Lyn Alden – Global Macro Series - 26th August 2020

Lyn

Ever since my view, in early 2020, of becoming more firmly bullish, it seems odd to me not to have, say, 1% in bitcoin because the market cap, right now, fluctuates between one and two hundred billion but gold’s market cap is like ten trillion based on estimates for how much gold (above ground gold) exists in the world and what its current price is. It’s roughly eight, nine, ten trillion. Bitcoin is still a small market cap. It’s still a very low investor allocation to bitcoin. Gold is like a large-cap store of value; bitcoin is a smaller cap speculative store of value. So, it’s not hard to see bitcoin eventually hitting a one trillion dollar market cap. I’m not saying it will, but I’m saying I wouldn’t be utterly shocked if one day it did.

Niels

For me, the best part of my podcasting journey has been a chance to refine my own investment framework through a series of conversations with extraordinary investors in every corner of the world. In this series, I along with my co-hosts, Robert Carver and Moritz Seibert, want to continue our education by digging deeper into the minds of some of the thought leaders when it comes to how the world economy and global markets really work to try and learn how they think.

We want to understand the experiences that have shaped them, the processes they follow, and the historical events that have influenced them. We also want to ask questions outside our normal rules-based playground. We’re not looking for trade ideas or random guesses about an unknown future but rather knowledge accumulated over the course of decades in the markets to try to make us better-informed investors and we want to share those conversations with you.

Our Guest today is absolutely brilliant when it comes to removing financial noise and filtering it down into precise and actionable information. So, I’m convinced you will enjoy our conversation with Lyn Alden of Lyn Alden Investment Strategy.

Lyn, thanks so much for joining us today for a conversation as part of our miniseries into the world of Global Macro where we relax our usual systematic, or rules-based framework, to provide you, with a broader context as to where we are in a global and historical framework and, perhaps, discover some of the trends that may occur in the global markets in the next few months or even years and, ultimately, how this will impact all of us as investors and how we should best prepare our portfolios.

So, we are super excited to dive into many different topics in the next hour or so, not least because you are someone who publishes a lot of great content that is based on detailed data and charts and analysis and history and you are very generous when it comes to sharing this on Twitter and other platforms. Let me kick it off with a 30,000-foot question, that is, I would like to know (and we’ve asked all of the guests in this series the same question, to begin with), where do you think we are in a bigger global macro picture?

There has certainly been a lot of people comparing these times to history; different bubbles and also, of course, back to the ’30s and ’40s. I know we’re going to come to that for sure but just for now, when you look at the world right now what do you see?

Lyn

Thanks for having me. I’m happy to have this chat. So, to answer your question, I view us as bumping into the high point of two very long-term cycles. So, one cycle is the long-term debt cycle in the U.S. So, in addition to the normal five to ten-year business cycle, where credit builds up, and then it gets deleverage, and then it builds up again, that tends to compound over the long-term. So, even though it deleverages each time, it never really deleverages back down to the place that it started at, especially as interest rates have declined for about four decades now they’re able to build up more and more leverage as a percentage of GDP and as a percentage of other ways of measuring it.

So, historically every fifty to a hundred years you get to a point where you have a much larger deleveraging event and a much larger phase shift in that. There have been some investors that cover that a lot like Ray Dalio, but there is a lot of basic evidence that, ever since the Great Financial Crisis, and then still in that period now, we’re kind of bumping into that high-water mark of how much debt you can possibly have in the global economy. The last time we ran into this was back in the 1920s, 1930s, 1940s.

So, that’s one long-term cycle we’re witnessing right now. Then the other one is the current global monetary framework that’s very dollar centric. In many ways, the world has kind of outgrown that system and yet it is still constrained by it. So, over the past fifty years that the system has been in place, the U.S., has basically had to run very large trade deficits and has basically had to export its supply chains to facilitate global trade in dollars and to maintain the global reserve status for the dollar. Now, the globe is kind of at a peak stage of globalization and seems to be pulling back. So, much of the accumulated trade deficits resulted in the U.S. having a very negative international investment position, and have really decreased its ability to manufacture things. We’ve really bumped into that over the past several years.

So, we’re watching these two really long-term cycles start to run into the ceiling here.

Niels

Yeah, absolutely, it’s quite interesting, right? When I mentioned to our previous guests this thing about that some people are comparing this to the 30s like, as you say, Ray Dalio is certainly one of the more vocal people for a while about the way he lays out his playbook. A lot of these people have kind of pushed back a little bit and said, “Yeah, you can always find similarities to these periods.”

Then I ran into some of your recent research where you make a really, really, compelling case about the 30s and the 40s and how you compare that to the 2010s and 2020s. So, if you don’t mind, take us into that comparison. I really think all of our listeners will benefit a lot to hear how you line that up and why we need to pay attention.

Lyn

Sure, so, in every one of these cycles there are always differences. There’s that common phrase that, “History repeats.” It doesn’t repeat but it does rhyme. So, that’s kind of what we’re seeing now. It’s not identical, point by point, as it is to the 1930s and 1940s, but it has a lot of similarities. There are generally certain patterns to how this plays out even though it’s a little bit different every time.

So, if we go back, starting with the 1920s, we had a really big credit cycle buildup; a huge accumulation of credit for a couple of decades there and really culminated in the late 1920s when we had, of course, the famous Market Crash and the beginning of the Great Depression. During that period private debt, as a percentage of GDP, reached all-time highs. Federal debt was still pretty low, in the U.S., because we had a more lean government back then so we still had a pretty low federal debt. But private debt had reached extraordinarily high levels.

So, as we entered the 1930s we had a huge deleveraging event. Banks didn’t have FDIC insurance and things like that so many banks failed and the broad money supply actually went down by about a third. So, the amount of broad money in the system went down. So, we had a really big deflationary shock; official deflation levels went to 10%. So, instead of inflation every year, they had a really big deflationary impact; prices went down. The way that they got out of that was that they devalued their currency significantly. So, they de-pegged the dollar from worth about 1/20th of an ounce of gold to about 1/35th of an ounce of gold. Then they printed a ton of money; they did a ton of infrastructure programs; they increased federal debt.

So, we had this big expansion of the monetary base and a big increase in federal debt and then, eventually, it worked down the private debt but not really in nominal terms, mostly in real terms. So, they basically devalued the dollar so much that they reduced the private debt as a percentage of GDP. So, in the 1930s, we started with a really big deflationary shock, and then we had this inflationary response to it. It mostly balanced out. It was not a period of high inflation. It was just a big deflationary period and then some degree of reflation.

By the 1940s the private debt bubble was mostly worked off, but then, of course, we entered the WWII period; we had massive federal deficits as a percentage of GDP. They upped it 20%, 30%. So, we had this huge fiscal spend; we had a really strong rise in federal debt, up to over 100% of DGP.

That ended up being inflationary, right? We had supply shortages in certain materials and we had massive deficits. In order to fund those deficits, the Federal Reserve had to part over the Treasury because there wasn’t enough natural appetite for the public to buy all those treasuries. So, the Federal Reserve did something that was, basically, quantitative easing, even though they didn’t call it that back then. That’s our new term for it.

Basically, the Federal Reserve bought treasuries. They printed dollars, they bought treasuries, and they actually did formal yield curve control. So, they said, “OK, we’ll buy as many treasuries as we need to in order to keep the yields at 2.5% or less. So, throughout that whole decade, the whole 1940s, treasury yields were locked under 2.5%, but inflation, in some years, went into double digits for a period of time. We had a pretty staggered inflationary environment.

So, anyone who invested in treasuries, over that decade, they made money in nominal terms because they got about 2/5% a year. So, by the end of the decade, they got a little over 25%. But their purchasing power, in real terms, diminished because it failed to keep up with CPI inflation. That’s actually how they managed to reduce their federal debt as a percentage of GDP because even though they never actually decreased the nominal amount of debt, they had locked the yield curve below the inflation rate and they cut it and inflated away a lot of that debt.

So, if we fast forward all the way to the Great Financial Crisis, we had a similar event to the 1929 period where we had a massive build-up taking decades to do in the private sector. So, we reached total debt levels that were even slightly bigger than back in 1929. So, we had this huge deleveraging event where we had a lot of people lose their homes, we had some banks go under, and then a lot of that debt was moved up to the federal level. So, the federal government went into that crisis with about 65% of debt to GDP. By the end of that crisis, we were up to over 100% of debt to GDP. So, a lot of that leverage was pushed up to the Sovereign level.

Then, for several years, we’ve had a very dis-inflationary environment because even though we’ve had inflationary policy response in the form of QE, a lot of that just went to recapitalize banks and it was offset by a lot of that deleveraging, especially in the consumer market. But, as we went into this crisis, we had corporate debt buildup again; we had federal debt at 106% of GDP; now, with COVID happening and the economic shutdown, we have deficits that are as large as they were (roughly) in WWII. So, we’re running 20%, 30% deficits because we’re already at like 20% deficit and the year is not over yet. They’re still talking about more fiscal. So, we don’t know what the final number is going to be.

So, we’re running very large deficits and this isn’t going to go away in a year or two. Even as things start to recover the amount of joblessness means that the tax base is damaged; the amount of stimulus that they have to do to kind of keep people afloat is higher. So, we’re going to see deficits that are very large for several years.

It’s kind of mimicking, in my opinion, a lot like the 1940s where we see we’ve already kind of worked off a private debt bubble and now we’re kind of working with sovereign debt bubbles both in the U.S. and elsewhere in the world.

Niels

Yeah, it’s a very, very logical way of comparing things, for sure. As you say, of course, it’s never going to be exactly the same. We certainly know that from our world as well.

Rob, what’s on your mind today?

Rob

Yeah, it’s a very neat comparison and the fact that the dates work so well, from 1929 to about 2008, and we’re sort of ten years on from that in the same way that the 1940s was ten years on from 1929. Obviously, there are some differences, right? So, I guess the way the economy was affected by the war is quite different from how the economy has been affected by COVID. That’s the first thing. The second thing is interest rates. So, I think in the 1940s U.S. ten-years, you actually gave the figure that they were at about 2.5%. Now we’re about 70 basis points, so we’re somewhere below that.

Actually, I did a quick back of the envelope calculation. I multiplied the interest rates in 1930 by the federal government GDP ratio and then I did the same calculation today and that’s kind of a very vague proxy for sort of the debt burden on the federal government in terms of interest payments. That came out, scarily, almost exactly the same number. So, intuitively the interest rate, the lower, is kind of compensating at least on the federal government side for the debt to GDP ratio being higher.

I guess the other thing is that we hope that people have learned stuff, right? So, if your analysis is correct, I’m sure it is, it took about ten years (at least ten years) before the fed started doing something a bit like QE after 1929, whereas, of course, this time around, they started doing something a bit like QE relatively quickly after 2008. So, you talk about similarities which are striking. What about those differences and how do they affect how this may play out?

Lyn

Sure, there are several differences. One is that we have a very different demographics situation now. So, we have a slower growing and more aged population. So, all else being equal, it can be harder to get those higher inflation levels that we saw in the 1940s. Also, we don’t have, at the current time (hopefully), a war, a hot war. So, we have more of a cold war, a little bit, sort of a decoupling, an economic decoupling.

Another thing that’s different is that this time we have a very high federal debt and very high private debt at the same time. So, back then we had one after the other; first, we had a private debt bubble then we had a federal debt bubble. So, they worked them off kind of separately, a decade apart. Whereas, in this time, we had a partial deleveraging ten years ago (particularly in housing, in the consumer segment), but we did not have a deleveraging in the corporate sector. Then, of course, we’ve had an increase in the federal sector. So, at the current time, overall public and private debt to GDP is very high if you combine all sources of debt it’s something like 350% of GDP if you look at federal debt and private debt.

Basically, we have a larger debt problem to work through and we also have a more diversified economy; we have slower demographics. One thing that can make somewhat of a comparison to World War II is that back then we had supply shortages, right? So, we had a lot of materials used for the war. One thing that we’re finding ourselves in now is that, because of our globally diversified supply chains, we already have some shortages. So, we had a shortage of masks, for example, at a critical time when we needed masks. We’ve had the U.S. military raising concerns for a while now where they have components that are made in China. So, imagine if we were during the cold war and we had Russia making some of our components. It’s not a situation you want to be in.

Actually, during the recent China and India conflict; they’ve had some border squabbles and India has a lot of their military equipment and their system that they’ve gotten from China. So, it’s a really interesting situation where, if they’re trying to resource supply chains and try to avoid having those supply chains in cheaper places in the world, that can be inflationary – if they try to bring some of those supply chains home, which can be higher cost but can be more resilient. So, we have situations where it rhymes in some ways, but we have pretty stark differences as well.

Moritz

So Lyn, how do you think (and this may sound like the million-dollar question) how do you think we’ll get out of this? There are, obviously, the deflationary forces that you’ve just mentioned: one of them being demographics, the other one being the economic environment, and all of that. But then, when we look back on fiat currencies, one observation is, essentially, all of the fiat currencies that still exist (many of them don’t exist anymore, they’re long forgotten), those that still exist, they’ve all devalued. It seems to me (and I might be the uninitiated here) but the feeling that I think people get (myself included) is that there is more and more debt; more and more federal debt; more and more private debt; interest rates are at zero; there’s more QE; QE forever; QE infinity; this, that, and the other thing; there’s a new trick pulled out of the hat every single time.

I guess at some point (this may be completely wrong), but maybe the end game is they will (they being the Fed or any central bank) they will at some point succeed in generating inflation, or our behavior will succeed in generating inflation because we think differently about the world, or supply chains break, and there’s a different behavior of people in the economies. The thing that has happened so many times before happens again, which is inflation. That’s the “solution” to the problem rather than a default.

Lyn

Yeah, so my base case is that we’re going to see higher inflation in the 2020s; now, exactly how high will depend on a lot of variables. So, just like the 1040s were more inflationary than the 1930s, I think we’re going to see a high probability that the 2020s are more inflationary than the 2010s. A big reason for that is because back in the 2010s, a lot of this QE that they did mostly went to recapitalize the banking system.

Banks went into that crisis with about 3% cash as a percentage of assets because we had deregulated the financial system. So, we had very low cash levels. Part of the way that they got out of that crisis was that the Federal Reserve created a bunch of dollars and they bought assets from those banks. After the first round of QE, banks were brought up to about 80% cash levels as a percentage of assets. By the time QE 3 ended, around 2014, banks had 15% cash as a percentage of assets.

They slowly worked that down over several years. They got down to about 7%. That’s when we had the repo crisis last year, in September. Ever since then they’ve been treading water. In this most recent QE that was brought up to 15% cash again, by the Fed.

Now, back then, that’s where most of the QE wound up. It went into treasuries; it went into mortgage bank securities; and it went onto bank balance sheets, for the most part. Whereas, now what we’re seeing because physical deficits are so large; they did twelve hundred dollar checks to people; they did six hundred dollars a week in extra federal unemployment for four months there, going through the end of July. We’re probably going to see more rounds of fiscal. We already have an agreement between both the president and the Democrats and the Senate that they’re going to do some sort of fiscal most likely, again. They just don’t know what shape that’s going to take yet. Probably in the years ahead, we’re going to see some infrastructure because it’s going to take a long time to get out of this unemployment mess.

So, a big difference that can actually have them “succeed” in causing inflation is that instead of a lot of this QE winding up in asset prices and winding up in the financial system, a lot of it is getting injected more into the economy in the form of business loans that turn into grants and helicopter money to consumers, extra unemployment benefits, that sort of thing. As we have a massive run-up in deficits and the money supply and as they lock treasury yields, wherever they want them to be by buying more treasuries than needed, we could start to see a more inflationary environment and currency devaluation compared to harder assets like, say, precious metals.

Moritz

Yeah, wouldn’t you say, I may be completely wrong here, in order to get rid of all of that debt shouldn’t they aim, or won’t they aim for, “You know what, we’re going for 20% inflation. We’ll just make this… It’s like the pain, let’s get over with it and have it quick and short: two, three, four years, real super high inflation and then we start again.”

Lyn

I think the challenge with that… because fiat currencies are entirely a confidence game. It’s all faith-based in the stability of that currency. So, we had situations now where they’re doing QE but they don’t want to call it debt monetization. For example, even though in many countries now most of the sovereign bond issuance is being accumulated by the central bank, but they don’t want to refer to it as debt monetization, so they prefer to… I think in their perfect world they want this to be somewhat gradual.

The Fed’s inflation target is 2% and that inflation target uses a bunch of statistics to understate real inflation. They’ve also talked about having symmetric inflation. So, because 2% is the ceiling is that, because we went under that target for several years, they’re happy to above that target for several years. I think, in their view, above that target means, say, 3%. So, if we look at it and say, OK, they want 3% inflation but that 3% would still understate what actual inflation is at that time. So, it might be up to 4%, or 5%, or 6% for the cost of goods, or higher. I think that their ideal world is to have yields at 1% or 2% and then inflation at 3% or higher.

Now, if you have a sharp spike in inflation, it depends on how long that lasts. I think in their mind they also wouldn’t mind, “Ooops, inflation had a big spike to 8% this year,” but we got it back down and conveniently we inflated away some of that debt. So, you could have mid-single-digit sustained inflation with an occasional spike, especially in a yield curve control environment where they don’t raise rates to stop inflation. But, that could quickly get out of control if the global investors lose confidence in the currencies and bonds.

So, the way that the whole system is structured, I don’t think they’d want a really sharp inflation. I think they want to kind of tapper, but that’s always harder to do in practice than in theory.

Niels

Maybe just as a quick comment, we were talking to Jim Bianco, also on this series, and he said something quite interesting. So far it seems like the central banks have been pretty much in control, to a large extent. But he did say was that the bond markets are way bigger than the Fed, but, at the moment, they’re not speaking with the same voice. So, when the bond vigilantes, as he called them, start to really get in tune, there’s just no way that the Fed will be able to control that. Also, to your point about inflation, yeah, and to your point, Moritz, well, let’s take three years at 20% inflation; it kind of assumes that you can control that. I just don’t think you can; at some point, you lose control and that’s probably not something they want to risk.

Moritz

I guess it’s a question of, like Lyn was saying, it’s all a relative game. All the other countries, all the other major currencies may be doing it at the same time, in which case it isn’t that painful. If only one country is doing this; if only say the U.S. was running 20% inflation but none of the other countries would, well that’s a big problem for the U.S. But if everybody is in a super high inflationary environment then, because it’s a relative game in terms of currencies, maybe it’s something that you can get through. I don’t know, the thing about 2% inflation is, yeah, to me, compound that for ten years, you’re getting 25% or something like that. Does that really solve the problem? If we have 25% less debt ten years from now, I don’t think that solves the problem in any shape or form. If you don’t want to default if you really want to get rid of the debt and don’t leave it as a burden to generations to come, it really needs to get way, way, way down and you don’t do that with 2%.

Lyn

Yeah, that’s my base case is that we’re going to see higher than 2% inflation over the next decade. But how high I think if it gets much higher than that we’re going to see these big volatile periods where you could have spikes of inflation and then decreases in inflation. If you look back in the 20s and 30s when all the major sovereigns reduced their gold pegs. That’s generally what we saw back then, instead of just one country reducing their currency, we saw all the majors reducing it: the Dollar, the Yen, the Swiss Franc, the Pound, they all reduced their currencies by varying amounts to gold. Switzerland reduced it one of the least, whereas France and Japan reduced it more. It was still somewhat a relative gain, but they all diminished their currencies significantly. So, I do think we’re going to see pretty significant currency devaluation by the time that 2030 comes around. Let’s call it.

Now, that can take a couple of different forms. So, we could have, for example, a very large devaluation versus commodities and other hard assets, whereas, everyday prices might not change a ton. They might only go up 3%, 4%, or 5% a year for a couple of years. Or we could see a more 1970s environment where you have pretty high everyday inflation. I think that’s going to depend on a lot of different variables. It’s going to depend on supply chain. It’s going to depend on policy response. It could depend on election outcomes. There are all sorts of things and it’s very hard to say, “OK, we’re going to have 8% inflation five years from now.” It’s more like looking at the direction and the trends and then going from there. Every year we reevaluate, “OK, what are they doing now? What’s happening in this situation?” My base case is much higher than 2% inflation in this decade. But I don’t really have a ceiling for where it might get to.

Niels

It’s not like we don’t have inflation right now. We might not have official inflation, but if I look at my healthcare costs every year they go up quite a lot.

Moritz

It’s because you’re getting older, Niels.

Niels

I know, I know, and my kids are as well. It is a little bit deceptive when we talk about 1% or 2% inflation. Also, the way that Europe calculates inflation doesn’t take into account shelter, so there are no housing costs in the number either. So, it’s a little bit of a jungle.

I just want to circle back to some of the things that you mentioned. You mentioned Ray Dalio, so I just wanted to ask you a little bit about… I think he’s come out recently to say that he thinks we will get into a depression, actually. He does, obviously, want to clarify what he means by depression, but minus 10% GDP, etc., etc., he thinks we’re there or we’ll be there. So, that’s one thing.

The other thing is that you mentioned these long-term debt cycles where he’s also done a lot of work on this, of course, we have other cycles, in general. You talk about the business cycle. But we also have war cycles. Even though we say, right now, we don’t maybe envisage a world war or something large. We have people like Nouriel Roubini who definitely believes that the U.S. is going to be in a hot war with Iran before the election. We have North Korea/South Korea that seems to be heating up. We have Taiwan and China. You mentioned India and China. I mean it’s not like there isn’t the potential for war. Then on top of that, we have this other cycle which we have talked about on this podcast which is a demographic cycle based on the work from Niel Howe and Bill Straus in terms of the generational turnings. We are in a fourth turning, according to their work. They wrote it 30 years ago and it’s been spot on, really. Often these cycles actually end in war. I don’t think there are many examples where it didn’t end in big conflict. So, do you take that into your perspective when you look at the world?

Lyn

Those certainly are things to consider. I think Howe’s work has been great because his fourth turning seems to coincide with the popping of these long-term debt cycles. I don’t think that’s a coincidence. Now that we’ve had this big COVID thing; this huge kind of global pandemic; even more impactful is the actual government shutdowns. In order to control the pandemic, all these different countries experimented in different ways: like locking down the whole country, or in many cases Asian countries have been able to do partial shutdown because they’ve had more experience with pandemics and their populations are more apt to self-quarantine, in a way, while still keeping things functional. In the U.S. we’ve been hit or miss depending on certain areas. Some countries, like Sweden, elected to stay open more. So, we’ve had experiments to see how countries handled the pandemic and how seriously they take it.

So, we’ve already had our… in some ways it’s more of our war event because we’ve had the biggest economic shock since WWII, essentially, and the biggest deficits, globally, since WWII. Now, whether or not that ever translates into a hot war later this decade, I think there’s a lot of variability there. So, one deterrent is that many of these countries are nuclear powers. So, the whole cold war never really ended in a hot war. It just kind of burned itself out. I think we’re certainly entering into a period where the U.S. and China are more in a cold war situation. Whether or not that translates into hot wars, in the Middle East, or proxy wars like that. That could be kind of considered a proxy war, or if we had more India and China skirmishes. Both of those are nuclear powers. So, there’s certainly a ton of risk there if we see hot war among these countries.

My emphasis is less on the geopolitics though it’s something that I always keep in mind and I follow certain people that kind of specialize in that area. I do think that kind of leads back to the point of countries wanting to localize their supply chains more because the worst situation you want to be in is that a fifth of your supply chains are in your adversary’s country. So, you don’t want to rely on masks from China if you’re in a contest with China in a great war struggle. Even if it’s not a hot war if it’s a cold war you still don’t want most of your medicines made by your cold war antagonist. So, that re-shoring of supply chains can be quite inflationary.

As you pointed out, we’ve had very uneven inflation. So, things like healthcare, education, services in general, things you can’t outsource, we’ve had pretty high inflation. If you look at, say, the money supply. Over the past decade, the broad money supply in the U.S. has increased by about 7% per year, on average. If we were having this conversation last year I would have said it was 5% or 6%, but because we’ve had a massive 25% increase in the money supply just in the past six months, that ten-year rate has already increased to 7% or 8%.

So, we’ve had pretty high monetary base inflation but it hasn’t really translated into a ton of prices because some of those prices were offset by technology and off-shoring. So, things like televisions, phones, and any sorts of devices, in general, have gone down. Commodities have been in a pretty cheap decade because we’ve had a ton of exploration in the past decade and we’ve had this period of excess supply. So, we’ve had pretty cheap commodities, pretty cheap electronics, all of this off-shoring. So, if we start to enter a period of higher commodity prices, and a period of re-shoring of the supply chains, that kind of puts a bottom in how much deflation we can get in those areas. We could have inflation in those areas while we also have high inflation in some of those services areas.

So, that’s why I think the 2020s, in addition to the amount of money printing that’s happening is that we have a re-shoring effect and I think, together, that could be pretty inflationary.

Rob

Yeah, I guess the other thing that has gone up in value is housing as an asset, but also the kind of cost of housing which is another one of these things you can’t offshore. You can’t go and live in China. You have to live in New York, or near London, in my case, or Switzerland and Germany for the other guys. So, it’s always interesting to think about the likely portfolio that one should have if you have some expectations about the future. If you want to put together a portfolio that you think will be protected against inflation you can do it a couple of different ways. One way is to go and look at past inflationary periods and what assets did well in the 1970s, for example, or even further back into the early 1940s.

The other thing you can do, I guess, is to try and reverse engineer from these ideas and say, “Well, I think there’s going to be inflation in these things, which were off-shored and therefore that brought the cost down, and if they’re re-shored…” So you know a principles first approach if you like.

What are the main differences between those two approaches? What kinds of different answers would they give you? This is a very long and complicated way of basically asking you, given this current inflationary period that’s coming, what assets would you advise using to potentially hedge against that, given that the nature may be quite different from what we’ve seen in the past?

Lyn

Yeah, so I’m pretty bullish on precious metals and commodities more broadly. So, specifically around late 2018, I turned bullish on gold because we saw the top of the growth cycle. So, even though GDP continued to grow into 2019 we had a much slower period of growth. Also, gold was pretty cheap and had some positive trend signals. I turned bullish on gold then. Throughout this cycle, we’ve had dips and troughs along the way, but I continue to see this as part of a long-term trend that gold, silver are going to do very well in the 2020s even though they’ll have big corrections along the way, most likely.

Then, commodity producers, I’ve been more hesitant on until very recently. So, I’ve been sticking to some of the most conservative commodity producers because, even though I considered that we’re probably looking forward to inflation in the coming decade, my analysis was also showing that we’re probably toward the end of a business cycle. So, as things are slowing down in 2019, I’m saying, “OK, we have to kind of separate durations here.” So, I’m bullish on commodities long-term but I’m worried that we’re going to get a drop in the near term. Of course, we had COVID come along and we had a bigger drop than I would have guessed. I wouldn’t have expected negative oil prices back in 2019.

So, going forward now, I’m more broadly bullish, for the long-term, on commodities including copper produces, all the different kinds of metals that are useful for solar panels, electric vehicles, electrical grid. People often talk about renewable energy which is, essentially, a shift from oil to metals because electric vehicles, solar panels, electrical grid, they all use more copper, silver, nickel, battery metals, all these different kinds of commodities and we have not had a lot of expiration.

So, I like to combine the present and the past when looking at how this plays out. So, we know from the past that in inflationary environments, scarce assets, do pretty well, so that’s gold, silver, commodities. Now, in the 1940s you had an exception because gold was pegged to the dollar. So, gold in nominal terms did not really appreciate in the dollar. But we had silver go up pretty significantly. We had other commodities go up. Of course, in the 1070s, when they were all depegged, we had a very strong commodity cycle. I do expect that a broad basket of commodities and high-quality commodity producers should do pretty well throughout the 2020s.

I think real estate is more hit or miss. So we could have… City real estate is very expensive, whereas, in the U.S., for example, a lot of suburban real estate is still pretty reasonably priced. So, for investors that can get a very low, long-term, fixed-rate mortgage on a decent home, I think that could be a decent hedge against inflation. Whereas a really expensive penthouse in Manhattan, for example, is unlikely to have that kind of hedge especially if people want to move out of cities a little bit.

So, that’s kind of my view going forward is that we look at the past to see what is generally considered an inflationary hedge, and then now we have this environment where we want to have similar assets but it’s always useful to pay attention to what’s going on with a specific metal. Is that metal an exception to the rule, or can we consider it part of something that is going to do well? There is also bitcoin now a days. There are scarce digital assets that are pretty controversial that people can dabble in. I think the same sorts of things will do well, but it’s always a little bit different.

Moritz

It’s not my intention to put you on the spot here. Do you have a price target for gold? Where do you think it will go?

Lyn

Not a specific price target, but I do expect to see probably over $3,000 by the end of the decade and that’s kind of a lower-end target. So, it really depends. I don’t predict sentiment right, so I have a couple of models that compare gold to the money supply and other metrics. So, I do think we’re going to see notably higher gold throughout the next ten years. So, I would expect to see, probably a doubling, or probably at least $3,000 in dollar terms. But there are kind of tail snares that could see much higher than that, especially if momentum people get into it or if we have a more significant, more rapid currency devaluation.

Moritz

We’re definitely in it, we, the momentum people. Yeah, so cool, if it goes that way we’ll probably be happy definitely given our current position. So, where do you think (in that same context) the electro dollar (AKA bitcoin) is going to go?

I guess there are many, many different schools of thought, one of them being it’s digital gold but you need a socket and it’s kind of this new thing, it’s crypto. So, that’s all the upside ride and it has twenty-one million coins and that’s about it. There’s no inflation built into the model and into the algorithm. So, it’s a scarce asset and it may be a store-hold of wealth but what is that thing going to be worth if a central bank, say, the Fed, decides to come up with its own Fedcoin, saying, “This is now our Fed/crypto thing. Forget about this other thing.” Is it going to be a store-hold of wealth then?

Lyn

So, my view on bitcoin has changed a little bit over the past couple of years. So, I started officially covering it in 2017. We had that pretty big run-up in cryptocurrencies in general. I had tons of readers ask me, “Hey, what are your thoughts on bitcoin?” I got twenty of these emails or fifty of these emails so I’ll start writing an article.

So, I covered it around the autumn of 2017 and the price was in the upper $6,000s at the time. I analyzed it from a couple of different points of view, either valuing it as a medium exchange or valuing it as a store of value. At the time, both of those were narratives that more and more people were going to supposedly use bitcoin for transactions but that also it was like digital gold. So I was like, “Let’s take each of these scenarios and kind of play out how it is.”

So, I determined that it was most likely overvalued as a medium of exchange, but potentially reasonably valued as a store value. If you compared it to, for example, how large bitcoin’s market cap is as compared to gold. So, if the global kind of investor committee wants to put a quarter of a percent of their net worth (collectively) in bitcoin, what would the market cap have to be? What if they wanted to put a half a percent? Or what if it reaches 10% of the market capital of gold? Things like that. So, if this actually takes off how big could the market cap get combined with the fact that the number of coins is scarce?

I analyzed it a couple of different ways, and I ended up concluding, at the time, with kind of a neutral to bearish outlook. I didn’t call it a bubble, but I also decided not to invest my own money, at the time, and I didn’t really want to play that at the time. One big reason was because even though bitcoin is scarce (there’s never going to be more than twenty-one million coins), the number of cryptocurrencies is not scarce. So, anyone can create a cryptocurrency. Whereas precious metals, in addition to each one being pretty scarce, there’s only a handful of precious metals. So, each one is an element and we can’t just come up with new precious metals. So, each one is scarce and there’s a scarce number. Whereas, cryptocurrencies each one has their own program scarcity but anyone can make one. At that time we were seeing the rise of a lot of altcoins and we were also seeing the hard fork in bitcoin, so bitcoin was splitting.

It was like, OK, these could all dilute. So, even though you could have, overall, cryptocurrency market cap increase, you could have a lot of dilution so that the per coin value of all these different cryptocurrencies doesn’t do much.

Now, over the next two and a half years we had a pretty volatile environment. I started the analysis in the upper $6,000s. By the end of the year, it had that big run all the way up to $20,000, roughly; then it collapsed to under $4,000; then it bounced back to $12,000; then it collapsed earlier this year and it got down to really low levels again of like $4,000 or $5,000 or so. In April of this year, bitcoin had done kind of a round trip. So, after two and a half years it was back in the upwards $6,000s. So, I’m glad I didn’t invest back then because it kind of went nowhere for two and a half years.

But, we’ve seen a couple of things strengthen. We’ve had a decline in altcoins, so the bitcoins market share has regained levels compared to 2017. So, bitcoins network effect has strengthened. So, instead of bitcoin being diluted by a lot of these other coins, bitcoin uniquely is retaining a lot of market share. Also, we’ve seen a settling of these hard forks, so we’ve had bitcoin retain almost all of the market cap from these hard forks. We also have things like Robinhood, Square, and PayPal (just announced). All these different kinds of platforms include cryptocurrencies and particularly bitcoin. So, some of them are bitcoin-only, other ones include trading for multiple cryptocurrencies. So, I think bitcoin has unique has become kind of established as sort of a digital speculative store of value for many people and has a very well designed protocol.

So, my view is, since April 2020, I have been bullish on bitcoin and I consider it a more volatile speculative asset, so I wouldn’t allocate to it as much as I would, say, gold. But, I am bullish on that going forward. There are some tail risks from governments trying to ban it. I don’t consider something like a Fed coin to be a real threat to it because even a central bank cryptocurrency, even though it could have similar traits, it wouldn’t be scarce. They control the protocol so they can create all sorts of extra currency, whereas, bitcoin is decentralized and inherently scarce. That is part of what makes it unique. It also has a really well-designed protocol where it’s got the halving event that happens. So it has a slower supply over time. It has difficulty adjustments. It’s a very well-designed protocol. So, my concern is it not competing with central bank currencies, my concern would be government attempts to ban it or disallow it which kind of makes it a black market item rather than kind of a broad asset. So, that’s kind of the tail risk I’m watching.

Moritz

Yeah, it may do that, but one of the things I also see is bitcoin now has, kind of like, there’s a tribe behind it. There’s a bunch of people that really think, “You know, this is it.” Millennials, younger types of guys, they’re like, “This is our thing.” Even if the government came in and said, “Yeah, you know, we don’t want you dealing in that stuff anymore. It’s now illegal.” Its value isn’t going to be zero because they can’t turn off the internet. It’s always going to be there. There are now a couple of people that they’ve gotten infected by the bitcoin virus and they’re not going to let it go. So, if there are only twenty-one million coins, what I always say is, “There’s a great risk not being exposed to bitcoin than there is being exposed to bitcoin because at least your downside is defined at zero, but your upside is completely undefined. It could be anything.

Lyn

Yeah, that’s how I view it. Ever since my view, in early 2020, of becoming more firmly bullish, it seems odd to me not to have, say, 1% in bitcoin because the market cap, right now, fluctuates between one and two hundred billion but gold’s market cap is like ten trillion based on estimates for how much gold (above ground gold) exists in the world and what its current price is. It’s roughly eight, nine, ten trillion. Bitcoin is still a small market cap. It’s still a very low investor allocation to bitcoin. Gold is like a large-cap store of value; bitcoin is a smaller cap speculative store of value. So, it’s not hard to see bitcoin eventually hitting a one trillion dollar market cap. I’m not saying it will, but I’m saying I wouldn’t be utterly shocked if one day it did.

So, putting, say, 1% allocation of a portfolio into bitcoin, it could go to zero, it could see its value get cut in half, it could diminish. I don’t think it would ever actually reach zero. But it could go down, significantly but you’ve wasted almost none of your capital, whereas you could have another one of these massive run-ups. Especially, we’ve had the recent halving so we have supply getting lower and lower. There are people that just never sell their coins. So, I’m pretty bullish over the next two or three years to see how this plays out.

Moritz

Let’s not forget that the government has made the possession of gold illegal before. So, if they make the possession of bitcoin and dealing in bitcoin illegal, maybe they’re doing the same for gold again, and that would have a much, much greater impact.

Lyn

That’s interesting because back in the 1030s when the U.S. made possession of gold most illegal, some people turned it in, but a lot of people just held it. So, it wasn’t a very enforceable policy. They didn’t go door to door with guns trying to get everyone’s gold. Anyone who had gold, a lot of them just kind of went underground and just kind of never mentioned it again.

So, with bitcoin, because it’s encrypted, it’s decentralized, a lot of that could just go underground and they don’t turn in their bitcoin. So, I do think that bitcoin is not unique in potentially being banned and it also has some resistances to being banned. So, I do think that banning it could affect its price negative, potentially. I don’t think it would make it go to zero especially because not every country is going to ban it because it’s mined worldwide, it’s traded worldwide so it’s got a lot of resilience.

Niels

I take your point about that, but I’m pretty sure that I read some articles last week about China actually confiscating people’s accounts that had bitcoin. So, OK we might not think that that is going to happen on our side of the world but it’s certainly happening elsewhere, it seems like.

The other thing is, I get the point about bitcoin and I see the attraction of it and the same with gold. What worries me a little bit is that there are so many people who agree that gold is going to fly, and bitcoin is going to fly. As long as gold hasn’t broken that $1,923 level, which was the high in 2011, I would say this could be just one big correction.

If I’m not mistaken about it, I’m sure you do this because you seem to be doing an incredible amount of detailed research, and I had this discussion with a client of mine yesterday about commodities in general. Should you have as a buy and hold type strategy? In our discussion, of course, he was thinking that it was better to have it as a trend following, long/short type of investment. If I’m not mistaken, you may know this better than I do, if I think about gold cycles (and it could be the same for other commodities), I wouldn’t be surprised if some of them are a little bit like the interest rate cycle – about 35 years. Actually, most of that time, so about 20 plus years of that time, is spent going down not going up.

So, if you time it perfectly, with any investment, you’re golden, so to speak. I think there’s a little bit of a misconception that these things go up, and up, and up over time. I think history shows us that they spend more time going down than they go up. Last time that we had this perfect commodity situation (and I know commodities, in general, have been going down for the last few years so I’m not comparing the time) but I certainly remember when Jim Rogers came out with all these long-only commodity indices, right at the peak, everybody poured in, but it’s just been a very hard investment to sit with for the last twenty years or whatever it is. But it’s interesting.

One thing that I just want to come back to (I know we’re jumping around a little bit) in terms of this massive amount of debt that we have in the world. What about debt Jubilees? Is that something that you’ve studied or have an opinion about? Is that the only way we can get out of this mess, so to speak?

Lyn

Sure, I guess to answer your earlier question, first, I do think a trend following approach works particularly well with commodities because they tend to have these more boom/bust cycles. So, anyone who bought gold in 1980, during that previous massive spike took a very long amount of time before they made their investment back again. I think there’s a case to be made that people can have a small allocation to precious metals at all times, but if they want to allocate an extra amount to it, like a more specific active position, I think you do have to take into account intermediate signals.

So, for example, gold has historically tended to trade very inversely correlated to real interest rates. So, a lot of those really bad periods for gold were because it reached very high valuations and then real interest rates went up, when Paul Volker raised interest rates and killed inflation, we had a very long period where treasuries and bank accounts provided you with a much higher return than inflation. So, that was the opportunity cost to owning something that is scarce but doesn’t provide a yield.

So, in that sort of high real yield environment generally precious metals and, to some extent, other commodities don’t do very well. Whereas, in an environment with low or negative real yields, which is currently what we’re in and what I think we’re going to be in for much of the 2020s, I do think gold is likely to do well. It’s certainly possible that we could have some resistance like when we start to bump into previous highs, that could be a big psychological thing to try to get through. So, I do think we could have pretty significant corrections along the way, but I do think that this is a very good fundamental environment for precious metals. I do think that a trend following approach can reduce risk of being on the wrong side a really major downtrend.

To your later question about debt Jubilees: historically debt Jubilees have been common in many places in the world. So, going back to Greece and the whole Mesopotamia, there are literally thousands of years of debt Jubilee history. In more modern times it has often taken the form of currency devaluation as opposed to outright debt Jubilee. So, we’ve had things like yield curve control or de-pegging a currency so it was backed by gold and it’s not anymore. For example, the dollar as gone from 1/20th of an ounce of gold to what it is today, almost 1,800. So, we’ve had a very significant devaluation of these currencies. So, it’s almost like we have a mini debt Jubilee every couple of decades with a big inflationary cycle.

So, I think debt Jubilees are something to look out for in this 2020s period, but I think a lot of them can take the form of currency devaluations. So, you basically do a soft debt Jubilee rather than a nominal one. So, if you look in the 1040s and the 1970s, anyone holding treasuries basically provided the U.S. government with a debt Jubilee because it didn’t default but it lost purchasing power. So, generally in the case of both the 1040s and the 1970s, anyone who bought treasuries at the beginning of the decade lost about 1/3 of their purchasing power by the end of the decade because those treasury yields underperformed inflation. Of course, it was bumpy along the way, especially in the 1070s. A ten year period of negative returns is very poor. Basically what they did was they provided the government with a partial debt Jubilee. The main thing to watch out for, from my view is currency devaluation. I wouldn’t totally rule out periods of outright debt forgiveness.

Niels

Sure. Rob, Moritz, obviously being mindful of Lyn’s time, one more round of questions. Rob, what’s your…?

Rob

Yes, I’d like to take the opportunity to ask something completely different. One of the things that I found most interesting, after 2008, over the last ten years, generally, is that we talk mostly about things that, I guess are on most people’s radar like inflation, bitcoin, even if we don’t know what’s going to happen, they’re on everyone’s radar. But a lot of stuff that came out of the last crisis was things that most people weren’t really aware of. It was stuff really buried deep within the financial plumbing if you like.

So, I think you mentioned the repo crisis as one example. Another example which I think you’ve written about is the dollar shortage. As a result, the central banks had to set up these dollar swap lines during the last crisis. Where do you see those things that are lurking today that people haven’t really thought about because they’re not on people’s radar, they’re not obvious, but could actually prove quite nasty and unpleasant?

Lyn

So, it’s always one of those things where we always get surprised. So, anything I’d list now there could be something totally else. I would not have guessed, for example, a pandemic in 2020. I had been writing about how, with high debt levels, we’re very exposed to some sort of shock would have been a global pandemic coming out of China, for example. So, that’s always that unexpected thing.

So I think if we look at how much enthusiasm there is for precious metals or bitcoin and stuff. A lot of that still tends to be pretty niche. So many pensions, big money portfolios, institutional portfolios, common investors with 60/40 portfolios, there’s not a lot of interest in that space. There’s not a lot of interest in precious metals or commodities or bitcoin. We have some of these early people saying and looking really long-term out and starting to highlight these things. We have people that are more concerned about the financial system wanting to buy these things. We have trend followers starting to get into things like gold. But we don’t have, for example, the Robinhood crowd flooding into gold stocks. I wouldn’t be surprised to see that happen years down the line after the earlier trend followers already got in, so they benefit from that.

We don’t, for example, have a lot of retail enthusiasm about precious metals, bitcoin, things like that. It’s more niche. So, my view is that some of the big shocks out there are basically around currency devaluation. So, I don’t think that a lot of people expect that treasuries might provide a significant negative real return over the next decade. I don’t think that’s on a lot of people’s radar even though it’s on the radar of some sophisticated investors and some niche investors. I don’t think that’s something that the average 60/40 portfolio or pension system is necessarily considering. Or, if they’re considering it they’re allocating a small percentage against that possibility rather than fleeing bonds, for example.

In addition, because we’ve had such weak expiration in commodities, particularly non-energy commodities, especially the metals, I do think there’s a significant risk of supply shortages in certain metals by the end of this decade. So, that could be copper; that could be some of the other ones. Even energy, you talked before about some of the tail risks if we see more military actions in the world. Those supply chains for oil can be disrupted. We saw that happen in Saudi Arabia where they were attacked and they lost energy output. So, I do think we could see a period where we have more commodity scarcity this decade. So I think there’s some of the tail risk to look out for is either certain commodity scarcity or how significantly we could have currency devaluations.

Moritz

Maybe not really a question but more of an observation on my part, but you just mentioned the pensions, and let’s see if we can agree on that. I think some of them probably would like to feel from the bonds but they cannot, they’re not allowed to do it. The asset-liability measurement frameworks don’t permit them to do it; regulatory boundaries don’t permit them to do it. And they’ve given out guarantees that they can no longer meet. Now they’re talking about levering up their bond exposures. I regularly get contacted by providers of savings and retirements products that tell me, “Hey, Moritz, here’s a thing, here’s a twenty, twenty-five-year product, you’ll get 90% of your money back and you’ll get a lifelong pension.” So, I say, “What are you going to do with my money?”

“Well, we’re going to put 80% of that stuff in bonds.”

“What type of bonds?”

“Well, you know, government bonds and investment-grade type of stuff (which essentially yields nothing or negative).”

I don’t want to have any of that type of stuff because if there is any type of inflation on a twenty whatever, twenty-five-year duration investment that stuff gets just slaughtered. Maybe in twenty years’ time, if an inflationary period is over us by then, it’s worth nothing. So, no, thanks but no thanks. I’m really not interested in being long bonds apart from my trend following portfolio which is long bonds for as long as it needs to be but it can change in an instant. But, for saying, “I’m happy, I want to be long in pension, and I’m going to be twenty, twenty-five year long bonds and I’m not going to touch it. I think that’s just ridiculously stupid.”

Lyn

I agree. I think there are a lot of pensions that have to own bonds and I think that… It’s built on models that have been based, over the past couple of decades, where we’ve been in this big disinflationary trend. We’ve had a forty-year global cycle in lower and lower yields so bonds have had a really great run. But now that bond yields are equal or less than inflation and debt loads are so high that they can’t really raise rates, I do think that there’s a pretty big risk to these institutions of having so much bond exposures. They’re kind of stuck between a rock and a hard place because, on one hand, they’re supposed to invest conservatively, which historically meant bonds, but on the other hand they’ve moved into equities. Especially in the U.S., they’ve put a lot into hedge funds and other private investments. As you pointed out, some of them are levering up now. So CALPERS is taking on leverage to try to meet their target which is… Taking on leverage because you feel like you have to is never a good, sound investment strategy. There are cases where a sophisticated strategy could use a certain amount of leverage appropriately, but levering up purely because you feel that you have to is a way to blow up your portfolio. So, we’re kind of seeing that at the pension level now.

So, I do think it’s a significant risk for any of these kinds of institutions that have obligations that they have to meet. A lot of them have 7% rate of return targets. So, I think we’re likely to see pension failures and/or government bailouts of some of these programs. But that can lead to further currency devaluation if you are basically printing money to bail out a pension.

Moritz

That’s right, I could step back and say, “Oh, you know what, it doesn’t matter, I’m just going to be long bonds because if something really bad happens it’s going to be bailed out by the government.” But if that happens, whatever it is that they’re bailing out it’s going to be worth less because they’ve bailed it out with so much debt and so much money that it’s not going to be having the same purchasing power. So, again, I’m not going to do it.

Lyn

That’s why I prefer to focus more on harder assets, this decade. I think that’s going to be a pretty good way to get defense against that sort of environment. Especially if you combine it with a trend following model where other kinds of approach to value it so that you know to get out of certain spikes or bubbles in those commodities.

Niels

You know, I don’t think it could have been a better ending to our conversation – you mentioning trend followers and us being trend followers by nature. With that, we thank you so much for spending time with us, today. We really do appreciate it as I’m sure all our listeners do. By the way, make sure you follow Lyn’s work on Twitter and on Lyn Alden.com. From Rob, Moritz, and me thanks so much for listening and we look forward to being back with you as we continue our Global Macro Miniseries. In the meantime be well.

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