and there, but mostly fixed income for sure. But we’re in every single market globally. Credit, we’re quite known for credit, from high yield, levered loans, investment-grade corporates. Structured products are a big part of what we do, and so from CLOs or CMBS to Esoteric ABS, and the core sovereign.

So on the multisector side and as a CIO, it’s about putting together these component pieces, creating an asset allocation scheme that pushes you up and out the efficient frontier. So utilizing all those different tools and instruments, that’s what we do on the multisector side.

[00:06:28] Alan

Okay, great. We’ve obviously had a lot going on in fixed income this year. It’s been a very interesting few months. So it’s very timely to have you on to get your perspective. Maybe firstly, from an economic perspective to set the stage, obviously, coming into the year there’s a lot of expectation around recession, and the economy has been very resilient.

So good to get your perspective on why that has been the case. And then obviously looking ahead, I guess, a general expectation of a soft landing now and, I suppose, a virtuous scenario of declining inflation and rate cuts being priced into markets. How do you see things? First of all, were you surprised about the resilience of the economy? How do you see things playing out looking ahead?

[00:07:16] Gregory

Yeah, so just zooming out for a moment and then I’ll delve into it. I think importantly and critically, we are in the midst of a series of secular shifts. I think growth is on a different plane globally. I think we broke out of this secular stagnation story. Part and parcel to that is the influence of China into the global economy which is very different and will continue to be very different across multiple dimensions.

Inflation also, I think, is in a different realm than what we’ve seen before. Geopolitics as well; there’s the importance of geopolitics. I also think there’s this trend in place where there’s a return to labor, a focus on labor, labor gains away from return to shareholders. Then there’s in-raft by central banks as the response function; the reaction function of central banks, given those secular shifts, is very different. So I think we’re in a different world, a different regime.

Candidly, I’m not sure investors have completely accepted or let’s say agree with my assessment here, but I think it’s really quite important. I don’t want to sound melodramatic about the whole thing, Alan, but at the same time, I do think it’s important. That gets me to the resiliency. You go back 18 months ago, two years ago, and the prevailing wisdom is that the economies would not be able to withstand higher interest rates, and I mean higher interest rates off of zero.

So we’ve clearly moved well above that and I think that has been a surprise to everyone, myself included. So that’s for sure. Going forward, we’re pretty positive on the global economy. We think about the world in a scenario-based way, probabilistic way. I don’t believe in a single point forecast type of measure. So if you just allow me to walk through how I see the US economy as an example, and we’ll start with recession first.

We have a 25% probability of a recession in the US, which is clearly lower than what was talked about last year, but still high. It’s still 3x what the normal probability is. So we still have to be vigilant around that downside tail, which makes it tricky from an investment standpoint. When the downside tail is 3x the normal tail, that is something that clearly influences asset allocation and markets.

We have a soft landing probability of about 15%. And then we have what we call this weakflation which is our moral scenario of 35%. Weakflation is essentially an environment where GDP is slightly below trend, 1%, 1.5%, with inflation remaining above target. So that’s our moral scenario. The other scenarios that we have are more bullish actually.

We have a nominal GDP boom, we call it, and a roaring 2020s. Really, the scenario there is stronger growth, a much more favorable backdrop economically. But if you put it all together, the maths of the probabilities are quite favorable, and we have this tail. So we’re pretty constructive, actually, on the global economy as we think there’s elements in the economy that have shifted, as I mentioned before. Productivity is one aspect and we’re on a different growth plane.

[00:11:44] Alan

Okay, interesting. As I said, it’s been an interesting year in fixed income. I suppose if you were to trace the trajectory of bond yields, maybe over the last 18 months or so, obviously for a period, we had Fed tightening but bond yields being slow to fully respond to that and then the curve inverting. Then, as we went into the summer of this year, there was a sharp catch-up in long-term bond yields and a move up in the 10-year up to 5%.

Since then, we’ve had a rally on rate hope expectations. Taking those bits in turn, were you surprised at that initial period when you had such an inversion in the curve and the long end didn’t respond as much? Secondly, how did you see what the key drivers were of that catch-up phase as we went through the summer?

[00:12:41] Gregory

I think in short, the markets have been pushing against central banks. There’s not been an acceptance of what central banks have been telling the markets. So the curve has been inverted, essentially, because the belief was rate cuts are on the calm and this can’t stand. I’m oversimplifying, but I do think that’s the core of it all. There’s technical influence that, maybe, helped the back end of the curve and those types of things.

But the bottom line is markets have been pushing back on central banks and not listening to central banks, and you still have it today. I also think the markets have not fully appreciated the new regime that we’re in. Let’s go back to March of 2022, so March of this year. We had a regional banking wobble here in the US. The concern clearly was a systemic shock to the system.

But what was notable about that event was how quickly and severely the markets repriced the front end. Literally, in half a day, the front end in the US priced in 200 basis points of cuts instantaneously. What’s notable about that is inflation at that time was above 6%, growth was strong. I know banking crises are scary, of course. But the snap reaction in the markets is cuts, cuts, cuts.

That really emboldened us around our positioning as we feel the markets are utilizing this outdated playbook. It’s really difficult for central banks to cut rates when they’re above target on their inflation and growth is still reasonably strong. So I think that was a very important event for us in our thinking. The way I’ve been looking at it all along is that the markets have been volatile around the rhetoric of central banks and the acceptance of that rhetoric, and it’s still that way today honestly.

There’s been a big rally in the bond market here as the belief is central banks are done, which is likely true, but continues to push the envelope around forward rate cuts. To me, that seems heroic.

[00:15:30] Alan

Okay. Obviously, the other big theme in terms of fixed income and bonds, at that time during the summer, was around debt sustainability, which, I guess, had been in the background for a long time but didn’t seem to be a market concern and then suddenly appeared as a market concern, but equally has gone away just as quickly. Is that something that you’re concerned about?

When you look at both the issuance outlook, going ahead, and the likely composition of the demand side, how, I suppose, relaxed are you on the outlook from that perspective?

[00:16:09] Gregory

Yeah, so I never accepted debt sustainability as a reason for the sell-off earlier this year. I think that was a politically-driven red herring in many respects. I think it was really just boiling down to the pushing back on central banks more than debt sustainability. I will say though, you look at fiscal deficits and they are quite eye-popping. In the US, it’s the worst fiscal deficit that we’ve had, without a recession or a war. So these are very eye-popping types of numbers and it does matter.

This is something that we know doesn’t matter till it matters. But I do think it’s been important, from a pricing and market structure standpoint. That fiscal deficit obviously has to be funded. You have a lot of treasuries coming to the marketplace. That Treasury supply has to be absorbed at a time when the compositional shift of buyers has changed.

If you look at who’s buying this new supply, it’s really quite interesting. We know that foreign investors have stepped away from the US Treasury market. I don’t think there’s a nefarious backstory there, I just think there’s a home bias type of element as yields have increased across the globe, so there’s just less demand for that. As a consequence, what we’ve seen is a real shift in what we call the household share.

If you look at the shift in who’s absorbing this record supply, 73% is coming from the household. Now, the household is interesting because 90% of that household is hedge funds. So hedge funds are in that household category. What’s notable about that is that hedge fund type of investing, and this is done on this basis trade element, they’re more sensitive to price. So the marginal price setter is much more sensitive to the pricing.

That creates a lot more volatility in the marketplace and makes the markets much more fraught as a result as global investors coming in are not as sensitive. I think this is the big story in the market and is driving the volatility and the moves in the marketplace more than anything else. So while I’m not worried about debt sustainability per se, the supply that’s coming out and the market absorption and the composition of the buyer base has shifted so dramatically that that’s the knock-on effect.

[00:19:36] Alan

Okay. Interesting. You mentioned the reduced demand from foreign buyers. What we’re seeing, outside the US, is a shift in the yield landscape as well. Is that something to be concerned about from a US perspective in terms of say Japan, for example, with the ultra-low yields there we’ve had for the last period?

Anecdotally, I haven’t looked at the data, but the theme has seemed to be of Japanese institutions investing overseas to pick up yield and now concerns that that may be unwound. If that was the case, it would have multiple implications across a number of asset classes. Where do you see things in Japan?

[00:20:25] Gregory

I think that is really important as we think about 2024. I think the consensus is that the BOJ is finally going to tweak their policy. That I do think is important. I do think that will have a marginal impact on those global flows. But at the end of the day, the interest rate differential is just so large still.

You look at it and it’s really quite dramatic as the gap has just really grown quite dramatically over the past few years as global central banks have moved up rates and BOJ hasn’t. But it’s about hedge costs in the FX. So clearly, the FX, the yen is under pressure here, stabilized somewhat, but it’s still under pressure and it’s just basically the interest rate differential that’s driving it.

That coupled with the hedge cost just really puts Japanese investors in a really tough spot as it’s really quite costly for Japanese investors to go outside of Japan just given the interest rate differential in the hedge costs. So I do expect that to be less hateful, I guess, in 2024 and will have an impact on the margin. I don’t think it’s a wholesale change, but it’s definitely a marginal change that bears watching. No pun intended.

[00:22:11] Alan

Okay. As you said, there’s a growing expectation of a Bank of Japan move. We’ve already had incremental changes in the yield curve control, so now the next step is a move in official rates. From a bond market perspective, how high do you think yields in Japan could go?

Secondly, there’s some suggestion that you might start to see financial repression in Japan in the sense of private sector institutions being encouraged or a bit of moral persuasion being enforced for them to buy JGBs if the Bank of Japan is going to be less active in buying their government debt. Is that a scenario you think is plausible?

[00:22:58] Gregory

Yeah, I think it’s plausible. I would say financial repression has been going up for quite some time, so that’s not a new phenomena. Perhaps maybe the buyer base changes on the margin. But I do think there’s this natural home bias, this domestic bias, and I think that is something that will help. So I don’t know if it has to be a formal financial repression type of program. I think it happens more naturally than you think, I guess.

[00:23:29] Alan

Okay. So you’re not concerned about a big spike in JGB yields and then have a tail impact on global markets?

[00:23:42] Gregory

Well, it’s a concern, but I think it’s a remote one. I think it’s a remote one. I don’t see that as a moral scenario by any stretch. It could happen, but I also think the BOJ is quite vigilant around that and it’s another form of yield curve control. So I worry about it, but it’s not a predominant worry.

[00:24:12] Alan

I know you’ve written a little bit, recently, around the theme of yield is destiny in terms of the investment outlook and asset allocation outlook. What does that mean and what are the implications for investors?

[00:24:28] Gregory

I think if you go back and I think history will go back and shine a very unfavorable light on this zero and negative interest rate policy. It crushed savers. It had a lot of unintended effects. What ZERP, and QE, and all these programs were about is affecting the portfolio channel to use central bank primes.

In short, what that means is that the forced investors out the risk curve and uncomfortably so as they made owning cash and fixed income instruments just so unattractive. I think that was unnatural. The sell-off has been quite acute. I’m fond of using this path destination example where it’s like going on a family trip where, oftentimes, in the car with the kids and the dogs, it is not quite a pleasant experience. But once you get there, it’s good. Once you get to the resort, it’s all fine.

I kind of think about their journey of fixed income as a family vacation over the past two years. So yield is destiny is just the higher income that one receives from fixed income as back to what fixed income was intended to do. Income is in the name, and it’s about yield and carry. We’re in a much better yield and carry environment and that starting point matters a lot.

So if your starting yield is at 1%, as an example, your prospects for return is, really, quite muted. But when it’s 5%, it’s much better. If you look at it over history, when yields are higher, returns are higher. It’s not rocket science. You just get more income, more into the door. So yield is destiny is just a reflection of higher yields and the bull market is actually the yield itself. I’m one of the few folks I think who don’t want a fixed income rally.

I want yields to remain higher as I think that is, really, what investors and savers need. So I think the worst possible outcome would be going back to where we were in 2020. That period, I think the prospects for return and a balanced asset allocation scheme is much worse in that environment.

[00:27:31] Alan

A couple of follow-up questions to that. One is, obviously, yields touched 5% or so. Now we’re back to 4.20%, 4.25%. Where do you see that in the medium-term range? Are we in the middle, towards the bottom in terms of what you see as the normal range in this kind of new environment that you painted?

[00:27:57] Gregory

I think the range is wider than what we’ve been accustomed to. We have like a 100 basis point range, which is quite wide. But that’s the volatility that we see in the marketplace, so it’s not completely out of bounds. But, yeah, we see a range of between 5% and 4%. That’s the range that we see. I know that’s not a sharpened pencil answer, but we do see yields higher.

We’re in this higher-for-longer type of camp. We’re seeing curves starting to normalize and yields higher, and that’s our forecast.

[00:28:45] Alan

Higher for longer was maybe an accepted view going back two, three months, but the market has shifted a little bit in terms of pricing in rate cuts now. I guess the case on that front is we’ve had a fall in inflation so real yields have gone up. Obviously, inflation is heading back towards target. So even in the absence of a slowdown, there could be a case for cutting rates.

Do you think that inflation will be stickier than people expect or do you think that narrative is incorrect in terms of your belief in higher for longer?

[00:29:23] Gregory

The fall in inflation has been miraculous in many respects. The disinflation that has come through the system this year has been really notable and I think you have to give central banks a lot of credit for that. I think that’s a great story, for sure. At the same time, there’s this debate in the market and even within our own shop, the last mile. Is that the easy part or the hard part? I’m in the hard part.

A lot of measures that we look at, it seems to me that even in the goods sector which has really seen inflation come down meaningfully, that was the sector that had the supply and demand shock hit at the same time during COVID. Obviously, prices skyrocketed as a result of that. That has really normalized as supply chains opened up at all. But there’s still more inflation there than our models are predicting.

So to me, I’m reading that as there’s something in the system that is not being captured. I think it’s important to remember that inflation modeling, inflation forecasting is quite fraught, to be kind. It’s really difficult. Economic forecasting is really difficult. Inflation forecasting is difficult squared. So we have to be humble around that.

I’m in the camp that inflation is more sticky than what we’ve been accustomed to. The important part of inflation, particularly in the US, is the service sector. It’s a big part of GDP of course, but it’s 56% of the core PCE basket. That gets me to labor. It’s really difficult to see the service sector inflation come down meaningfully when we’re at close to record unemployment rates, wages are still rising, albeit at lower levels. So I think that’s a really difficult inflation piece of the puzzle to shake out.

In short, I think inflation will remain above that 2%. That gets me to a Fed policy and central bank policy. Yes, we do see some scope for modulating, being less restrictive; still restrictive, but less restrictive. So we’re penciling 50 to 75 basis points of cuts. You’re still on restrictive territory and we think there’s cover for the Fed to do that. But the markets continue to push more and more and more, and that’s where I disagree.

It goes back to this persistence above or below the 2% target. So we’re coming out of this long era of central banks not having to contend with inflation because it’s been persistently below that 2% target. Now I believe it’ll be persistently above, and that changes the degrees of freedom the central bankers have to cut rates. So that’s the disconnect between my way of thinking and what the markets are pricing in.

[00:33:07] Alan

That stickiness, I guess that’s related to some of those structural themes you mentioned at the outset, and possibly maybe that return to labor being a driver and I guess the labor market being a bit tighter and labor supply not as ample. Is that the case? Also, the other factors that people talk about in terms of this longer-term inflation outlook around deglobalization and decarbonization.

How important would you weight those factors in terms of that view? Is it more the labor market view or is it as much those other structural themes as being potential drivers of a slightly higher inflation rate over time?

[00:33:53] Gregory

No, I agree with that. I think this change in globalization matters a lot. We see more importantly, here, talk about onshoring and friendshoring. I think that’s been more rhetoric than reality at this point, but the clear desire is to bring supply chains closer to home or at home. So for the US, that’s hugely beneficial for not only the US but Canada and Mexico as an example.

This green initiative is costly. You’re spending on both. You’re spending on near-term energy security, as an example, and long-term solutions that are different, that are decarbonized, so that is definitely inflationary. I think those are definitely big drivers. The labor side is key of course. I view the labor story as critical to a more balanced economy as well.

I think a lot of the issues, both politically and economically, have been driven by inequality. If you look at the gap, it has just really grown quite substantially over the past couple of decades. Seeing a return to labor, wages moving higher, is a clear benefit for a more balanced economy that’s more sustainable. So I think all else equal, that puts more pressure on inflation as well on the margin. So I agree with you, Alan.

[00:35:43] Alan

I guess the flip side, the think that people might point to as being the wildcard that might counter all of that is on the productivity side. Obviously, this year, we’ve had a lot of talk about AI, generative AI and Chat GPT and all of this stuff. We have seen it after a long period of very poor productivity numbers, the most recent one was a movement in the right direction.

Where do you sit on that side? Is that something that could propel the economy into a higher growth path and contribute to maybe offsetting some of the concerns, those supply shock concerns?

[00:36:26] Gregory

Yes. Productivity is also quite tricky to model. Oftentimes, you don’t realize there’s a productivity boom until it’s a past or you’re deep into it. You think about the Greenspan era as an example. But that is a key driver of our potential bullishness going forward. So it’s tenuous, but we do see productivity gains that will allow the global economy, the US economy, in particular, to grow more and get out of the secular stagnation story.

This thing about the US for a moment, we are actually really quite constructive, quite bullish on the US on a medium to long-term basis. We think there’s real potential for the US to be a clear winner here. China we see in secular decline. We can talk hours about that, I’m sure, in different components. But we see the US as a clear, undeniable winner here.

A lot of it has to do with technology. A lot of it has to do with labor. A lot of it has to do with rule of law and FDI and capital attraction and those types of things. So we’re quite constructive on the US, here, over the medium to long term.

[00:38:06] Alan

That’s probably a good segue into talking about China. It sounds like you’re much more upbeat on the US vis-à-vis China on a multi-year basis. Good to get a sense on how you see the longer-term outlook playing out in China and its implications for global asset markets.

[00:38:26] Gregory

I think that is a big secular shift. The influence of China on global growth, so the second derivative growth, is not going to be what it was over the previous 20 years. I think that’s an obvious statement. But a lot of it is just the maturation process. Whether it’s an economy or a corporation, it’s just really difficult if not impossible to continue to grow at that rate.

But the issue with China is that it’s getting old before it became rich. So there’s lots of comparisons to Japan, and for good reason. But the key difference between Japan and China is that per capita GDP in Japan is three times what China is. So it still hasn’t created the wealth. I think that’s an important distinction. That gets you to the three major headwinds.

You mentioned, Alan, demographics. You’re seeing an outright decline in working-age population. That will continue. They also don’t have a social security net underneath. So that is a real tax on the economy for sure. The second is deleveraging. The property sector is front and center of course, but their property sector is three times larger than the US before the GFC. So it’s a big source of deleveraging and just general derisking.

So it’s kind of reinforced by the current government and Xi really crushing animal spirits in the private sector. I don’t think they will have the ability to attract foreign flows, which is critical to help support that economy. So I see China in a really difficult spot, here, over the next 10 years. I think that matters in how we think about emerging markets, how we think about global growth. It’s just a big change from what we’ve experienced over the past 20 years.

[00:41:12] Alan

Obviously, there’s going to be multiple channels by which that may impact the economy and global asset markets. Will it still have the same level of current account surplus that it needs to recycle? Do you think it’d be more of a disinflationary force or, maybe, less of a disinflationary force for the global economy?

What would you say is the most obvious implication of all of that in terms of, is it weaker economic growth for global asset prices?

[00:41:48] Gregory

I think the most obvious one, in my mind at least, is around commodity prices. I think China propping up commodity prices through their growth will be quite different going forward. So I see that as a source of disinflation in terms of the commodity side. But I also see an inward focus, and you’re seeing it today.

Even the contours of GDP is shifting or attempting to shift and it’s less focused on global trade. It’s more inward-looking around consumption. So that, all else equal, doesn’t drive global growth in the same way and has less of an influence on inflation. If I put the China story together with the onshoring, friendshoring, I see that as an inflationary force, not a disinflationary force. That’s my view of it.

[00:42:55] Alan

From a global fixed income perspective, obviously, I guess a weak China growth trajectory, and as people draw parallels with Japan, we might see rates trending down and possibly the need for more unconventional policies there. Is that a bullish scenario to invest in Chinese fixed income or do geopolitical concerns outweigh that on concerns around the currency? How do you think about China as a potential component in a global fixed income portfolio?

[00:43:28] Gregory

To me, the geopolitical concerns are front and center. I mentioned about our bullishness of the US, and the rule of law matters to investors. I don’t think you can say the same when you talk about China. So the fragility of those rules are important. If you look at the opportunity status mostly in the property sector, which clearly is under pressure for quite some time to come. So no, I don’t really personally see it as an opportunity.

I also see a loss of constraints given the amount of leverage that they have in the system of what they can and can’t do from not only a policy standpoint but from a monetary policy standpoint. So no, I don’t see China, from a fixed income standpoint, as a real destination at this point in time.

[00:44:29] Alan

More broadly, I suppose one of the interesting themes over the last number of years has been, maybe within the emerging market side, a bit of emerging market central banks pursuing policies that were, I suppose, a little bit more independent from the developed markets and they have been maybe at the forefront in terms of the easing cycle. Is that an area of opportunity? How do you see EM debt from a sovereign and a local markets perspective?

[00:45:00] Gregory

I think so. What’s notable about this cycle, it’s been led by emerging markets as far as central bank policy is concerned. They were the first to raise rates, first to cut rates. So they definitely have led the charge here. I do think there’s opportunity in emerging markets, particularly as China becomes less influential. Those other emerging market countries will step in and fill the gap in my mind. So I do think there’s a real positive outlook for EM.

The tricky aspect of EM is that it’s very bifurcated. Tricky and opportunity at the same time, but it’s very bifurcated. If you look at emerging markets, you have the higher quality of EM countries, let’s define it as investment grade. They’re doing really quite well but there’s not a lot of value from a fixed income perspective, necessarily. And then some of the lower quality problematic countries come with a lot of risks. So it is very much of a security selection type of marketplace in EM.

I guess the difference, which I view is a positive, honestly, the difference of EM markets today versus historically is that it’s less of a singular trade and more of idiosyncratic trade, which I think shows to the maturity of that market over the past 20 years. So broadly, EM, I’m not excited about per se, but there’s lots of opportunities within and I do see emerging markets benefiting here over the next few years for sure, and longer than that.

[00:46:49] Alan

Just going back to what you said at the very beginning around the secular shifts that we’re seeing, we’ve talked through most of them at this stage. But one of the things that I’ve noticed, that was the touch on, was a difference or a changed central bank response function maybe going forward versus the past. I’m curious to get your thoughts on that. Possibly, there was a sense in markets last year of an end to the Fed put. Is that part of your thinking? What are you thinking in terms of the central bank response function?

[00:47:25] Gregory

I think the put has changed and I think the central bank reaction function has changed, in my mind, simply due to inflation. You go back to what I was saying before around the persistence above versus below the 2% target. I just believe if you’re above that 2%, the degrees of freedom that you have to cut interest rates is much more constrained than if you’re below. I think that’s more than a subtle shift.

If you’re a central banker, and you don’t have to worry about inflation, which by the way, is the mandate (and in most cases, the sole mandate), I just don’t think it’s so easily dismissed. So that’s really driving my thinking more than anything else. It’s just that simple but important input. But as far as the put is concerned, I guess there are other ways to have puts into the marketplace.

You did see that in March of this year, in the US, around the regional banking crisis. The continuation of these new programs, lending programs, will continue, and they’ll provide liquidity into the system, adjust in different ways. So I don’t see the Fed put as an example of an interest rate put. I see it as a program put, and so they will continue to liquefy and make sure the market functions. It’s less obvious but still quite apparent as an investor.

[00:49:15] Alan

Okay. In terms of you have, as you mentioned, a 25% chance of recession, if we started to see more serious signs of economic slowdown, as we go into next year, but inflation is still running at maybe core levels of around 3% or so, that would create the dilemma for central banks which they haven’t been presented with to date.

How do you see that scenario playing out? Do you think they’re more likely to be hawkish and point to the 3% is still too high? Or will they say, well, taking a forward-looking view given the weakening of the economy, we can still cut rates? What’s your sense of that?

[00:49:59] Gregory

What you’ve described as the worst possible scenario for a central banker. It’s somewhat of an intractable problem to solve. But I think it goes back to the labor market. I think labor is key not only from an inflation standpoint but from a growth standpoint. The tricky part around the labor piece is that it’s quite volatile and it’s late cycle.

So oftentimes, what you see is a really strong labor market right up until the end, and it just goes. I think central banks know that. I think there’s more room to be less hawkish now with inflation closer to their target than where they were a year ago. So I do believe that they’re willing to have a little more inflation in the system to help the labor market from cratering. But that’s a real test.

The question that we often get is will central banks explicitly change their target? We don’t think so. We think that would be a really bad idea. You can’t change the rules of the game midway through. It doesn’t invoke confidence in the institution. But I think it’s one of those things where they’ll allow a little more tolerance than they have historically for protection of the labor market.

[00:51:34] Alan

As you say, you mapped out a distribution of possibilities in terms of distribution, so planning weakflation and a more upbeat scenario. Within the recession or even the hard landing possibility, what are the areas that you’re focused on as the potential weak spots? What are the signposts that you’re watching in terms of the high-frequency data that would tip you off that maybe we’re heading in that direction more than one of the other scenarios?

[000:52:09] Gregory

What’s unique about this cycle I would say in some respects is that there’s not a lot of excess built into the system. Some view that as a reason for a shallow recession if we do have one. I see it a little differently in a way. The excesses that I see are in the credit markets and outside the traditional credit markets.

If you go back to the GFC, there was a clear desire by regulators to diffuse the risk across the banking system, which is to push it outside the banking system. As a consequence of that, you’ve seen an explosion in private credit, even levered loans. So what I worry about is, one, it’s opaque so it’s really hard to have a true understanding. I think about higher for longer rate impact on these capital structures.

There has been so many capital structures, whether it’s real estate or corporations built on the backs of zero or low interest rates. With rates higher and cash flows lower, that puts a lot of pressure on these capital stacks. So I see a higher than normal default rate environment, distress environment, regardless of a recession or not. But if a recession does hit, then I think that’s where the stress and strain is going to be in the system.

What I worry about is that the central bank/fiscal ability to fix that is really quite challenged. They lost control. Effectively, regulators and central bankers lost control by diffusing the risk outside their sphere. The fiscal thing is important too as we started this conversation around the deficit. If in fact, we do hit a recession, the fiscal impulse that you typically receive in that environment, I think, is severely constrained just given where we are today.

Now, never underestimate a politician’s ability to change their commentary, but it is a constraint that is something to factor in. So you put it together, less fiscal impulse, central banks are constrained by inflation, that suggests to me if we do have a recession that it’s not simply going to be a shallow one because those tools that typically are available may not be available this time, which means it’ll float lower from the economic standpoint.

[00:55:10] Alan

In terms of the credit and the default in a private credit sector, part of, I suppose, the view was, as lending transitioned into private credit markets, that if there were defaults and problems there, it wouldn’t be systemic. But, presumably, if private credit lenders are suffering losses on loans, they will equally retrench as much as traditional banks would. So presumably, it would amplify a downswing in the economy. What would you think?

[00:55:46] Gregory

I think that’s quite right. The opacity of it all makes it more challenging. In simple terms, there’s just been an explosion of growth in that area. History tells you that you look for where growth has really ramped up in a meaningful way for a problem. We saw it in housing of course back in 2006, and today, I see it in private credit.

[00:56:21] Alan

Okay, good. I’m conscious that we’re coming up on time. We always like to ask our guests, before we wrap up, in terms of things that have been influential in their careers and pieces of advice they can pass off to people who are maybe starting off. What would you say to people who want to get better clued into economics, global macro and global macro investing? Any suggestions on things to read or to do?

[00:56:47] Gregory

It’s funny, I look at readings, books, articles oftentimes outside the financial world. I personally learn a lot by reading history. For me, for example, when the markets get crazy, which it’s been crazy for quite some time, I have this belief when things speed up, I want to slow it down. And then I also want to tune out the white noise.

So I typically read a lot less of the financial daily news, I don’t watch financial TV, and I read history or something that helps ground me as, oftentimes, that historical perspective is far more influential in how you invest in your thinking than listening to or reading a reiteration of the same thing over and over again. So that’s one of my tools or tricks I’d say.

[00:58:01] Alan

Okay. Well, very good. Greg, thanks very much for joining us today. It’s been a great conversation. I’ve learnt a lot. For all of our guests, make sure to follow Greg’s work because as you can tell from today’s conversation, we’re living in a truly global macro driven world and it’s more important than ever to stay informed. From all of us here at Top Traders Unplugged, thanks for tuning in, and we’ll be back soon with more content.

[00:58:26] Ending

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