Louis-Vincent Gave - Global Macro Series - July 5th, 2023

[00:00:06] Louis

The de-dollarization of the commodity trade that we’re witnessing in real time, the biggest macro consequence of that is an emerging market boom of epic proportions. The biggest constraint for most emerging markets was accessing dollars. It was a constraint today, but it’s also a constraint over the future. So you were always reluctant to embark on big infrastructure spending like, let’s say, India builds a railway, if tomorrow you can’t buy the iron ore because you’ve run out of dollars, now, it’s like I’m never going to run out of rupees so I’m in good shape.

[00:00:43] Intro

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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 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.

[00:02:23] Alan

Thanks very much for the introduction, Niels. Today, I’m delighted to be joined by Louis Gave. Louis is Founding Partner and Chief Executive Officer of Gavekal. Louis has been in the markets for several years as an economist and strategist. He is the author of several books. Louis, it’s great to have you with us today. How are you?

[00:02:41] Louis

I’m very well thank you. Thanks so much for having me.

[00:02:44] Alan

Well, I know you’re based in Vancouver, so you’re up early over there today. I guess it’s nice and sunny. Is it a good day there?

[00:02:54] Louis

It’s a beautiful day. This is a nice time of year over here. So it’s great to be here.

[00:02:58] Alan

Well, thanks for taking the time. Before we get started into the meat of the conversation, we normally like to get a sense of our guest’s journey in markets, how you got involved as an economist, strategist, researcher and what took you to your current role where you’ve founded Gavekal.

[00:03:17] Louis

It’s not a very complicated story. Again, thanks a lot for having me. I’m delighted to be here. My dad worked in the markets. My dad started actually a research firm on asset allocation in the mid ’70s when there were few of those around, and that morphed into a money management firm in the early ’80s. He grew a pretty decent sized business. That money management firm managed about 10 billion as a macro fund and then the firm was sold to Alliance Capital, which is now called AllianceBernstein, and he retired.

In the meantime, I had gone to university. I had actually gone to the army for a few years and became an officer in the French army. Coming out of the army, I realized I didn’t know how to do anything, so I went to the markets and I was hired by a French investment bank called Paribas. One thing I did know was I knew how to speak English, I knew how to speak Chinese. So I started off in Paris, but they took over a pan-Asian business, so they sent me over there with my then boss to do the integration.

It was a fascinating time because I got there just before the Asian crisis. So early in my career, I sort of had a front row seat on I think one of the biggest implosions, or at least it definitely felt like it at the time. I think the Indonesian stock market lost 97% in US dollar terms in the space of three or four months. So it was quite a powerful learning experience. After that, I decided macro was my thing. It’s hard not to sit in front of markets, go down 97%, and realize what the hell just happened here.

So I decided macro was my thing. My father had retired but I talked him out of retirement and he started to go back to his first love, which was a macro research firm. So we did that. Eventually, that also evolved into money management firm. So today we have both things. We have macro research and money management. From the start, we were joined by one of my father’s friends called Anatole Kaletsky, who might be known to some of your listeners because he used to be a columnist in the FT and a columnist in the Times. So he was I think one of the more famous financial journalists.

[00:05:28] Alan

Absolutely. I remember my time starting off in the mid to late ’90s when Kaletsky had a comment in the Times. It was typically market moving, at least back in those days. So thanks very much for that.

Well, maybe to set the stage for some of the other topics we’ll get into, I think maybe the big question in markets at the moment, there was an article in the FT in the last few days: Is the US economy about to crack? Is the tightening of monetary policy finally taking hold? I guess it’s been a bit of a strange cycle.

Rates have gone from 0% to over 5%. Apart from a brief shake in the banking system, nothing has really cracked. So what’s your perspective on that? Has something changed? Has the transmission mechanism of monetary policy adjusted or is it just the typical long and variable lags that are maybe taking a little bit of time to play out?

[00:06:26] Louis

It’s a very important question. It’s one we’re debating obviously. Like in every firm, we’re debating this heavily. We have two US economists in our firm called Will Denyer and KX Tan who’ve been very adamant the US is about to have recession. Anatole and I have argued precisely the opposite point to clients. I think a lot of that debate comes down to a flow versus stock debate. I think if you look at rate of change things, here’s a perfect example.

If you look at US M2, so broad money supply, if you think money makes the world go round, starting with money is just as good a place to start. So if you look at M2 growth, I think it’s down like 4.8% year on year or something like that. Let’s call it 5% to make things simpler. It’s never been negative year on year before, and here we are minus 5%. So you look at this and you think, of course, the US economy is going to implode.

But then if you look in absolute levels and you look at the long-term growth trend of M2 and you look at where we stand, we are still 2.5 standard deviations above where we should be in terms of historical because we pushed so much money in 2020, ’21, and even the first half of ’22, that it’s like the proverbial pig inside the Python. We pushed so much fiscal stimulus and so much monetary stimulus that we’re still digesting this. Now, to your point on we haven’t yet seen any impact on the US economy, I think we have to give credit where credit is due.

Something fascinating that’s occurred in the US economy is that when you had interest rates that were stupidly low, when you had interest rates at zero while inflation was already running at 4% or 5%, American consumers did the right thing. They were smart. They said, “Oh, I can lock in my mortgage for 20 years at 3%. I’ll do that. Thank you very much.” So did US corporates. US corporates massively extended the duration of their debt.

There’s two entities that did not do it, that in essence believed the Fed when the Fed said I’m going to keep rates for a very long time at 0%. Those were A, the banks, and as you’ve highlighted, they’ve run into trouble, and B, the government itself. The government actually massively shortened the duration of its debt. So if you start off with the premise that recessions are there to clean out the excesses of the past cycle, to basically wipe out the balance sheets of people who’ve leaned too far above their skis, US consumer balance sheets are not in bad shape, US corporate balance sheets are not in bad shape.

The balance sheet that’s in really bad shape is the government balance sheet. So logically, we should be in the phase of the cycle where the government should be tightening its belt right now, and that should be slowing growth. But here’s the fascinating thing is instead of doing that, it’s going the other ways. I’ll be very honest, if you told me five years ago, pre-COVID, that we could have a US economy where on the one hand, you’d have full employment, and on the other, you’d have a budget deficit of 6% of GDP, I would have said you were an imbecile. I would have said this just doesn’t happen, and yet, here we are today.

Not only that, with a government that’s basically probably running a budget deficit of $1.5, $2 trillion for the year, they’ve just come out and said we’re going to add another $4 trillion to the debt over the next two years. That’s the budget deal they just cut. They can move the debt from 31 to 35 over the next two years, and they’re going to do the Inflation Reduction Act, they’re going to do the infrastructure spending, and they’re going to do all this at a time, massively increased government debt, massively increased infrastructure spending, at a time when employment is full.

So I’m not a big believer in the US recession story. Maybe I’m stupid, but I just don’t see how when you have budget deficits of 6%, 7%, 8% of GDP you can have a recession. It really takes a contraction on the consumer and the corporates that’s just massive in scope to compensate for this massive expansion in government debt.

[00:10:40] Alan

Interesting. It sounds like two things. One, the budget deficit, and then obviously, you’re talking about the stock versus flows, so the excess stock of cash and savings, I guess, that are still in the system. I think that FT article that I mentioned referenced some research from I think the San Francisco Fed. They thought there was maybe $500 billion of excess savings still left, and that that might keep consumers going through to the end of the year.

Do you think we’ll have a scenario… You’re saying no recession yet. Do you think it means no recession this year or next year or do you think we get to a point where the excess savings roll off and then you have a sudden change in the environment or not?

[00:11:25] Louis

Well, I think first we have to clearly define what we mean by recession. Because if we mean two negative quarters in a row, we actually had that in ’22. We had two negative quarters in a row in 2022 but we had no increase, no meaningful increase in unemployment whatsoever. So if by recession you mean we’re going to get two negative quarters in a row, I would say, “Yeah. So what? We had that in ’22, it had zero impact on the markets.”

So I think by recession, we mean a period where unemployment goes up meaningfully to the point where people cut back on their consumption and what you get a sort of negative spiral. Where you get the because there’s unemployment, there’s less consumption; because there’s less consumption, there’s more unemployment, and you create this negative spiral. Now, are we going to see that? Right now, we’re definitely not seeing it again.

Employment is strong, wages are still rising, and especially, wages are rising at the high end if, by all accounts, we do get this big Inflation Reduction Act, this big increase in infrastructure spending, right in time for the presidential election. By the way, looking at the presidential election, you have two governors out of the two of the three biggest states, Florida and California. One has already declared, the other is inching to run, and both of them are putting pedal to the metal in terms of their budget.

So you’ve got two out of the three biggest states in the US that are going to be also ramping up the spending. So I look at all this and I think, okay, where is the increase in unemployment going to come from to really have a bite? Again, ask anybody who’s trying to hire people, labor market is super tight, especially at the low end. Wages are going up, especially at the low end, and so consumption stays strong.

[00:13:13] Alan

Yeah. That takes us to a piece you wrote recently, the inflation-deflation debate, which initially I was a bit surprised to see you talking about this because such a narrative has built up that inflation is coming down and coming down steadily. But I guess from your perspective, particularly if you see the economy as staying strong, fueled by fiscal expansion, where do you see inflation settling in the next couple of years?

[00:13:46] Louis

I’ve been a big inflationista and I’ll remain one partly because I still see no fiscal consolidation. I think if you’re serious about getting inflation under control, you’re not running budget deficits of 6%, 7%, 8% of GDP while you have full employment. You’re just not. Now, the reality is, if you look at the 1970s, which is the last big example of big inflationary periods, or in emerging markets who’ve experienced inflation over the past 30 years, what you find is that inflation is a very volatile variable. You go up to 10%, and you go back down to 3%, and then you go back to 6%, etc.

Everybody right now is cheering on the fact that inflation is back to 4% or 4.5% on the core. This is good news. We’re heading in the right direction and disinflation is back, etc. First, 4.5 is too high. Let’s put it out there. When I left the army, I was 74 kilos. I’m 95 kilos. Now, I’m still getting fatter every year, I’m just doing it at a slower pace, but I’m still not getting back to my optimal 75 kilos. So we still have inflation in the system. Let’s not kid ourselves.

But when you look at where the disinflation came from, it basically all came from energy, and that in the third quarter starts to roll off because the year-on-year comparisons get much tougher. Now, this isn’t to say there aren’t deflationary forces out there. I think right now, one of the big deflationary forces is that Asian currencies remained surprisingly weak to me. I’ve been a big bull on Asian currencies, but I’ve been wrongfooted by the weakness of the renminbi this year, I’ve been wrongfooted by the weakness of the yen.

So if you’ve got the yen, the won, the renminbi going down, that’s where most of the stuff in the world is produced nowadays between those three countries. So that’s been deflationary. Obviously, energy has been another big deflationary force, one that I don’t expect to continue. So I think if you’re looking for what’s deflationary going forward, that’s really it. I think your hope has to be that China continues to weaken, and therefore, the renminbi continues to go down and Japan continues to do yield curve controls so the yen continues to go down. But again, those two currencies are now seriously undervalued.

So betting that something seriously undervalued goes even lower over the long term, it’s not impossible, but it’s just a tougher bet. Now, on the inflation side, I’m fearful that there’s a number of things that could happen in the near future. The first is, I think we’re heading back to a summer of strikes in the US and it all starts, to be honest, with the weather. By all accounts, it looks like we’re going to have a pretty strong El Nino this year.

Now, with a strong El Nino, it means that the temperature goes up in a lot of places, not least of which in Central America. We already have a Panama Canal that’s running dry. So big boats can’t go through the Panama Canal right now because the Panama Canal is above sea level, it gets fed by a lake, so really big boats can’t go through anymore already. There’s not enough draft for them.

So this gives power all of a sudden to the dockers on the West Coast. Now, lo and behold, what do you know? These guys are going on strike. Teamsters, so basically, the truck drivers are also going on strike in the US. UPS drivers going on strike. So you’ve got all these strikes that are going to occur at a time when inventories are actually pretty low. Remember, because why? Six months ago, everybody was telling you there was going to be a recession. So every procurement manager everywhere was like I’m not going to stock up on inventories. It’s the typical boom-bust cycle.

We had too low inventories, we had supply chain dislocations, so everybody triple ordered. Then you had to work through the excess inventories. As you worked through the excess inventories like I’m not doing that mistake again. Instead, they’re doing the mistake they did the previous time where they under-ordered and now we’re back to strikes with the low inventories. So I think we could easily head back to a summer of supply chain dislocations. So that’s number one.

Number two, with El Nino, you typically get bad harvests. You get a very dry Midwest and you get a very dry Asia. Now, if it’s a one-year El Nino, that’s not that big a deal. So for this year, it might not be that much of a problem. Next year, it could become problematic. Finally, I think we still haven’t resolved Europe’s energy issues. We got lucky this winter. I say we because I’m French. We got lucky this winter because as a European, the winter was fairly mild. Hopefully, we get lucky again this year but that’s a coin toss.

[00:14:09] Alan

In the context of this overall inflation/deflation debate, the other factors that get mentioned a lot are de-globalization, certainly one of the big ones. If we were to go back maybe to last summer or last October, even Jackson Hole, that was the big theme. Some people may be less accepting of that idea. How real do you think that is and how much of a driver of markets that will be over the coming years?

[00:19:07] Louis

I think deglobalization is a polite word to hide what we really mean, which is desinofication. Because if you live in Shanghai, Beijing, Hong Kong, it definitely feels like your world is deglobalizing. All of a sudden, there’s fewer white people walking around the streets. All of a sudden, VC firms are shutting down their offices or whatever else and it feels like China is being shunned. If you’re Chinese and you’re a graduate student hoping to do a PhD in the US, things have gotten much harder, etc.

But if you’re in India, if you live in Dubai, if you live in Indonesia, if you live in Mexico, it doesn’t feel like your world is deglobalizing at all. Your world is globalizing at an accelerated pace. People in Mexico are complaining of the number of expats who have moved in. India all of a sudden is getting Apple factories. So deglobalization, I guess it all depends where you stand from.

Now, having said that, the reason everybody was in China in the first place was because of costs. They’re moving out of China not out of choice, but out of political imperative, and that comes with a cost. I don’t think Apple is saying, you know what, I’m going to move to India because it’s cheaper. No, they’re going to move to India because they get US political pressure to desinofy their chain of production. So desinofication is an inflationary force, just as China for the past 25 years for me was the world’s greatest deflationary force out there.

Now, whether we decided we wanted to turn our back away from China or not, I think China was going to be less of a deflationary force for the world regardless. Because I grew up in a world where we both grew up, I think we’re roughly the same age, but we both grew up in a world in which China was adding workers, 10, 15 million motivated, well-trained productive workers into the workforce every year. The Chinese workforce is no longer growing. So the years of China being this big deflationary force on global manufacturing wages is well and truly over.

[00:21:20] Alan

Obviously, you’ve spent a lot of time in Asia and with Gavekal based in Hong Kong, you can give a pretty interesting insight. At the start of the year, everybody was very bullish on the reopening trade.

[00:21:34] Louis

I was.

[00:21:35] Alan

Okay. There you go. I didn’t know that, but that was probably the consensus. It seems to have fizzled that very quickly. At the same time, if we were to go back, obviously, we had the structural challenges with the property side and from a demographic perspective. Is it those longer-term structural factors that are impacting that cyclical upswing or was there something about China that hasn’t experienced the same kind of reopening phenomenon that we saw elsewhere in the world?

[00:22:08] Louis

Yeah, so I’ve had to do a lot of soul-searching on this because I’ve been very wrong on this. I thought China’s reopening would lead to sparkles and champagne everywhere, etc., like we saw in the Western world. Now, if you want the kind explanation or the hopeful explanation, it would be that policy in China during the lockdowns was very different than in the Western world. In the Western world, as we were discussing before, we pushed in more cash in our economies than we ever had. Again, the pig in the python thing. Fiscal policy, monetary policy, we just went all in during COVID.

So when we reopened, people had cash in their pocket to burn, and everybody went out large. China actually did not do this. There was no growth in monetary aggregates. There was no easing of fiscal policy during the lockdown period. Instead, China really relied on its export industry to make it through so that when it reopened, people didn’t have money in their pocket that was burning holes. Instead, what you’ve seen is China started to reignite the economy or inject liquidity and push money in really starting around January.

If you look at bank loan growth, for example, it really picks up in January, February. So if you think, oh, well, there’s the usual leads and lags of monetary policy and so it’s going to pick up by the end of this year, that would be the kind understanding or the hopeful understanding. But it clearly seems that the Chinese government is starting to realize, actually. this isn’t enough. This isn’t enough because historically, what would happen in China is that the government would tell the banks, okay, you can go out and lend.

The property developers would take that money and immediately buy land, and they would buy land from local authorities because land was seen as a scarce resource. The local authorities would take this money and use this money to embark on infrastructure spending. So you had a sort of double impetus. You had the property developers going out, buying land, and therefore, building buildings, and you had local authorities doing infrastructure spending. So you had a twin growth and it would go pretty quickly.

I have not seen this at all this time. I think you haven’t seen this for a number of reasons. One of them is, of course, pre-COVID, the property developers spent two years getting beat up and half of them went bust. So the half that have survived were by far the most conservative half. If you were an aggressive Chinese property developer, you didn’t survive the past five years. The guys that have survived have been pretty traumatized. So what are they doing?

You’re seeing the increase in bank loans, they are tapping the bank credits, but you’re not seeing an increase in land sales at all. Instead, what they’re doing is they’re taking that money and they’re buying back their bonds. They’re buying back their bonds because if your bond is trading at 60 cents on the renminbi, buying back your bond is the smartest investment you can make. It’s got the highest return on invested capital. You clean up your balance sheet, you book 40 cents in profits, it flows straight to your bottom line, you should be doing this all day long, and that’s what they are doing.

But the traction on the rest of the economy is of course very limited. Because what happens is a lot of these bonds are actually owned by the banks themselves or the insurance companies or the pension funds. So the real estate company borrows money from the bank and basically buys back the bond from the bank. So the money comes right back into the bank and the impact on the economy is basically zero. Now, it still leaves you in a situation where today, the Chinese money supply growth, if you look at M2 growth in China, is now roughly twice the growth rate of nominal GDP.

Now, when I started in this business, my very first client told me, “Louis, remember, it’s an easy game. You have to know if there’s more money than fools, in which case you buy risk assets, or more fools than money, in which case you sell risk assets.” So the whole idea that money makes the world go round. Today, here’s perhaps how you can conceive China. It’s a closed capital economy. The government is shoveling money in and the banks are increasing their lending. Money growth is accelerating.

But on the other side of this money growth, the economy isn’t taking this money. Now the money is sitting at the bank but it has a vocation to go elsewhere. At some point, it has to go elsewhere. So will it go into financial markets and drive asset price inflation or will it go into the economy and drive stronger growth? That’s the billion-dollar question. If you look at the 2009 example, we did this in 2009. We injected (we being the Western world), we injected a ton of money in our system on the hope that this money would create more economic activity, and really all it did was drive asset prices higher.

So we’re in the phase in China, I think, that’s not that dissimilar to 2008, 2009 in the Western world. Remember in 2008, do you remember when post the bust everyone was saying, oh, there’s so many empty homes in Florida and so many empty homes in Arizona and so many empty homes in Nevada, they’ll never be used. We’ve got to write all these. We got to bulldoze all these homes, etc., and five years later, they’re all occupied. But for me, we’re all the fruits of our own experiences, but I’m having déjà vu all over again.

Right now, I’ve got everybody telling me there’s so much oversupply of real estate in China, it’s never going to get occupied, it should all get bulldozed and start again. Meanwhile, you’ve got to government that’s pushing liquidity in just like we did. So it’ll be interesting to see where that money ends up.

[00:27:56] Alan

Yeah. Well, I guess it’s possible parallel is then with Japan back in 1990 or 2000, and they tried pushing a lot of money in.

[00:28:08] Louis

I’m not sure they did, actually. Sorry to interrupt you there.

[00:28:12] Alan

Well they were first with zero interest rates and quantitative easing.

[00:28:15] Louis

Yeah, but it took them a while to get there. It took them a while to get there. Before that, they hiked taxes. So there was a big tax hike of 1995. I think the other key difference… there are a few key differences with Japan. The first key difference is the real estate bubble in Japan was on an epic scale. You had a shop in Ginza at the top of the bubble in 1989 that sold for $1 million a square meter, and this was back when $1 million was a whole lot of money.

I’m sure you remember the stats that the land under the Imperial Palace was worth more than the whole of California. It got to levels of stupidity that were really quite something. So that’s number one. I’m not saying that you didn’t have bubbles in Chinese real estate, but we didn’t have them to that scale, just like you had bubbles in US real estate in 2008. But they were bubbles that you could digest over a few years of income growth, etc. So that’s number one.

Number two, I think a key difference is that basically all the Japanese banks went bust, and they never really recapitalized the banks. So the banks were actually unable to extend loans in Japan. So you look through the 1990s, basically, bank loans in Japan kept falling, which is not the situation you have in China. Now, in China, you have banks that are in essence arms of the government and where you actually don’t have a regulator coming in and saying you’re bust here, you’re bust there, you have to liquidate those assets, etc.

China actually has the option to extend and pretend, which is what they do every cycle and it’s all the more so since they have capital controls. So I know the parallel with Japan is often drawn, and I’m not saying there’s no problems in China, but I think the parallel will Japan is too lazy, if I dare say so. It’s basically saying Japan had a real estate bust and then it had bad demographics, China is having a real estate bust and it has bad demographics, ergo, we should expect the same outcome.

There’s also another massive difference, I would say, between China and Japan. (Sorry to get on my soapbox about this.) But if you go back to 1989, you had a massive bubble in Japanese real estate. You had a massive bubble in Japanese equities. Forty-five percent of the World MSCI in 1989 was Japanese equities. Foreigners were loaded with Japanese equities because it was 45% of people’s benchmarks. Japanese banks alone that were bust, we didn’t know it then but we now know, were 25% of the World MSCI.

So you had a whole decade where foreigners, and actually probably three decades where foreigners kept on selling Japan. Nobody’s exposed to China today and the Chinese stock market is not a massive bubble. You can argue you don’t want to be invested in there for tons of reasons. But you know, Alibaba at seven times cash flow is not a massive bubble to the extent that Bank of Tokyo, Mitsubishi at six times book was a massive bubble, especially when we know what the book was.

So I highlight this because there’s a lot of problems in China, but I think it’s too lazy a comparison to say this is what happened in Japan, therefore, this is what’s going to happen in China.

[00:31:31] Alan

The big challenge or the big maybe question mark, obviously, on China, you have geopolitical risk. But the other big question that’s been hanging over really going back for a couple of decades has always been this idea of the transition of the growth driver from either, firstly, from net exports. Obviously, as you mentioned, investment demand was a real strong driver over the last decade or so. Would we ever see this transitioning to a more consumer-led economy? There are different views on this.

Obviously, it hasn’t really happened to date. Some people’s expectation was it would once GDP per capita exceeded certain thresholds, etc. At the same time, there is a view that structurally because of the lack of social welfare and pensions mesh there, that savings rate will always be higher in China. So I’m curious to get your perspective on that debate. Do you see it transitioning at some point?

[00:32:30] Louis

I think we’re in the middle of this transition, to be honest. But I want to make first a small observation and then I’m going to answer your question. I’m not trying to avoid it. But I think all of us who’ve worked in markets for the past 25, 30 years, have been formatted to think of the world in terms of the US and China because that’s where all the growth came from for the past 25 or 30 years.

So we’ve basically spent a lot of time talking. We started off with talking is there going to be a US recession or not, and then we moved on to what’s happening in China because these are always the two main concerns of every major investor out there. Because if you got those two calls right in the past 25 years, you ended up in a broadly okay place. But is the next 10, 15 years going to be the same? I’ve written a number of pieces on this.

But what if the growth in the next 10 years doesn’t come from either China, or the marginal growth doesn’t come from China or the US, but it comes from the fact that if you’re India, you can now buy your commodities in your own currency, add credit, do long-term contracts with Russia in rupees, which basically removes the greatest uncertainty to any kind of infrastructure spending you need to make? It’s the case for India, it’s the case for Indonesia, it’s the case for Thailand, it’s the case for Brazil.

So what’s interesting to me is today, we have one message from the equity markets, which is the next bull market is artificial intelligence. We have a message from the bond markets that the next big bull market is going to be in emerging markets. If you look at the past 18 months, Brazilian government bonds have outperformed US Treasuries by 50%. That’s never happened. Indian government bonds have outperformed US Treasuries by like 25%. That’s never happened. Same for Indonesia. Same for so many of these markets.

Now, to me, a real proper bull market, something that goes on for 10 years where you make five times your money is what we call in our research a triple merit scenario, where you make money on the currency, you make money on the bonds, you make money on the equities, where basically, you get falling real rates, rising exchange rates, rising asset prices. Today, where you’re seeing this is places like Brazil, like India, like Indonesia, like Mexico.

If you take just an axis from basically Istanbul to Jakarta, you draw a line, you’ve got 3.5 billion people that live there, incomes are growing by 5% a year, and infrastructure spending in that area is going absolutely bananas because they have access to commodities that they never had before. So I think we’re going to wake up in five years’ time and say, actually, the growth of the world, forget the US, forget China, that’s not where the excitement is. The excitement is in all these other emerging markets that are trying to do what China has accomplished.

Because what China has accomplished throws the gauntlet down to the Indias of this world, to the Saudi Arabias, to the Indonesias, to the Brazils. It’s like, well, how come they’ve got all this great infrastructure and we don’t? Everybody can now see on social media. Do you remember, it said that the Berlin Wall fell because people in East Germany through TV stations, through satellite TVs could see how the people in the West were living, and they’re like, how come I don’t have a Walkman, how come I don’t have blue jeans and whatever else?

Well, increasingly, the same is true in emerging markets. They see China’s high speed rails, they see China’s airports. They see the fact that China now is producing its own commercial air jets and they’re like, how come we don’t have that? If you’re India, it’s like, “Are we stupid? We produce just as many engineers as China.”

[00:36:12] Alan

Well, maybe just on that one, it sounds like you are bullish on India and these economies.

[00:36:18] Louis

I’m very bullish on all emerging markets.

[00:36:21] Alan

A counterpoint against that, the India-China debate was always China could basically centrally plan the economy in some ways, obviously, capitalist and other elements. But obviously, no democracy so the government can always direct the economy wherever it wants and policy. That was always seen as in contrast to the Indian model, which was one step forward…

[00:36:50] Louis

The Indian model was the economy grows at night because that’s when the government sleeps.

[00:]36:54 Alan

Yeah. Why is that changing now then that you’re so optimistic?

[00:37:02] Louis

Let me just first say that what China did in terms of infrastructure spending won’t be repeated, ever. China in 10 years, basically, from 2001 to 2011, China poured more concrete than the United States did in the 20th century. Nobody’s going to do that again. But China was 1.2 billion people back then. This whole area is 3.6 billion. So if they do a third of what China did, you end up in the same place. So that’s number one.

But number two, look, what China was able to do was basically grab capital, human capital, and financial capital, mobilize financial capital and human capital in a way that had never been done before, in so doing, basically overcome its commodity dependency or its commodity weakness. My belief is that the silver lining to this horrible Ukraine war is that for emerging markets, it gives them the same opportunity.

Basically, if you’re an emerging market today, you have access to commodities at a price that you never had before because it’s now in your own currency. That’s a game-changer. If you’re in India, not having to first earn US dollars. If you’re India, you’ve always struggled to earn US dollars. What can you as India sell to the Americans that Americans want that you can then earn enough dollars to fund your massive commodity needs because you’ve got 1.4 billion people? You can’t sell enough IT services for that.

Now all of a sudden, Russia comes in and says, “Don’t worry, we don’t need US dollars. We’re fine with rupees.” Oh, okay. Well, that’s a huge game changer, a massive game changer. Same story for Indonesia, same story for Brazil, same story for all these guys. So the de-dollarization of the commodity trade that we’re witnessing in real time, the biggest macro consequence of that is an emerging market boom of epic proportions.

The biggest constraint for most emerging markets was accessing dollars. It was a constraint today, but it’s also a constraint over the future. So you were always reluctant to embark on big infrastructure spending, like let’s say, India, build a railway if tomorrow you can’t buy the iron ore because you’ve run out of dollars. Now, it’s like I’m never going to run out of rupees so I’m in good shape.

[00:39:23] Alan

Is it only a select group of countries such as Russia that will hold rupees in reserves?

[00:39:31] Louis

To your point, I think what’s happening in emerging markets is you’re splitting now increasingly emerging markets where you have the emerging markets where basically Russia and maybe a few other people will accept your currency. So obviously, China’s one, India’s one, Thailand is actually another because the Russians love to go on holiday in Thailand so they’re happy to earn and Thai bahts.

Then you have the emerging markets that are more frontier markets, where nobody wants their currencies. Think your Egypt, your Sri Lanka, your Pakistan. If you’re Sri Lanka and you turn to Russia and say, hey, I’ll buy your oil for Sri Lankan rupees, it’s not going to work. So I think you’re seeing a split, but the really big ones, the ones to be honest that you can invest in, they’ve just had a massive, massive shift.

[00:40:20] Alan

So let’s go to the structural growth in China.

[00:40:25] Louis

So look, growth is productivity gains plus population growth. There is no more population growth in China, so we have to accept that China is now just on a much lower growth space. But that happens to every economy, right? When you’re have a very small economy, it’s decently easy to grow fast partly because you have a lot of low hanging fruits in terms of harvesting productivity gains. Now, China still has some of these low hanging fruits in terms of productivity gains, but let’s not kid ourselves that growth is going to be strong.

Now, to your point, what growth there is, as you become more mature, is increasingly in services. Here, I think there’s a lot of work published on the demographic transition in China. For me, perhaps the most interesting part of the demographic transition is if you take your 30 to 45-year-olds, which is typically your biggest consuming group. When you’re 30 to 45, you tend to buy an apartment and then you put stuff in your apartment, your fridge, etc., you tend to buy a car, you need to buy the pushchair for the baby. It looks like you spend your whole time writing checks.

Here’s what’s happening in China. If you go back 10 years ago and you look at that 30 to 45-year-old age group, 5% of those people were single, living by themselves in apartments, living in single-person households. Today, it’s 10%. By the end of this decade or beginning of next, they’ll probably be around 30% at least if you look at the experience of Taiwan, Korea, Japan, Hong Kong, Singapore, basically, once you reach a certain level of income, but also a certain level of urbanization, basically once you move to above two-thirds being urbanized, partly because when you live in the countryside, you get married young.

When you live in the cities, people don’t get married, or they don’t get married as much or they get married much later. So I highlight this because when you’re single, and so China is going to move from basically their single biggest consuming age group, the 30 to 45-year-olds, it’s going to move from what was 5% single just a few years ago to 30%, 35% over the next decade or so. The consumption patterns change completely. When you’re single, you spend a lot more on services than you do on goods. You don’t buy a car. You might not even buy an apartment, you might just rent. You go to the movies, you go to bars, you go to restaurants, you go on holidays.

One of my jokes is I always say if China really moves 35% single, there’s not enough rice wine in the world. Moving services, you’re seeing it already. You look at the ISM surveys for China, manufacturing has been weak. I think your last reading was around 48. Services is at a 15-year high. I think we’re at like 56 or something. So you get this split. By the way, it’s a split you’re seeing everywhere. Services all across the western world are booming and manufacturing is not.

[00:43:28] Alan

Maybe just going back to the upbeat view on emerging markets. You mentioned drawing the line from Istanbul to Jakarta and that 3.6 billion people I think you said. Obviously, yes, huge demographic potential there. But obviously, you’re drawing a line through some of the most unstable areas geopolitically in the world. How do you reconcile a bullish view with the fairly obvious geopolitical risks that we’re seeing playing out in multiple dimensions at the moment?

[00:44:00] Louis

So here, I think this is where we’ve had one of the single most important events this year that most people have sort of not paid enough attention to which is the Saudi-Iran peace deal. For me, it’s a massive game-changer. Look, the Middle East has been torn asunder for the past 20 years with various proxy wars between Iran and Saudi Arabia. You’ve had Syria, Iraq, obviously, Yemen, Lebanon, all these have been proxy wars between Saudi and Iran. Now they’ve decided to bury the hatchet. They’ve decided enough is enough.

To me, to be honest, it reminds me of France and Germany. We went at each other’s throats for 70 years and then in 1946 said, okay, well, let’s stop doing that. Let’s bury the hatchet and let’s try to grow together and we had 30 years of uninterrupted growth. It was called the [inaudible] in French, and infrastructure spending. There comes a time I think, it’s always after 20, 25 years, sometimes longer, unfortunately, where people say okay, enough is enough, let’s just not do this anymore.

You have something similar in Ireland where people decide that let’s put our differences aside. We have more in common than we have that separates us. Once that happens, growth invariably follows. You’re seeing this today with the announcements of massive infrastructure bill. This is such a bullish development. I’m not saying it’s all rosy and hunky dory, but the two players that were doing so much to fund wars in that zone have just decided to call it quits. So, no, I’m very hopeful for the region.

[00:45:37] Alan

Is that shift from Saudi’s perspective towards more Middle East integration to be less US-centric and less positive in terms of the relations with the US? Is that a natural corollary of that?

[00:45:55] Louis

I think it is, I think it is. Look, the fact that the Saudis didn’t even tell the US they were signing a peace deal with Iran I think tells you everything you need to know. You just look at the US reaction and how pissed the US was. For the US, it’s not great news, far fewer weapons sales across the region. Look, for me, the biggest announcement that literally, I almost spit up my tea was the announcement about 10 days ago that Iran, Saudi Arabia, Oman, and the UAE were working together to form a joint Navy to patrol the Persian Gulf and deal with the Somali pirates.

In a million years, I would have never thought that was possible, and yet, here you are. Why would you form a joint Navy if it wasn’t in the expressed goal of telling the US to bugger off? So, no, I think this is dramatically, dramatically important everything that’s happening there, and it’s happening at an accelerated pace. It’s fascinating.

[00:46:52] Alan

You mentioned the de-dollarization theme being underway in real time as you described it. I know you wrote a piece recently talking about monetary policy and fiscal policy and how that is driving the dollar or not at the moment, and the idea being that we’re in an interesting scenario, as you mentioned, the US running a 6% budget deficit and obviously rates up at 5%. So what you might call a tight monetary policy, loose fiscal policy.

As soon as you say those words, everybody thinks back to the early 1980s and a big rally in the dollar. So that might be a reasonable expectation at the moment. But obviously, we had that last year. It’s reversed and now we’re seeing signs of, well, we had dollar weakness for a while, a bit more stable in the last month or two. But you don’t think that translates into a stronger dollar, that policy mix. Is that largely because of these structural headwinds and this shift towards less dollar usage?

[00:47:58] Louis

So here to be perfectly honest, I’m not sure. This is what I’m most nervous about. Probably the best investor, one of the best investors that’s ever lived is Stanley Druckenmiller. He always tells how he made his first billion realizing how the German reunification was going to lead to very easy fiscal policy, that the German government would have no choice but to spend a ton of money to integrate East Germany.

Meanwhile, the Bundesbank stood there and said, I’m not giving you that money. In fact, I’m going to hike interest rates and I’m going to tighten things. When they did this in the early ‘90s, that the Bundesbank basically sucked all the liquidity out of everybody else’s markets. Sweden went bust, the pound had to leave the EDRM, France went to 15% unemployment rates. There was a massive crowding out from the German government bond issuance of everybody else.

So today, when you look at the USA, I’m going to increase my debt $4 trillion over the next two years, the big question has to be, where’s that $4 trillion going to come from? That’s with a T, not with a B. $4 trillion, that’s a lot of money and it increases the US government debt from 31 to 35. Not only that, but over that same period, over the next few years, the US has to roll over roughly half of its debt.

So all of this begs the question of who’s going to stand on the other side of this? Especially if foreigners, the foreign central banks decide, you know what, I don’t need to keep as many US dollars as I used to in the past because now I can buy my oil in renminbi, I can buy my oil in Indian rupees, I can buy my oil in Thai bahts, I don’t need to keep all these US Treasuries I was keeping. So the question becomes, who’s going to buy all this debt?

Now, it could be the US commercial banks if the yield curve was steep, if there was something in it for them. But right now with the yield curve inverted, it can’t be. So as I look at that massive issuance of debt, I come to the conclusion that either the Fed is going to monetize this, the Fed is going to have to step in and buy a lot of this debt that the US government is going to issue. If they do, the US dollar goes down, bonds go down, commodities go up, gold goes up, etc.

So that’s scenario one, and that’s what I think will eventually happen. The problem is, first, we have a Fed that says I’m not doing it, it’s not my problem. If we do have a Fed that says it’s not my problem, then do we have a US dollar that spikes up just like the Deutsche Mark spiked up? Do we have a bond market meltdown and a much, much steeper yield curve? So that’s my concern. I think the Fed folds. So I’m a bear on the US dollar. But it does make me lose sleep at night that I could be wrong on this.

[00:50:43] Alan

Obviously, we’re not seeing that yet. If you look at 10-year yields, 3.75%, 3.8%. So no sign there really. That’s one of the bits that may be missing from the tight monetary policy, loose fiscal mix, although short rates are high in the US, bond yields half and track them higher, you’ve got this big inversion in the yield curve. So what would be the catalyst you think for that to start seeing that play out in the bond markets?

[00:51:13] Louis

That’s a great question. To be fair, I expected bond yields to be higher by now. One potential catalyst is people realize, hold on, the US is now going into recession, and quite the contrary, you get massive fiscal expansion, etc. So that’s the obvious catalyst. But I think also, when you look at the term structure of US debt, it’s really quite odd. Because European countries, when interest rates were super low, European countries took advantage of the low interest rates to massively extend the duration of the debt.

You remember Austria did 100-year bond even though it hadn’t even been in existence for 100 years. France, Italy, Belgium, I don’t know if Ireland did, I would imagine you would have, everybody did 50-year debt. If you didn’t do 50, you did 30. The US never did. The US massively shortened the duration of their debt. You can look at the term structure of debt on Bloomberg and it’s amazing that half of the US outstanding debt is below two years, and there’s actually very little outstanding debt to 10 years, 10 to 15, there’s basically very few issues, very, very few issues, practically nothing.

So people tell me the yield curve is inverted so we’re going to have a recession. I’m like, well, if you issue all your debt at 12 months and zero at 10 years, and at the same time, you force through regulation people to own the 10 years, pension funds, insurance companies and the like, and you tell them you have to own the 10 years, and you don’t issue any, then lo and behold, the 10 years trades at a huge premium.

So perhaps what might simply happen is that in the next 12 months, as the US government increases its debt, it looks at the yield curve and says, you know what, I’m better off issuing 10 years at 3.8 than one year at 5% because the Fed isn’t cutting in time soon. So I might as well just go out and capture the lower rates of the 3.8. As it does, maybe the yield curve comes back into a little bit of equilibrium.

[00:53:12] Alan

Do you think the Fed would like to see higher long-term rates?

[00:53:17] Louis

Well, it depends what you mean by higher.

[00:53:20] Alan

It’s a bit like the Greenspan conundrum back in the 2000s.

[00:53:24] Louis

I think for the health of the financial system you need a positively sloped yield curve. So if you’re the Fed, you have many jobs. One of them, you need to fight inflation, but the other is you need to maintain financial stability. Now, you could say, well, keeping the banks under pressure is one of the ways to ensure that there’s no increase in bank loans and that inflation stays under control. But to the extent that inflation rolls back below 4%, I think the Fed will be happy to see the yield curve steepen a little bit.

But to be honest, where the Treasury decides to issue doesn’t depend on the Fed, it depends on the US Treasury itself. So it depends on what Janet Yellen wants to do.

[00:54:09] Alan

Just one topic before we run out of time. We’ve had a huge run-up in the NASDAQ in the last two months seemingly disconnected from what’s been moving. Typically, technology stocks are heavily driven by yields, but obviously, AI has been the main driver in the last couple of months and obviously not without some justification in terms of the earnings we’ve seen from some stocks.

From a macro perspective, how do you think about AI? Is it for real? Is it going to be very disinflationary? Will it change the world? Will have serious consequences for monetary policy or do people know yet?

[00:54:57] Louis

I think it is for real and yet another one of those challenges. One of the reasons you have to stay modest today is that we talked about deglobalization, we talked about big changes in fiscal and monetary policies, we talked about the demographic shift. All these are structural trends that mean that the world we’re investing in is extremely different than the one you and I grew up in. Now you’ve got another shift that also means the world is very different, this AI shift. I’ll give you a couple of examples. At Gavekal, we’ve got a couple of software programmers to help us with things, write code, etc.

I was asking one of them recently when I was back in Hong Kong last week or two weeks ago, I was asking him, so this Chat GPT, how do you use it? How does it change your productivity? He said, well, what used to take me a week now takes me four hours. Chat GPT does 90% of the work and I do the last. I just check that it’s okay. So it does change things dramatically. I think if you’re an Infosys, for example, and if your business has been IT outsourcing, AI is going to completely upend your business model. A lot of business models are going to be completely, completely upended, so it is for real.

Now, the question is, from there, how do you play it in the markets? So, right now, I think when you look at Nvidia trade at 38 times sales and 190 times earnings, the market is in essence telling you there is going to be a capital spending boom in this space of epic proportions, and that I’m less convinced of actually. Because we subscribe to Chat GPT. It costs us 50 bucks a month, but that’s it. We use it and it helps our productivity but we don’t need to massively increase our CapEx budgets.

Now, I think you’re at a very simple crossroad when you look at the AI thing. It’s like, okay, are we going to see a massive new CapEx spending boom? If we are, then why should I worry about growth? Coming back to your very first question, if we’re on the verge of an epic capital spending boom, yeah, growth is going to be strong. If you tell me no, we’re not going to see a capital spending boom, then there’s no reason Nvidia should be at 38 times sales.

So let’s assume there’s going to be a massive capital spending boom. The next question becomes, how’s it going to be funded? Because if it’s going to be funded, it’s not going to be through bank loans, bank loans are now falling. So it’s going to have to be funded through cash flows, corporate cash flows, which is fine. But that means that one of the pillars that has supported US equities for the past decade or so which has been share buybacks is about to disappear. Nobody’s going to do share buybacks because everybody’s going to have to do AI investments, just like in the late ‘90s, everybody had to do internet investments and everybody had to buy PCs for all their staff, etc.

Now, you could say, well, it’s okay, because all this is going to be funded very quickly through productivity gains. But then, okay, fine, we’re going to be able to fire. Instead of having two software programmers, maybe I can only have one. But that means that then all these excess workers get dumped onto the lap of governments. If they get dumped onto the lap of governments, then we’re going to have even bigger budget deficits that are going to have to be funded through money printing. So everybody tells me this is so deflationary, I’m not so sure.

As you go through your decision tree, you can end up in many, many different places. For what it’s worth, I do believe it’s for real. I don’t believe is going to lead to a massive capital spending boom though of epic proportions. Therefore, I think that the big rally we’ve seen in some of these AI names is more typical of an echo balloon. Each time you’ve had a big 10-year bull market and it goes bust, you still have 30%, 40%, 50% rallies in the decade that follows. Japan, we talked about it earlier. Nikkei had three 50% rallies in the 1990s, NASDAQ had three 40% rallies in the 2000s.

So for me, it’s one of these echo balloons that you get after a bust. For me, the real story of the next 10 years, where the capital spending is going to occur, where the boom is going to occur, is in the broader emerging market space. I think that’s why we started the year with European equities doing well, that’s why Japan is doing well, because a lot of companies in Japan and Europe are actually pretty well positioned to participate in this emerging market boom.

[00:59:22] Alan

Very good. Well, we’re over an hour. We normally wrap up by just getting some general perspectives. Obviously, you’ve been working in the markets for a number of decades. For people who are starting their journey in markets and investing now, any advice? What would you encourage people to read or do if they want to get more informed on global macro and global macro investing?

[00:59:45] Louis

Read as much as you can, read whatever you can get your hands on. I think one of the most interesting developments of the recent years is the number of terrific podcasts that are put out there. Whenever I’m driving, whenever I do anything, I listen to podcasts. Find the ones that are right for you. Now, I think the main thing when it comes to working in financial markets is knowing what your own strengths and weaknesses are.

The challenge is, you can’t really know until you’ve done it for a while. There is no right or wrong way to do financial markets, there’s just the right or wrong way for you. You have to know your own strengths and weaknesses and then you have to always strive to not put yourself in a position where your own weaknesses are going to be found out. More often than not, that means right-sizing your positions so that you don’t become emotional over them.

What to read, to be honest, I would read a lot of books. What I found has helped me the most over the years is actually a lot of financial history books. Edward Chancellor’s books are terrific. I think When Genius Failed was another great book. I think you learn a lot reading books about various crises, how crises unfold. Perhaps that’s on my own bias because I started in a crisis.

I started in the Asian crisis and I was dumbfounded at how quickly things unraveled. So for most of my reading pleasure, I’ve tried to find out okay, how do these crises start? So When Genius Failed was a book that really marked me.

[01:01:31] Alan

Yes, very good. Well, before we wrap up, I know you’re a big rugby fan so it would be remiss of me not to get a French man’s perspective on the upcoming Rugby World Cup. Are you feeling pretty confident at this stage?

[01:01:45] Louis

Yeah, quietly confident, quietly confident. I don’t want to sound cocky, but no, I like the way our team looks. We obviously have a great home advantage. I think it’s going to be a France-New Zealand final, but in a final, anything can happen.

[01:02:00] Alan

Good stuff. Hopefully, Ireland have a better progress this time round. But thanks very much, Louis. This has been a tremendous conversation. Thanks for joining us today. Make sure you follow Louis’ work because as you can tell from today’s conversation, we are living in a true global macro-driven world with a lot going on so it’s as important as ever to stay well-informed. From all of us here at Top Traders Unplugged, thanks for tuning in and we’ll be back soon with more content.

[01:02:27] Ending

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