Michael Kao - Global Macro Series - June 14th, 2023

[000:00:07] Michael

I’m calling this era an era where we’re in a geopolitical mosh pit. These different power centers, as you put it, whether they are the different central banks of the major economic zones or even the Central Bank of Oil, which we call OPEC Plus, these are all actors acting in their own interests first and foremost. It produces kind of an every-man-for-himself dynamic, which is why I call it this geopolitical mosh pit.

[00:00:38] Intro

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

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

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

[00:01:33] Niels

Welcome and welcome back to another edition of our Global Macro Series where today as usual, I’m joined by my co-host, Cem Karsan, as well as our very special guest, Michael Kao, to try and make sense of the ever-changing global economy. Welcome to the show, Michael, and thank you so much for joining Cem and I for what promises to be a lively and very insightful conversation as part of our Global Macro Series. How are you doing? How are things in sunny California today?

[00:01:57] Michael

Thanks for having me. You do realize that you just said “Gemini”, so you guys are like twins.

[00:02:02] Cem

We’re twins.

[00:02:04] Niels

We’ve grown together.

[00:02:04] Cem

If only you can see the video and see how much alike we look.

[00:02:10] Michael

No, that’s pretty cool. Thanks for having me. Cem, I feel like you and I know each other. We’ve participated in so many spaces together and I think we share many macro views that are simpatico, but yeah.

[00:02:24] Cem

Absolutely. Mutual respect. Very excited to have you on the show.

[00:02:27] Niels

Absolutely. Well, let’s just kick it off. I think just to kind of warm up our voices for this conversation, why don’t you start out, Michael, with just sharing a little bit of your current big-picture macro framework? Maybe also, if you don’t mind, maybe add how it’s changed perhaps in the last year or so given all the crazy stuff that’s happening right now.

[00:02:56] Michael

I’ve been looking at the oil space for a long time now, for about a decade. When I was still running my fund Akanthos during the 2015 to call it 2020 bear market in oil, we were heavily involved in the distressed sector, especially in distressed debt. When I officially retired from active hedge fund management in 2019, the only position I kept was SPV in a post-reorg equity from one of the energy restructurings that we participated in all the way back in the 2016 to 2018 period.

So even though I am now semi-retired and managing my own money, I focus on oil very much. I’m in constant contact with the management team that runs this private equity. We have a unique strategy because given the volatility that was experienced during that 2015 to 2020 cycle, and a lot of the terrible capital reallocation decisions that we saw in the public sector, when we restructured this company, we decided explicitly that we would run it as a full-harvest play and take the capital reallocation decision out of the equation.

So I guess my bet is a long-term bet. It’s designed to be a duration-shortening bet because as we produce our barrels, it eventually liquidates the inventory over time. It’ll take many, many years to fully harvest this asset. So I’ve been watching macro and oil for a long time. I’ll start by saying that in 2020, at the end of 2020, it became evident to me especially with the consequence of Biden’s election, he was very, very vociferously against the oil and gas industry. That was one factor.

The other factor obviously was coming out of COVID with the vaccinations. The market started tightening up, and I think in early ’21, you saw the first flip from contango to backwardation. I remember doing a study back then at all the different contango and backwardation flips over the last, I don’t know, 25, 30 years, and found that in something like 7 out of 11 times, it produced much, much higher future spot prices. So it was a very interesting signal.

The four times where it failed were exogenous circumstances, the most recent being what I call the Trump run pull of 2018. Everybody remembers how bloody Q4 of 2018 was where Trump had pulled us out of JCPOA, promised no waivers, and then got the Saudis to flood the market and then granted 11 waivers and the bottom fell out of the market. Around the same time, that was when I started- that’s when I found Twitter, so to speak, and I started tweeting about oil. I said I think we’re in store for a strong bull market in oil.

So that obviously started panning out throughout 2021, 2022. But I’m not a permabull or a permabear. I think you have to adapt your at least shorter-term trading views as things change. One of the things that I worried about, especially with the war premium being injected into oil right after the Russian invasion, I was thinking, boy, this run-up into the hundreds is a bit premature. I think this is worrisome because there’s always a negative feedback loop dynamic.

At the end of ’21, I started making the link between oil inflation and what it would do to the Fed. It’s almost hard to envisage this now, but at the time, if you remember, we were still in a world of ZIRP. It was very out of consensus to say that, hey, you know what, the Fed is going to get very hawkish and cause a huge sell-off in risk assets and cause the dollar to be strong. But that was a big contrarian call I made at the end of 2021. In 2022, you saw the dollar ramp very strongly. The Fed started its hiking cycle.

Probably around like middle of 2022, it was a little bit early, but I said I think oil is going to have some trouble with these negative feedback loop dynamics. A strong dollar, especially with a dollar-based commodity is not going to be good for oil. So you bring that all the way forward to now at the end of 2022 also, I was thinking China. I started thinking about China a lot and how vulnerable China’s debt situation is. When you look at the PBOC balance sheet, I think it’s a complete facade, because China to me is Enron writ large.

They have financed themselves completely through an investment-led, centrally planned investment-led economic approach which is all financed by all these state-owned enterprises, these One Belt One Road projects, these LGFBs, and it’s all off balance sheet. But they have a huge, huge debt problem. I thought, well, if it weren’t for capital controls, I think the yuan would be at risk of a major devaluation in and of itself. But I started thinking about the interplay between oil and the yuan.

I think where we’re at today is that in the short-term, I see oil and the Chinese yuan in kind of a dangerous short-term doom loop, almost like a vicious cycle. Because in March of this year, I wrote a piece at the height of the regional banking crisis, and I said, look, I ultimately think the regional banking crisis is a provincial worry. I think the global elephant in the room, the global black swan I worry about is a major deflationary bust caused by China.

If you think about the PBOC’s quandary, I love to use the Homer’s Odysseus myth of Odysseus trying to cross that strait between the Scylla and the Charybdis. I say, look, if Odysseus is the PBOC, to the right of him is the Scylla monster. The Scylla monster is a weak yuan. A weak yuan would mean that they could potentially import commodity-based inflation since China imports 90% of its oil, which is dollar-based. But it also potentially sets off their debt bomb because it’s kind of opaque just how much dollar-denominated debt they have.

A lot of people say that it’s all local currency based. I know though that at least all of the One Belt One Road debt is dollar-based. So I think they have the potential. In that blog post that I wrote, I called it a ball in a China shop, meaning the US dollar wrecking ball. There’s this guy, Andrew Hunt out of the UK, who did this interesting bottom-up study of I think like 36 of the largest banks. He said that basically, the discrepancies that he and his team found versus the publicly available balance of payments data show a discrepancy of $4 trillion. So that’s a scary thing to me in and of itself.

But back to the Scylla versus Charybdis. So the Scylla monster is the weak yuan. The Charybdis monster is the strong yuan. A strong yuan is bad for China, because as we all know, their entire economy is export-driven, and export-driven to the west, to the Western consumer. What’s happening to the Western consumer? Well, so far, they’re held up, they’ve held up. But as we all know, we’re in a competition with the world central banks to see who can out-hawk each other, so that’s not going to hold. That’s my opinion.

I think we are in a higher for longer regime. So as the Western consumer starts to really buckle, I think China will have serious pressure to devalue their yuan. The reason why I think they are now going to be okay steering the ship closer to that Scylla monster with a weaker yuan is because back to oil. Oil has collapsed despite two OPEC cuts, which I’ve written about. I’ve written that I think they are premature because OPEC cuts are themselves restrictive and they’re basically fighting the Fed.

So we’re going into a third OPEC meeting right now and I think OPEC, in a way, is stuck because they’ve reset these expectations where people expect a cut. But we all know that Russia has been free riding because they need oil revenues to fund their war machine. What I am concerned about, the black swan in oil, is that there could be a rift between Saudi Arabia and Russia. We all saw what happened in COVID when Russia… Before OPEC became OPEC Plus, Saudi Arabia and Russia got into a pissing match over market share and absolutely destroyed the oil market. That’s when WTI went to negative $38 a barrel.

So that’s a black swan that is out there that worries me in the short term. But again, this is why the PBO- it emboldens the PBOC to weaken the yuan without worrying about importing commodity-based inflation. They’ve also restocked their SPR at our expense essentially. We’ve gutted our SPR, they’ve filled their SPR. So anyways, I’ll pause there for questions. That was a lot of stuff.

[00:14:09] Niels

There’s a lot of stuff in there. Luckily, you pivoted to China. I think we’re going to come to a lot of the other things. China was also very high on mine, and I know Cem wants to also dive into oil, so lots of things to go into. Just a couple of comments.

What’s confusing for me with China, and I’m certainly not an expert in this, but I am listening to I think a lot of smart people and I think there is definitely some divergent opinions about these things. First of all, you often hear well, the China reopening, it’s going to be great for the global recovery.

So far, I haven’t really seen anything that suggests that it is. But then on the other hand, when you look at their imports of energy, their products based on that data, they seem to be actually at all-time highs now again, both in March and April, according to the people that I listen to. So that’s also a little bit confusing. But I do agree. I’ve certainly heard from other sides as well this thing about the debt.

Actually, Bloomberg is out today with a podcast where I just caught the first 10 minutes, and apparently, there’s this province or city called Hegang, which is a remote coal town in the northern part of China and they have faced a mountain of debt and have been forced to undergo a very severe financial restructuring. So I do think you’re absolutely spot on that there are some issues there. Andrew Hunt from I think it’s Longview Economics or something like that in the UK, I did pay attention to his stuff as well with China, who knows, but he seems to have done a lot of digging into those numbers.

So interestingly enough, Michael, we have had many guests on the show, but not a lot of them really put China as high on the list as you do, but I think it’s worth paying attention to. Then I heard another one of our guests today from last year, Peter Zeihan. He came out today, and for the first time, he was saying, actually, it’s probably a coin toss between China invading Taiwan or not. That’s the first time I’ve heard him say that.

I think he’s always been on the side of they don’t really want to do it. But now he’s saying there’s so much bad information going on in the CCP and around Xi that actually, it could happen. So interesting.

[00:16:39] Michael

Okay, yeah. So a couple of interesting threads to pull on. I actually am a fan of Peter Zeihan’s books. I’ve read a bunch of his books, and I think for like long-term geopolitical predictions, he’s been pretty prescient. Actually, on May 11, I chaired this private event with Peter as the keynote and just listened to his updated news and found that it was very interesting, because we also followed it up with a panel afterwards with a bunch of Indo-Pacific experts. So there was some interesting back and forth about that.

But I think to paraphrase Peter, I think China has got a serious demographic issue, as we all know. I think Peter thinks that China is very, very, woefully unprepared to start a big kinetic escalation across the street. But one of the things that I brought up in this panel and also, I tweeted it out, is that one of the biggest geopolitical risks for the US and the West, I think, is actually a bloodless coup scenario, a peaceful reunification. let’s think about it. Why would that happen?

Because two years ago, I had a conversation with a friend of the family. In Chinese culture, a friend of the family is called an uncle. Everybody’s an auntie or an uncle. So I’ll label him my uncle. He, like my parents, fled to Taiwan from China originally in that 1949 revolution with the KMT. Growing up, I always heard about the enmity between the KMT and the CCP, because CCP obviously took over.

So imagine my surprise when my air quote “uncle”, I asked him, “Do you think that China would invade Taiwan?” This is two years ago. He said, “Oh, we would just welcome them with open arms.” I’m like, “Wait, what? You were in the KMT, served in the KMT. You would welcome reunification with the CCP?” He said, “Well, the opposing party, the one that’s in power, the DPP, basically wants to distance themselves from our Chinese heritage, our ethnically Chinese heritage, and we don’t like that. We are ultimately Chinese by heritage and we’d rather reunify with Taiwan.” I’m like, “Wow, that’s crazy.”

I’ve also heard in recent weeks that the officer core of the Taiwanese military is primarily KMT. So to me, this is a gray rhino risk. A gray Rhino risk is a risk that it’s out there, but it’s just poo-pooed, it’s discounted by everybody. I think politically, if something like that happened, it would be very, very hard for the US to intervene because the world will say, hey, they want to get together peacefully. But I think geostrategically, it would be disastrous for the US and the West if that were allowed to happen.

TSMC alone is a very, very dangerous choke point, as we all know, in the semiconductor supply chain. But then Taiwan’s position in the first island chain represents a crucial way for China to break out and project power outside of that. So I think the implications on instability in the region for all the countries in the area like Japan, South Korea, Vietnam, the Philippines, it would be a big disaster.

[00:20:39] Cem

We’ve actually interviewed Peter Zeihan before, and I’ve read one of his books as well. Obviously, China is structurally weak from both a geography perspective, commodity perspective, and demographic perspective. These are kind of the major points. I think it’s an incontrovertible reality that if they are going to lose, as projections say, about 500 million in population in the next 25 years just based on the one-child policy and demographic shifts, especially without any major immigration, which they don’t have, they have an input problem.

It’s one of their few sources of strength and has been for some time, that labor force. I think that’s what makes the semiconductor issue so important. It’s a labor replacement. As we see with AI and the move towards things, you have to move up that technology chain, kind of like Japan did to some extent, if you want to compete in all these ways, particularly if you have a demographic issue like you had. So I don’t think they have a choice. Never mind all the cultural aspects that you mentioned, never mind the first island chain issue and the geographic issues that they have.

They are at a structural… Maybe, to your point, there may be a reconciliation that happens. Maybe it may happen another way. But what I don’t think they’re willing to do is let Taiwan move away. It’s too much of a risk for them given how fragile their position is as it stands. I think they’re very aware of that. That’s my personal view. So I think, to Peter Zeihan’s point, I think it’s a very high likelihood that if, unless you’re right and that it’s a peaceful reunification, which, again, you would know better than I do, but based on what I know, I’m somewhat skeptical. I think at some point, this does become kinetic. But that’s my personal view.

[00:22:45] Michael

Yeah. I think the way Peter hedged himself, of course, he brought up all of those issues, the demographic one being one of them. But I would note that I think Peter also incorrectly predicted that because of the same reasons and same rational thinking that Putin wouldn’t necessarily invade now, but in fact, the logic actually was exactly opposite. Because if he sees the writing, you could also say that if he sees the writing on the wall from a demography perspective, then he also realized that this is as good as it gets, it’s now or never. That’s what kind of worries me.

The other point that Peter brought up is that Xi, like Putin, has isolated himself and essentially done this huge purge and essentially cut him off from a good feedback loop of information. So who knows what goes on in the mind of a dictator that has cut himself off from a good feedback loop of information? It is scary. I don’t know. Essentially, back to the currency, back to the yuan, the reason why I think that’s a pretty interesting bet even it’s run up a little bit or run down a little bit is that, to me, it represents an option. There’s a negative correlation with oil.

As dollar-yuan goes up, I think oil goes down. There’s this geopolitical option in the event of any sort of escalation across the Taiwan Strait, and then there’s just a natural gravity of an over-levered national balance sheet. So that was my chicken way of hedging my long-term oil exposure.

[00:24:50] Cem

So, which is a natural transition to energy. Again, you’ve been playing in that sandbox for quite some time. Niels and I have talked to quite a few energy specialists in the last call it six months, nine months, a year. Obviously, there’s the supply issues. There’s a lack of supply for lots of reasons, which again, I know you’re very familiar with. The big question has been demand. The big question is, you have a very inelastic supply curve which is very favorable for if you can get demand, what will happen to price?

But the big question is, are we going to get that demand? What are your views on that, both short-term, medium-term, long-term? How do you think this plays out more from just a supply and demand perspective, not as it relates necessarily to China? Again, take it how you will.

[00:25:55] Michael

I’m glad you brought up the issue of supply elasticity, because last year, last summer, I wrote a thread about forward curves and holy grails or the lack thereof, I think that’s what I called it. I basically said that, at that time, all the markets were in pretty steep backwardation. But I basically said, beware of the sword of inelastic supply. That sword cuts both ways.

When you have an inelastic supply curve, which is a much more vertically-sloped supply curve, meeting an unexpected downward demand shift, that results in a very, very steep decline. That’s exactly what you saw, by the way, in 2007, 2008. You had $140 oil, a very backwardated market, and then all of a sudden, GFC hit and you had this downward demand shift. There’s no leading indicator for that type of demand shock really, and that’s what gets a lot of people in trouble.

At the start of our talk today, I was saying how in 2021, one of the reasons why I was confident that oil was going to have a bull run was the significance of that first shift from contango to backwardation because that signifies the first time that the market is willing to pay you a convenience for a spot over forward contracts. So that’s a sign that the regime of supply and demand is shifting. But there’s no equivalent signal the other way around.

Once you’re in backwardation, usually what happens is that something bad happens in the world like a credit crunch inspired by a very hawkish Fed. That looks like what’s happening, right? So I think the danger is that the barrel counters are still looking at, oh, the market is so tight, and blah, blah, blah, blah, blah. But demand is notoriously hard to forecast and based on all of the other macro indicators, this is where I think it’s very important to not just pigeonhole yourself into barrel counting and looking at oil data, because the central banks of the world are hell-bent on destroying aggregate demand for everything, not just oil, just for everything. They have a very blunt tool.

Pro-cyclical commodities are typically very, very vulnerable in a recessionary environment, oil included. Going back to the elasticity thing, the reason why I think that the two OPEC cuts, one in October of last year and one in April of this year, were premature is that by doing those cuts, those two cuts together I think total about probably about 2 million barrels per day of additional spare capacity. I was already in the camp, unlike a lot of the permabulls who basically said oh, we’re already out of spare capacity. I’m like no, that’s bullshit.

If we were out of spare capacity, oil would have hit 300 a barrel earlier at the start last year, not 140 or whatever. So whatever that spare capacity number was before the cuts, it’s now at least 2 million barrels more. The forward supply curve, not to be confused with the forward curve itself, but the forward supply curve for oil has effectively become much more elastic. So my concern with that is that when we eventually emerge out of the recession that hasn’t even hit yet, I think it probably precludes the flyaway oil scenario that many people are hoping.

I myself, I’ve had this view that sometime this decade, we will have a molecule shortage just due to all the factors that everybody knows about, long-term CapEx starvation, all these things. I call a that the supply demand singularity point where essentially, demand exceeds all available spare capacity and you have this potential flyaway scenario where OPEC loses control and oil could go to like 300 a barrel.

The problem though is that now, I think between the central bank’s actions and also, I think, frankly, OPEC prematurely trading all this supply elasticity while still, I guess, keeping shale afloat, allowing shale the continued incentive to keep spending on CapEx, I think that pushes that supply-demand singularity out a couple of years and it also shortens the viable quarter under which that scenario might happen.

[00:31:19] Cem

I’ve been thinking a bit about this. This is kind of a step back from 30,000 feet, but we’ve been in a 40-year period of complete Fed monetary dominance. The Fed put has been omnipresent, which has driven interest rates top left to bottom right. The Fed could do that because they had two mandates. At the end of the day, they had the benefit of having both go their direction. They pumped that money in and created a massively deflationary system via globalization and technological development by sending money to capital.

The problem with that is that it created inequality and now we have populism. That’s the quick summary. But if we have secular inflation coming back, which I believe we do, which is driven by people and populism and deglobalization, and all these things, the important takeaway of that for me is the diminishing strength of the Fed put, and the fact that the Fed, essentially, they’re losing some level of control of what’s otherwise been a very controlled system.

What that does is it takes something from what’s been essentially two dimensions like a cyclical model and increases dramatically the dimensionality of a system. It is a much less controlled system. In a situation where you no longer have a bully in the room that’s fully in control of everything, now you have a bunch of other power centers.

Those power centers, they can be commodities, somebody who owns some fundamental thing of value, it can be military power. There’s still currency power. But any true fundamental source of value or power becomes more valuable. Whereas some of these things really paled underneath what was Fed dominance. So, I take that thread and I pull it over to oil in particular. It’s not a coincidence in my mind that the last time we had inflation, we had a major OPEC crisis. Why? Because they had more power during that time, because the US monetary system was not in control.

So I believe, based on this broad theory that higher interest rates, which I believe are structurally increasing, will lead to not just more leptokurtic crazy things happening across parts of the market, but ironically, in true sources of power like commodities, actually, less volatility in some ways than the downside, more maybe upside, but more at a oil put, for example.

I think OPEC will be much more activist. I think they will be much more willing to underpin and flex their muscles more in this environment. So what do you think of that? I’d love to hear your thoughts.

[00:34:23] Michael

I love that. There are so many strings to pull on here. First of all, I’ll say that your way of thinking about the world, in terms of just the loss of control by the Fed, I think back to if you look or envisage a long-term chart of core PCE from the early ’90s until now, what you see is exactly what you said. You’ve got this tight quarter of call it between zero and 2% core PCE throughout this entire multi-decade period until recently where it shot up to 5%. Now, what that tells me is this regarding the Fed put.

The Fed put was there every step of the way through the tequila crisis of 1994, the Asian contagion of 1998, the dot-com bust of 2000, the GFC of 2008, COVID of 2020. Every single time, the Fed put was there and was able to flood the market with liquidity at the first sign of an economic downturn, but that was because of how well-behaved that core PCE is. Now that core PCE sticky, and I agree with you, it’s sticky for structural reasons.

I would even say that I think oil inflation, if you look at the components of CPI, what’s very interesting is that initially, it was oil inflation that kicked it off. It was the energy component that was dominant. But even as the negative feedback loops of high oil prices kicked in and the energy inflation piece came back down, it had already ignited expectations in the shelter and labor components and those components are now also I think underpinned by structural demographic factors. This is a very, very different regime than in the past.

You put it so much more eloquently than I did, but I’m calling this era an era where we’re in a sort of geopolitical mosh pit. These different power centers, as you put it, whether they are the different central banks of the major economic zones or even the Central Bank of Oil, which we call OPEC Plus, these are all actors acting in their own interests, first and foremost. It produces an every-man-for-himself dynamic, which is why I call it this geopolitical mosh pit. I agree with you.

The other thing about oil specifically, is that we have now, in my latest piece that I wrote about this, about the deep dive on oil, I talk about these different oil regimes that we found ourselves in. During that 2015 to 2019 regime, that was a very rare period where the US was clearly the swing producer and OPEC really had no ability to influence prices.

I would say that we’re not quite in a regime where OPEC is the full swing producer yet because shale is still out there and shale is still growing, albeit at a slower pace. But we’re clearly moving towards a regime where OPEC is now the swing producer. The flip side of the argument, I have this debate with the management team of my oil company all the time, I think OPEC moves have been premature and a mistake.

They have a different view. They would say that the OPEC cuts are symptomatic of an OPEC that is much more confident in being able to control supply without fear of undisciplined shale. So that kind of goes to your point, Cem, about how in this new regime, OPEC Plus is now a much bigger power center than it was, at least during that last regime of US as swing producer.

[00:38:41] Niels

Can I just add to that, because I’m listening to both of you and I think this point about being in control is incredibly important. It leads me to something I want to talk about as well later, which is about trust in these authorities. But I’m thinking we’ve kind of seen, as Michael pointed out, or maybe it was you, Cem, that the Fed has lost control. But to some extent, OPEC lost control as well. I’m thinking these cuts, which are in size not that different from what the US has released from the SPR, that these cuts are actually their way of trying to gain control of what’s going on.

So in a sense, we have both these institutions slightly out of control, trying to get back in control because they both are in charge of two very important parts of the economy, either the oil price or the rates of the US. So I don’t know. Maybe there’s a bit of an overlap in what’s going on. If they both are slightly out of control, obviously that paints an uncertain picture, for sure.

[00:39:52] Michael

The very complicated dynamic that we find ourselves in is that most of OPEC’s history, the Plus wasn’t in OPEC Plus. It’s only after this incredibly mutually destructive market share war, post-COVID, that finally, MBS and Putin decided to make amends and say, hey, we’re going to band together. My point is that that period of solidarity between core OPEC and Russia has been a brief one and it’s been a bit of an experiment.

I worry, though, that because Russia has to rely on oil to fund its war machine and they’ve already been free riding, that there’s a black swan risk now of fracture within OPEC Plus itself. So it will be very, very interesting. It’s also very, very interesting that yesterday, Javier Blas said that he, along with a whole bunch of reporters, for the first time in his, I don’t know, 27 years of covering OPEC, they’ve been banned from this meeting.

So I’m like, what are they trying to hide here? I suspect it’s that there’s probably some rift going on and they don’t want to air their dirty laundry in front of the press.

[00:41:23] Cem

Yeah, it’s very interesting. I think you guys both bring up an important point. In the 1970s, the US was not the oil producer it is now, and that’s a dramatic difference in the power center. The US has more structural power as a function of that in that relationship and that could mean that the level of control in that system on the oil side is less secure than it was in the ’70s.

[00:41:54] Niels

Now, it brings me to the point I mentioned before. I think we’ve witnessed one or two decades in terms of irresponsible policies from many fronts. My big worry today is that one day, we’re going to wake up and we’re going to realize that the markets and investors have stopped trusting the people in power. First of all, I wanted to find out whether you think this is a real risk.

Also, I wonder if there is any set of data, Michael, or it could be even, dare I say, policymaker that you trust more than others, kind of like the old Bundesbank days where actually, you could be pretty sure that they weren’t trying to score any brownie points when making policy. But is there anyone out there that we can still trust or is it just a matter of time when people wake up and say, this is just a step too far and then the markets literally will go crazy?

[00:42:56] Michael

You know what? For me, the way I think about the world, I always used to tell my analysts, I would much rather be generally accurate than precisely wrong. What I always worry about is getting lost in the weeds and looking at a specific set of data without considering a broader framework. I think that is more important than ever.

I think frankly, in the world of oil, a lot of folks I think get lost in the minutia and barrel count and look at balances and things like that without necessarily considering the world outside of the oil vacuum. I remember very clearly having this discussion, probably I think it was on Twitter, with people about… This was when oil prices were substantially higher than they are now. People were arguing that look, the physical market is super tight, backwardation is super strong, there’s no sign of demand weakness.

But my point is, look, as an analyst and investor, you’re trying to anticipate where the puck is going, not where the puck has been. You have to consider that, again, going back to this idea that the inelastic supply cuts go both ways, I think that framework is a powerful one because demand, a downward demand shift for oil can come not just from high oil prices, it can come from high prices for other things.

When we talk about inflation and the perniciousness of inflation being the most regressive tax of all, and the fact that we have sticky components in inflation that are unrelated to oil and barrel counters of oil might just completely dismiss, well, that’s where you miss the forest from the trees. Because that same beleaguered investor has to make life choices between okay, now that I am barely able to afford cost of living, do I carpool with a friend?

There are all these things that are hard to quantify, and if you get lost in the weeds without considering the bigger picture, I think that’s where you can get completely shafted in this environment.

[00:45:29] Niels

There’s so many places we can go with Michael. I’m thinking concerned about maybe the shadow banking system, refinancing risk. Is that something that’s on your radar as well?

[00:45:41] Michael

I really think that the world is focusing on yesteryear’s war because there’s a crunch for the regional banks, and unfortunately, that’s leading to larger and larger money-centered banking power, but this is very, very different from GFC. There is no systemic banking crisis. I’m much more concerned about some hidden iceberg in the shadow banking sector, which I define very broadly as essentially any financial intermediary that’s generally in the business of lending long and borrowing short.

That would include hedge fund guys like ourselves, or ex-hedge fund guys like me, and also, gosh, even endowments and private equity funds, etc. It’s just that the nature… Every financial crisis has its roots ultimately in asset-liability mismatch. I think that the reason why it’s very easy to focus on banking as the epicenter of every crisis is that demand deposits can leave on a whim. But the thing is, in the shadow banking sector, even asset-liability mismatches can still happen, albeit on a different timescale.

I have experienced it in 2006 when Amaranth blew up, if you guys remember that hedge fund. It had crazy repercussions on my business. This is how it had because one of my largest anchor investors was a giant, like a $5 billion fund of funds that was invested in Amaranth and they wound up getting a rash of redemptions in 2007. They had been promising 30-day liquidity to their investors but they were invested in quarterly and annual liquidity managers like me.

So they had a run on the bank at the fund of funds level which prompted them to shut their entire hedge fund, their entire fund of funds and redeem from every investor. This was a very, very big LP for me and it put me in a very, very difficult spot going right into 2008. So, yeah, I’ve lived through that. I’m frankly surprised that we haven’t seen another Bill Hwang level implosion. I’m still wondering where that might be.

On the flip side, though, I will say that some of the bets in my idiosyncratic book right now are long bets going the other way where I think there are certain companies that have been brought down in a big way based upon regional banking fears but they themselves don’t have the forcing functions that banking models do. So I’ve actually taken some contrarian long positions in certain parts of shadow banking, where for these idiosyncratic companies, I don’t believe there is a forcing function that creates an insolvency risk.

[00:48:54] Cem

Yeah, that’s really interesting, Michael. I don’t think the regional banking crisis is over, by the way. I think it’s dormant, because to your point, there’s a structural problem. There always is in banks, to be clear, but I think it’s been dramatically exacerbated in this environment because of two newer things. One, just technology. The ability and speed with which people can withdraw money and are willing to is not what we’ve seen before.

We talk about, oh, those guys at Silicon Valley Bank are idiots, they’re mismatching their short-term assets with their long-term liabilities. But how do you match a five-second asset to any liability? I don’t care if you’re in one-month T bills, you’ve got a problem, especially given the amount of leverage that banks have just structurally in the system. That’s a problem at its core.

Add to that now derivatives and options and the amount of speculation now that’s happening in very illiquid parts of the market and the amount of leverage that’s structurally embedded in that and the fact that there’s a feedback loop that if you can speculate with leverage against these entities, that people are going to pull their money out very quickly. That whole thing is just a Bitches Brew. It’s a structural system where all it takes is a bit of speculation the wrong way when illiquidity is bad, and the whole thing just blows up, and that’s still there, that hasn’t changed.

So until we have a broad writ large, like all deposits are secure, it’s going to take that. We haven’t had a liquidation. The center has held. When I say the center, it’s really the index vol and all the compression of vol. The center of the system is holding things firm. But if and when that breaks, which it invariably will, I think that tail is a major problem that we have not really addressed yet.

The weakness is very clear to any speculator. The cat’s out of the bag. So I think we’re going to see a much worse version of that. Again, I don’t think it’s structural to the way the money center banks were during GFC. We’ve dealt with that part, but it can definitely cause some major liquidation issues.

[00:51:34] Michael

Yeah. The money centers ultimately are the bastions of strength in the system. But yeah, I could see more regional banking stress. But I do think that that’s very, very different than the concoction that we saw in GFC where there was truly a systemic issue where even money centers were potentially at risk.

[00:51:59] Niels

In a world full of uncertainty, that doesn’t seem to become any more certain at the moment, at least. Playing on the theme of this thing about trust, maybe my last question for both of you really would be, is it time for us to reimagine what are safe assets? If so, what do you think? Of course, I would always say trend following but there we are. What are your thoughts in terms of safe assets?

Because I think actually, a lot of investors struggle today in terms of, where do I keep my assets safe without taking silly risks that I’ve been forced to do during the ZIRP period? So what are your thoughts? Cem, I’d love to start with you, actually. What are your thoughts on that?

[00:52:53] Cem

You mentioned trend following. Guess where I’m going to go?

[00:52:56] Niels

I can’t imagine where you want to go.

[00:52:59] Cem

I structurally believe in this environment, that we are in an incredibly leveraged environment due to all the malinvestment and everything that comes with ZIRP and the 40 years of liquidity being pushed into the system. This is not a new concept. This is how these things go. We’ve been on an extended cycle in terms of liquidity being pushed in the system because of the Fed’s involvement.

I believe that means we have historic leverage and risk in the system. That’s not just equities, that’s across the board in all kinds of different areas of the market, private equity, venture capital, real estate. The reality is things can hold together for a very long time. But what’s happening is we’re hollowing out that sandpile from underneath. What you see first is the regional banking crisis is a symptom of what is increasing fragility due to less liquidity and less Fed control and less systemic control. So, higher interest rates, less liquidity means higher risk premia, but that’s always true.

It’s particularly a leptokurtic fat tail distribution across the market, in my view, structurally, because of the amount of leverage that’s paired with that now decreasing liquidity, and that is a very, very dangerous situation. A fat tail environment doesn’t mean we’re going to crash tomorrow. It doesn’t mean that markets go down tomorrow or next week or next month or next year even.

What it means it’s a much more fragile system. When things do break, they tend to break big. I think we’re just in a much more multi-dimensional system with much more tail exposure.

[00:54:38] Michael

Owning tails has been expensive. I know that because I’ve given how many tear-ups of options that I’ve had throughout the last year?

[00:54:51] Cem

Yeah, absolutely. So the answer there, you have to be smart about it. Owning the tail doesn’t mean you just go own puts. There are ways to own the tail and be structured in a much more efficient way, one. Two, and I think this is important, you have to be aware of when and how to be aggressive in that place. It is expensive to your point. So this concept of dealer positioning, which I talk so much about, is very much critical because things tend to not break when the supply is there.

It’s when the positioning weakens amidst a bigger structural liquidity issue, that’s when you really have to be more aggressive. So understanding of market microstructure positioning needs to be paired with the bigger macro reality and the macro liquid flows. I think if you use those two tools, there’s both this relative value, understand the distribution, what part of the distribution is overvalued, relatively paired with kind of a better broader understanding of when positioning is particularly weak in terms of timing and how to be aggressive at those moments, I think you can really structure.

Again, that focus doesn’t mean you just blindly go do it without market intelligence. But I do think that should be the focus is trying to find those tails in ways that you can, in an asymmetric way when the opportunities present themselves in timing in a relative way.

[00:56:21] Michael

Well, for me, because I’m a private investor now and I’m not actively managing other people’s money anymore, I have a big degree of freedom that perhaps you gentlemen don’t have, which is I can just park a lot of my liquidity in basically treasuries and just wait. So honestly, over the last year or so, probably as I get my distributions from my private equity, I’ve been essentially recycling them into treasuries, just kind of waiting for the fat pitch.

For my trading accounts, to your point, Cem, I’m not going to comment on the idiosyncratic names, but I’ll say that generally, my strategy has been that I like to own tails. I’ve wasted a lot of premium on the tails, but I view them as hedges and I’ve paid for those hedges by selling optionality in certain idiosyncratic names where I have high confidence that I’m being overpaid for that risk. That’s generally actually worked out pretty well. It’s my way of having the tail protection without really paying for it because I’m basically getting that premium back in other ways.

When I ran a convertible arb cap stocks or strategy, it was a very, very similar type of mentality. I wanted to get paid to wait for the optionality. It’s harder than it sounds, obviously, because generally, you need to pay for insurance. But I do think you can find ways of paying for that insurance without just constantly bleeding theta.

[00:58:11] Niels

Well, I certainly know one place where that can happen. As we talked about before we pressed record, Michael, you could have been one of my colleagues in the CTA industry when you were very young, so people won’t know what that means, but that is a fun fact.

Anyways, I think this is a great time to wrap up our conversation for today. No doubt, we will be waiting for another opportunity to do this. This really has been an awesome conversation, Michael, and we really appreciate your time.

[00:58:45] Michael

Thank you.

[00:58:45] Niels

Yeah, you’re welcome. Make sure you go and follow Michael’s work as well as his engaging Twitter feed. You can of course find all the links in the show notes today for today’s episode. As you can tell from our conversation, we are living in a truly global macro-driven world and perhaps it is more important than ever before to stay well-informed.

From Cem and me, thanks ever so much for listening. We look forward to being back with you as we continue our Global Macro Series. In the meantime, as usual, take care of yourself and take care of each other.

[00:59:17] Ending

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

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