Peter Berezin - Global Macro Series - August 16th, 2023

[00:00:07] Peter

My sense about what we’re seeing with the regional banks now is a bit more akin to what we saw during the S&L crisis. In other words, you have all these problems but they’re not bad enough to induce a recession quickly. You just need to wait for things to escalate to a point where the economy is so weak that it falls into a recession. Again, that’s sort of a statement suggesting the recession will come, but it could come later rather than earlier.

[00:00:35] Intro

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

[00:01:31] Niels

Welcome and welcome back to another conversation in our series of episodes that focuses on markets and investing from a global macro perspective. This is the series that I not only find incredibly interesting, as well as intellectually challenging, but also very important given where we are in the global economy and the geopolitical cycle. We want to dig deep into the minds of some of the most prominent experts to help us better understand what this new global macro-driven world may look like. We want to explore their perspectives on a host of game-changing issues, and hopefully dig out nuances in their work through meaningful conversations. Please enjoy today’s episode hosted by Alan Dunne.

[00:02:15] Alan

Thanks for the introduction, Niels. Today, I’m delighted to be joined by Peter Berezin of Bank Credit Analyst. Peter is currently BCA Research’s Chief Global Strategist and Research Director. Since joining BCA Research in 2010, he has served as the Managing Editor of the Bank Credit Analyst. Prior to joining BCA research, Peter worked as a senior global economist with Goldman Sachs, and prior to that, he spent time in the research department of the International Monetary Fund. Peter, great to see you. How are you doing?

[00:02:43] Peter

I’m doing well. Thank you.

[00:02:46] Alan

Well, I gave you a bit of an intro there about your background, but it’d be great to hear from your own perspective how you got interested in the markets and investing and you ended up working at BCA Research.

[00:02:57] Peter

Yeah. I’ve always been fascinated by economics. I did my undergraduate and my graduate degrees in economics. When I finished school, I had the opportunity to work at the International Monetary Fund. I did that for seven years, had a great experience, worked in the Asia department, got involved in program negotiations with different countries, worked in the research department on the World Economic Outlook, the IMF’s flagship publication.

During that time, I was also very interested in the markets. I did a lot of trading just on my own accounts, even wrote a blog about my trading experience. I think people can still find it online. Just google stockcoach@blogspot.com. It’s still there. I haven’t updated it in many, many years. But I was really fascinated by financial markets and then an opportunity came up to go to New York, work at Goldman. I did that for three years, really enjoyed it as well.

But I’ve always wanted just to have a lot of intellectual freedom, and when the opportunity to work at BCA came up, I took it because BCA is the world’s biggest independent macro research shop and I had the privilege, initially, of working on the Bank Credit Analyst, which is BCA’s flagship publication, and it was a wonderful, wonderful experience.

[00:04:32] Alan

Pretty good. BCA has a long history in the markets. Can you tell us a little bit about how long the business has been in existence and your investment and research approach?

[00:04:45] Peter

Well, we’ve been around since 1949. It began just as a very small one-man research shop publishing a newsletter and then over the years grew into a company that covered every asset class, every region, every time horizon, providing tactical views in the markets, structural long-term thematic views. What we’re really trying to do at BCA is not just talk about economics but talk about economics in a way that’s relevant for investors. So all of our reports always have some investment conclusions. Great. Now that we’ve discussed what the economy is going to do, tell me how to make money off that, and we try to do that for our clients.

[00:05:35] Alan

Very good. I know you’ve had an upbeat assessment of the economy relative to maybe the consensus and have been upbeat on the equity market, which has been the right view. I think I read a recent report where you summarized the view as this time is longer as opposed to this time is different. So maybe give us a sense on the current sense of the US economy.

[00:06:02] Peter

Economists talk about long and variable lags, but sometimes investors forget just how long those lags can be. The Fed only started raising rates last year, they’re not even finished raising rates. You wouldn’t really expect higher rates to impact the economy immediately. In fact, they have not. Indeed, if you look at say the average mortgage rate that homeowners are paying, it’s still lower than where it was in 2019. How did that come to be?

Well, a lot of homeowners refinanced their mortgages during the pandemic. Most mortgages are 30 year fixed. Only about 5% to 10% of homes are sold every year and so household debt which is dominated by mortgage debt was low going into this Fed tightening cycle because of the prevalence of fixed rate mortgages. We just have to wait before the impact of higher rates really make their way through to the economy.

[00:07:12] Alan

It’s interesting. Economists often find it hard to forecast recessions. Last year, you had the opposite view that it was the prevailing view that we were going to have a recession this year and then I saw in your report you were making the point the recession will probably come when people least expect it. So why do you have that dynamic that these things are so hard to forecast? As soon as everybody says a recession is likely, it’s a pretty good bet that it probably isn’t.

[00:07:44] Peter

I think that’s kind of the irony. Because so many people have been expecting a recession, long-term bond yields are not terribly high. They’re high by the standards of where they were a few years ago, but relative to where they were a decade or two ago, they are not especially elevated. The yield curve is incredibly inverted. It’s those longer-term bond yields that actually matter the most for the economy. So ironically, you almost need more confidence that the economy will avert a recession to lift those yields to a level that actually could be restrictive for the economy.

[00:08:29] Alan

Yeah. Is that the key reason why we’ve had those yields? As you say, they haven’t really gone up that much, particularly given we’ve started quantitative tightening as well, and yields overseas, maybe not in Japan, but certainly in Europe have gone up a decent amount. Maybe it is as surprising as the conundrum that Greenspan faced, but is there something different that’s constraining, that’s keeping yields in check at the moment? Is it that kind of pervasive expectation of recession?

[00:09:04] Peter

I think that’s the main factor. An inverted yield curve isn’t necessarily a recession indicator. All it really says is that the Fed is going to cut rates. But usually, the market thinks the Fed will cut rates because the economy is going to weaken by enough to require rate cuts, and that normally only happens during recessions. So, arguably, monetary policy is somewhat restrictive now in the sense that job openings are declining. That’s kind of telling you that labor demand is coming down, but there’s still a long way to go should get to a point where recession is likely.

So if you look at job openings, right now in the US, there’s about 1.7 job openings for every unemployed worker. It should be closer to like one job openings per unemployed worker. Until you get that number down, most people who lose their jobs are just going to walk across the street and find new work. So unemployment isn’t going to rise. If unemployment doesn’t rise, you can’t have a recession. So again, a recession will occur, but it’s just going to happen later than most people are anticipating.

[00:10:15] Alan

Okay. The other big driver of markets has obviously been inflation. Again, you’ve had different views on this. I know your view has been that inflation would come down. I suppose people have been looking for the immaculate disinflation, you could say, in the sense that if we had gone back six months, you had that debate, maybe Larry Summers on one side saying that you’d have to see a significant rise in unemployment to get inflation down.

So maybe give us a sense on where you see inflation heading, why you thought inflation would come down without that rise in unemployment, and how does it look looking ahead.

[00:10:56] Peter

One of the things I’ve written quite a lot about over the last few years is this idea, the so-called Phillips Curve, which is just the relationship between inflation and unemployment is nonlinear, in fact it’s sort of kinked when you get down to very low levels of unemployment.

What that means in practice is that once the economy gets overheated, the aggregate supply curve gets really, really steep, which means that initially, as demand comes down, sort of just sliding down that steep portion of the supply curve, you get a lot of disinflation, but initially, you don’t get much in the way of higher unemployment. That’s what we’ve seen over the last year or so, this benign disinflation. I suspect that can continue.

If you look at the forward-looking indicators for inflation, they’re fairly tame. So the Fed likes to take the inflation numbers and break them up into three categories, core goods, shelter, and services excluding shelter. Goods prices are not going up anymore. The New York Fed’s supply chain pressure index has gone from a record high to a record low, so no issues there.

On the shelter side, we know that the best leading indicator for shelter inflation is asking rents. What are landlords asking for the properties that they’re putting onto the market? We have data from Zillow, CoreLogic, Apartment List, and that data very clearly shows that asking rents aren’t going up anymore because they lead shelter inflation, so shelter inflation is going to come down.

Finally, on the services side, wage growth is the key driver of services inflation, and wage growth is coming down. Average hourly earnings on a year-over-year basis have decelerated from around 7% to about 5%. If you look at leisure and hospitality, there the deceleration in wage growth has been extremely significant. So all of that is telling you that services inflation will fall because shelter inflation is falling, because goods inflation is very low, then overall inflation probably still has further to decline.

[00:13:21] Alan

Okay. It’s an interesting idea, this kinked Phillips curve that you talked about. The Phillips curve itself is a much-debated topic. If you were to go back a few years, there was this view of a very flat Phillips curve. Some people just dispute the whole idea of a Phillips curve, but I think the view was it was a flat Phillips curve, and that was part of the Fed narrative around running the economy hot because you could do that.

Obviously, if you have this nonlinear or kinked Phillips curve at very low levels of unemployment, inflation picks up quite quickly. These are all quite theoretical concepts. People who are trying to estimate the slope of the Phillips curve, come up with all manner of numbers. How would you have confidence in that framework, that that is a good reflection of reality to give it the conviction of saying this is what we think is going to happen to inflation and base your investment strategy on it?

[00:14:22] Peter

Well, I think partly, it’s a question of just intuition and also just a question of what the data says. On the intuitive side, it’s very easy to understand why the Phillips curve is nonlinear. When unemployment is really high and starts to fall, there’s still going to be a lot of workers eager to find a job so firms don’t have to raise wages. But when you get down to super low levels of the unemployment, like 3% or 4%, at that point, you don’t have a surplus of workers.

If you’re a company and you want to hire somebody, you’ve got to poach them from a different firm. You have to offer a higher wage. So the idea that unemployment can fall without inflation ever rising doesn’t make sense. At some point, you know that relationship has to end. When it ends, that means that inflation needs to start to rise in order to ration demand. You can’t just expand demand indefinitely. At some point, you run into these supply-side constraints.

In terms of the evidence, we kind of look back at what happened to inflation in say the 1960s. In the first half of the decade, nothing happened to inflation. Inflation was remarkably stable, core inflation was around 2%, 2.5%, even though unemployment was falling during that whole period. So the Phillips curve looked to be very, very flat. But then 1966 comes around, we’ve got the Great Society programs, you got Vietnam War starting to heat up, massive labor shortages. Boom! Within the span of six months, inflation doubles.

So we’ve seen this before and we saw it again during the pandemic. At one point in the first quarter of last year, the so-called jobs-workers gap, this difference between labor demand and labor supply, got up to four percentage points. It was the highest on record. So labor demand exceeded supply by 4%. Not surprisingly, we got inflation.

[00:16:24] Alan

One of the interesting themes that we got through last year was you’re talking about your aggregate supply, aggregate demand framework. If you go back to maybe Jackson Hole of last year and all of the speakers at that, a big theme was around looking ahead, aggregate supply may be more constrained because of deglobalization or lower labor force participation rates, etc. All of that seems to have gone away. We’ve had lower inflation. Was that wrong do you think, or do you think those structural impediments are still there looking forward?

[00:17:00] Peter

Well, the pandemic-related supply constraints have largely gone away. So if you look at the labor force participation, it’s still a bit depressed for older workers. But for prime-age workers, 25 to 54-year-olds, it’s actually higher now than it was in 2019. So that problem has largely disappeared. As I mentioned, the issues around the global supply chain, that’s been largely resolved, although there are still component shortages in some areas, but that problem is quickly receding. The problem is more on the structural side.

If you look at US productivity growth, it’s actually been very weak since about 2005, in fact, close to where it was in the 1970s. So unless structurally, productivity growth accelerates, then we’re going to continue to face fairly mediocre prospects for aggregate supply growth going forward. Maybe AI is the ticket that boosts productivity growth. I certainly hope that that’s the case. In fact, the work that I’ve done suggests that it’s very likely to be extremely productivity-enhancing, but that could be a story more for the end of this decade, the 2030s, than the next say 18 months.

[00:18:21] Alan

Yeah, that seems to be the consensus. Obviously, McKinsey had a report out about this saying significant gains, I think $4 trillion per annum was the number they came up with. They said a lot of those gains were probably between 2030 and 2050, I think. But again, I think their estimate of the boost to productivity was anywhere between 0.1% and 0.6% per annum. So it seems like something potentially very positive, but something with a wide range in terms of how significant it might be and a big range in terms of how quickly we might see the benefit of it. Would you say that’s fair to say?

[00:18:58] Peter

Yeah. I think the confidence band there is very, very wide. I think one issue that we don’t really have a good handle on is what happens when we go from standard AI like Chat GPT to something that might be more like AGI, Artificial General Intelligence, where you have actually AI that can do pretty well everything that a human can do in terms of intellectual tasks. Once we get there, you’re going to have basically super intelligence that can make itself even more intelligent.

So you could have what some people are calling technological singularity, a technological explosion, akin to perhaps what we saw in the agricultural revolution or in the industrial revolution. Both of those revolutions saw growth increase 40-fold relative to the previous epoch. So right now, trend growth may be 2.5%. We’re talking about, 100% growth now if that happens. So those McKinsey estimates could actually be too conservative.

But again, the question is, when does this happen? Is it a story for the next couple of years? Probably not. Is it a story for the next 10 to 20 years? Possibly. I think that’s the interesting thing. This could actually happen within our lifetimes.

[00:20:23] Alan

Obviously, that’s been an important driver of markets in the last number of months, optimism around AI. When you look at it from a market perspective, obviously, you have different dimensions to the AI boom. Obviously, what you’re talking about in terms of possible impact on productivity, but then also, I guess investors in the more immediate term are playing what am I translating in terms of earnings growth, etc. So how do you take a big-picture topic like that and think about, tactically, how should investors think about that?

[00:20:57] Peter

I think we can probably draw some lessons from the dot-com boom. Productivity growth accelerated in the mid-1990s, and then as I mentioned, fell back to more ho-hum levels around 2005. Now, interestingly, around 2005 is exactly when companies figured out how to monetize the internet. So the productivity gains actually came before the profits and when they figured out how to make money off it, usually by exploiting natural monopoly effects, like these network effects. People use Facebook because others use Facebook. Companies really figured out how to exploit that.

So I think with AI, we could see a lot of hype, we could even see productivity gains before companies start to really make money off AI. In fact, it actually might be quite difficult to make money off AI. Think about Google, for example. Suppose Google replaces its search engine with a really powerful chatbot so that if I wanted to go from say Montreal to Houston, rather than typing some search words into the search bar, I could just ask Google, “How should I go to my destination? What’s the cheapest flight that will take me there on the day that I want to travel?”

Well, if the chatbot is honest and accurate, it’ll just tell me what the cheapest flight is. So the question is, how does Google actually make money off that? The company that offers the cheapest flight has no incentive to advertise because the Chatbot if it’s honest and ethical is going to tell me the right answer anyway. So the irony here is that Google makes money because its search engine is good, but not great. You still have to do that last leg of search on yourself, click on a bunch of links. If Google takes that out of the equation, how does it monetize it? Maybe they’ll figure out a way, but history suggests that it could take a few years before they get there.

[00:22:59] Alan

Okay. So that would say maybe there’s a bit too much optimism around AI in relation to the tech companies, and then in relation to the wider economy because, as you said, the confidence band around the timing of the magnitude is too great. Would you say that’s not something that is a support for banking stocks should in theory benefit from gains related to AI, but probably not being influenced by that at the moment. Is that fair to say?

[00:23:32] Peter

Well, I think there are two channels. One, there’s just the direct channel of what’s happening to companies such as Nvidia and their impact on the S&P index. But there’s also an important indirect channel. Once people become really excited about these new technologies, stocks go up, that generates a positive wealth effect, people feel richer because their portfolios are worth more, they spend more, and that actually has the effect of delaying a recession.

On the business side, we’re seeing CapEx starting to pick up. Manufacturing construction has soared in the US over the last few quarters. A lot of that is in semiconductors. But that’s adding demand to the economy, that’s delaying the onset of recession. So the AI boom, even if it doesn’t deliver productivity gains anytime soon could still push up confidence by enough to keep the economy out of recession longer than what most investors have been expecting.

[00:24:40] Alan

Yeah, it’s interesting. You touched on this boom that we’ve seen in manufacturing construction, which has come even at a time of weakness in the manufacturing sector. Obviously, partially that’s related to semiconductor, but it’s also possibly related to all of these incentives that have come from some of the policies, CHIPS and the Inflation Reduction Act in the US, and this new doctrine of industrial policy in the US of providing subsidies, etc.

So I’m curious to get your thoughts. Is that something significant that could support growth even longer or has that been part of the reason why the economy has withstood higher rates and could it continue to be an important support?

[00:25:28] Peter

I think it’s part of the reason, but it’s not the main reason. I think a key reason why the economy has withstood those higher rates is that the interest rate sensitive sectors of the economy are really lean and mean. So if you look at business CapEx, it’s been weak now for over two decades. US manufacturing capacity has not grown since about 2000. Core capital goods orders in real terms are 25% lower today than they were in 2000.

So we’ve had now over two decades of underinvestment by US businesses in domestic manufacturing capacity. Now they’re saying listen, maybe we need to invest more to make up for the lack of spending before, invest more because we want to relocate some manufacturing production capacity from say China back stateside, and of course, also to invest in some of these new areas like AI, green energy, and so forth. So CapEx is starting to pick up despite the fact that rates have gone up.

On the housing side, which of course is the most interest rate sensitive sector of the economy, we’ve had 15 years of under-building. The homeowner vacancy rate is at 1%. That’s a record low. The average age of US homes has risen to 31 years, the highest since 1949. So when you have a lack of access in interest rate sensitive sectors, you shouldn’t be too surprised that higher rates don’t curb spending in those sectors by very much.

[00:27:11] Alan

Maybe taking some of those things in terms of the investment implications, obviously, at a high level, the view on economic strength and low inflation has translated into an upbeat view on equities. You seem to think that will continue for a while. How do you balance just that kind of top-down relationship between, okay, we’re at that stage of the cycle, reasonably solid growth should be good for equities, versus other factors such as valuations or things like other analysts maybe focusing on liquidity and flows and positioning? I guess that’s all part of the picture. But is it fair to say you’re placing most emphasis on that growth equity relationship?

[00:28:01] Peter

Yeah, I think a lot depends on what time horizon you’re focused on. I’ve developed a model at BCA, a macro quant model. I look at that every day. It gives a very good read on the near-term and longer-term direction of stocks. The near-term signal from that model is very, very positive. It’s sensing the fact that we might get a turn in the manufacturing cycle, it’s sensing the fact that housing has already stabilized, it’s sensing the fact that positioning is still very, very defensive. All of those are bullish for stocks in the near term.

The model also recognizes the fact that, as we started off discussing earlier on, unemployment is very low and it’s kind of hard to keep the economy at full employment indefinitely once unemployment gets to these ultra-low levels. So the near-term signal from the model is bullish, the longer-term 12-month signal is actually somewhat defensive. So I’m just waiting for this model to give me the cue to turn a little bit more cautious. I haven’t gotten it yet, but maybe we’ll get it within the next few months.

[00:29:14] Alan

Back to the point about valuations, I guess if you were to just look at those macro factors going back a few years, part of the bullishness was around TINA, there is no alternative. How does the model factor in the fact that rates are now 5.5% for three-month T-bills, whatever it is, possibly going higher? So there is an alternative now, and obviously, there are lots of alternatives across the fixed income markets as well.

[00:29:44] Peter

Valuations matter a lot for the longer-term direction of stocks. The model currently says that the S&P is overvalued by about 13% relative to a discounted cash flow model, which means that over a five-year horizon, returns are probably going to be fairly low, below average. But those valuation factors don’t have a big impact on the outlook for stocks over a three-month horizon. You really have to go beyond the year before they start to matter, which again kind of reinforces the view that the near-term direction for stocks is probably higher. The longer-term direction is a lot more challenging.

[00:30:29] Alan

Okay, interesting. Is that based on the five-year bond yields that you’re taking that valuation? What would that translate to? Obviously, you’re seeing more muted returns, but on a total return perspective, what would that mean in terms of total return of stocks, US stocks, over that five-year period?

[00:30:50] Peter

It would probably mean a total return of about 5%, so not horrible but not much better than what bonds are currently yielding. So from that perspective, more conservative investors who are not really interested in the tactical picture who want to really think about the next 5 to 10 years, I certainly wouldn’t fault them for putting more money into bonds now. Tactically, I don’t think it’s the right step, but that’s kind of a three-month view rather than a long-term view.

[00:31:33] Alan

Okay. Also, from a fixed income or high yield credit perspective, what are your thoughts there given I guess in the short term, if you think the momentum in the economy is solid, presumably that view is similar to the equity view in terms of potential gains. Do you see I suppose any potential challenges in the credit space if we do get a recession next year?

[00:32:03] Peter

Yeah. A lot depends on how the banking system evolves. If the turmoil that we saw in March returns, which is possible, we don’t know, then you would kind of expect high yield spreads to widen again because they’ve narrowed quite a lot since March. The good news is that US corporates are in decent shape. They’re not in fantastic shape. They have taken on a lot of debt, but they’ve also trimmed out a lot of that debt. Indeed, during the pandemic, a lot of companies refinanced their long-term debt at very low rates, and now actually, an inverted yield curve is helping them because they’ve got this long-term debt which isn’t paying very much. Their cash balances are earning 5% and that’s helping to flatter their cash flows.

So yeah, if we have a recession, then of course, high yield credit is going to do very, very badly. It always does. But again, my expectation is that recession will come but probably won’t come until the second half of next year. So tactically, I think being exposed to corporate bonds right now is okay, but you do need to have at least one eye fixed on the exit door because the market outlook for corporate credit will sour probably by early next year.

[00:33:34] Alan

Okay. So maybe just picking on a couple of more points on that. Going back to the valuation and this S&P 13% overvalued translating into maybe a 5% annualized return. So that kind of sentiment is maybe not unusual, a few people are saying that pointing to more muted returns. In some cases, it may be pointing to even more muted and lower returns on the basis of not just the valuation in terms of the multiple but potential profit margin compression, which I guess will depend on a whole range of factors such as inflation and wages and costs, etc.

Curious to get your thoughts on what kind of assumptions you have on that score looking ahead over the medium term, and obviously, how that links the macro perspective. You’ve seen wage growth has been coming down, but would you be concerned that we could see, on a more sustained basis ,higher wage growth than we’ve seen in recent years given the kind of more of a shift towards labor power of late?

[00:34:38] Peter

Yeah, I think that’s a reasonable expectation. In fact, real wages in level terms are still about 3% below where they ought to be based on the pre-pandemic trend, and that means a couple of things. One, it means that even if inflation gets back to the Fed’s target, nominal wage growth may not need to fall quite as much as it normally would because you’ve got to keep real wages higher than normal just to bring them back up to their pre-pandemic trend. That’s sort of the first point.

The second point related to that is that if real wages are rising rather than falling, as they were last year when inflation was so high, then that’s going to potentially weigh on corporate profit margins. Now, margins have come down. If you look at US profit margins, they’re basically back to where they were in 2019. But they were quite high in 2019.

If we have a recession, it’s quite reasonable to expect margins to fall further. The model tries to take that into account to some extent, but it’s really hard to know because the increase in margins that we’ve seen over the last few decades, a lot of that has been driven by tech. The weight of tech within the S&P has increased. Tech company profits typically are higher than normal. So how much of that is cyclical, how much of that is structural, that’s not obvious.

[00:36:10] Alan

Okay. A second point to pick up on something you alluded to earlier, you mentioned in relation to credit may be influenced by how things pan out in the banking sector. Obviously, there was a wobble in the banking sector in March and a series of closures and acquisitions, and things seem to have stabilized since then. I guess maybe a crude analysis of tightening cycles historically might be when you get higher rates, inevitably, something breaks, and at some point, things seem to be okay for a long time and then you hit the Minsky moment.

When you survey the landscape, do you see that risk in any shape or form in terms of the commercial real estate market or flows into the private markets or any obvious area where you’re looking at potential weaknesses in the system were that would give you a more pessimistic view, or do you think, no, that because of the better balance sheets at the household and corporate sector, that that’s less of a risk this time around?

[00:37:16] Peter

I think you have to be worried. We need to be humble in this field. We don’t know what’s going to come out of the woodwork. I certainly didn’t expect these issues around regional banks in March. I think most people didn’t either. So who knows what’s out there? Where’s the bottom for commercial real estate? It just seems like you just can’t give away office towers anymore. Nobody wants to buy them, so maybe there is further downside. There probably is further downside there.

I think just a critical question is whether these issues around the banks, the regional banks, commercial real estate, whether they’re more akin to the sort of stuff that we saw in 2008 where you had this fast burn crisis that erupted and dragged the whole economy down with it, or whether it’s more akin to what we saw say in the savings and loan period beginning in the mid to late 1980s, which festered for like three, four years before it culminated in a recession in 1991.

My sense about what we’re seeing with the regional banks now is a bit more akin to what we saw during the S&L crisis. In other words, you have all these problems, but they’re not bad enough to induce a recession quickly. You just need to wait for things to escalate to a point where the economy is so weak that it falls into recession. Again, that’s sort of a statement suggesting that a recession will come, but it could come later, rather than earlier.

[00:37:17] Alan

Okay. From a timing perspective, obviously, you have a broad framework in terms of sometime next year, but if you were to be looking at certain variables that will say okay, now we’re actually seeing science and it’s coming through. You touched on the job applicant ratio I think as one key measure or variable to watch. Is there anything else that you would say, okay, these are the two to three key variables you’re going to be monitoring to tell you now we’re actually moving into a stage where it looks like a recession is looking more likely in the near term?

[00:39:21] Peter

Yeah. One of the things I try to do with my macro modeling is to have a lot of leading indicators and just look at a whole basket of them rather than focusing on one or two. So most of those leading indicators are not saying recession is imminent, but some of them are. The fact that the yield curve has inverted, historically, that is a leading indicator for recession.

Now, often the yield curve inverts like 18 months before a recession starts, so maybe we shouldn’t be expecting recession imminently even with this inverted yield curve. But other data I think is a little bit more reassuring. We’re not really seeing a massive surge in initial unemployment claims. We’re not seeing core capital goods orders collapse. If anything, they seem to be stabilizing right now. Even the new orders component of the ISM, that actually ticked up in the last reading.

In fact, globally, if you look at the PMI new orders minus inventories component, that bottomed earlier this year. That’s kind of a good leading indicator for where the overall manufacturing PMIs are likely to go. So I’m looking at all these variables, and right now, they’re still saying to stick with a positive view on stocks. But they can change and if they change, my view will change with them.

[00:40:46] Alan

Okay. Obviously, our conversation so far has been quite US-centric. But if you look outside the US, how does that fit into your analysis and your outlook? Obviously, a lot of people anticipated a much stronger reopening from China. It hasn’t come through and there seems to be a suggestion of maybe structurally weaker growth there. Europe, obviously, there was a lot of pessimism in Europe at the start of the year, late last year, around energy prices, etc., but by and large, dodged a bullet on that. But at the same time, more recent data now are starting to show signs of weakness.

What’s your sense there? Do you see it broadly following the US trajectory in terms of Europe? Obviously, from a structural perspective, that Chinese scenario of a fairly weak reopening, how is that influencing your thinking?

[00:41:35] Peter

Yeah, I think in China, there’s a couple of things that are weighing on the economy. One, we’ve been in the midst of this shift in spending globally from goods to services. People of course splurged on goods during the pandemic and that created an air pocket in demand for goods once economies began to open up again and people started going out more often. Because China is such a big manufacturer and exporter of goods, that’s obviously hurt their economy. As I said, that problem will probably go away over the next few quarters.

If you look at spending on goods versus services in the US, it’s already kind of normalized. So that issue I think will probably abate. That will also help Europe, which is a big center for global manufacturing, especially countries such as Germany. The one thing that China has working against it is the housing market. The housing market in China really does look as though it’s in the early phases of what’s likely to be a very long, difficult, challenging bear market, probably similar to what Japan experienced in the early 1990s.

In so many respects, the Chinese housing market looks like the Japanese market. Too much supply. At least 10% of homes in China are completely vacant compared to 1% in the US. Rental yields, which are incredibly low in China. China has some of the most expensive real estate in the world. Highly levered developers, like earlier on this year, there was a bit of a rally in Chinese developer bonds, but that’s ended.

Chinese developer bonds are now trading 30 cents to the dollar again, and then on top of all that, you’ve got the demographics, which are as bad if not worse in China than they are in Japan. If household formation is falling, as it will based on the demographic estimates, that means all this supply of homes just has nowhere to go and that’s going to push down construction. So that’s kind of the bad news. The good news is that the government is kind of aware of all this, so they’re trying to support the economy to some extent.

The other piece of good news which is a little bit ironic is that maybe we don’t really want China to do exceptionally well at a time when inflation is still a big concern. Now producer prices in China are falling. They’ve declined 3% year over year. China is exporting deflation to the rest of the world when people are concerned that the Fed might not be able to stop raising rates because inflation stays too high. Having some Chinese disinflation, it’s not the worst thing imaginable.

So from that perspective, I think if China achieves middling growth this year, that might be just what the doctor ordered for the rest of the global economy.

[00:44:44] Alan

Okay. That might be a good segue into a couple of other things from an investment perspective. One, maybe currency. Obviously, we’ve had this weakness in China and a weakening trend in the renminbi of late. Obviously, it kind of stabilized a little bit in the last few days. But is that part of the policy response do you think in China and do you think there’s the potential of something, a structural move higher there in the sense that if this US recession isn’t for another six, nine months and that US rates stay at a high level, could we see much higher rates for the dollar versus the renminbi which in turn might influence the rest of Asia? Could that be a disrupting force in the markets?

[00:45:34] Peter

Potentially. It depends on how quickly the Chinese currency weakens. It’s been weakening on a trade-weighted basis. The dollar has been weakening as well, so if the RMB weakens relative to the dollar, you know that it’s really weakening against most other currencies too. Now, the authorities need to be a little bit careful. As we saw in the past, if the currency weakens a lot, that can exacerbate capital flight. The capital account has become much tighter in China, but nevertheless, the government does not want a disruptive move in the currency.

My guess is that if the dollar continues to weaken, it is my expectation the dollar will weaken on a trade-weighted basis, then that would just drag the RMB down with it. China will become a little bit more competitive relative to its neighbors, which is what it wants at a time when it’s trying to look for a substitute for housing to fill the hole in aggregate demand, and also at a time when a lot of companies in developed economies are becoming wary about having a lot of investments in China and are looking to make a transition to other economies, perhaps even move the manufacturing production back home. China wants to become more competitive in order to delay those decisions and having a weaker currency is one way to do so.

[00:47:04] Alan

Good. From an equity market perspective, does that leave you still constructive on China or not? Also, from the perspective of a lot of people, I think yourselves included, have an upbeat view on maybe the longer-term outlook for emerging market equities, saying that that is to play in the sense the US markets may be overvalued and undervalued in emerging equities. But obviously, within the index at least, China is a big chunk of that index. So how do you reconcile this or is that part of the bullish case for emerging markets or is it a risk factor?

More generally, the geopolitical risk about China, only a few months ago, people were saying maybe China’s uninvestable given the trend of disengagement between the US and China. What are your thoughts on that?

[00:47:59] Peter

Typically, emerging market equities do well when, A, the dollar weakens, and it has been weakening since October, and B, when the manufacturing cycle starts to improve, which hasn’t happened yet. But if it does happen, and my expectation is that the ISM will probably bottom over the next month or two, we’re going to see an upswing in global manufacturing. If that occurs, that should be positive for emerging markets at least over a 12-month horizon.

Now, is that a structural reason to be overweight emerging markets? No. I think the challenge that emerging markets have faced has just been around corporate governance. In the US, the number of shares outstanding typically declines by around 1% every year because companies are always buying back shares and they’re very reluctant to issue new shares. In emerging markets, the number of shares outstanding has grown on average by 5% every year.

So there’s just a lot more willingness to dilute shareholders in emerging markets, and that means that the strong growth that many emerging markets have experienced has not filtered down to the level of equity investors. So to be bullish on emerging markets, I think you have to have a view that corporate governance will improve. You have to have a view that the geopolitical situation in China at least isn’t going to get any worse, it might not get better, but it won’t deteriorate.

On that structural side, I don’t have a lot of confidence. I’m hopeful, but the hope isn’t a recipe for sound investment decisions. I need to see some evidence first.

[00:49:45] Alan

Elsewhere in Asia, obviously, we’ve seen a strong run-up in the Japanese equities of late. Looking at your reports as well, I think I saw somewhere “2024, year of the yen.” Obviously, we’ve had a big dislocation there. So presumably, that’s a bullish view on a valuation basis or is it the end of yield curve control or sustainably higher inflation or a mix of all those factors going to drive the yen?

[00:50:15] Peter

So this year, Japanese stocks have done quite well because they were very cheap and earnings growth and sales growth has actually been reasonably decent in Japan for the first time in a long time. So our models are overweight Japan, they’re overweight Europe relative to the US. That’s not so much a call on the yen. That’s more of a call on Japanese stocks. I think next year, the yen could do well for different reasons than money pouring into Japanese equities.

Next year, I think, as I mentioned earlier, we’re probably going to see a renewed weakening in the global economy as the lag effects of those higher rates finally begin to bite. You’re going to see investors start to price out rate hikes in many economies. So bond yields are going to start falling as we get closer to the onset of recession. In Japan, of course, bond yields haven’t risen very much to begin with. So those interest rate spreads are going to narrow in favor of Japan, which is good for the Japanese yen.

The Japanese yen is a very cheap currency. It’s trading about 40% undervalued relative to purchasing power parity exchange rates. These are the exchange rates that equalize the price of a basket of goods and services across countries. Japan is 40% undervalued, the US 18% overvalued if you look at the PPP value of the US dollar. So you’ve got a very cheap currency environment where spread differentials are likely to move it against favor. That’s a recipe for a stronger yen next year.

[00:52:11] Alan

We’ve talked a lot about these kind of, to an extent, tactical views over the next one to two years, but maybe even thinking about the recession and then what the economy might look like beyond, do you think we’re into a different environment now than we were in the 2010s from the perspective of in the next downturn, the next US recession, will rates go all the way back to zero or are we looking at a lower band around 2% to 3%?

From an inflation perspective, we’ve had this kind of discussion around is 2% the right level. Do you think that we’re going to move into a point where that’s actively discussed, that maybe the inflation target should be 3% and that leading to structurally higher inflation in the next decade or not?

[00:53:01] Peter

I think the Fed would be very reluctant to change its inflation target. First of all, it would need congressional approval, which it won’t get, to do so. But even beyond that, if you start saying that we’re going to tolerate 3% inflation going forward, long-term bond yields are going to go up and it’s going to actually have a contractionary effect on the economy. So I don’t think the Fed would do that, certainly not under J. Powell. But that being said, there are structural reasons to expect somewhat higher inflation going forward.

You mentioned earlier that globalization is on the back foot, that historically was a very deflationary force. Fiscal deficits seem to be structurally higher now and they’re going to remain high as more people retire and start collecting social security and become eligible for Medicare. Those baby boomers who are going to be retiring, by the way, they hold about 52% of household wealth in the US, so they’re going to qualify for all these programs. Plus, they’ve got all these accumulated savings.

When you have a group of workers that all of a sudden stops working, so they’re not producing anymore but they’re still consuming because they have all this wealth, well, if you’ve got consumption that’s not matched by production, that tends to be inflationary as well. So I’ve certainly been in the camp that has argued the neutral rate of interest, A, is not as low as people think, and B, will probably trend higher over time.

[00:54:42] Alan

Obviously, that’s the neutral rate that sets the equilibrium for the real economy. From a policy perspective, do you think the Fed would be reluctant or would be keen to avoid going back to those ultra-low rates or do you think that they may have to in another downturn?

[00:55:02] Peter

Well, I think if there’s a downturn, the Fed will cut rates of course. Bond yields will fall. It’s a question of how much will they fall. In a typical recession, if you look at all the recessions since 1960, the 10-year yield has fallen on average by about 2.5 percentage points peak to trough. So if we get something like that again the 10-year yield could fall to like 1.8%. I would bet against that, however. I think that the 10-year yield might fall to around 2.5% during the next recession. It’s not going to get lower than that partly because the recession isn’t going to be especially deep.

As I said earlier, we don’t have a major imbalance of homes, we don’t have a major imbalance of CapEx, so those interest rate sensitive sectors of the economy will spring back to life when the Fed starts cutting rates, but also because I think the neutral rate is rising over time and so the Fed just will need to bring rates to ultra-low levels. We don’t have this big deleveraging cycle anymore. During that period when households were looking to save more, spend less, the Fed needed to keep rates really low just to keep the economy from sinking back into recession. That need is no longer there given that the deleveraging cycle has ended.

[00:56:22] Alan

Okay, fair enough. Thinking about investment strategy on a multi-year basis, it sounds like more muted returns in equities, but not disastrous. Obviously, starting bond yields are at reasonable levels now, but then structurally, higher inflation rates would erode real returns. Any other observations to make? The 2010s was a period of very low growth, low inflation, but strong stock returns. The 2000s was more muted stock returns but a strong period of growth punctuated with crises. How do you see the big picture view over the next decade if you were to try and characterize that?

[00:57:07] Peter

Well, I think you mentioned earlier the role of valuations. Valuations are very important when you’re thinking about these longer-term questions. Stocks were super cheap in 2008. The Shiller PE I think came down to close to 10 or so, which was a very, very low number. That’s not the case anymore. So the valuations are not attractive for equities, or at least not attractive enough to expect above average returns on stocks. For bonds, they have become more attractive.

So my view is and continues to be that while I’m tactically bullish on equities now, I will be looking to reduce that exposure, bump up my exposure to bonds as we get closer to the next recession. The only real wildcard in this, and we talked about AI earlier, is what happens if we truly do get an AI boom. Could that create such an increase in supply for all these digital workers that are all of a sudden going to be available to companies? This has a major disinflationary effect and potentially allows bond yields to fall more than I’m expecting. That’s certainly a possibility, so you have to be on the watch for that.

[00:58:25] Alan

Very good. Before we wrap up, we always ask your guests if they have any advice or suggestions for people who want to build their careers in global macro and in investing, anything you would suggest doing or reading, or things you found useful in the course of your own career.

[00:58:41] Peter

Oh, gosh, I think if you want to be successful in this field, you have to A, be willing to learn a lot about global macro. It’s not easy, but it can be done. So pick up a few economics textbooks. There’s a lot of free stuff out there on Twitter. I’m on Twitter, a lot of people are on Twitter. There’s some very informed voices out there, listen to them, listen to podcasts such as your own because you’re going to learn a lot, and then get involved in the markets.

If you have a macro view, don’t put a lot of money into it. But there are a lot of ETFs that are linked to currencies that you can trade. There are ETFs that are linked to bonds, not just stocks. Trade little bits and you’ll find that you’re going to learn by doing so. The more you learn, the more successful you’ll become at actually making money by trading macro.

[00:59:39] Alan

Good stuff. Peter, this has been a great conversation. Thanks very much for doing this today. So make sure to follow Peter’s work. As he mentioned, he’s on Twitter and you’ll find him generally on social media, because as you can tell from today’s conversation, it’s an interesting global macro environment we’re living in at the moment. So from all of us here at Top Traders Unplugged, thanks for tuning in, and we will be back soon with more content so stay tuned.

[01:00:06] Ending

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