Structural Shifts - A Threat to the Economy? ft. Frances Donald

[00:00:07] Frances

We are in this sizeable shift where governments will become bigger, and it’s the governments that recognize their job is to support the supply side that will actually support disinflation and bring prices in line and actually probably allow their economies to accelerate. It’s not going to be about how big is your deficit or how big is your government. It’s going to be, have they made the critical shift towards rebuilding the supply side of their economy or not?

It’s not going to be the amount of dollars the government spent that will be most important to the inflation or growth story. It’s going to be how they spent it, which has always been true. But the idea that government spending could be deflationary, people are probably turning your podcast off right now, Alan, as I say that, is a new theory that we need to consider.

[00:00:59] 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.

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

[00:01:55] 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.

[00:02:39] Alan

Thanks very much for the introduction, Niels. Today, I’m joined by Frances Donald who is Chief Global Economist and Strategist at Manulife Investment Management. Frances focuses on the global economy, focusing on macroeconomic trends and financial market developments. Frances is also a senior member of the multi-asset solutions team at Manulife. She has been an economist for many years at various banks and research firms and was at the Bank of Canada previously.

Frances, good to see you. How is everything with you today?

[00:03:09] Frances

I think we’re doing okay. That sounds like a very boring introduction for a very exciting job. So maybe we can dive into it.

[00:03:17] Alan

Good stuff. I probably didn’t do it justice. We always like to start off by getting our guests to give their own take on their background. So, I think you can probably give a slightly more upbeat version of your background.

[00:03:28] Frances

Oh, no. I should blame the bio writers, not so much you Alan, who always makes things come to life. So, thank you for that. Sure. I’ve been with Manulife Investment Management priorly, known before that as Manulife Asset Management, for about eight years, usually in the economics and strategy department. And yeah, it’s been a very interesting place to be as an economist strategist because, unlike in other shops where you are reporting to marketing or you are paid or receive your year-end based off of visibility, the bulk of this role is really supporting the fund for retail and institutional clients.

That’s a privilege and a responsibility that I and my team take very seriously, but it also means we have to do economics a little bit differently than maybe where you would go to grab headlines or book client meetings. So, we support all manner of funds: tactical, multi-asset funds to fixed income to (when they will listen to us) some bottom-up stock pickers. You can kind of weasel your way in there every once in a while. And of course, we try to be there for our clients and help them understand this really interesting new economy that we live in. So, there’s a lot of components to the role but it keeps us busy and very market-focused.

[00:05:05] Alan

Good stuff. Taking a step back, I think I mentioned you were at the Bank of Canada earlier in your career. I guess you must have studied economics somewhere. How did you get involved in economics or get interested in economics and then policymaking and then markets?

[00:05:21] Frances

Yeah, rather accidentally. I thought I was going to be a professional violinist, and then right before I went to go study music, I broke my hand, which is an ill fate for a violinist. My backup degree was economics. So, I went to Queen’s University in Canada. We call it Harvard of the North. I think we’re reaching there.

Following that, I did do a couple of research assistant years at the Bank of Canada and then I wanted to see the world, somehow ended up at NYU for a master’s degree. And that’s when I came to the realization that you could do some pretty exciting things with economics, work on Wall Street, get close to financial markets.

But it really wasn’t until after my master’s degree that I fell in love with what markets really are, which, to me, has just been all of humanity reacting and absorbing information in the world, You get to see like a soul moving, that ticks on my Bloomberg terminal, to me, are just emotions and analysis and the general heartbeat of the world across the screens. I fell in love with that and that’s where I’ve been ever since.

[00:06:39] Alan

Okay, great. Well, you mentioned how your role is very market-focused and you have to be very tactical in terms of your analysis. Maybe to get started on the tactical view then, we’ve had a pivot, again, from the Fed at the back end of last year which is dominating the conversation at the moment. Can you give your sense on how we got there and that kind of abrupt change in outlook with respect to rates? How do you see that playing out over the next few months?

[00:07:13] Frances

Yeah, Alan, the hard truth is that I’m not really sure what created the big pivot from the central banks. I know what would have created my pivot, if I were at the central bank, but the data didn’t suddenly change. Therefore, the decision-making function changed from the Federal Reserve in December. I do have a rather bearish outlook for the US relative to the soft-landing narrative.

We have the so-called two quarters of negative GDP, which I still believe is a funny, made-up technical statistic. For most people around the world, whether we’re at negative 0.1 or plus 0.1 GDP will change your recession definition but doesn’t change the reality for businesses. And therefore, I don’t spend too much time talking about the recession call with portfolio managers.

What we spend more time talking about is what’s priced in and where are the risks around it. And to me, the risks are for a much more difficult economic environment over the course of 2024, particularly at the front end. So, I’d like to believe that the central banks became aware that the bulk of the leading indicator was sharply negative, not just a little bit, not consistent with mild recessions but something worse, and it became clear that maybe if they had moved earlier.

I think if you study historical examples, you wouldn’t be convinced that a December narrative pivot would save you from a Q2 contraction, but it could get you out of a sticky situation faster and certainly make it less severe. So, I’d like to believe that the Fed came to this recognition that the other side of its mandate, the full employment side, was at risk.

But it’s challenging, Alan, because the trend in the disinflation was already in place in October, November yet we hadn’t seen the change. We heard so much about how financial conditions were so important. Yet, when financial conditions eased, this didn’t appear to be a deterrent at all.

We’ve got this overlay of geopolitical instability, and election years and it’s hard for me to ignore that, even though on paper these should be completely irrelevant. We’re all human beings and central bankers are human beings, how could they not be coming into play? However, the challenge, though, is that we have the best of all worlds priced.

Right now, we’ve got the fundamental narrative being that the economy is in for a soft landing and we’re going I get a good amount of rate cuts. Well, that sounds lovely. I’d like to play in that sandbox all year. But the balance of risk is problematic across a range of horizons. Tactically, we’ve already seen the move. But even two weeks ago, we had as much as 90%. We got to be careful about how we interpret this priced in, but a good chunk of a full rate cut expected in March.

As an aside, the average time between the last rate hike and the first cut is seven months, and March would be seven months. So, it’s not a crazy assertion. But as much as we’re concerned about the US economy, we don’t think we’ll have the data that really proves that to be an issue by the March meeting. So logistically, it’s hard to see that happening. At the same time, we do think that the best of the soft-landing narrative is probably priced.

So, either the data comes in really strong, and it pushes out those rate cut expectations more materially than even the past two weeks, or the data starts to deteriorate. I think we are at a point where bad news can be bad news. So, in the near term, I’m concerned about that. I think we did get a little bit of nerves on our team. We have this view that China is leading the easing cycle.

Twenty percent of global central banks are already easing. We’re already in a global easing cycle. We’re there. And it’s led by China. And then we had the surprise last week where they expected the MLF to get cut. It didn’t get cut, and I thought, oh, this is the example of the central banks pushing back. But even in the few hours I’ve been awake, so far today, Alan, we of course are getting sizable new stimulus from China in the form of Triple R cut and maybe some stock market support.

It’s hard for me to see the incremental good news for this broad market in any of the major asset classes. So tactically, I’m little bit concerned about some of the timeline there. We do however also spend a lot of time talking to clients, and the vast majority of retail and institutional investors are not thinking about the next three months or even the next six months. They are running on 12 to 18-month investment horizons at a minimum.

A lot of the time when I speak to our institutional clients, and these might be pension funds or groups that are managing retirement savings, they’re asking me what my 5, 10-year forecasts are. A recession is irrelevant to them this year. And so, as we look through 2024, we also spend a lot of time thinking about what our narrative will be for when it’s time to jump back in.

I know that seems so premature. How can you be bearish and see a recession and also be thinking about upside for later this year? But that is the nature of this business. We both have to be really tactically minded and also aware of what these longer-term sticky money investment horizons are.

So, I think our theme, as we put it in the marketing materials, was darkest before dawn. Somewhere down in 2024, the dawn will be back and we’ll want to get in.

[00:13:09] Alan

Okay. Well, I’d love to jump into there. One thing that stands out, obviously, people have been anticipating an economic downturn in the US for quite a while. You touched on leading indicators. I think leading indicators have been negative for a long time as well. So why now? Is it just the lags, that we’re at that point where the lags are not so far away anymore or is it something new? Have you been surprised at how resilient the economy was through 2023 or was that always what you were thinking?

[00:13:44] Frances

Surprised is putting it mildly. I was straight up wrong. I was the most wrong I’ve ever been in my career and it’s hugely humbling and uncomfortable, especially when you are sitting around a table every morning looking at attribution reports. So, we are doing a lot of work on why we were wrong and do we need to pivot our frame of thinking.

Effectively, the way that I interpret why everyone called for a recession last year and why everyone is pulling that call (and not everybody). There were shops that nailed this call this year. I’m not sure they nailed it for the right reasons, but who cares? It’s your P&L that matters, right?

What happened is that at the end of 2022, it became somewhat clear that the manufacturing data was deteriorating. The leading indicators of the leading indicators, which are largely manufacturing-based, were starting to decline. When that happens, your standard economic model tells you that a manufacturing recession portends a services recession.

That’s why the bulk, almost all traditional economic models are heavily weighted towards manufacturing. Even though in the US where manufacturing is only 10% of GDP, the manufacturing sector is a really solid leading indicator. So, what happened is manufacturing declined and then it fell into a straight-up contraction, globally, and the average time that takes to hit the services sector is about three months.

So, you could handicap that and say it’s going to be six months. The conditions for a 2023 recession were so in place that you saw massive conviction around that view. But manufacturing did not bleed into a recession in the United States. It did across vast swaths of Europe.

We have a whole bunch of European economies that are in recession and a whole bunch more that, when Q4 GDPs come out, will be in a recession. We’ve got developed market economies, like Canada (where I secretly live), that are clearly in a recession by a variety of metrics. So that no-recession call is extremely US-centric. Nowhere I go in the world are people questioning soft landing versus hard landing, except if they’re US-focused.

Manufacturing has now been in a global recession for 18 months. It’s the largest, longest global manufacturing recession in modern economic history. And yet in the US, it hasn’t bled into services. Even problematically now, that manufacturing recession almost looks like it’s troughed and you’re beginning to see the manufacturing indicators going upwards.

So, if you believed that manufacturing was a helpful economic signal on the way down and you stick to that view, then you should be abandoning your recession call. The challenge now, the big divide amongst economists, is do you abandon the view that manufacturing must bleed into a services recession? There are all types of reasons why you would rationally do that: excess savings, liquidity…

You could be of the camp that the interest rate sensitivity in the economy is lower, especially in the United States, because of the construct of its housing market. You could say that these governments who didn’t have to suffer through Keynesian economics classes forgot that government spending is supposed to be counter-cyclical. That’s what I had tattooed on my brain, but no, I guess the current governments did not read that part.

So you could say the lag between manufacturing and services is zero and the relationship is broken, or you could be in the other camp, which is that it still very much exists and that the lags from interest rate hikes are long and variable. The average time from the first rate hike to the impact on the economy is two years. That’s January 2024. It’s two years from the first rate hike.

The second mistake, in calling for a recession in 2023, was believing that the lag and the impact of interest rates would be faster and sooner. The thought behind that was the rate hikes were so aggressive that the lag must be shorter. But that wasn’t the case for sure. So, what I’m having trouble with, is to throw out every existing historical example.

I’m having trouble saying these relationships are useless and everything we’ve learned about historical examples needs to be thrown out the window. I can’t do that. I can handicap it and say there are elements that are different. But sometimes I see other strategists in the media saying, these crazy people with their idiot calls.

It’s not crazy to look back on history and say this is the standard economic relationship between things and therefore we have to consider the wealth of probabilities around it. I actually think it’s crazier to abandon them completely. So, in practical terms, what that means is that we have become much more scenarios-based than we ever have been.

I, actually, moved my team away from base case, bear case, bull case towards probability-based forecasts, which is really simple. I think Goldman does this too. They were the first. It’s not like Goldman follows me. So, we spent a lot more time thinking about what’s a better way to develop the central scenarios, over time, in a world where we don’t know if our standard economic models work.

I was just reading, yesterday, the Bank of Canada just announced that, actually, it’s had two models that it’s used for its entire existence. It has literally thrown them out the window and bringing forward a new model and 2025. This central bank, in particular, its model of the output gap, it’s dogmatic about that thing. So, when you have these large institutions who are beginning to say we need to rethink the standard relationships between variables, I think that’s really significant.

But I can’t say that the standard relationships go to zero. Given how bad a lot of the leading economic indicators are, and how aggressive the rate hiking cycle is, for me to have just two shallow quarters of negative GDP is throwing out a bulk of what we know has historically been true about economics.

[00:20:44] Alan

Okay. Just to delve into it in a little bit more detail, where do you see the transmission mechanism playing out? Where do you see the weak spots where we’re likely to start seeing more and more evidence of that economic downturn as we go through the year? Is it in the consumer or the interest rate sensitive sectors or where?

[00:21:05] Frances

It’s employment. That’s our big concern. And it’s complicated by the fact that we still exist in labor scarcity. The unemployment rates have bottomed just about everywhere. The counterargument is that there were so many job openings that the labor market can remain resilient because people will just take down job postings. But hiring and quit rates are at or below where they were pre-COVID.

Survey data from PMI data to NFIB surveys all indicate significant slowdown in hiring activity. Confidence about jobs is weak. When we put this dashboard together, we see an employment market that begins to weaken. That’s how you end up at two quarters and a shallow recession forecast, is that it bleeds through to the consumer and that there is an interest rate shock.

What’s really critical is that this interest rate shock, I think, will turn out to be one of the most unevenly impactful across the world because the US is becoming substantially less interest rate sensitive, particularly via it’s housing market. One thing I find fascinating, where I live, we have five-year fixed mortgages or five-year variable rate mortgages, and about a third of the population has already refinanced at substantially higher rates. So, your interest rate cycle runs on this like rolling five years.

The US, as you know, has 30-year fixed mortgage rates. And until lately, I’ve never heard the discussion in the US talk about how when central banks ease, it has a 30-year easing impact. It’s relevant for 30 years when central banks drop rates. I think that makes it all at once extraordinarily powerful.

But were I a US central banker, I would also feel that that was hugely limiting, because you have to recognize that you squeeze the toothpaste out of the tube of easing, you can’t get it back in there for 30 years. That’s crazy. I don’t remember what your question was, Alan. You really got me going there.

[00:23:31] Alan

We were just talking about the transmission mechanism and obviously you’re seeing it personally in the labor market. This is the point that has been a point of debate. Yet you had the Larry Summers view or the Waller view, the Waller view being that the imbalance between supply and demand would be adjusted by less job openings I guess it’s fair to say. So, in you base case, your most probable scenario…

[00:24:04] Frances

You can use the term.

[00:24:07] Alan

You’re looking for just two negative quarters, so kind of a shallow recession. So presumably not much of an increase in the unemployment rate. Paint a picture of what does the economy look like.

[00:24:18] Frances

I think we have 2% higher. So, here’s the thing. Again, this call seems bearish, but the US is still one of the better economies in 2024. Even as I can say out of one side of my mouth, I do have a technical recession, I also am much more comfortable in US assets. The challenge here is that we are speaking about the economy in absolutes, but it is and always will be a relative trade.

This is why I wrote a piece last October or November that said, yeah, having a US recession call doesn’t matter, A, because the recession may look different. And because of the desynchronized nature of manufacturing and services, we could enter a US recession with manufacturing accelerating, which would be bananas. Or we could not go into a recession because services are in a recession, but manufacturing are not. So, if you’re a bottom-up stock picker, you’re looking at an opportunity there given that this is desynchronized.

The second issue is that the cycle is being led by emerging markets, which is atypical. Europe is already in its recession and may, actually, exit it before the US heads into a recession, and many other economies in the world are already in a problematic situation.

So, this desynchronized nature of this, what some would consider a bearish economic outlook, means that there’s still a host of opportunities that exist. So here we are, over the course of the last three months, everyone was like, oh, it’s going to be higher for longer and is this a pivot and when is the Fed cutting. Meanwhile, we’ve got China that’s in active easing and straight up deflation.

We haven’t talked about the inflationary risks either, which I think may end up being far more important than whether GDP is negative or not and for how many quarters. We have a range of indicators that suggest we may, in the next six months, actually undershoot; that the momentum may actually push us sub 2% slightly before rising back up on the other side.

So, depending on your investment horizon, in the near term, you can capitalize on that. But what is it going to look like, around June or July and especially if we continue to have these supply chain disruptions, when inflation actually starts rising just as the Feds cutting rates, which just empirically, based off base effects, is a very fair base case? So, I know that it’s my job to have this recession forecast and explain what it is, but I would much rather say the balance of risk is towards hard landing not reacceleration.

If soft landing is the base case, what would I rather trade? In this particular situation, I would really say the balance of risk is towards a more severe situation than what is currently priced. whether we get one quarter or two-quarters of negative GDP, the trade will be the same. Even if we have 0.1% GDP and we never hit a recession but it’s not a soft landing, however you want to describe it, the trade is the same.

[00:27:36] Alan

Yeah. Translating that into some tactical positioning or some positioning for the next number of months, as you mentioned, you’re involved in supporting tactical and multi-asset teams. Obviously, based on the scenario you’re presenting, the rates cuts that are priced in would probably seem reasonable. Are they too much or too little?

As you had mentioned, in the near-term, equity markets are behaving on the basis of we’re getting the best of both worlds of easing and the economy does okay. But at what point, given the momentum we’re seeing in stocks at the moment, at what point do you think, or what do you need to see for bad news to be bad news as you expect to start happening?

It takes a lot of bad news it seems for equity investors to shift their perspectives to saying actually that that is the case. So how do you see that playing out from an asset market perspective?

[00:28:33] Frances

Depending on who you are and what kind of investor you are and what sort of tools you can use, I think there is some mispricing at the very front end of the curve. By that, I mean it’s come off a little bit. My least favorite thing at work is when I have a great idea and then that great idea is priced in in like four days, and then I got to come up with the next great idea.

I prefer when it goes over the course of like a month so I can take a Friday afternoon off. But a March rate cut, very, very difficult I think empirically to see happen. We have the bulk of a 25-basis point cut already in the June, July and September meetings, which makes sense, and then the pricing starts to come off. So, we’ve got about 200 basis points of rate cuts in here. The average is 400, and 200 in the presence of a recession feels inconsistent to me.

Now, listen, I acknowledge that if inflation, we’ve just gone through a massive price level shock and central banks may say that’s all you’re going to get even with a recession. We have to acknowledge that possibility. We have to listen for that possibility. But right now, this is a Fed that in my view will wait longer and then go much faster. So, there are trades on the curve that you can play if that’s your fancy.

When it comes to what sort of economic news becomes problematic for equities, it’s like Goldilocks, not too hot, not too cold. My concerns are if we start seeing more rapid deflation, it’s going to become clear that that’s coming from the demand side of the economy. We see the nonfarm payrolls in the United States and other job market data softening quite a bit over the course of Q1, and then it becomes clear that the consumers is more challenged in that type of environment.

So, when you start seeing evidence that the economic data is going to bleed through into earnings, and that really has to come from jobs, even the bottom-up stock pickers get a little bit more nervous. The number one thing that a US stock picker is going to ask me is tell me about the US consumer. Their favorite chart is always going to be the really strong starting place for the consumer. So, the balance sheet doing much better, wage growth looking relatively good, and solid jobs.

If the job market starts to weaken, it won’t matter if you don’t have the rate relief to the same extent. Rates will not be the excitement for equities if the job market starts to go, which we think it does in the next few jobs reports.

The other challenge is inflation. I mentioned that we do see some downside risks to inflation, more so outside of the US. But there are some recent developments, we have to keep our eye on them, particularly on the supply side of the economy and when it comes to general conflicts, that may lift inflation slightly.

While employment will always be more powerful than rate relief for equities, in my view, from a macro perspective, I think you may go through a period where they recognize they’re not getting rate cuts as early as they want or central banks push back against rate pricing. So, we’re always trying to figure out is bad news good news or bad news.

I see good news as bad news and bad news as bad news because we’re walking this fine line. Again, it’s really about what’s currently priced. Because if we were looking at no rate cuts priced for May or June, I would have exactly the same macro view and a very different trade associated with it, if that makes sense.

[00:32:31] Alan

Yeah, that makes sense. Maybe just to take a couple of other factors into account, just curious to get your thoughts. Obviously, when rates went up from zero to 5.5%, it was a big shock. Obviously, cash in money market funds has increased, so that’s on the sidelines. Anecdotally, I hear people in the wealth management community saying it was so hard to get people to invest last year.

So, is there a risk of a melt up here in the short term do you think? Obviously, there’s a risk, but how meaningful is that risk if the data stays okay and we get rate cuts? Or do you think that’s all fully priced in by now?

[00:33:13] Frances

I’m going to speak anecdotally. I’ll give you the business perspective that I have. I think last year, I did 156 client meetings, something like that, give or take a few. And similar the year before. Every meeting started with, why am I not in cash or a cash-like product? I can get 5%, blah, blah, blah. And it was really hard, Alan, because that was a great thing to do.

That was a great trade. That’s what you should do if you’re short-term focused. Not everybody should be doing something like that. But for certain investors, that was the best play. I don’t think we’re going to hear that this year. And again, anecdotally, I don’t know if we can even look at this data. But you can put two and two together, I think those allocations came predominantly from fixed income.

Now when you look at the fixed income market, again, from the client perspective, both retail and institutional, do you remember? We’ve known each other for 47 minutes, Alan, but I spent the bulk of my career doing presentations on search for yield. I was explaining what ZIRP and NIRP were like eight times a week. I had charts that showed you the amount of yield in the world that was negative, how many central banks had negative yielding debt, and fixed income was really hard to sell.

We run five-year asset allocation, or capital markets assumptions, and five-year return forecasts, and I would have equities annualize like 6%, 7%, 8% return, EMs always off the chart. My fixed income returns were like 0 to 1 and sometimes negative, but we would have to pitch people on the idea that this is important because one day we’ll hit the recession, you want the stability.

For the first time in my career, I get to talk to clients about how exciting bonds are for both the price return that we anticipate and also the income return. We haven’t been able to do that for a really long time. So, do I think cash on the sidelines is going to flow into equities? Probably some of it. But from the business perspective, it is much easier to advocate for, and the interest that I see, on that money heading back into fixed income.

Even after seeing some of the greatest outflows we’ve ever seen and the worst performance for bond funds ever, people are much more interested in the fixed income space because they are still scarred by the search for yield narrative, which we almost forgot about but is now becoming more interesting. Also, I saw the two-year in Japan go briefly negative for a moment there. So, I’ll have to bust out the negative yielding charts again.

[00:36:13] Alan

Okay. It sounds like, at a high level, you’re bullish fixed income overall because there’s not enough priced in and because your starting point, from a yield perspective, is favorable and equities more cautious because of the labor market and bad news will become bad news.

[00:36:29] Frances

It kind of sounds simple the way you put it. But I wonder if we’re overcomplicating, in the search to say something fascinating, just missing the big point, which is that in December we experienced a major macro inflection point. The value of macro is not constant. It fluctuates over the course of the cycle, over the course of the day. Sometimes macro is irrelevant to a certain position.

In fact, right now, we send out weekly core macro views and what we do, and what we’ve said is that (I can read it to you probably. This is probably compliance approved.) “Tactical macro Goldilocks nearing its end, as majority of good macro news priced in, and sentiment positioning no longer a tailwind to the global macro trade. Eco data has a few more months of strength to run and month-over-month inflation prints, while trending lower, will be bumpy, pushing out rate cut expectations to later this year, and therefore, other non-macro factors will be necessary to drive risk on sentiment.”

This is really key because the value of macro changes over time. It is not constant. But sometimes it is more relevant. It is relevant at inflection points in the cycle, and it is relevant at bottoms, tops, and when we’ve had big developments. We’re about to enter an easing cycle. There have only been five in my lifetime. I don’t want to extrapolate to you, Alan. Maybe there were more for you. I’ve had five in my lifetime.

These are huge macro events. While we can get into the semantics of whether it’s March or May or June, we just went from the most aggressive tightening cycle of many of our lifetimes, by some measures, to experiencing an easing cycle. That requires a change in your asset allocation outlook. It requires a change of narrative.

I think recognizing that, is it a 180°? Recognizing that 180° is 80%, 90% of the job of the macro strategist right now, and the rest is coming up with some cute trades around it, and within that context, being aware that uncertainty is extremely high and that this is a market for a macro strategist that requires a significant amount of humility.

Whether you got it right or wrong last year, no economist worth their salt should be looking at any model right now and saying I have 100% conviction in this outlook when we are certainly in a variety of uncharted territories.

[00:39:22] Alan

You mentioned that a lot of discussions you have with clients are not about the one-year outlook, they’re about the two, three, four, five and beyond. So maybe going back a couple of years, a lot of people said bond yields are too low. We were talking about ZIRP, search for yield and saying it’s not going to last forever, inflation at some point is going to make a comeback, etc., and that view was correct.

But then we have last year, inflation comes down. I sense, talking to people,now, we’re at a point where some people are still in the view that we had a regime shift, that inflation is going to be structurally higher, we’ll have higher rates over time. Some people, maybe not as many, but some people still have the view, actually, we’re heading back to where we were in 2019 with very low inflation. We’re going to go back towards that world and are things really going to be that different this decade?

So, it would be good to get your sense on that.

Within that, I guess there are a lot of themes that people talk about in terms of deglobalization, back to fiscal policy, industrial policies, all of that. So, do you think the world is structurally different and we’re into a different rates and inflation environment generally for the next number of years?

[00:40:40] Frances

As I said, I think we need be cautious about throwing everything we know about economic relationships out of the window, but we should be very conscious that the drivers of our economy and inflation are shifting. We all kind of get forced to do these annual outlooks. So, when I did, I have five themes. One of the themes, the third theme, we call it the big shift, and it’s a move from a demand-driven world to a supply-driven world.

The thing that really keeps me up at night is what central banks are supposed to do and what is their purpose and their function as these institutions, within our economic financial systems, if this is true. Because, particularly for inflation, we began to see in 2016, of course, the push against globalization.

We began to see, with tariffs and Brexit, survey data saying that companies were looking to reshore or have multiple supply chains, which was gently inflationary but acted as an insurance policy against future disruptions. And then we experienced COVID, scarring in the sense that we became very naked and exposed to our global supply systems very, very quickly.

What concerns me, especially on the inflation front, is, like I know it’s taboo to talk about it, it’s still my view that the bulk of the inflation that we saw, in the past three years, was supply-side driven. If you just look at a chart of OECD inflation and supply chain stressors, they’re like one-for-one on the way up and the bulk of the declines that we’ve seen so far, which requires a lot of data but also an interpretation which we’ll call an opinion, is supply side.

It’s only now that the standard lags on central bank rate hikes would be hitting the demand side. This is why I say there is a scenario in which we gently undershoot inflation of 2% for a while. When I look at where we’re going to be over the next five years, it is clear that the structural level of geopolitical uncertainty and stress is higher. I’m not a believer in trading event risk around geopolitics.

It’s only January 24th and I think I’ve had four bajillion questions on the US election. I don’t think that’s a tradable theme. I’m going to say that for the next 10 months. But we have a heightened level of geopolitical risks. We have major conflicts around the world which, based on the geopolitical experts that we subscribe to, are not likely to subside anytime soon. We don’t try to be geopolitical experts. And then we have all manner of other disruptions like the Red Seas and what we’re supposed to do with that, and we have seen a gentle increase in shipping costs.

It’s not just about those events. It’s about how this changes corporate psychology around shipping and the movement of people and goods everywhere. And then we have more frequent and severe weather events. Where I live, wildfire is very destructive. Where my boss lives, floods that damage bridges. I think we were a couple of hours into the new year and Japan suffers terrible destruction. These are all supply-side issues. And then we have bugs that are eating the orange crops in Florida.

I used to say it rather facetiously that central banks could hike interest rates all they want and it wouldn’t change President Putin’s military strategy and it wouldn’t solve bug infestations in Florida. But central banks are now starting, even just in the past couple of months as they pivot with inflation still above, and the ECB is writing about this, now starting to more tacitly admit that the supply-side factors were a very big part of inflation moving up and that they don’t want to create unnecessary damage on the economy. It’s too late, but whatever.

What worries me is that there’s a bulk of global central banks that have only one mandate, the ECB, the Bank of Canada. The Fed is more alone in its dual mandate. So, what does the central bank do when inflation becomes less interest rate sensitive when it’s driven by supply? They can do a myriad of things. They can pretend that’s not true and create deflation in some elements of the economy, which they can control, and allow inflation in other areas.

I think that’s silly. That’s the worst of all worlds. So, they can create this binary inflation track. They can acknowledge that maybe 3% is a more appropriate target. But does that change inflation expectations? I don’t know. When I started working at the Bank of Canada, Alan, people would ask me if I was a teller, which I think goes to show you how much the general population really understands central banking, and I don’t blame them.

So, what do central banks do when their main job that they’re supposed to do they become rather impotent at supporting? Now, if I were just writing a textbook, I would say that the way that you bring down inflation, if you have supply-side challenges, is actually to rely on fiscal to build up supply. I don’t know if you’ve noticed, there’s a lot of political pressure on governments globally to reduce deficits.

Wasn’t it rapid spending that led to inflation? Some spending leads to inflation. Some spending from federal governments can be disinflationary or deflationary. But political realities do not always align with economic realities. So, I think we are in this sizeable shift where governments will become bigger, and it’s the governments that recognize their job is to support the supply side that will, actually, support disinflation and bring prices in line and actually probably allow their economies to accelerate.

The governments that hand out inflationary checks are going to run into problems. I was asked yesterday, on another podcast that was focused on Canada specifically, should the government reduce the deficit or not, how important is the deficit? But in this new context, in this new, big shift, it’s not going to be about how big is your deficit or how big is your government? It’s going to be, have they made the critical shift towards rebuilding the supply side of their economy or not?

It’s not going to be the amount of dollars the government spent that will be most important to the inflation or growth story. It’s going to be how they spent it, which has always been true. But the idea that government spending could be deflationary, people are probably turning your podcast off right now, Alan, as I say that, is a new theory that we need to consider.

[00:48:00] Alan

So, taking that example, take the US, I guess the US did give out checks, but they also initiated policy. Well, it was called the Inflation Reduction Act I don’t know if it, necessarily, really did that. But it is aimed at addressing some of the concerns around supply disruptions in terms of encouraging domestic manufacturing, etc.

[00:48:29] Frances

This is, in my view, what the economic advisors to governments are going to be focused on moving forward. I mentioned I have five themes. My fifth theme is actually disruptive big government. It may sound like I’m advocating for bigger governments. That’s not what I’m saying at all. What I’m saying is that how we evaluate government spending is going to have to be more careful.

In this environment where, by every measure, governments are substantially larger globally than they were even four or five years ago, and it’s disruptive. It can be disruptive to bond markets. I didn’t have almost failed bond auction in the US for my 2023 scorecard. It can be disruptive from a technical perspective.

Twenty percent of US Treasuries are still held by the Fed and now the Fed is going into QT. I don’t think we talk about that enough. It can also be disruptive in the sense that if we didn’t have government spending, in 2023 in the US, private sector payrolls would already be recessionary. So, we have this procyclical policy that is changing the way we have to look at our economies. And we know that in general, government spending (this is just the empirical numbers), government spending is less productive than private sector spending.

So, if you’re trying to combat inflation and you’re just growing the size of your government, you’re not getting the productivity boost that comes off of it. So, these are all ways in which it’s disruptive. I think you know, as well, we’ve got more elections than we’ve ever had in a single year in modern economic history this year. Fifty percent of the global population is going to be voting.

We’ve got countries like India, the most populous democracy in the world. We have already had some elections that may be relevant from a geopolitical context like Taiwan’s election just a couple of weeks ago. So, the power and the importance of government is going to grow and I doubt it’s going to be smooth.

But the policy prescription, for an inflationary environment or a stagflationary environment, is not going to be government’s retreat. In that context where it’s supply-side driven and the central banks cannot help the cycle, it’s not going to be central banks that become the main drivers of our cycles anymore. It’s going to become government that has to carry the weight of that.

[00:51:07] Alan

So just a couple of things on that. Maybe one, you said you wouldn’t talk about politics or you’ve got too many questions and it’s not tradable. But it is an important question if we’re in this world where government spending is becoming more important and has been a big driver in the US in the last number of years. I guess at a high level, what’s the likelihood that that would continue in the next administration.

Presumably, if it’s Biden, you would expect a similar set of policies. But if it’s Trump, will we seeing a very different set of policies with respect to that kind of thing in terms of industrial policy, the Inflation Reduction Act? And potential protectionism, will that be back on the agenda again in force? So, does that radically change that big picture view or is it more at the margins?

[00:52:01] Frances

Even if, incrementally, we saw fiscal deficit decline next year, which I think it’s expected to, it doesn’t change the multi-year trend and theme. We are still likely to see government’s share of our economies grow in relative terms even if spending pulls back. The context of your question is really in this sort of multi-year type of development, but this is happening on a global basis.

It also will depend on whether or not we technically do hit a recession in the next year or two. If we don’t get a recession in 2024, then we’ve got another one coming at some point and there will be automatic stabilizers and outlays at that point. There will also be a lot of political cover to spend in a recession, because that’s what you’re supposed to do. Especially if it’s a new government, and this is true for countries everywhere, well, if such and such a government, prior to us, spent in good years, that’s not our fault, the people need us now.

So, a lot of this is really predicated on do we see a rise in the unemployment rate and do you see automatic stabilizers just come through? But there will probably, I’m not a politics expert, but there is both economic merit and political cover to spend in a supply-driven world with supply-side problems and a rise in the unemployment rate.

[00:53:35] Alan

Okay. Last year, for a number of months during the summer, we had this concern about debt and deficits that kind of came into the market psychology and left almost just as quickly it seems. We had a change in issuance pattern from the Treasury which seemed to impact sentiment. But it is there lurking in the background and obviously if this government spending pattern continues, and as you say, we get into an economic downturn, you have political cover for doing more as the debts and deficits get even bigger.

You were saying fixed income is investable, but will we get even more investable fixed income markets in the coming years in the sense so much higher yields? Do you think that’s a possibility?

[00:54:20] Frances

I think everything is a ledger of upside versus downside pressures. Of course, we categorized, as I say, disruptive big governments into the upside on yield pressure. When we look at our five-year forecasts, I think before COVID, we used to have long-term US inflation running around 1.8, and now we have at around 2.3. That may not seem dramatically different, but I believe we ran some calculations as to how much longer every person would have to work just to offset that.

The younger you are, the more years it is. I think for me, it’s seven years. Seven more years of work for 50 basis points of long-term inflationary pressure, which is not nothing, seven years, that’s something material. Where’s this coming from? It’s coming from supply-side inflation that’s more difficult to offset, whether geopolitical tensions, reshoring, trends, etc.

So, of course, bigger governments also fall into that side of the ledger. We’ve had a lot of really heated discussions, it takes a lot for a group of economists to get all heated about something, about what the terminal rate is. We have gradually moved it higher from 2% all the way up to 3% in the past two years, because I’m very optics-focused, I didn’t want to do the last one from 2.75 to 3 because I said we’re going to be simultaneously putting a bunch of cuts into our forecasts but also saying the terminal rate is higher.

I thought that would be confusing and feel like it was different stories. And then I kind of realized, no, actually, that’s the big story. That’s also really important to the curve, that we could be in a pretty big easing cycle this year but simultaneously believe that rates will end higher than where they are. And so, is it 3%? We don’t know. Terminal rate is like a sort of fictional unknown. But all of these things contribute to the terminal rate being higher.

Are we going to end up at 6% yields with a 2.3% inflation, a 3% terminal? No. Does it matter incrementally? Absolutely. But it’s not in and of itself, in my opinion, a tradable macro theme. I’m not going to stand in front of a group of PMs and say, governments are getting bigger and this is the core trade. Does it add conviction to our view that the terminal rate is higher? Absolutely. It goes into the ledger. Is that fair? Yeah,

[00:57:08] Alan

Absolutely. As you say, hard to argue for 6% yields of inflation. It’s only 3%. But I guess, combined, if you have these periodic supply shocks, I guess you’re saying we could see spikes in inflation at a point in time.

[00:57:23] Frances

This is a very good point, which is that in addition to supply-side inflation being more common, we also have much more volatility of inflation. When I speak with governments, for example, and we talk about the concept of reshoring, I try to explain, reshoring is inflationary initially, but it creates less volatility of inflation.

But you can see even the conversation that we’re having Alan, here, about volatility of inflation; is the terminal rate 3% or not? How disruptive will large governments be, and the trend of large government not being politically driven? These are new conversations, effectively, that are changing the way that we have to consider these 5 to 10-year trends. I don’t think we’re going to be in an environment where the world is so radically different that we throw out every playbook that we have.

Standard economic relationships still work. If you give me less money and things cost more, I’m going to spend less. If I’m out of work, I’m going to spend less. If a company has to cut costs because prices went up, they’re either going to raise rates or raise prices, or if they can’t, they’re going to cut jobs and costs. All these standard economic relationships still hold, and it’s why we can’t throw out the playbook on everything.

But we can recognize that the drivers behind prices and growth are changing. We can recognize the volatility behind them are coming. We can move towards more nimble investment strategies. I think that that’s going to become much more important in active management than what we’ve seen historically. We can be aware of where the appetite is in our retail and our institutional clients and where their fears are.

To me, that’s the new macro. It’s not line charts on jobless claims. It’s putting together all of these pieces on how our business runs and recognizing that it’s not that economics is different. It’s that the value of macro and how we use it is changing.

[00:59:37] Alan

Pretty good. Well, we’re pushed up against time but we always like to ask our guests, before we wrap up, for any advice they might have for people coming into the markets or anybody really on good things to read to get better briefed on global macro and global asset allocation investing or anything that you found being very helpful for you in your career.

[01:00:00] Frances

Oh, wow. I think if you love macro, there’s all the standard books and podcasts and you might be tempted to turn on the TV. But I’d say turn off the TV because a lot of macro right now is used more for entertainment and is less practical. The most helpful thing I’ve ever done is read a ton of history books. History books, social sciences, demographics, social sciences, because your job as a macro strategist is really to put all the pieces together.

When you take a step back and really become a more holistic thinker, I think that can serve you really well. I also think as a macro strategist, a big part of your job is communication. People ask me all the time, how do I become a better speaker, and my number one piece of advice is actually watch stand-up comedians.

I think stand-up comedians are some of the best speakers in the world. They know how to put a speech together, they know how to be succinct, and that’s a lot more fun than having to go to Toastmasters. So that is a piece of advice I give to everyone all the time. Watch stand-up comedians and how they do things and I think you may become much better communicator than reading some boring textbook about it.

[01:01:18] Alan

Good stuff. Well, Frances, thanks very much. This has been a great conversation, so we really appreciate you joining us today. Make sure you follow Frances’ work because as you can tell from today’s conversation, we’re living in a truly global macro driven world and it’s more important than ever to be well informed. From all of us here at Top Traders Unplugged, thanks for joining us and we’ll be back soon.

[01:01:40] Ending

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